The Supreme Court of the United Kingdom (“UKSC”), in its recent judgment of Cavendish Square Holding BV v Talal El Makdessi; ParkingEye Ltd v Beavis [2015] UKSC 67, has re-examined the principles underlying the law relating to contractual penalty clauses (the penalty rule) and, in doing so, has restated the law relating to the penalty rule.

Background Facts to the Appeals

In Cavendish Square Holding BV v Talal El Makdessi, Mr Makdessi, the Respondent in this appeal, and Mr Ghossoub agreed to sell to the Respondent, Cavendish Square Holding BV, a controlling stake in the holding company of the largest advertising and marketing communications group in the Middle East that was founded by the Respondent (“Group”). At that time, the Respondent was one of the most influential Lebanese business leaders, and his name was closely identified with the business of the Group. The contract provided that if the Respondent was in breach of his contractual obligations, including breach of certain restrictive covenants against competing activities, the Respondent would not be entitled to receive the final 2 instalments of the price paid by the Appellants (Clause 5.1) and the Appellant could also require the Respondent to sell his remaining shares to the Appellant at a price excluding the value of the goodwill of the business (Clause 5.6). The Respondent argued that clauses 5.1 and 5.6 were unenforceable penalty clauses.

In ParkingEye Ltd v Beavis, the Appellant in this appeal, ParkingEye, had entered into a contract with the owner of a retail park for the management of the carpark on the site. ParkingEye displayed about 20 signs all around the carpark stating that failure to comply with a two-hour parking limit would result in a parking charge of £85. On an occasion, the Respondent in this Appeal, Mr Beavis, parked his car in the carpark and overstayed the limit by nearly an hour. ParkingEye issued a parking charge notice and demanded that Mr Beavis paid £85. Mr Beavis argued, inter alia, that the parking charge of £85 was a penalty and unenforceable.

The UKSC’s Decision On The Law Relating To The Penalty Rule

The UKSC, in examining the historical development of the penalty rule, described the penalty rule as an “ancient, haphazardly constructed edifice which has not weathered well”. However, it covers types of contract which are not regulated in any way (e.g. non-consumer contracts), and should not therefore be abolished, but neither should it be extended.

The UKSC emphasized at the outset that the penalty rule regulates only the remedies available for the breach of a party’s primary obligation, and not the fairness of the primary obligations themselves. As such, the penalty rule is engaged only when the relevant provision operates upon a breach of contract. In other words, a contractual provision is not capable of being a penalty if it is framed as a conditional primary obligation instead of a secondary obligation providing a contractual alternative to damages at law.

The UKSC then elucidated on the approach that the court should take to determine whether a contractual provision was penal. The UKSC thought it unfortunate that the 4 tests formulated by Lord Dunedin in Dunlop Pneumatic Tyre Company Ltd. v New Garage and Motor Company Ltd. [1915] AC 79 (the “Dunlop tests”) have too often been treated as a code in subsequent case-law. The court also expressed the view that while the Dunlop tests are useful tools to deal with simple damages clauses in standard contracts, the tests have not been adequate for dealing with less straightforward cases, in the context of supposed commercial justification for clauses which might otherwise be regarded as penal.

The UKSC considered that the penal character of a clause depended on its purpose, and therefore recognised that a damages clause may be properly justified by some other consideration than the desire to recover compensation for a breach. This would depend on whether the innocent party had a legitimate interest in performance extending beyond the recovery of pecuniary compensation flowing directly from the breach. 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 interests of the innocent party in the enforcement of the primary obligation. This is a question of construction judged at the time of the making of the contract, to which evidence of the commercial background is relevant.

Application to the Facts of the Appeals

Cavendish Square Holding BV v Talal El Makdessi

The UKSC concluded that neither clause 5.1 nor clause 5.6 are unenforceable penalty clauses. In relation to clause 5.1, the UKSC held that the clause was not a contractual alternative to damages at law. Clause 5.1 was in reality a price adjustment clause, and belonged with the provisions which determined the Appellant’s primary obligations relating to the quantum and method of payment of the purchase price. The Respondent earned the consideration for his shares not just by transferring them to the Appellant, but also by observing the restrictive covenants. Therefore, the Appellant had legitimate interests in the Respondent’s observance of restrictive covenants, which was to safeguard and protect the goodwill of the business, which was critical to its value. As regards clause 5.6, the UKSC found that the logic of the price formula reflected the reduced price that the Appellant was prepared to pay for the acquisition of the business in circumstances where it could not count on the Respondent’s loyalty and the risk of that part of the goodwill may be lost. Further, a contractual provision conferring an option to acquire shares for such distinct commercial reasons, and not for compensation for a breach of contract, belongs among the parties’ primary obligations, even if its operation is conditional on a breach.

ParkingEye Ltd v Beavis

Unlike Cavendish v El Makdessi, the UKSC held that the penalty rule was engaged.  However, they concluded that the £85 was not a penalty as both ParkingEye and the landowners had a legitimate interest in charging overstaying motorists. The interest of the landowners was the provision and efficient management of customer parking for the retail outlets. The interest of ParkingEye was in income from the charge (because otherwise parking within the time limit was free), which met the running costs of a legitimate scheme plus a profit margin. The court also found that the charge was neither extravagant nor unconscionable, taking into account the practice around the United Kingdom, the use of the particular car park and the clear wording and prominence of the notices.

Brief Comments

The UKSC’s judgment is significant in that it represents a shift in the approach taken by the English courts in analysing whether a contractual provision is penal – it is a departure from the  previous approach of categorisation since the formulation of the Dunlop tests. The restated test better reflects the underlying purpose of the penalty rule by allowing the court to make a realistic appraisal of the substance of contractual provisions operating upon breach and to give effect to parties’ legitimate interests that may be properly protected by the contract.

The Dunlop tests have been adopted in Singapore as recently as in the Singapore Court of Appeal case of Xia Zhengyan v Geng Changqing [2015] 3 SLR 732. It remains to be seen if the Singapore courts will find the UKSC’s reasoning persuasive and adopt the restated test. Should the Singapore courts accept the UKSC’s reasoning, this potentially has a significant impact in contract negotiations for the future in providing a disincentive or deterrence against contract-breaking.