The Supreme Court has recast the test for penalties to bring it into line with modern commercial practices. The new test is less formalistic and leaves the courts with greater discretion to look at the commercial rationale for a clause. The decision also emphasises the freedom of sophisticated parties to agree default provisions so is likely to give parties greater confidence that such provisions are less likely to be deemed unenforceable.
The Supreme Court held in Cavendish Square Holding B.V. v Talal El Makdessi andParkingEye Limited v Beavis  UKSC 67 that the tests that had developed over the past century under the penalty doctrine were unsatisfactory. The court swept aside the distinction between a penalty, a deterrent and a genuine pre-estimate of loss, to replace it with a clearer analysis of the penalty doctrine. It confined the test to considering whether a secondary obligation which is imposed on a contract-breaker for breach of a primary obligation under the contract is out of all proportion to the interest of the innocent party in the enforcement of the primary obligation which has been breached.
The Supreme Court heard joined appeals: one relating to a consumer contract and one arising out of a complex business sale.
ParkingEye v Beavis
Mr Beavis parked his car in a car park managed for ParkingEye which displayed notices that failure to comply with a two hour parking limit would "result in a parking charge of £85". Mr Beavis overstayed the limit and received a demand for payment of £85. Mr Beavis contested the charge on the basis that it was an unenforceable penalty at common law and/or that it was unfair and unenforceable under the Unfair Terms in Consumer Contract Regulations 1999. The Court of Appeal upheld the first instance decision rejecting both arguments.
Cavendish v El Makdessi
Mr El Makdessi's dispute arose out of a clause in a share purchase agreement by which Cavendish Square, part of WPP, purchased a controlling interest in his Middle Eastern advertising and marketing company. The agreement contained a number of covenants which prevented Mr El Makdessi from competing with the business which was the subject of the agreement or soliciting customers or employees. Mr El Makdessi breached those covenants and, under clauses in the agreement, he lost the right to the balance of the purchase price from Cavendish Square or his shares (up to US$44 million) and he became obliged to sell his remaining, minority, shareholding in the business to Cavendish Square for a discounted value. Mr El Makdessi challenged these clauses. He was unsuccessful in the High Court but his appeal was allowed by the Court of Appeal.
The existing four tests
The approach to penalties which has dominated judicial thinking for a century was set out inDunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd  AC 79 in which it was held that, "[t]he essence of a penalty is a payment of money stipulated as in terrorem of the offending party; the essence of liquidated damages is a genuine covenanted pre-estimate of damage". While liquidated damages clauses have been enforced by the courts in the century since, courts have provided relief from penalty clauses.
In Dunlop v New Garage the court formulated four tests to help distinguish penalty clauses which have proved very influential in subsequent case law. The court determined that:
- it will be held to be penalty if the sum stipulated for is extravagant and unconscionable in amount in comparison with the greatest loss that could conceivably be proved to have followed from the breach;
- it will be held to be a penalty if the breach consists only in not paying a sum of money, and the sum stipulated is a sum greater than the sum which ought to have been paid;
- there is a presumption that it is a penalty when a single lump sum is made payable by way of compensation, on the occurrence of one or more or all of several events, some of which may occasion serious and others "but trifling" damage; and
- it is no obstacle to the sum stipulated being a genuine pre-estimate of damage that the consequences of the breach are such as to make precise pre-estimation almost an impossibility.
The revised test
The court concluded that, due to an over-literal reading of the four tests set out in Dunlop, the law relating to penalties had become the "prisoner of artificial categorisation" because of "unsatisfactory distinctions" between a penalty and a genuine pre-estimate of loss, and between a genuine pre-estimate of loss and a deterrent. The court noted that when the four tests were first advanced it was as considerations rather than hard-and-fast rules. The court considered that the tests were still a "useful tool" in deciding whether a simple damages clause in a standard contract was 'unconscionable' or 'extravagant'. However, the court considered that the tests were not appropriate for more complex cases and approved the trend in recent authorities which asked whether the innocent party's interest in protecting its trade gave rise to a "commercial justification" for the sum stipulated.
Rather than looking to the four tests in Dunlop in more complex cases, the court explained that the real question when a contractual provision is challenged as a penalty is whether it is penal, not whether it is a pre-estimate of loss. The court also clarified that it was not helpful to consider whether a provision is intended to act as a deterrent as this does not add anything because a deterrent provision in a contract is not inherently penal or contrary to the policy of the law. Instead the question as to 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, the court explained, will usually amount to the same thing) 'extravagant' by reference to some norm.
The court held that the true test for a penalty 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 court held that the innocent party can have no proper interest in punishing the defaulter.
The court allowed the appeal in Cavendish v El Makdessi and dismissed the appeal inParkingEye v Beavis.
Cavendish v El Makdessi
The court held that the price adjustment clause and the forced share sale clause in Mr El Makdessi's sale agreement were primary obligations, the former because it operated as a price-adjustment clause rather than regulating the measure of compensation for damages for breach of restrictive covenants and the latter because it operated as an option to buy shares for commercial reasons. As both were primary obligations, the penalty rule was not engaged as it only concerned the regulation of secondary obligations. The court considered that, if the rule had been engaged, the clauses existed to further a legitimate interest of Cavendish Square and so Mr El Makdessi would not have been entitled to relief.
ParkingEye v Beavis
In ParkingEye, the court held that the £85 charge imposed on Mr Beavis did engage the penalty rule but did not constitute a penalty. Although ParkingEye was not liable to suffer any loss as a result of overstaying motorists, the charge furthered legitimate interests of both ParkingEye and the landowner and it was not extravagant or unconscionable when compared with a relevant benchmark, the charges imposed by local authorities for overstaying in car parks on public land. The continued use of the car park by motorists despite the prominent display of the charge was some evidence of its reasonableness. The court also found that the term imposing the £85 charge was not unfair and did not infringe the Unfair Terms in Consumer Contract Regulations 1999.
The Supreme Court's new test offers a much greater coherence to what had become a difficult concept in English law. The court has taken a conservative approach in retaining the penalty rule despite invitations from counsel to abolish the rule altogether or to extend it to primary obligations. However, this approach should be welcomed, not only because the decision brings the law into line with modern commercial practice but also because the court chose not to follow courts in Australia by extending the principle to primary obligations in such a way that would interfere with the parties freedom of contract. With appropriate drafting, parties should be more confident that their contractual agreements will avoid the application of the rule. The court indicated that this is particularly the case where the parties are equal and have both been well-advised. Finally, because the court heard appeals arising out of a complex business sale as well as a consumer agreement, the court's decision has wide application.