The English Supreme Court has delivered a judgment which revisits the test of when a liquidated damages clause is a penalty. It expressed the view that a liquidated damages clause will only be a penalty when wholly disproportionate.

In its judgment in the combined cases of Cavendish Square Holding BV v Talal El Makdessi and ParkingEye Ltd v Beavis the Supreme Court has revisited the test for determining if a clause is an enforceable liquidated damages clause or an unenforceable penalty clause.

Given that English judgments are persuasive in Hong Kong, this new test may find favour with the Hong Kong courts in future.  The Hong Kong courts have historically favoured freedom of contract and this judgment strongly reinforces the continuing reluctance of the courts, in Hong Kong and the UK, to overturn such clauses.

Liquidated damages and the rule against penalties

It is common practice to include a clause in a contract which specifies that pre-determined compensation (commonly a sum of money or transfer of an asset) is due to the innocent party on the specific breach of the contract by another party. A key concern for these clauses is whether they are classified as liquidated damages or penalties. The cases concerned three different forms of contractual compensation for breach: withholding of payment (a "withholding clause"); transfer of an asset (a "forced transfer clause"); and payment of a fixed sum, such as £X is payable by party A if party A breaches clause Y (a "classic clause").

The Cavendish case and the ParkingEye case are the latest in a series of high profile cases which examine the difference between liquidated damages, which are enforceable, and penalty clauses, which are not. In these two cases the Supreme Court was asked to re- examine the long-standing rule against penalties to determine if it was fit for purpose and whether it should www.hoganlovells.com be extended or dispensed with entirely. The court decided not to abolish the rule, but it did significantly narrow its scope.

The new test for penalties

Although acknowledging that the rule against penalties, originating in the Dunlop Pneumatic Tyre case of 1915 and developed in subsequent case law, was an "ancient, haphazardly constructed edifice which has not weathered well", the Supreme Court decided to retain the principle but stated that its scope should not be extended.

In this landmark decision, the Supreme Court took the opportunity to clarify the test for determining if a clause is a penalty. This new articulation of the test emphasises: (i) determining the legitimate interests of the innocent party which are served or protected by the relevant provision, and (ii) assessing whether the clause is out of all proportion to such interests.

The Test:

"The true test is whether the impugned provision is a secondary obligation which imposes a detriment on the contract-breaker out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation."

"The first step is to consider whether any (and if so what) legitimate business interest is served and protected by the clause, and if so and secondly, whether the provision made for that interest is extravagant, exorbitant or unconscionable?"

In a significant change to the previous law, the court commented that the concept of deterrence is unhelpful when assessing if a clause is penal and, significantly, noted 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 for breach of contract". However the court did also make it clear that it would not enforce a clause which was simply a disguised punishment for breach.

In addition to the new test, the Supreme Court emphasised that the penalty rule regulates only the contractual remedy available for the breach of primary contractual obligations, and not the fairness of those primary obligations.

What does this judgment mean for liquidated damages clauses and the rule against penalties?

The Supreme Court has confirmed that the rule against penalties has very limited application in complex commercial relationships between sophisticated parties of equal bargaining power, particularly where the contract has been freely negotiated with the benefit of legal advice.

Provided that the relevant contractual provision: (i) serves a legitimate business interest(s); and (ii) is not extravagant, exorbitant or unconscionable, it will not be a penalty and therefore will be enforceable. The new test opens the way for parties to specify a pre- determined consequence, even in situations where the innocent party does not suffer a significant or easily quantifiable loss. This suggests that contracting parties will no longer need to consider whether the compensation for breach is a "genuine pre-estimate of loss", particularly as the Supreme Court referred to this concept as "unhelpful". Indeed this test has for some time been inconsistent with the leading authorities.

It remains to be seen how the courts will determine what is and isn't extravagant, exorbitant or unconscionable, particularly where the contracting parties have different negotiating strengths, and whether the courts in certain circumstances will still look to make some comparison between the value or quantum of damage suffered by the innocent party and the value or quantum of the compensation given by the breaching party.

The result is that a party seeking to challenge a liquidated damage provision on the grounds that it is unenforceable as a matter of public policy is likely to find it significantly more difficult to succeed with such an argument.