The Supreme Court has provided long awaited clarification of the law on penalty clauses and liquidated damages, upholding the "penalty rule" but further limiting its utility in a commercial setting. In the adjoined appeals of Cavendish Square Holding v Talal El Makdessiand ParkingEye Limited v Beavis the Supreme Court created a new authority for consideration of the penalty rule doctrine, termed by Lordships Neuberger and Sumption to be "an ancient, haphazardly constructed edifice which has not weathered well".

Under common law, it has long been established that if a contractual clause is determined to be a penalty, it will be unenforceable (although the claimant may still be able to claim general damages). This raises particular issues for parties who rely on pre-determined liquidated damages clauses to ascertain the rate of damages that are applicable for a particular breach, an important feature of many commercial contracts, particularly in the construction industry.

The case of Dunlop Pneumatic Tyre Company Ltd v New Garage & Motor Company Limited[1915] has traditionally been used as a leading authority on the penalty rule for the past century. In Dunlop Lord Dunedin formulated four tests to provide guidance in deciding whether a clause is a penalty for the purposes of enforceability and held that a clause requiring payment of a sum of money will be a penalty, and therefore unenforceable, if it cannot be said to represent "a genuine pre-estimate of loss".

Nevertheless, courts have struggled to apply standardised tests to determine the scope of the penalty rule and even the esteemed Lord Diplock declared in Robophone Facilities Ltd v Blank [1966] that he could "make no attempt, where so many others have failed, to rationalise this common law rule". In Cavendish Lordships Neuberger and Sumption criticised the "over-literal reading" of Lord Dunedin's four tests and a "tendency to treat them as almost immutable rules of general application which exhaust the field" - Indeed, they found that the clause in question in Dunlop would actually fail three of Dunedin's four tests if rigidly applied and the judgment would only be justifiable in reference to the wider commercial interests of the party seeking to uphold the clause, an aspect of the case cited in the judgment of Lord Atkinson.

Whilst the Supreme Court would not abolish the penalty rule entirely in Cavendish, as advocated by the appellant's counsel, the case restricts the grounds in which it would be applicable in a commercial context and holds that a clause that is not a genuine pre-estimate of loss should not necessarily be deemed penal.

Facts of Cavendish Square Holding v Talal El Makdessi

Mr Makdessi founded a group of companies which became the largest advertising and marketing communications group in the Middle East. The simplified facts of the case are that in 2008 Mr Makdessi and Mr Ghossoub, who both predominantly owned the holding company, agreed to sell their majority interest in the company to Cavendish, such that Cavendish would own 60% of the share capital and Mr Makdessi and Mr Ghossoub would retain 40%.

Mr Ghossoub agreed to remain an employee and director of the company and Mr Makdessi agreed to become a non-executive director and non-executive chairman for an initial period of 18 months. Payment for the shares was in instalments, and under the purchase agreement they would only receive all of these payments if they did not default on their duties. Shortly before trial Mr Makdessi conceded that he had breached his duties, such that he constituted a Defaulting Shareholder, as he continued to provide his services to a rival agency and additionally set up competitor agencies in Lebanon and Saudi Arabia, poaching staff from the company he owned with Cavendish. This triggered two clauses which had the effect of substantially deflating the purchase monies paid to Mr Makdessi. Mr Makdessi argued that the clauses should be held to be unenforceable under the penalty rule.

When the case was heard at first instance Burton J considered that both clauses had been the subject of detailed negotiations between sophisticated commercial parties which would negative any element of oppression. He determined that the clauses were not penal, were not designed to deter and that each clause had a legitimate commercial purpose.

The Court of Appeal disagreed, determining, in reference to Dunedin's four tests, that the clauses constituted penalties as they were "not genuine pre-estimates of loss" and were "extravagant and unreasonable". Although stating that this in itself was not conclusive, on the facts of the case the court determined that the clauses were not commercially justifiable but were rather designed to act as a deterrent and were therefore penal.

ParkingEye v Beavis

Prior to the hearing at the Supreme Court the case was joined by ParkingEye v Beavis.

ParkingEye allowed people to park their cars outside a retail park for a maximum of two hours at no cost. There were a number of conditions to this, most importantly that if the two hours of free parking were exceeded, a penalty fare of £85 would be incurred. Both the Court of First Instance and the Court of Appeal determined that this did not constitute a penalty, largely due to the fact that it was in the legitimate interests of ParkingEye to make such a charge in order to facilitate a high turnover in the car park.

Although the factual matrix of ParkingEye bore no resemblance to Cavendish, both cases concerned clauses which had nothing to do with compensating for breach.

Judgment

In a judgment spanning 123 pages and handed down on 4 November 2015, the Supreme Court rejected that the clauses in Cavendish and ParkingEye constituted penalties and accepted that there was a legitimate commercial justification in both matters, which extended beyond what would amount to a "genuine pre-determined estimate of loss", as per Lord Dunedin's dictum in Dunlop.

In Cavendish the judgment was predicated on the basis that the purchase agreement was made between commercial parties with equal bargaining power. A majority of four Lordships held that "In a negotiated contract between properly advised parties of comparable bargaining power, the strong initial presumption must be that the parties themselves are the best judges of what is legitimate in a provision dealing with the consequences of breach".

The Supreme Court agreed that the fact that a clause may not be a "genuine pre-estimate of loss" would not necessarily result in it being determined as penal. They set out the real test as being "whether the clause is a secondary obligation which imposes a detriment on the contract breaker which is out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation".

It was found that Cavendish had a legitimate interest, extending beyond recovery of the related loss, in ensuring that Makdessi observe the restrictive covenants. His loyalty was important to the business and much of this goodwill was vested in Mr Makdessi; breach meant that the business was worth much less to Cavendish. A clause which would allow the innocent party to withhold a sum of money upon breach was in proportion to Cavendish's legitimate interest as it revised the basic price calculation for the shares, shares which had been negotiated between "sophisticated, successful and experienced commercial people bargaining on equal terms over a long period of time with expert legal advice".

The court held that the same interests also determined the second clause in question, which granted Cavendish an option to force Mr Makdessi to sell his shares at Net Asset Value, ignoring the price of goodwill. The option reflected the reduced price which Cavendish would have been willing to purchase the business without the loyalty of Mr Makdessi and Mr Ghossoub. The Supreme Court thus determined this clause was in proportion to Cavendish's legitimate interest.

In reference to the ParkingEye matter, the court determined that the £85 fee was not penal as it had two main legitimate objectives, to manage the efficient use of parking space in the interests of the retail outlets and to provide an income stream to ParkingEye to cover the costs of the scheme. His Lordships Neuberger and Sumption further held that "deterrence is not penal if there is a legitimate interest in influencing the conduct of the contracting party which is not satisfied by the mere right to recover damages".

Current position of the law

The current test effectively has two constituent elements. If the clause both protects a legitimate business interest and is not extravagant, exorbitant or unconscionable it will not be a penalty.

As noted above, the new test for the penalty rule was set out by the Supreme Court to be "whether the clause is a secondary obligation which imposes a detriment on the contract breaker which is out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation". Unhelpfully, the Lords could not agree on the distinction between a primary and secondary obligation, and this is likely to be the subject of further dispute in the future. To confuse matters further, the Supreme Court has not definitively stated that a primary obligation will never be a penalty. 

An innocent party must have a legitimate interest in the performance of a primary obligation. In its simplest terms, this interest may simply be compensation; however this interest could extend further and the parameters of what constitutes a "legitimate interest" have not been delineated. Therefore, it may be prudent for a party to clearly identify and set out their commercial interests within the preamble to their agreement, or even in the liquidiated damages provision itself.