A specially convened seven judge Supreme Court panel adjudicating on a sophisticated acquisition agreement, and an orange car park sign have re-written the law on penalty clauses. The century old power to strike down such clauses survived the attack on its very existence, but in a form re-scoped and re-fashioned for the 21st Century.

This significant legal development, which gives parties greater latitude to develop contractual provisions capable of robustly protecting their commercial interests, will have an important impact on how commercial contracts are drafted and litigated.

Definitive guidance has been given confirming the expanded application of the power to strike down penalty clauses covering both money and asset transfers, and to both the making of payments and the withholding of payments, but only where the provision concerns the consequences of a breach. The terms setting the primary obligations of an agreement are now declared to be outside the scope of the penalty rule.

Introduction

The law governing penalty clauses has been definitively recast following the Supreme Court’s combined judgments in the two cases heard together: Cavendish Square Holding BV v Talal El Makdessi; andParkingEye Limited v Beavis1.

An important consequence of these judgments is that commercial parties now have more freedom to include clauses which would previously have been unenforceable as penalties.

What has happened?

The judgment considered two appeals.

In Makdessi, the Supreme Court overturned the Court of Appeal’s ruling that one party to a sophisticated acquisition agreement, Cavendish, could not enforce provisions which imposed a disproportionately severe financial detriment on the other party, Mr Makdessi, for breaching certain non-compete restrictions. The Court of Appeal had concluded that the provisions were unenforceable as they were designed to deter Mr Makdessi from breaching the non-compete restrictions and because the detriment they imposed had the potential to far outweigh any loss suffered by Cavendish.

In ParkingEye, the Supreme Court upheld the Court of Appeal’s decision that ParkingEye, a car park operator, could charge Mr Beavis, a motorist, for overstaying a free parking limit even though the charges primary purpose was to deter overstaying and despite the fact that the charge levied was far greater than any loss caused to ParkingEye by overstaying motorists.

As set out below, the Supreme Court’s decisions have both redefined what constitutes a penalty clause and restated the test of whether a clause is unconscionable and extravagant taking into account all legitimate interests of the beneficiary of the clause and is not tied (in non standard cases) to the simple genuine pre-estimate of damages formula.

Background

For the last 100 years the English courts have traditionally followed Lord Dunedin’s tests in Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd2 and applied a strict approach to clauses which impose an enhanced financial detriment on a party who has breached a contract.

Traditionally to be enforceable, such a clause had to compensate the innocent party for the loss caused by the other party’s breach of contract. This compensation had to be a “genuine pre-estimate” of any likely loss, although the actual loss in any particular case might be much less or even much more. By contrast, clauses which did not reflect a genuine pre-estimate were treated as penal, leading to ever increasing ingenuity being applied by a party facing such a clause in discovering circumstances where it might apply without the beneficiary having suffered any significant loss.

Now, following the Supreme Court’s decisions in Makdessi and ParkingEye, the law on penalties has changed again. This marks an important departure from the traditional approach.

The new approach

In its leading judgment, the Supreme Court described the historical development of the traditional approach as “unfortunate” finding that the absence of a genuine pre-estimate of loss did not necessarily mean that a term was penal and instead there could be other equally legitimate factors which the beneficiary of the clause may have cause to protect.

In reaching this conclusion the Supreme Court dismissed the attack on the power to strike down penalties, noting that this power was replicated in many other common law and civil law jurisdictions dismissing the suggestion that the jurisdiction should be disapplied from commercial matters.

Accordingly, the Supreme Court took the opportunity to restate the test for identifying penalties:

  1. Penalties only take effect on terms which make provision for the consequence of a breach, the rule has no application to the primary obligations under any agreement. A clause can only be a penalty if it is engaged by the breach of another clause in the contract.
  2. The rule is not limited to clauses concerning payments of money but also applies to provisions permitting the withholding of money and the transferring of assets such as the share option in theMakdessi case.
  3. To be a penalty, a clause must impose a detriment, which is out of all proportion to the innocent party’s “legitimate interest” in enforcing the primary obligation that has been breached.

The definition of “legitimate interest” is the crucial aspect and will depend on the facts of the case. In many commercial contracts, compensation will remain the appropriate means of protecting this interest. However, the court recognised that parties often have interests such as business disruption, which are not adequately protected by compensation. In such cases, it is now – in contrast to the traditional approach – permissible to protect these interests by using provisions designed to influence another party’s conduct, including as deterrents.

For example in Makdessi, the Supreme Court held that Cavendish had a legitimate interest in the observance of the non-compete restrictions because their breach posed a significant business risk which could not easily be quantified. This justified the inclusion in the contract of clauses which had purposes other than compensation.

In ParkingEye, the Supreme Court said that it had a legitimate interest in preventing misuse of the car park and in generating the income needed to manage it. The charge for motorists exceeding the time limit was a justifiable way of meeting these objectives, even though it was clearly a deterrent/penal.

HFW perspective

The decision raises some important points which are relevant to many of HFW’s clients.

Firstly, the compensation/genuine pre-estimate against deterrent/penal distinction is not entirely redundant. In straightforward, uncomplicated agreements it will remain the framework for analysing clauses. Such agreements generally cover simple legitimate interests which are adequately protected by monetary compensation and do not raise the same issues which arose in Makdessi and ParkingEye.

Secondly, the decision’s impact will be felt in the context of more sophisticated agreements negotiated by commercially experienced parties who have a range of commercial interests at stake, not all of which can be precisely quantified in financial terms. The Supreme Court was clear that such parties should have more freedom to design clauses protecting their commercial interests without the risk that the courts will declare them unenforceable.

Thirdly, the court’s finding that only secondary obligations can be penalties means that well-drafted clauses can avoid the rules on penalties altogether. Clauses expressed as primary obligations, for example price adjustment clauses as in Cavendish, are incapable of being penalties, and careful drafting will further minimise the risk that the courts will decline to enforce certain clauses.