ENGLISH RULE ON PENALTY CLAUSES RE-WRITTEN

In a recent decision handed down on 4 November 2015 (concerning two appeals heard together)1 the UK Supreme Court has in effect re-written the rule on penalty clauses, rejecting the traditional test of whether a clause is a "genuine pre-estimate of loss", or whether its purpose is to act as a deterrent.

The Supreme Court held that the true principle is whether the clause is out of all proportion to the innocent party's legitimate interest in enforcing the counterparty's obligations under the contract.  If yes, it will be penal and therefore unenforceable.

Background

The Supreme Court heard appeals on two matters relating to whether certain sums payable on breach of contract were penal and therefore unenforceable.

  1. In the Makdessi matter, the share purchase and shareholders' agreement provided that if Mr Makdessi (the seller) was in breach of certain non-compete restrictions, he would lose his entitlement to deferred consideration that would otherwise be payable, as well as a put option to sell his remaining shares at a price determined by reference to goodwill.  Rather, a call option would be triggered, allowing Cavendish (the purchaser) to buy the remaining shares at a price based on net asset value, with no provision for goodwill.  The Court of Appeal held that the provisions were penalties and were therefore unenforceable. Cavendish appealed to the Supreme Court.
  2. In the ParkingEye matter, Mr Beavis was fined £85 for overstaying a two-hour permitted period of free parking. The Court of Appeal held that while the sum was not a genuine pre-estimate of loss and was aimed at deterring motorists from staying beyond the two-hour permitted period, the sum was not extravagant or unconscionable, and was commercially justifiable.  Mr Beavis appealed to the Supreme Court.

Supreme Court decision

The Supreme Court allowed the Makdessi appeal (by a six to one majority), and dismissed the ParkingEye appeal, finding in both cases that the provisions were not penal, and were therefore enforceable.

The Court confirmed that the rule against penalties is engaged only where a clause sets out a remedy for breach of contract.  Additionally, while payment of money is the classic obligation under a penalty clause, the Court held that there is no reason why the rule should not apply to an obligation to transfer assets, either for nothing or at a significantly undervalued price.

As for what makes a clause penal, the Court rejected the traditional test of whether the purpose is to deter breach of contract, rather than compensating losses caused by the breach.  Rather, the new test set out by the Court is whether the clause imposes a detriment that is out of proportion to the innocent party's legitimate interest in enforcing the relevant contractual obligation.

The Court commented that in a simple contractual dispute, the innocent party's interest will rarely extend beyond compensation for breach of contract, and therefore the traditional test would be adequate in assessing whether the damages clause is a genuine pre-estimate of loss.  However, this decision recognizes that an innocent party may have a legitimate interest in enforcing the contract beyond  being compensated for breach, in which case the damages clause will be upheld unless it is out of all proportion to that interest.

Traditional test still used in other common law countries

In other common law countries such as Hong Kong and Australia, the traditional test remains the test applied by courts when assessing whether a clause is a penalty clause.

In Hong Kong, the court has only gone so far as to hold that where parties have equal bargaining power, the court will not readily strike down a provision requiring a stipulated sum to be paid on breach of contract.2

More recently, the full court of the Federal Court of Australia upheld the traditional test of whether the clause is "extravagant and unconscionable in amount in comparison with the greatest loss that could conceivably be proved"3   Furthermore, according to the full court, the question of whether a clause is "extravagant and unconscionable" must be determined at the time of entry into the contract- in other words, the sum is "extravagant and unconscionable" when compared to the greatest loss that could have been foreseen when the contract was entered into, rather than comparing to the damages caused after the breach.

This approach was also taken by the High Court of New Zealand in a judgment handed down on 19 October 2015.4

What now for governing law of contracts?

When negotiating the governing law of contracts, parties should be aware of the differing positions under various common law jurisdictions. If a contract contains a clause specifying a sum to be paid on breach of contract, particular care is required to ensure the clause will not be struck down for being unduly punitive.

For contracts governed by English law, a balancing test is required to determine whether the clause is out of all proportion to the legitimate interest of enforcing the contract. When considering jurisdictions still applying the traditional test, the following tips should be kept in mind:

  1. Is the amount a genuine pre-estimate of the loss that is likely to occur?
  2. Where a genuine pre-estimate is not possible, is the amount commercially justifiable?
  3. Keep a record of all negotiations (oral and written) and any commercial factors considered by the parties to justify the specified amount.
  4. Avoid a single amount payable for all or a number of breaches, irrespective of whether the loss is minor or of a greater magnitude. 

On a final note, as common law jurisdictions have derived their laws from English law, there is a chance that other common law jurisdictions will follow the Cavendish decision and reject the traditional test.