Supreme Court shifts test away from “genuine pre-estimate of loss” but declines to abolish rule against penalties
Cavendish Square Holding BV v. Talal El Makdessi; ParkingEye Limited v. Beavis  EWSC 67
In two conjoined appeal decisions recently handed down, the UK Supreme Court has re-focused the long-established test for identifying a penalty clause, but has declined to abolish the rule against the unenforceability of penalties altogether. The decision is consistent with the general trend of the courts in recent years to become more reluctant to interfere with the parties’ freedom of contract and particularly so in a commercial context. This is highlighted by an acknowledgement in the lead judgment by Lords Neuberger and Sumption that:
“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”.
The brief background facts
In Cavendish v. El Makdessi, Mr Makdessi agreed to sell his controlling stake in a company to Cavendish. The sale contract provided that if Mr Makdessi breached certain restrictive covenants, he would not be entitled to receive the final two instalments of price for his shares and he would also be obliged to sell his remaining shares to Cavendish for a reduced amount that did not take into account any goodwill. Mr Makdessi breached the restrictive covenants and then subsequently challenged the clauses in question on the grounds they were unenforceable penalties.
In ParkingEye v. Beavis, Mr Beavis challenged the levy of an £85 parking charge for having overstayed the two-hour time limit permitted in a car park in a retail centre. ParkingEye managed the car park and displayed numerous notices throughout, clearly stating that a failure to comply with the two hour time limit would “result in a Parking Charge of £85”. Mr Beavis argued that the £85 charge was unenforceable as a penalty (and/or unfair and unenforceable by virtue of the Unfair Terms in Consumer Contracts Regulations 1999).
Penalty clauses under English law: the traditional position
Under English law, a contractual provision requiring a contract breaker to pay the other party a specified sum of money in the event of a breach of contract has traditionally been treated either as:
a. an enforceable requirement to pay liquidated damages if the amount concerned is regarded as a genuine pre-estimate of loss; or
b. an unenforceable penalty – when the amount concerned is not a genuine pre-estimate of loss but in the nature of a deterrent against breach.
In order for a clause to be penal, the traditional view was that the sum that the contract breaker is required to pay must be “extravagant and unconscionable in amount in comparison with the greatest loss which could conceivably be proved to have followed from the breach”. Consequently, the comparison usually made was between the loss that would likely be incurred by the innocent party relative to the amount payable pursuant to the clause.
The Supreme Court decision
The Supreme Court upheld the validity of the disputed clauses in both appeals; albeit for different reasons. In Cavendish, the Supreme Court distinguished between “primary obligations” (i.e. those obligations that are required to be performed by the terms of the contract) and “secondary obligations” (i.e. obligations that are triggered by a breach) and held that the clauses in that case were in the nature of primary obligations and therefore not susceptible to the rule against penalties.
In ParkingEye, the Supreme Court found that although the parking charge did potentially engage the penalty rule, the level of the charge was not such as to constitute a penalty. The Supreme Court stated that “deterrence is not penal 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”. In that case, the legitimate interest was ensuring the efficient use of the car park by seeking to prevent users overstaying the two hour time limit which, in turn, benefitted ParkingEye.
Therefore, the Supreme Court has in effect shifted the focus from the loss that could conceivably have resulted from the breach as being the key question in identifying whether a contractual provision is penal. Rather, even where a damages clause imposes a liability in excess of that which the innocent party might suffer by reason of the breach, the clause may properly be justified by other considerations. This will depend on whether the innocent party had a “legitimate interest” in performance of the contract extending beyond the damages it would otherwise be entitled to receive from the contract breaker.
Following this decision, the question so far as enforceability of the relevant provision is concerned will be whether it is penal, not whether it is a genuine pre-estimate of loss. Therefore, a clause may require a payment that significantly exceeds a pre-estimate of loss but that will not necessarily make it penal.
The true test is whether the relevant provision imposes a detriment on the contract breaker that is out of all proportion to any legitimate interest of the innocent party in enforcement of the primary obligation. While the various Lord Justices take slightly different approaches, essentially the key questions are whether:
a. there is a legitimate business interest served and protected by the clause; and
b. the contractual provision to protect that interest is extravagant, exorbitant or unconscionable
If the clause satisfies a legitimate business interest and is not extravagant, exorbitant or unconscionable, it will be enforceable. In order to fail the latter part of the test, the provision would effectively require a detriment to the contract breaker out of all proportion to the legitimate interest of enforcement by the innocent party.
Consequently, when considering whether a clause is penal, it is not just the financial loss that would have been suffered as a result of the breach that is relevant. Potentially relevant factors in applying the test would be: whether others in the same industry impose similar charges; the indirect business cost to the innocent party of breaches of the relevant obligation; and whether the secondary obligation was brought to the contract breaker’s attention in an appropriate manner.
The Supreme Court has provided a welcome update of the law in relation to penalties. Parties must now have a greater expectation that provisions agreed by commercial parties on an equal footing will be enforced by the courts, providing the innocent party can show that the clause protects its legitimate business interest. Greater consideration will now be required at the drafting stage as to whether an obligation should be drafted as a primary obligation (which would avoid engagement of the rule against penalties) or a secondary obligation, and the distinction between the two is likely to provide fertile ground for disputes.