Soccer fans consider themselves experts on whether a player has been fouled within the opposing team’s goal mouth area (“the box”), or outside of it. A foul committed inside the box brings a penalty kick for the victim’s team.

Until very recently, lawyers considered themselves similarly skilled in knowing whether or not a contractual provision was a penalty clause. A penalty clause requires a party who commits a breach of contract to pay the innocent party a pre-agreed amount of damages that exceeds the actual loss the innocent party suffers as a result of the breach. The idea is to dissuade the party from committing the breach. Conversely, a clause containing a genuine pre-estimate of the loss that would be sustained on breach is not a penalty clause.

Persuading a judge that a clause qualified as a penalty clause was a great benefit to the party in breach. That is because the English courts would not enforce a penalty clause. So it became standard practice for the lawyer for a party in breach of contract to plead that a contractual clause requiring his client to pay a set amount of damages for that breach was unenforceable. It was unenforceable because it was a penalty clause. Just as a footballer tackled within the opposing team’s box will instinctively shout plaintively to the referee, “Penalty!” a lawyer faced with a clause requiring his client to pay pre-agreed damages would likely do the same to the court, albeit adopting a more respectful tone. If the court agreed and struck down the clause, then the innocent party would have to prove by evidence at trial the extent of its actual loss, just as if the contract had not contained the penalty clause in the first place.

As a result of the decisions in two recent Supreme Court appeals heard together,[1] it is now apparent that many lawyers were not quite as skilled in identifying penalty clauses as they may have liked to think. In fact, all seven Supreme Court Justices confirmed that for the past century, many legal professionals have been applying the wrong test to identify when a clause is a penalty clause. Fortunately, the Supreme Court also provided the correct test to identify a penalty clause. In the future, the application of the correct test will likely make the courts far more reluctant to categorise clauses that pre-set amounts payable on breach as penalty clauses.

The Clauses Before the Supreme Court on the Two Appeals

In Cavendish Square Holding BV v Talal El Makdessi, the Supreme Court considered whether provisions in a share sale agreement that significantly restricted the earn-out consideration payable to the vendors if they breached it were penalty clauses. It is common in share sale agreements for a portion of the purchase price (the consideration) to be payable only if certain post-sale conditions are met, and only if the vendor complies with restrictions on his future commercial activities. The restrictions are designed to protect the newly acquired interest of the purchaser of the shares in the goodwill of the business. All the more so where the vendor is retained by the purchaser as a director or consultant to grow the newly acquired business.

In this case, Mr Makdessi and Mr Ghossoub together owned 87.4 percent of the shares in the holding company of a leading marketing and advertising communications group that they had built up in the Middle East (“the Makdessi business”). Cavendish Square Holdings BV (“Cavendish”), which is part of the global market communications group WPP, held the remaining 12.6 percent.

Under a 28 February 2008 agreement, Cavendish ultimately acquired further shares from Mr Makdessi and Mr Ghossoub, which left Cavendish with 60 percent of the shares in the holding company of the Makdessi business. Mr Makdessi’s and Mr Ghossoub’s combined shareholding was reduced to the remaining 40 percent. The $65 million purchase price was payable in one tranche on completion and then the two remaining tranches were staggered over three years as an interim payment and then a final payment.

Mr Makdessi entered into a service agreement with the holding group to serve as its non-executive chair. In recognition of the goodwill of the Makdessi business in which Cavendish had invested so heavily, and of the need to protect that goodwill, Mr Makdessi undertook not to compete in any way with the Makdessi business. If he did breach that obligation, then:

  1. clause 5.1 prevented him from receiving both the interim payment and the final payment, which for Mr Makdessi was a loss of $45 million, and
  2. clause 5.2 gave Cavendish an option to force him to sell to it his remaining shares at a formula that excluded any goodwill from the forced sale price.

Mr Makdessi admitted that he had breached his undertaking. His legal team pleaded that clauses 5.1 and 5.2 were penalty clauses, which the court should strike down as being unenforceable.

