Introduction

It has long been accepted in Australia that a contractual clause which confers a benefit on a party to remedy breach of contract or non-performance will constitute a penalty, and therefore unenforceable, unless its effect is to compensate a party on the basis of a ‘genuine pre-estimate of loss’. This was also the position in the United Kingdom until the recent decision of the Supreme Court of the United Kingdom Cavendish Square Holding BV v Talal El Makdessi; ParkingEye Limited v Beavis[2015] UKSC 67 (delivered 4 November 2015).1 The new UK position contemplates a more flexible test, where a clause will only be a penalty if the clause is out of all proportion to the innocent party's legitimate interest in enforcing the counterparty's obligations under the contract.

The decision recognises that, in some instances, a party can legitimately penalise contractual breach or enforce performance by imposing a compensation requirement which exceeds what can reasonably be estimated as the losses flowing from that breach. The judgment has also widened the gulf between the English and Australian approaches to contract law, which could prove significant when drafting governing law clauses in contracts given the now differing level of acceptance of penalty provisions between the two jurisdictions.

Australian Position

The High Court of Australia decision in Andrews v ANZ Banking Group Ltd2 remains the leading authority on the penalties rule in Australia. It considered whether particular fees charged by ANZ were unenforceable penalties.

As explained in Andrews, a contractual obligation will be a penalty if it imposes an obligation to pay (or forgo) an amount of money, or other benefit, as security for the fulfilment of some condition, even when the party liable to pay the amount did not promise that the condition would be fulfilled. As the High Court explained:

"In general terms, a stipulation prima facie imposes a penalty on a party ('the first party') if, as a matter of substance, it is collateral (or accessory) to a primary stipulation in favour of a second party and this collateral stipulation, upon the failure of the primary stipulation, imposes upon the first party an additional detriment, the penalty, to the benefit of the second party."3

Importantly, unlike the new UK position articulated in Cavendish, in Australia a contractual clause which imposes an obligation to pay an agreed sum, even when it is not payable on breach of contract, may constitute a penalty.4 Additionally, as recently confirmed in the decision by the Full Court of the Federal Court of Australia in Paciocco v Australia and New Zealand Banking Group Limited5 the dichotomy between a penalty, and an obligation to pay an amount which is a genuine pre-estimate of loss is still ‘central to the operation of the penalty doctrine.’6

In Paciocco, where bank fees were also the relevant subject matter, the court determined that the participants in the customer class action had not proven that, as at the date of the contracts between the Bank and customers, the fees were not a genuine pre-estimate of loss. The decision, accordingly, was fact specific, and did not displace the fundamental principles articulated in Andrews. However, that the decision in Paciocco is currently under appeal, and the High Court may further clarify the application of the penalties rule.7

While Australian courts have recognised that it is appropriate to take into account that sophisticated commercial parties are generally capable of protecting their legitimate interests when contracting, and that it is appropriate to take this fact into account when interpreting commercial contracts, the courts remain reluctant to take into account the surrounding circumstances of a contract unless ambiguity is present.8

UK Supreme Court decision

The UK Supreme Court decision in Cavendish related to two appeals about whether particular contractual provisions were penalties and, therefore, unenforceable.

The first case dealt with by the UK Supreme Court was the appeal in Cavendish v El Makdessi, involving a dispute in relation to a share purchase agreement, and a related shareholders agreement, and the consequences for default by the sellers. If the sellers (including in this case, Mr El Makdessi) breached a clause imposing an obligation to protect the goodwill of the subject business, and the competition restraints imposed by the contract, Mr El Makdessi lost his entitlement to receive deferred compensation for the sale, and the benefit of a put option. The UK High Court found that the clause was enforceable. However, the UK Court of Appeal determined that the clause was a penalty, and therefore unenforceable.

The other appeal considered by the UK Supreme Court, ParkingEye v Beavis, related to a charge imposed on Mr Beavis for over-staying a two hour free parking limit in a private retail carpark. The charge imposed was £85, with an early payment discount of £35 if paid within 14 days. The County Court rejected Mr Beavis’ arguments – that the charge was an unenforceable penalty at common law, and it was prohibited by the applicable English regulations in relation to unfair consumer contracts, were rejected. Mr Beavis’ appeal was rejected by the UK Court of Appeal.

