The UK Supreme Court has decided the conjoined appeals of Cavendish Square Holdings BV v. El Makdessi and ParkingEye Ltd v. Beavis. The penalty rule – described as an ‘ancient, haphazardly constructed edifice which has not weathered well’ – survived a sustained, and sometimes brutal, attack. The fight, however, took its toll with the 100 year old rule being battered into a different shape altogether.
Both cases focussed on the correct application of English contract law to penalty and liquidated damages clauses – for more information, see Part 1 of this article » The Supreme Court held that concepts of ‘deterrence’ and ‘genuine pre-estimate of loss’, for so long thought to be the appropriate tests, were deemed unhelpful. The true test is whether the alleged penalty 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.
Agreeing with his English colleagues, Lord Hodge summarised 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. A clause fixing a level of damages payable on breach will be a penalty if there is an extravagant disproportion between the stipulated sum and the highest level of damages that could possibly arise from the breach.
For too long the focus of the rule has been confined to cases requiring the payment of money on breach. This was too narrow. The focus ought to be on the proportionality of the remedy to the protected interest. It applies to clauses such as those withholding payments on breach, clauses requiring the party in breach to transfer property, and clauses requiring payment of a non-refundable deposit if that deposit is “non-reasonable as earnest money”. The courts will look at the substance over the form of any drafting which seeks to circumvent this rule.
The Supreme Court concluded that the relevant clauses in Makdessi were primary, rather than secondary, clauses dealing with price adjustment. In ParkingEye, the clause in point did engage the penalty rule. However, the £85 charge for contravening the terms of the contractual licence to park in the car park was held not to be a penalty.
Further, the charge was also held not to infringe The Unfair Terms in Consumer Contracts Regulations 1999 (Lord Toulson dissenting). The landowners and ParkingEye had a legitimate interest in inducing Mr Beavis not to overstay in order to efficiently manage the car park for the benefit of the generality of the users of the retail outlets. The charge was no higher than was necessary to achieve that objective. ParkingEye had a legitimate interest in charging overstaying motorists, which extended beyond the recovery of any loss to meet the running costs of a legitimate scheme plus a profit margin. The charge was neither extravagant nor unconscionable, having regard to practice around the UK, and taking into account the use of this particular car park and the clear wording of the notices.
Businesses will need to revisit their approach to remedies for breach of contract in light of the Court’s decision, both retrospectively and prospectively. Liquidated damages clauses and other remedies following breach of a primary obligation, need to be re-assessed by asking 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.
Looking prospectively, liquidated damages clauses will continue to play an important role in commercial contracts. Pre-estimation of loss ought to remain a relevant consideration for transactional lawyers but the primary focus now needs to be on the proportionality of the remedy to the protected interest, taking into consideration the relevant commercial context. Whenever possible, evidence of the parties’ reasoning for agreeing the particular contractual remedy ought to be captured contemporaneously and safely retained…just in case it is ever needed.
Businesses, as far as possible, want certainty in their commercial transactions. There is a sense that, in concluding that different questions need to be asked in relation to the penalty rule, the Supreme Court has expanded the areas for advisors to address when asked about the enforceability of a secondary remedy flowing from the breach of a primary obligation. That may be correct. However, one imagines that many businesses will welcome a ruling which supports the innocent party enforcing an agreed remedy on the grounds that they have a legitimate interest in seeing it enforced. That, for me, may provide greater certainty to businesses rather than less.
Is there more change on the horizon in Scotland?
Lord Hodge made reference to the authority given to the Scottish Courts to modify penalties imposed for non-payment contained in obligations for sums of money in terms of The Debts Securities (Scotland) Act 1856, an authority not available to the Courts of England & Wales. With the Scottish Law Commission bringing forward a Discussion Paper in the summer of 2016, it may be that, in time, the penalty rule in Scotland will be capable of being further distinguished from its English counterpart.