- The Supreme Court refused to abolish the penalty rules under English law but stated that the scope of penalty law should not be expanded;
- A clause which is challenged as a penalty should be analysed in terms of whether it creates a primary or secondary obligation and only secondary obligations will normally fall foul of the penalty rule; and
- If a secondary obligation imposes a detriment on a party out of all proportion to any legitimate interest of an innocent party under the relevant primary obligation (that is the clause giving rise to the breach) then the penalty rule will be engaged.
There were two conjoined appeals.
The facts of Makdessi are probably more relevant to finance transactions in the sense there was a commercially negotiated agreement where solicitors were involved and the position of the parties was subject to a great deal of learned thought before contracts were signed. M sold his shares in a company. Part of the consideration was deferred. The SPA provisions had the commercial effect that M would receive reduced deferred consideration and would have to sell certain remaining shares at a lower price if he breached certain non-competition restrictive covenants. M breached those restrictive covenants. M argued the two types of provision reducing the deferred consideration and requiring him to sell remaining shares at a lower price were penalties and so unenforceable. M lost at first instance and won in the Court of Appeal.
The facts of Beavis were different in nature. This was a case where someone parked their car and overstayed. They were charged a fee of £85 and claimed that was a penalty. Beavis raised both penalty issues and whether the term allowing this charge to be imposed was unreasonable under the Unfair Terms in Consumer Contracts Regulations 1999.
In Beavis the Court held the term was not a penalty or unreasonable and nothing more need be said about it other than it will be relevant where the penalty issue is considered in a consumer context.
In Makdessi the Court held that the two provisions in the SPA were primary obligations and so the rule against penalties was not even engaged. Those terms were enforceable.
The Court went on to make some general observations about the law relating to penalties and it is this guidance which is the most interesting aspect of the case.
First the test of whether a contract term is a penalty has been rewritten:
“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.”
Second the Court accepted that sometimes the rule can be circumvented by clever drafting but thought this was acceptable and that there was no need to extend the concept:
“We would accept that the application of the penalty rule can still turn on questions of drafting, even where a realistic approach is taken to the substance of the transaction and not just its form. But we agree …. that, while it is true that the question whether the penalty rule applies may sometimes turn on “somewhat formal distinction[s]”, this can be justified by the fact that the rule “being an inroad upon freedom of contract which is inflexible … ought not to be extended”, at least by judicial, as opposed to legislative, decision-making.”
Thirdly the Court suggested the presumption with heavily negotiated agreements where both parties have professional advisors would be that there is no penalty.
“The background to [the relevant contract terms] is of some importance. Burton J found that the Agreement was negotiated in detail over a considerable period by parties dealing on equal terms with professional assistance of a high order.”
“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.”
The new test will make it much more difficult for parties to wriggle out of contract terms on the basis they are unenforceable penalty clauses. There are some echoes of the Edgeworth Capital success fee case from earlier in the year. Along with that case the new Supreme Court decisions must be good news for lenders who contract for additional returns from their borrowers.