Supreme Court clarifies when to regard contract clauses as "penalties".

In two conjoined appeals, the Supreme Court has provided a landmark restatement of the law relating to contractual penalty clauses. It did this in order to better reflect the complexity of modern day transactions.

In Cavendish, Mr Talal El Makdessi agreed to sell Cavendish Square Holding BV a controlling stake in the holding company of the largest advertising and marketing communications group in the Middle East. Two clauses of the agreement provided that if he breached certain restrictive covenants, Mr Makdessi (a) would not be entitled to receive the final two instalments of the sale price (clause 5.1); and (b) may be obliged to sell his remaining shares to Cavendish at a price that excluded the value of the goodwill of the business (clause 5.6). When Mr Makdessi breached them, he argued that the two clauses were unenforceable penalties.

In ParkingEye, ParkingEye Ltd and the owners of the Riverside Retail Park in Chelmsford agreed to manage a car park together. ParkingEye put up several notices around the car park stating that any failure to comply with a two hour parking time limit would "result in a Parking Charge of £85." When Mr Barry Beavis overstayed that two hour limit by almost an hour, he argued that the £85 charge was a penalty at common law and therefore unenforceable, and/or that the charge was unfair and unenforceable by virtue of the Unfair Terms in Consumer Contracts Regulations 1999 (SI 1999/2083) ("the 1999 Regulations").

The Supreme Court held that asking whether a clause is a genuine pre-estimate of loss or not (as per leading case, Dunlop v Pneumatic Tyre (2015)) is unhelpful since the fact that the clause is not a pre-estimate of loss does not automatically mean it should be regarded as a penalty. There may be other justification for the clause and the true question is whether the clause is penal, not whether it is a pre-estimate of loss. The penal character of a clause is a question of construction, to which evidence of the commercial background is relevant.

Further, the Court must ask whether the provision imposes a detriment out of all proportion to any "legitimate interest" of the innocent party in the enforcement of the primary obligation. The penalty must be a secondary obligation flowing from a primary obligation, rather than a primary obligation itself: "if the contract does not impose (expressly or impliedly) an obligation to perform the act, but simply provides that, if one party does not perform, he will pay the other party a specified sum, the obligation to pay the specified sum is a conditional primary obligation and cannot be a penalty."

In Cavendish, the Supreme Court held that both clauses 5.1 and 5.6 were primary obligations and not subject to the penalty rule. The clauses were price adjustment clauses and had a legitimate function that related to achieving Cavendish’s commercial objective in acquiring the business and protecting its goodwill.

In ParkingEye, Mr Beavis had a contractual licence to park in the car park on the terms of the notices put up around the car park, including the two hour limit. The £85 was a charge for breaching the terms of that contractual licence. Whilst the penalty rule was engaged in this case, the £85 charge was not a penalty. The charge protected two legitimate business interests: (a) the efficient use of the car park, which benefited the Retail Park's shops and customers by deterring long-stay or commuter traffic; and (b) the generation of income in order to run the scheme, which benefited ParkingEye. These interests extended beyond the recovery of any loss and the charge was no higher than necessary to fulfil those interests.