In a landmark decision, the Supreme Court has today handed down its judgment in two cases concerning the law relating to contractual penalty clauses (Cavendish Square Holdings v El Makdessi andParkingEye Limited v Beavis).
In both cases the Supreme Court upheld the validity of the clauses in question and revisited the law on penalties, “an issue which has not been considered by the Supreme Court or the House of Lords for a century”. In doing so, the Supreme Court held that the true test as to whether a clause was penal (and therefore unenforceable) was whether it imposed a detriment on the contract breaker “out of all proportion to any legitimate interest of the innocent party” in enforcing the primary obligation breached.
The Supreme Court also clarified that the rule against penalties regulates only the remedies available for breach of a party’s primary obligations and not the primary obligations themselves. In claims where the rule against penalties is engaged (i.e. secondary obligations arising from breaches of primary obligations), the Supreme Court recognised that an innocent party’s legitimate interests may not be limited to compensation. Such legitimate interest may extend to the performance, or appropriate alternative performance, of the obligation in question. In a negotiated contract between properly advised parties of comparable bargaining power, the Supreme Court held that the strong initial presumption must be that the parties are themselves the best judges of what is legitimate.
In reaching its judgment, the Supreme Court explained that the previously considered concepts of ‘deterrence’ and ‘genuine pre-estimate of loss’ were unhelpful but could still be considered in straightforward damages disputes. More generally, and for claims beyond damages, the real question is whether the relevant contractual provision is penal because it is out of all proportion to any legitimate interests of the innocent party.
The law of penalties has always been recognised as interfering with freedom of contract and is one of the few exceptions to the principle of the freedom of contract. However, the Supreme Court stopped short of abolishing the rule against penalties, but noting that “we rather doubt that the courts would have invented the rule today.” Today’s judgment provides welcome clarification that, although the rule remains, contractual parties are more likely to be held to their negotiated contracts where they reflect the legitimate interests of the parties concerned. It remains to be seen how this new formulation of the rule will be applied in future and, in particular, what will be “out of all proportion” to the legitimate interests of an innocent party. Careful drafting of contractual provisions may evolve to address this issue in an attempt to avoid the rule on penalties altogether or, at least, to state their legitimacy.
Commercial contracts will often provide that where one party is in breach of the contract, they must pay a pre-determined amount of damages to compensate for that breach. Traditionally a distinction has been drawn between a liquidated damages clause, which is enforceable, and a penalty which is unenforceable. The traditional approach, laid down by Lord Dunedin in Dunlop Pneumatic Tyre Company Ltd v New Garage and Motor Company Ltd, was to ask “Are the damages a genuine pre-estimate of loss or a deterrent?”
In Cavendish, Mr Makdessi sold to Cavendish part of his advertising and marketing company. The contract provided that if Mr Makdessi breached certain restrictive covenants against competing activities, Mr Makdessi would not be entitled to receive the final two instalments of the purchase price (clause 5.1) and could be required to sell his remaining to shares to Cavendish, at a price excluding the value of the goodwill of the business (clause 5.6). Mr Makdessi subsequently breached these covenants but argued that clauses 5.1 and 5.6 operated as penalty clauses and were unenforceable. The Court of Appeal agreed and, overturning Burton J at first instance, held that clauses 5.1 and 5.6 were unenforceable penalties.
In ParkingEye, ParkingEye Ltd managed a car park on behalf of its owners. ParkingEye displayed numerous notices throughout the car park, stating that a failure to comply with a two hour time limit would “result in a Parking Charge of £85”. Mr Beavis parked in the car park but overstayed the two hour limit by almost an hour. ParkingEye demanded payment of the £85 charge. Mr Beavis argued that the £85 charge was unenforceable at common law as a penalty, and/or that it was unfair and unenforceable by virtue of the Unfair Terms in Consumer Contracts Regulations 1999 (“UTCCR”). The Court of Appeal upheld the first instance decisions rejecting those arguments.
The Supreme Court allowed the appeal in Cavendish and dismissed the appeal in ParkingEye, upholding the validity of the disputed clauses in both cases. The Supreme Court held that:
- The penalty rule only applies to secondary obligations arising out of a breach of contract.
- In the case of a straightforward damages clause, Lord Dunedin’s tests in Dunlop will usually be adequate to determine the validity of the clause.
- In other cases, the concepts of ‘deterrence’ and ‘genuine-pre estimate of loss’ are unhelpful. 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.”
Lord Mance concurred. He added that, in order to determine the validity of a clause providing for the consequences of a breach of contract, the first step is to consider whether any (and if so what) legitimate business interest is served and protected by the clause. Secondly, if so, whether the provision made for that interest is extravagant, exorbitant or unconscionable.
Application to Cavendish
The Supreme Court held that clause 5.1 was a price adjustment clause, and not a secondary provision but a primary obligation. Similarly, clause 5.6 was a share forfeiture clause and also held to be a primary obligation. As such, they were not unenforceable penalty clauses. Nonetheless, the Supreme Court also appears to have considered both clauses as if they were secondary obligations and therefore subject to the rule against penalties.
On that basis, clause 5.1 was held not to be a penalty because Cavendish had a “legitimate interest” in the observance of the restrictive covenants, in order to protect the goodwill of the business. The Court could not determine how much less Cavendish would have paid for the business without the benefit of the restrictive covenants. This was a matter for the parties, who were “sophisticated, successful and experienced commercial people bargaining on equal terms over a long period and with expert legal advice.” The same “legitimate interest” justified Clause 5.6 and, although the clause acted as a deterrent by intending to influence Mr Makdessi’s conduct, it was not “penal” since the object was not to punish.
Application to ParkingEye
Both ParkingEye and the owners had a legitimate interest in charging overstaying motorists, which extended beyond the recovery of any loss. The landowners were interested in the provision and efficient management of customer parking for retail outlets and ParkingEye was interested in income from the charge. Further, the charge was neither extravagant nor unconscionable in the circumstances.
With regard to UTCCR, the charge did not come within the basic test for unfairness. ParkingEye had a legitimate interest in inducing customers not to overstay, in order to efficiently manage the car park for the benefit of users of the retail outlets. The charge was no higher than was necessary to achieve that objective. Objectively the reasonable motorist would have, and often did, agree to the charge.
Lord Toulson, dissenting in part on ParkingEye, was of the opinion that the penalty clause infringed UTCCR, on the grounds that ParkingEye had not proved that the consumer would have agreed to the penalty clause in individual negotiations on level terms.
Today’s judgment provides welcome clarification that, although the rule remains, contractual parties may be held to their negotiated contracts where they reflect the legitimate interests of the parties concerned. How this new formulation of the rule will be applied in future may require further clarification, including what will be “out of all proportion” to the legitimate interests of an innocent party. In the meantime, careful drafting of contractual provisions may evolve to address this issue in an attempt to avoid the rule on penalties altogether or, at least, to state their legitimacy.