Not A Penalty Kick: Supreme Court reconfigures the test for penalties
09 May 2016
What are penalty clauses?
It is often the case that a party to a commercial contract will seek to include provisions which incentivise the other party to perform its obligations or, more accurately, seek to make the other party think twice (or more) about failing to keep up its end of the bargain by stipulating particularly onerous consequences (often taking the form of a financial sum being payable by the offending party). Although it is possible to provide for liquidated damages claims of this nature in a manner which is permissible and legally enforceable, it is often the case that clauses of this nature are drafted with little thought given to whether the damages are manifestly excessive or unreasonable having regard to the nature of the default or what the consequences of the default will be on the injured party. The courts have shown themselves willing to step in and determine that provisions of this nature have overstepped the bounds of what is acceptable and into the territory of being “penalty clauses”.
The test of what is or is not a penalty clause has usually been stated to hinge on whether the provision provides for a sum representing a genuine pre-estimate of damages (and therefore a liquidated damages provision which the courts will enforce) or something beyond what could reasonably be considered to be a genuine pre-estimate of the damages that would be likely to result (and therefore a penalty clause which the courts will not enforce). The traditional test was set out by the House of Lords in Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd  AC 79. In Dunlop, Lord Dunedin referred to four tests to determine whether a clause is an unenforceable penalty:
· The provision would be penal if the figure is extravagant and unconscionable in comparison to the greatest loss that could conceivably follow the default in question.
· The provision would be penal if the breach consisted only in the non-payment of money and the provision provided for the payment by a defaulting party of a larger sum than it had failed to pay.
· There was a presumption that the provision would be penal if the sum was payable in a number of events of varying degrees of seriousness – although that presumption was capable of being displaced.
· The provision would not automatically be regarded as penal due to the difficult or impossibility of accurately or precisely pre-estimating the liely adverse financial consequences of the default.
The test is reasonably easy to state but it has proved harder in practice to interpret or determine with any real degree of certainty and it has often been mooted that the Supreme Court might welcome an opportunity to bring some valuable clarity to the position on penalty clauses. In a judgement delivered on 4 November 2015, the Supreme Court was afforded the opportunity to consider what makes a contractual provision penal when considering two appeal cases, namely Cavendish Square Holding BV v Talal El Makdessi; ParkingEye Limited v Beavis  1 LRC 631.
Details of the cases
The first appeal involved a share purchase agreement between Cavendish Square Holding BV (“Cavendish”) and Mr Makdessi and Mr Ghossoub (the “Sellers”) in relation to shares in Y & R Holdings Hong Kong Ltd (the “Company”). Amonsgt other things, the share purchase agreement provided for the purchase price to be paid in several stages. One of the Sellers, Mr Makdessi, breached a provision in the share purchase agreement prohibiting him from participating or engaging in competitive or potentially competitive activity. The share purchase agreement provided that a breach of the relevant restriction would result in him forfeiting any entitlement to receive the full payments which would otherwise have been due and also to sell the remainder of his shares in the Company as a discounted value. Mr Makdessi argued that these provisions represented unenforceable penalty clauses. Mr Makdessi failed at first instance but the Court of Appeal held that the two provisions were unenforceable penalties under the penalty rule as it was traditionally formulated.
In the second appeal, Mr Beavis was the owner and driver of a vehicle which he had parked in a retail shopping car park adjacent to Chelmsford railway station. The owner of the retail site and car park had engaged ParkingEye Ltd (“ParkingEye”) to provide ‘a traffic space maximisation scheme’ involving limitations on the maximum period of time for parking in the car park and a parking charge of £85 being charged for non-compliance. Mr Beavis left his car parked for almost an hour beyond the maximum period allowed and was required to pay the parking charge. The claimant maintained that the £85 charge demanded of him by ParkingEye (reducible to £50 if he had paid within 14 days) was an unenforceable penalty. ParkingEye acknowledged that £85 was payable upon a contravention of the terms and was not a pre-estimate of damages; the purpose of the £85 charge, it had contended, was twofold; it allowed effective management of the parking spaces, by deterring long-stay drivers from occupying spaces for long periods of time, and secondly it produced revenue to enable ParkingEye to operate the scheme and profit. Mr Beavis’ claim failed at first instance and also when appealed to the Court of Appeal.
