The rules on penalties have long been controversial because they restrict parties’ freedom of contract and allow parties to escape from bargains they freely entered into. This week, in conjoined appeals, the Supreme Court will hear two very different cases on penalties. This could result in the law being substantially reformulated or even abolished. At the very least, it is hoped that the Supreme Court will clarify a number of important areas of uncertainty.

Given the widespread use of liquidated damages clauses in commercial contracts, this decision is likely to be relevant to most businesses and this is reflected by the fact that the appeals will be heard by a panel of seven justices of the Supreme Court.

THE CASES

In Cavendish Square Holdings BV and another company v Makdessi [2013] EWCA Civ 1539, two clauses in a share sale agreement had the effect of depriving a selling shareholder of deferred consideration and requiring him to transfer his remaining shares to the buyer as a result of him breaching his restrictive covenants. The Court of Appeal held that these two clauses were unenforceable penalties. The clauses were extravagant and unreasonable because there was no proportionate relationship between the losses suffered by the buyer and the sanctions imposed on the seller. Furthermore, there was no sliding scale of severity: a small, insignificant breach of the restrictive covenant meant forfeiture of the total amount of deferred consideration, transfer of the remaining shares at potentially significantly less than market value and the worthlessness of a put option.

In ParkingEye Ltd v Beavis [2015] EWCA Civ 402, the Court of Appeal held that a charge imposed for overstaying the free period of parking in a car park was not an unenforceable penalty. This was despite the fact that the purpose of the charge was to deter a breach of the agreement between the car park operator and the person using the car park and the charge was not a pre-estimate of the car park operator’s loss arising from the breach.

SOME KEY ISSUES

Key issues for the Supreme Court to consider include:

  1. Should the rules on penalties be abolished? The appellant in Makdessi will be arguing that the laws on penalties are anachronistic and should not be applicable to contracts between sophisticated commercial parties.
  2. Does a liquidated damages clause have to be a “genuine pre-estimate of loss”? Some relatively recent cases suggest that a liquidated damages clause, which is not a genuine estimate of the losses likely to be caused by a breach of contract, may nevertheless be enforceable if there is sufficient commercial justification for it.
  3. Can a clause be enforceable even though its primary function is to deter a breach of contract? At least until ParkingEye Ltd v Beavis, this was generally considered to be a defining characteristic of an unenforceable penalty but it did not prove fatal in that case.
  4. More specifically, does the law on penalties apply to the type of clauses at the centre of the dispute in Makdessi? This is of general interest because one of the two clauses under consideration is similar to bad leaver provisions often used in a private equity context and the other is related to the payment of deferred consideration.

COMMENT

The Supreme Court’s decision is unlikely to be published before the autumn and possibly not before the end of this year. In the meantime, whilst there remains a degree of uncertainty surrounding the law on penalties, the cautious approach would be to ensure that liquidated damages clauses are genuine pre-estimates of likely losses or at least that there are good commercial reasons for them. Once the judgment is published, businesses will need to revisit their approach to liquidated damages in light of the Supreme Court’s decision