Supreme Court clarifies what is meant by an unenforceable penalty.

What’s the issue?

Commercial contracts often include a clause agreeing that a set amount of money will be paid or some other remedy may take effect if a particular provision of the contract is breached. Where the provision is a liquidated damages clause, it is enforceable. If, however, the clause is found to represent a penalty, it is unenforceable. This is a long-standing principle of English law. Since its formulation in 1915, the test laid down in the leading House of Lords judgment in,Dunlop Pneumatic Tyre Co Ltd v Garage and Motor Co. Ltd, has become increasingly entrenched as the one to consider when deciding whether a clause is a liquidated damages or a penalty clause. This held that:

  • a sanction would be a penalty:
    • if the specified sum is extravagant and unconscionable in comparison with the greatest loss that could conceivably be proved to flow from the breach; or
    • if the breach consists only in not paying a sum of money which is greater than the sum which ought to have been paid.
  • There would be a presumption of a penalty (but no more) when a single lump sum is made payable by way of compensation for breaches of varying degrees of gravity.
  • An inability to make a precise pre-estimate of true loss would not, in itself, make a compensation/sanction penal.

More recently, the courts have also considered whether there is commercial justification for the sanction.

What’s the development?

The Supreme Court has handed down judgment in two appeals, both relating to penalty clauses. The judgment clarifies and, ultimately, restates the rules on penalties. The test in Dunlop remains valid and is of particular use in straightforward damages clauses but it was held that the test has become too entrenched. The traditional distinction between contractual sanctions designed to act as deterrents and those which aim to provide compensation for loss based on genuine pre-estimates, was found to be unhelpful. Lords Neuberger and Sumption gave the leading joint judgment in which they held that:

“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.”

What does this mean for you?

This judgment is relevant to anyone negotiating or drafting commercial contracts, bringing some clarity to the law on penalties and updating it. It broadens the considerations to make them more easily applicable to a wider range of situations beyond mere financial compensation, recognising that a party may have a legitimate interest in enforcement of the contract beyond financial compensation for breach.

Crucially, the courts will not interfere with the commercial arrangements; the penalty issue applies only in relation to secondary obligations and not every clause requiring additional payment or a reduction in contract price will be a secondary obligation. While it is recognised that whether a clause forms a primary or secondary obligation is a matter of substance rather than form, there is also recognition that the drafting can make a difference to the treatment of the clause. Where a sanction for breach is intended to form a primary obligation, this must be made absolutely clear if the risk of it being held to be a penalty is to be avoided. Commercial context will be relevant: the extent to which the contract has been negotiated; the bargaining powers of the parties; and, most importantly, the commercial grounds for imposing the sanction.

This judgment does not provide a ‘magic’ solution for preventing a contractual sanction for breach from being regarded as an unenforceable penalty because what is a “legitimate interest” of the innocent party and whether the sanction is out of all proportion to it will depend on the facts and how the courts interpret them. It does, however, provide a welcome update to this area of law.

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In the first case, Cavendish v Makdessi, Mr Makdessi sold Cavendish a controlling stake in the holding company of the largest advertising and communications group in the Middle East. The contract provided that were he to breach restrictive covenants set out in the contract, he would not be entitled to receive the final two instalments of the price payable by Cavendish and could be required to sell his remaining shares to them at a price which did not reflect the value of the goodwill in the business. Mr Makdessi went on to breach the restrictive covenants but argued that the sanctions for this were unenforceable penalties. The court of first instance ruled in favour of Cavendish. The Court of Appeal held that the clauses were unenforceable penalties.

The second case, ParkingEye v Beavis, related to a fine of £85 for overstaying time in a car park which gave users two hours of free parking. Mr Beavis argued that the charge was an unenforceable penalty or, alternatively, that it was unfair and unenforceable under the Unfair Terms in Consumer Contracts Regulations 1999. Both lower courts ruled against Mr Beavis.

