Many legal systems worldwide will not enforce contractual provisions which are penalties. However, the courts’ desire to enforce parties’ commercial bargains has led to inconsistent application and tortuous interpretation of the rule against penalties. The UK Supreme Court’s decision in Cavendish v Makdessi and ParkingEye v Beavis has provided clarity in this area.

In construction contracts we commonly encounter the rule against penalties when considering liquidated damages (LDs) clauses.

LDs provide that on certain specified breaches of contract (for example, failure to complete the works on time), a pre-determined sum of money is paid by the defaulting party to the innocent party. LDs are an alternative to general damages, which require proof and quantification of actual loss, which can be time consuming and complex. In most cases LDs can be deducted from monies otherwise due to the defaulting party without the need for formal dispute resolution procedures.However, LDs clauses which are penalties will be unenforceable.

Historically, the main factor in determining if LDs were a penalty was whether they represented a genuine pre-estimate of loss, or if the purpose of the clause was to serve as a deterrent.

A similar principle applies in many Middle Eastern legal systems. For example, the UAE Civil Code permits courts to adjust LDs to reflect the actual loss suffered.

The difficulty is, concepts of “pre-estimates of loss” or “penalties” are not necessarily mutually exclusive.

Cavendish Square Holding BV v Talal El Makdessi

Mr Makdessi agreed to sell Cavendish a controlling stake in the holding company of the largest advertising and marketing communications group in the Middle East.

Cavendish sought to protect its interest by including provisions preventing Makdessi from competing with it. If Makdessi breached these restrictive coventants (a) he would not receive two final instalments of the purchase price; and (b) he would have to sell his remaining stake in the company to Cavendish at a value excluding goodwill.

Makdessi admitted breach of the restrictive covenants, but argued that the clauses in question were penalties and therefore invalid. He argued that the effect of the clauses would preclude him from receiving significant sums of money (up to US$44 million) and force him to transfer his shares at an undervalue. Makdessi said neither of the clauses in question represented a genuine pre-estimate of loss, since it was unlikely that Cavendish’s losses – if quantifiable – would have been anything close to US$44 million.

At first instance, the court held that neither clause was a penalty, since they were commercially justifiable. The Court of Appeal, however, found that they were penalties, since they were “extravagant and unconscionable”.

Abolishing or extending the rule against penalties?

The Supreme Court was not prepared to abolish the rule against penalties as it is a long standing principle of English law, and common to almost all major systems of law.

For example many Middle Eastern legal systems permit the courts to adjust LDs clauses in contracts to achieve the shari’a principle of fairness. Under the Qatari Civil Code the courts have discretion to reduce the rate of LDs which are found to be grossly excessive.

The Supreme Court also declined to extend the rule against penalties, as the High Court of Australia recently did in Andrews v ANZ (2012). In that case, the court relied upon the rules of equity to offer relief from bank charges levied in response to account “irregularities” (which did not amount to breaches of contract), and held the charges could potentially amount to penalties.

The Supreme Court did not follow the Australian approach in Andrews v ANZ, holding that such inroads into freedom of contract should not be extended by judicial, as opposed to legislative decision making.

Types of clauses

The Supreme Court declined to restrict the rule against penalties to clauses that required the defaulting party to pay money, as opposed to clauses that in the same circumstances allowed the innocent party to withhold moneys which were otherwise due.

The court accepted that withholding clauses were capable of falling within the penalty doctrine, but they will not always amount to penalties. That depends on the nature of the right which the defaulting party is being deprived of, and the basis for depriving him of it.

However, the court was of the view that clauses which related to the build up of the contract price were primary obligations, rather than secondary obligations, which only operate on breach of a separate primary obligation. As such, the penalty doctrine would not bite where not all of the contract price was payable because a particular obligation had not been met.

The proper test for a penalty

The court stated that the law in this area had, in the past, been dominated by the artificial categorisation of mutually exhaustive concepts of genuine pre-estimates of loss and deterrence. However, not all clauses obviously fall within this dichotomy.

The lower courts have tried to avoid this by developing a “commercial justification” test – in other words even if a clause did not represent a genuine pre-estimate of loss, did it nevertheless have a commercial justification? The Supreme Court rejected this approach, since it is questionable that a provision cannot be a deterrent if it also had a commercial justification.

The Supreme Court did, however, accept that a clause operating on breach (like LDs) could be justified by considerations other than monetary compensation. Therefore, even if LDs are not a genuine pre-estimate of loss the clause will not necessarily be a penalty. Deterrence is not important. The real question is whether the clause is a secondary obligation which imposes on the contract-breaker a detriment out of all proportion to any legitimate interest of the innocent party, in the enforcement of the primary obligation.

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.

Application of the test: Cavendish v Makdessi

The clauses in question were held to protect the legitimate commercial interests of Cavendish – protection of goodwill. Neither was concerned with the measure of compensation for breach. Although the clauses were intended to deter breach, they nevertheless had a legitimate function that had nothing to do with punishment, and everything to do with achieving Cavendish’s commercial objective. In any event, the clauses in question were primary obligations, concerned with the build up of the contract price, and as such, the penalty doctrine was not engaged.

ParkingEye v Beavis

ParkingEye manages a car park which displays notices stating that overstaying the two hour time limit would result in a charge of £85. Billy Beavis parked in the car park for almost three hours. ParkingEye demanded the £85 charge, but Mr Beavis refused to pay on the basis that it was an unenforceable penalty. The court at first instance and the Court of Appeal both rejected Beavis’ arguments.

ParkingEye conceded that £85 was not a genuine pre-estimate of its losses. Because ParkingEye managed, rather owned the site, it would be hard to argue it had lost anything through Beavis overstaying his allotted two hours.

The Supreme Court found that the charge was not a penalty. The court found that the charge had two main objects. The first was to manage the efficient use of parking spaces, by deterring long stay parking. The other was to provide an income stream to enable ParkingEye to meet the cost and obtain profit from the scheme.

The court found that deterrence is not penal if there is a legitimate interest in influencing the conduct of the contracting party, which is not satisfied solely by recovery of damages.

Of course, ParkingEye could not charge overstayers an amount which would be out of proportion to its interests. However, on the evidence, the £85 charge was not found to be disproportionate.

How has the law changed in England?

Since the Supreme Court’s ruling the test of whether a clause is a penalty is (1) does it protect a legitimate interest? and if so (2) is the clause nevertheless extravagant and unconscionable?

For simple LDs clauses in standard contracts the answer to these questions might be whether the clause is a genuine pre-estimate of loss. But that does not solve more complex cases, or cases where parties to an agreement have commercial interests which go beyond mere monetary compensation.

Financial compensation is not the only legitimate interest that parties may have. Properly advised parties of equal bargaining power are presumed to be the best judges of what is legitimate.