The second appeal, ParkingEye Limited v Beavis, concerned a parking fine of £85 levied on a motorist who had exceeded his two hours’ free parking permission at the Riverside Retail car park in Chelmsford. He refused to pay, contending that the charge was a penalty clause.

Identifying a Penalty Clause: The Wrong Test

As well as being a Justice of the Supreme Court, Lord Sumption JSC is an outstanding medieval historian and has been regarded as the leading author in the English-speaking world on the Hundred Years War. It is therefore apt that before addressing the facts of the appeals, he started his joint opinion on the two appeals with Lord Neuberger by tracing the history of the rule against penalty clauses and how it has been misunderstood. He referred to the comments of Lord Dunedin in 1915 in Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd,[2] and noted that whilst they had been intended as guidance to assist in the identification of a penalty clause in appropriate circumstances, lawyers had since elevated that guidance to a statutory code to be applied in every single case in which one party pleaded that a clause was penal. His guidance was that:

“(a) the provision would be penal if ‘the sum stipulated for is extravagant and unconscionable’ in amount in comparison with greatest loss that could conceivably prove to have followed from the breach’; (b) that the provision would be penal if the breach consisted only in the non-payment of money and it provided for the payment of a larger sum; (c) that there was a ‘presumption (but no more)’ that it would be penal if it was payable in a number of events of varying gravity; and (d) that it would not be treated as penal by reason only of the impossibility of precisely pre-estimating the true loss.”

Lord Sumption explained that the courts’ post- Dunlop approach of trying to fit the potential penalty clause into one of Lord Dunedin’s four categories was wrong. So is lawyers’ subsequent distillation of it into the simple question of whether the clause is a penalty or a genuine pre-estimate of loss. So, too, is our attempt to apply it in more complex cases than simple claims for damages.

It is the wrong test.

Identifying a Penalty Clause: The Right Test and Its Application

Each of the Supreme Court Justices then removed the test for a penalty clause far away from the confines of the old “wrong test” of genuine pre-estimate of loss versus deterrent or punishment provision to enforce compliance with the primary obligation. In Mr Makdessi’s case, the primary obligation had been to obey the non-compete clause. In Mr Beavis’ case, the primary obligation had been to move his car before two hours had expired. Each of the Supreme Court Justices agreed that a party can contract to protect a legitimate interest in having the counter-party perform its primary obligation. It is important to note that legitimate interest can extend beyond merely receiving damages for a breach of the primary obligation. 

On the first appeal, Cavendish had a legitimate interest in Mr Makdessi’s observing the non-competition clause in order to protect the goodwill in the Makdessi business in which it had invested. It was entitled to protect the goodwill by not paying Mr Makdessi the interim and final payments and by forcing a sale of his shares without accounting for goodwill. Clause 5.1 was not a penalty clause. It was a price adjustment clause.

As for Mr Beavis’ appeal, the Supreme Court ruled that ParkingEye Limited also had a legitimate interest in securing the observation of the two-hour parking rule. Although ParkingEye Limited would not suffer any loss by the presence of Mr Beavis’ car beyond 2 hours, in charging £85, it was protecting its interest in achieving the maximum level of availability of car parking space so as to increase customer footfall and therefore potential purchases at the Riverside Retail centre.

But the charge could not be out of all proportion to that legitimate interest. There still appears to be some life left in the rule that penalty clauses are unenforceable. Following the Makdessi and Beavis appeals, we now know that the correct test to determine whether a contractual clause is penal 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 on the innocent party in the enforcement of the primary obligation. The innocent party can have no proper interest in simply punishing the defaulter.”

Those drafting commercial contracts which provide for payments on breach may wish to consider setting out their client’s legitimate interests in the recitals section of those contracts.  In addition, those litigating such contracts may wish to be more circumspect in raising the clamour of “Penalty!” as often as footballers do in their matches.