The Supreme Court upheld the validity of the contractual clauses in both cases, with one dissenting judgment in ParkingEye in relation to compliance with consumer regulations.

Lords Neuberger and Sumption gave the leading joint judgment in which they held:

  • the penalty rule is an “ancient, haphazardly constructed edifice which has not weathered well”. However, as it is long-standing, similar to rules in all other developed systems of law and it covers types of contracts which may not be regulated in any other way, it should not be abolished, nor should it be extended;
  • the test for what makes a contractual provision penal has too often been taken as the tests set out by Lord Dunedin in Dunlop. These have been treated as a “code” for determining whether a clause is penal but they fail to take into account the speeches of the rest of the Appellate Committee and other factors. As a result, confusion has arisen between clauses which are a penalty, a deterrent and a genuine pre-estimate of loss. The latter two are unhelpful categorisations;
  • the validity of a clause providing for the consequences of a breach of contract depends on whether the innocent party can be said to have a legitimate interest in the enforcement of the clause – this may extend beyond financial compensation but the law will not generally uphold a contractual remedy where the adverse impact of the remedy significantly exceeds the innocent party’s legitimate interests;
  • “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 innocent party can have no proper interest in simply punishing the defaulter. His interest is in performance or in some appropriate alternative to performance. In the case of a straightforward damages clause, that interest will rarely extend beyond compensation for breach…but compensation is not necessarily the only legitimate interest that the innocent party may have in the performance of the defaulter’s primary obligations”;

Lord Mance, in a supporting judgment, went on to say that the first step is to consider whether (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.

Lord Hodge, also concurring, stated the test as being whether the sum or remedy stipulated as a consequence of a breach of contract is exorbitant or unconscionable when regard is had to the innocent party’s interest in the performance of the contract.

While it is the test in the leading judgment that will be applied to contracts initially, the tests stated by Lords Mance and Hodge provide additional guidance as to what will be considered when making the analysis, as does the test in Dunlop which, the leading judgment said, is still likely to be sufficient in cases of straightforward damages.

The Court stated that it is not a function of the penalty rule to empower the courts to review the fairness of the parties’ primary obligations. It serves only to regulate the remedies available for breach of those obligations:

“This means that in some cases the application of the penalty rule may depend on how the relevant obligation is framed in the instrument, ie whether as a conditional primary obligation or a secondary obligation providing a contractual alternative to damages at law. Thus, where a contract contains an obligation on one party to perform an act, and also provides that, if he does not perform it, he will pay the other party a specified sum of money, the obligation to pay the specified sum is a secondary obligation which is capable of being a penalty; but 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…..However, the capricious consequences of this state of affairs are mitigated by the fact that, as the equitable jurisdiction shows, the classification of terms for the purpose of the penalty rule depends on the substance of the term and not on its form or on the label which the parties have chosen to attach to it.”

In the case of Cavendish v Makdessi, the rule against penalties was not engaged as the relevant clauses were held to concern primary rather than secondary obligations. The first clause in question (which dealt with withholding of the final two payment instalments) was held to be a price adjustment clause. Similarly, the second disputed clause (the requirement to sell shares at a price excluding the value of goodwill) was justified by Cavendish’s legitimate interest in compliance with the restrictive covenants in order to protect the goodwill of the business and represented a primary obligation. Both clauses reflected the reduced price Cavendish was prepared to pay for the business without the benefit of Mr Makdessi’s compliance with the restrictive covenants.

In the case of ParkingEye v Beavis, the rule on penalties was engaged but it was held that the landowners had a legitimate interest in charging overstaying motorists beyond the recovery of any loss, namely that of running an efficient car park. The charge was neither extravagant nor unconscionable and there were clear notices around the car park about the charge. The result was the same under the 1999 Regulations. Lord Toulson, dissenting, believed that the clause did breach the 1999 Regulations because the burden is on the supplier to show the consumer would have agreed to the terms under individual negotiations on level terms and ParkingEye had not done so.