Supreme Court clarifies the position on penalty clauses
This article was produced by Nabarro LLP, which joined CMS on 1 May 2017.
Summary and implications
The Supreme Court has today handed down two important judgments in relation to penalty clauses, which go some way to clarifying the law in this area, and which will impact on how liquidated damages clauses in construction, engineering and infrastructure contracts are interpreted in the future.
The two cases are Cavendish Square Holding BV v Talal El Makdessi (Cavendish) and ParkingEye Limited v Beavis (ParkingEye). The facts of the cases are summarised below.
Cavendish
Mr Makdessi and Mr Ghossoub, founders and owners of the largest advertising and marketing communications group in the Middle East (the Group), entered into an agreement to sell 47.4 per cent of The Group to Cavendish (giving Cavendish a stake of 60 per cent overall).
Under the terms of the agreement, Mr Makdessi was obliged to refrain from competing activities for a number of years. If he did not comply with these restrictive covenants, the contract stipulated that:
- he would no longer be entitled to two of the payment instalments still due to be paid (clause 5.1); and
- he could be required to sell his remaining holding in The Group to Cavendish, for a sum ignoring any value for goodwill (clause 5.6).
The effect of the clauses was that Mr Makdessi could receive up to $44,181,600 less for his share of the Group if he breached clauses 5.1 and 5.6.
By the time the case went to trial, the fact that Mr Makdessi had breached the restrictive covenants was not in dispute. He alleged that clauses 5.1 and 5.6 constituted penalty clauses, and were therefore unenforceable.
ParkingEye
ParkingEye was the manager of a car park at a retail park.
Numerous notices around the car park stated that a failure to comply with the two hours free parking 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. He refused to pay the £85 charge arguing that it was unenforceable as a penalty and / or unfair and unenforceable by virtue of the Unfair Contract Terms in Consumer Contracts Regulations 1999.
The clauses in both cases were held not to be penalties and the reasoning of the Supreme Court is set out below.
Summary of comments from the Supreme Court
- There is still a place in English law for the penalty rule despite the Supreme Court noting that, “The penalty rule in England is an ancient, haphazardly constructed edifice which has not weathered well …”.
- However, the law relating to penalties has become "the prisoner of artificial categorisation", with unsatisfactory distinctions being drawn between a penalty and a genuine pre-estimate of loss and a genuine pre-estimate of loss and a deterrent.
- The established test set out by Lord Dunedin in Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd [1915] AC 394 has been applied over-literally and did not reflect the complexity of modern commercial transactions.
- The real question when a contractual provision is challenged as a penalty is whether it is penal (i.e. a punishment), not whether it is a genuine pre-estimate of loss. The fact that a clause is not a genuine pre-estimate of loss does not necessarily mean that it is penal.
- To describe a clause as a 'deterrent' does not add anything – a deterrent is just another provision in a contract designed to influence the conduct of a party. Whether a deterrent provision is enforceable will depend on the means by which the contracting party's conduct is to be influenced are "unconscionable" or "extravagant" by reference to some norm.
The True Test
The true test for whether a clause is a penalty, as set out by Lord Neuberger in Cavendish, 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".
The interest of the innocent party will usually be in the performance of the contractual obligations or some other appropriate alternative to performance.
In relation to straightforward damages clauses, this interest will rarely extend beyond compensation for the breach. But, compensation is not necessarily the only legitimate interest that the innocent party may have in the performance of a defaulting party's primary obligations.
Cavendish Square Holding BV v Talal El Makdessi
The Supreme Court allowed the appeal of Cavendish on the basis that the penalty rule had not been engaged on the basis that clauses 5.1 and 5.6 were primary obligations and not secondary provisions i.e. the clauses could not be treated as invalid without re-writing the contract and it was not for the Court to assess the fairness of those provisions.
Whilst clause 5.1 had no relationship, even approximate, to the measure of loss attributable to the breach, Cavendish had a legitimate interest in the observance of the restrictive covenants (in order to protect the goodwill of the business) which extended beyond the recovery of that loss.
Goodwill had been highlighted during the contract negotiations as very important – it was critical to the value of the business from Cavendish's perspective.
Whilst clause 5.6 may be described as a deterrent, it will only be invalid if the object was to punish. In this instance, it had a perfectly legitimate function which was to achieve Cavendish's commercial objective in acquiring the business.
Importantly, the agreement had been negotiated in detail over a considerable period of time and both parties were dealing on equal terms and with experienced and sophisticated professional advisors. On that basis, the parties were in the best position to negotiate the commercial position and reflect this properly in the contractual documents.
ParkingEye Limited v Beavis
The Supreme Court rejected the appeal of Beavis on the basis that whilst the penalty rule had been engaged, the charge was not a penalty.
As set out in Cavendish, a deterrent will not always be a punishment – particularly if there is a legitimate interest in influencing the conduct of the contracting party which is not satisfied by the mere right to recover damages for breach of contract. The charge protects against overstaying, which is important for the efficient management of the car park in the interest of the general body of users – it prevents the car park being clogged up with commuters and other long-stay users. Signs / notices were prominently displayed around the car park and the charge was not exorbitant in comparison with the general level of penalties imposed for parking violations.
Comments
These cases provide some welcome clarification to the law in this area and whilst they are not related to construction, engineering and infrastructure contracts, they will have an impact on how liquidated damages provisions in those contracts are likely to be interpreted going forwards.
The previous test of a 'genuine pre-estimate of loss' would seem to no longer be relevant. This is good news for owners and developers as on complex projects assessing the likely actual losses that will be incurred if a project is delayed can be difficult if not impossible.
Instead, what the Courts will be concerned with is whether the clause in question imposes a detriment on the contract breaker "out of all proportion to any legitimate interest of the innocent party". In determining this, the Courts will now consider the wider commercial context of a transaction. Even if the amount required by a clause bears no relationship to the loss actually attributable to the breach, it will not necessarily be a penalty if it can be shown that there is a legitimate reason why compensation for the actual loss suffered would not be sufficient. For example there may be significant reputational issues, or losses that are almost impossible to quantify, if a project is so delayed that a tenant or end user is entitled to walk away from the project.
In light of the decision in Cavendish, it seems that where parties have negotiated a contract, on a level playing field and with the assistance of professional advisors, it will now be much harder for the party paying liquidated damages to challenge the validity of those provisions on the basis that they are a penalty.
