Cavendish Square Holding BV v El Makdessi; ParkingEye Ltd v Beavis [04.11.15]

Supreme Court holds that clauses in question are enforceable; guidance provided in relation to the application of the penalty rule.

Implications

The Supreme Court has considered the often criticised rule for differentiating between liquidated damages clauses (LADs) and unenforceable penalty clauses. While its judgment stops short of radical change, it provides welcome guidance for future application.

As a result of this judgment, employers may propose higher damages figures at the contract negotiation stage where justified by some legitimate interest. Contractors will need to consider when to push back and should ask employers to outline the grounds on which they justify their figures.

The judgment reaffirms that where parties are properly advised and of comparable bargaining power, there should be a strong initial presumption that they are the best judges of what is legitimate. This tips the balance back in favour of freedom of contract and courts may be less inclined to interfere with agreed terms in future.

While further guidance is awaited, it is worth considering the following questions when negotiating LADs:

  • Is there a legitimate interest? Contractors should be wary of agreements where the employer’s interest in performance goes beyond the purely financial. Projects with a reputational risk, for example, might see employers seeking to agree greater damages amounts.
  • Is the proposed amount out of all proportion to the legitimate interest? InParkingEye, the appellant was charged £85 for exceeding the parking limit by one hour. While it is highly unlikely that anyone would expect to pay £85 for an hour of parking, it was deemed reasonable in the circumstances. The extent of the innocent party’s interest will be a persuasive factor.
  • Has the clause been clearly drafted? The ruling has blurred the lines between primary and secondary obligations. It will be a ‘matter of substance, not form’ when assessing the true nature of a clause. We can expect judges to look past the drafting when determining whether a clause is either primary or secondary in nature.

Background

The use of LADs is common practice in construction contracts. They provide for payment of a pre-determined damages amount in the event of a particular breach. Traditionally, the amount would need to be a genuine pre-estimate of the loss, otherwise it would be deemed an unenforceable penalty. This is commonly known as the penalty rule.

The existing rule was established in Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd [1914], which proposed four tests for identifying a penalty clause:

  • Is the penalty sum extravagant and unconscionable?
  • For non-payment breaches, is the penalty sum larger than the unpaid amount?
  • Is the penalty sum payable in a number of events of varying gravity?
  • A clause would not be penal only by reason that it was impossible to pre-estimate the true loss.

These conjoined appeals provided the Supreme Court with an opportunity to consider the application of the rule in both a commercial and consumer context. Cavendish related to a share sale agreement that sought to limit competition by the seller. ParkingEye centred on an £85 charge for overstayed parking.

Decision

In both cases, the Supreme Court concluded that the clauses were enforceable.

However, the most important part of the judgment relates to revisions to the penalty rule. The leading judgment described the existing rule as “an ancient, haphazardly constructed edifice which has not weathered well”. The new test is to ask whether the clause 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.

This wording maintains the position that the rule will only apply to secondary obligations. Its purpose is to regulate the remedies available when a breach of a primary obligation occurs, not the primary obligations themselves. In addition, the proportionality element acknowledges that the four tests in Dunlop still have a part to play when assessing straightforward damages clauses. The real change is that such proportionality will now be assessed against the “legitimate interest” of the innocent party.

The Court accepted the concept established by recent authorities that an innocent party’s interest in performance of a primary obligation may extend beyond compensation. Where some other commercial justification exists, a clause will not fall foul of the penalty rule purely because a genuine pre-estimate of the loss is exceeded. The new test will be to weigh this and other factors, such as the commercial background, against the innocent party’s interest and determine whether the amount is justified in all circumstances.