Legal Updates

Penalty Clauses – Moving the Goalposts

Written by Alon Domb, Cassian Goode
14/12/2015

Legal Background

In its recent joint judgment on two cases, one involving a dispute relating to the Middle East’s largest advertising and marketing group and the other a disputed parking ticket, the Supreme Court has effectively rewritten the law on penalty clauses.

Having considered removing the prohibition on penalty clauses entirely, the Supreme Court settled on restating the law, adding some extra flexibility.

For hundreds of years, the courts in England and Wales have held that parties to contracts cannot rely on penalty clauses. Typically, a penalty clause provides that, in the event of a breach of contract, the party in breach must pay the innocent party an amount that goes beyond being a reflection of any actual loss caused by the breach and is instead an attempt to punish the party in breach.

The rule exists on the basis that the innocent party should not be permitted to punish the contract-breaker and is permitted only to seek a remedy proportionate to any loss it has actually suffered. Such a rule is common in common law jurisdictions but sits uncomfortably with the principle of freedom of contract, as it means that the courts cannot enforce penalty clauses even though the terms have been freely agreed between the parties as part of a contract.

The rule, along with the question of how to apply it, has long vexed judges but the issue has not been considered by the highest court for a century; in the majority judgment by Lords Neuberger and Sumption, it is noted that a famous judge said fifty years ago that he could “make no attempt, where so many others have failed, to rationalise this common law rule.” The Supreme Court has now made such an attempt.

Case background

The first case, ParkingEye v Beavis, came about when Mr Beavis left his car in a car park in Chelmsford for too long. Signs in the car park stated that parking was free for up to two hours but that if a motorist overstayed a fine of £85 would be payable. Mr Beavis left his car for just under three hours and was fined accordingly. He refused to pay, claiming that the change was an unenforceable penalty (he also claimed that it was in breach of the Unfair Terms in Consumer Contracts Regulations 1999 (1999 Regulations)).

The second case, Cavendish v El Makdessi, arose when Mr Makdessi, who, together with a partner was the majority shareholder in a holding company which owned the Middle East’s largest advertising and marketing group, sold a large proportion of his shares to Cavendish. The payment for the shares was to be spread over time across an initial payment, interim payments and a final payment. Two clauses in the sale contract provided that if Mr Makdessi breached a non-compete clause, he would not be entitled to the (substantial) interim and final payments for the shares and would also be forced to sell his remaining shares at a much lower price (one which did not reflect goodwill, to which much value had been apportioned). Mr Makdessi breached the non-compete clause and so Cavendish refused to pay him the interim and final payments and tried to enforce the sale of Mr Makdessi’s remaining shares at the lower price.  Mr Makdessi admitted that he had breached the non-compete clause but he claimed that the clauses removing his entitlement to payment in event of breach were penalty clauses and thus unenforceable.

The decision

For many years, whether a clause was considered a penalty rested on whether or not it was intended to provide a “genuine pre-estimate of loss”; if it did anything more than that (for example, if the clause was intended to act as a deterrent to any breach of contract by having a large amount payable in the event of breach) it was considered to be a penalty and the courts would not enforce it.

The Supreme Court found that this was wrong and that circumstances existed in which it was perfectly legitimate for a party to a contract to enforce a clause which is not a genuine pre-estimate of loss. As the majority judgment puts it, “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. These are not natural opposites or mutually exclusive categories.” The Supreme Court held that a clause designed as a deterrent is not inherently penal and should not therefore necessarily be treated as such. The question as to whether or not such a clause is enforceable ought to depend on whether the deterrent element is “’unconscionable’ or (which will usually amount to the same thing) ‘extravagant’.”

The Supreme Court found that “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.” Punishment is not a legitimate interest; a proper interest would be in seeking performance of the contract or some appropriate alternative to performance. The Supreme Court noted that with a straightforward damages clause, the interest will usually go no further than compensation for the breach, but that this is not necessarily the only legitimate interest that a party may have.

In ParkingEye v Beavis, the clause imposing the fine in the car park was found to be capable of being a penalty clause but was found, on the facts, not to be one. While ParkingEye did not make a loss as a result of people leaving a vehicle in the car park for longer than two hours, they did have a legitimate interest in changing them; the costs of their running the car park were met from the charges levied on motorists overstaying, and therefore the car park could be free for those who used it as prescribed and stayed for two hours or under. This did not mean that ParkingEye could charge a wildly high sum by way of a fine; the Supreme Court looked at the £85 figure and found that it was neither extravagant nor unconscionable. This was determined in part by an examination of charges in respect of on-street parking and local authority car parks; the charge was also less than the top-end figure suggested by the British Parking Association, an industry body. The figure was also held by the Court not to be in breach of the 1999 Regulations.

In Cavendish v Makdessi, opinion was divided over whether the clauses in question related to a secondary obligation at all; the leading judgment stated that the clauses were in fact a primary obligation and therefore could not fall within the penalty clause rule. Some of the other judges thought that they were secondary obligations and therefore were capable of being penalty clauses. This did not affect the outcome, as the judges then looked at the clauses as though they could have been subject to the rule and concluded that even if the clauses were secondary they were not penalty clauses. They came to this conclusion on the basis that Cavendish had a legitimate interest in ensuring that Mr Makdessi obeyed the non-compete covenants, as if he did not then the group could be worth much less than if he did obey them and could therefore provide a serious business risk to Cavendish.

Conclusion

This judgment, coming as it does at Supreme Court level, is likely to mean an increase in the use of clauses which under the previous law might have been considered potentially unenforceable as penalties, as parties will be more confident that such clauses will be upheld by the courts.

It may also mean that parties who might previously have taken the risk of breaching these clauses, because they would be confident of them being found unenforceable, may be more likely to adhere to the terms of the agreed contract.

Thank you to Henry Evans, trainee solicitor in our Corporate Department, for his help in preparing this article.

Contact the Author

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Alon Domb

After graduating from Manchester University with a BA Hons in Economics, I trained at Saunders Sobell and qualified in 1988. Before joining Gordon Dadds in 2014, I was a partner at Frank Charlesly & Co and head of the corporate department at Davenport Lyons. I have extensive experience in advising on M&A, joint ventures, structured real estate, corporate finance, partnership law and business affairs. Outside of work, I enjoy hiking, visiting the theatre and cinema, and spending time with my family.

Cassian Goode

Gordon Dadds