The Supreme Court unanimously allowed the appeal in Makdessi and by majority dismissed the appeal in ParkingEye. In each instance the court concluded that the impugned provisions were not penalties. The leading judgment, given by Lord Neuberger and Lord Sumption (with Lord Clarke and Lord Carnwath agreeing) set out the following proposition:

"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."9

Accordingly, whether or not the penalties doctrine applies will depend on how a particular obligation is framed in a contract – the penalties doctrine will only apply where that clause sets out a remedy for a breach of contract. If an obligation to pay a specified sum is imposed to secure performance of a particular obligation, rather than punish breach, the obligation will be a conditional primary obligation and not a secondary obligation, capable of characterisation as a penalty. The classification of a contractual obligation as a penalty depends on an assessment of the substance of the obligation, and not merely the form.10

The court also determined that a clause may be a penalty even if it does not impose an obligation to pay money. A contact term that imposes an obligation to transfer assets, or which may have the effect of withholding assets from a party otherwise entitled to them, in circumstances of breach or non-performance may constitute a penalty.11

In addition to clarifying the limits of the penalties doctrine, the court clarified what constitutes a penalty clause. The court rejected a clear delineation between a clause which is penal (i.e. is imposed to act as a deterrent), and a clause which imposes an obligation to pay a genuine pre-estimate of loss.12 The majority stated that:

"The fact that the clause is not a pre-estimate of loss does not therefore, at any rate without more, mean that it is penal. To describe it as a deterrent … does not add anything. A deterrent provision in a contract is simply one species of provision designed to influence the conduct of the party potentially affected. It is no different in this respect from a contractual inducement. Neither is it inherently penal or contrary to the policy of the law. The question whether it is enforceable should depend on whether the means by which the contracting party’s conduct is to be influenced are 'unconscionable' or (which will usually amount to the same thing) 'extravagant' by reference to some norm."

"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."13

Accordingly, the court recognised that there are legitimate circumstances in which a clause which imposes an obligation on a defaulting party to pay an amount which is more than a genuine pre-estimate of loss will not be penal. In this respect, the court recognised that there are legitimate interests which a party may protect beyond mere compensation for loss.14 However, in most cases, such as in respect of a straightforward damages clause, an innocent party’s interest will not extend beyond compensation for loss.15

Relevant to determining the legitimate interest of parties, and whether or not the penalties rule should be applied, is the background circumstances of the contract, including the relationship between the parties. The majority judgement outlined that:

"In a negotiated contract between properly advised parties of comparable bargaining power, the strong initial presumption must be that the parties themselves are the best judges of what is legitimate in a provision dealing with the consequences of breach."16

Accordingly, applying these principles, the court determined in relation to theMakdessi proceedings that the relevant provisions were not penalties for two reasons:

  1. in substance, the obligations were not secondary obligations but primary obligations under the contract. They were not contractual alternatives to damages, and the clause depriving Mr Makdesssi of the deferred compensation was more properly characterised as a price adjustment mechanism, to reflect the diminished goodwill if the restraint clause was not complied with,17 and
  2. the clauses were justified by the legitimate interest of Cavendish in the goodwill of the business under sale, in circumstances in which the court could not properly asses the precise value of compliance with the restraint obligations. Relevant to this determination was that the parties were ‘sophisticated, successful and experienced commercial people bargaining on equal terms over a long period with expert legal advice’.18

In the ParkingEye proceedings, the court determined that ParkingEye had a legitimate interest in imposing the charge, even if it went beyond the recovery of loss. The court recognised that there was a legitimate interest in encouraging drivers to observe the two-hour limit to enable customers of the nearby retail outlets and other members of the public to use the parking space, and that the imposition of an £85 charge for over-stayers was a legitimate means of income for ParkingEye to enable them to provide the free parking scheme.19

Consequences

As it stands, it may be observed that the penalties rule in Australia applies more broadly, and bites more frequently. In other words, in Australia, the penalties doctrine is capable of application to a greater variety of contractual obligations, and is more restrictive in relation to what are regarded as legitimate interests which a party may seek to protect by imposing an obligation to confer a benefit where there is a breach or non-performance.

The approach to penalties in the United Kingdom appears to place a greater emphasis on the freedom of parties to contract, and to protect other legitimate interests in contractual performance other than the avoidance of loss. While the High Court appeal in Paciocco may consider and deal with the decision in Cavendish and possibly shift the position in Australia, for now the decision in Cavendish has widened the gulf between Australian contract law and English contract law.

By way of example, in Australia, a contractual provision in a contract for a construction project imposing a strict time bar for variation payment claims by a contractor could constitute a penalty. However, in the United Kingdom, the principal could argue that there was a legitimate interest in ensuring compliance with the notice provision to ensure that project costs are properly managed. Similarly, a provision requiring a contractor to pay liquidated damages every day that a project is incomplete after a nominated date that are higher than the actual costs incurred by the Principal due to the delay would be invalid under Australian law, but could be valid in a contract governed by English law.

Those considering the choice of law or governing law clauses in agreements should consider what jurisdiction is appropriate for their particular contract needs and enforcement requirements given the now differing level of acceptance of penalty provisions in the two jurisdictions.