Both Cavendish and B appealed to the Supreme Court.
A new approach
In their joint leading judgement, Lords Neuberger and Sumption emphasised their dissatisfaction with the traditional approach to the rule and what they considered to be unsatisfactory and impractical distinctions that exist between a penalty, a genuine pre-estimate of loss, and a deterrent; per their Lordships: “the law relating to penalties has become the prisoner of artificial categorisation”.
Lords Neuberger and Sumption made clear their view that the question to be asked by courts asked to determine the question of a penalty clause was, self-evidently, whether the clause has a penal effect: “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 fact that the clause is not a pre-estimate of loss does not therefore, at any rate without more, mean that it is penal. To describe it as a deterrent does not add anything.” Warming to that theme, their lordships continued: “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. The innocent party can have no proper interest in simply punishing the defaulter. His interest is in performance or in some appropriate alternative to performance. In the case of a straightforward damages clause, that interest will rarely extend beyond compensation for the breach, and we therefore expect that Lord Dunedin’s four tests would usually be perfectly adequate to determine its validity. But compensation is not necessarily the only legitimate interest that the innocent party may have in the performance of the defaulter’s primary obligations.”
The Supreme Court held that the provisions in question did not constitute penalty clauses for the following reasons.
Cavendish v El Makdessi
· A contractual provision may in some circumstances be a penalty if it disentitles the contract-breaker from receiving a sum of money which would otherwise have been due to him but whether it will actually constitute a penalty depends on the nature of the right of which the contract-breaker is being deprived and the basis on which he is being deprived of it. It is not a proper function of the penalty rule to empower the courts to review the fairness of the parties’ primary obligations, such as the consideration promised for a given standard of performance. The consideration due to one party may be variable according to one or more contingencies, including the contingency of his breach of the contract. There is no reason in principle why a contract should not provide for a party to earn his remuneration, or part of it, by performing his obligations. If as a result his remuneration is reduced upon his non-performance, there is no reason to regard that outcome as penal.
· Although the contractual provision had no relationship, even approximate, with the measure of loss attributable to the breach, Cavendish had a legitimate interest in the observance of the restrictive covenants which extended beyond the recovery of that loss. It had an interest in measuring the price of the business to its value. The goodwill of this business was critical to its value to Cavendish, and the loyalty of Mr Makdessi and Mr Ghossoub was critical to the goodwill.
· The court cannot know what other provisions of the agreement would have been different, or what additional provisions would have been included on that hypothesis as these are matters for negotiation rather than forensic assessment. They were matters for the parties, who were, on both sides, sophisticated, successful and experienced commercial people bargaining on equal terms over a long period with expert legal advice and were the best judges of the degree to which each of them should recognise the proper commercial interests of the other.
· Price adjustment clauses are open to abuse, and if the relevant provision were a disguised punishment for the Sellers’ breach, it would make no difference that it was expressed as part of the formula for determining the consideration. In the circumstances of this case, however, the Supreme Court considered that there was no basis on which it could reach such a conclusion.
· In respect of the share forfeiture clause, the same legitimate interest justified the enforceability of that provision. It was an interest in matching the price of the retained shares to the value that the Sellers were contributing to the business. There is a perfectly respectable commercial case for saying that Cavendish should not be required to pay the value of goodwill in circumstances where Mr Makdessi’s efforts and connections are no longer available to the Company, and indeed are being deployed to the benefit of the Company’s competitors, and where goodwill going forward would be attributable to the efforts and connections of others.
ParkingEye v Beavis
· It was held that the £85 charge was not a penalty. Although ParkingEye was not liable to suffer loss as a result of overstaying motorists, it had a legitimate interest in charging them which extended beyond the recovery of any loss. The scheme authorised ParkingEye to control access to the car park and to impose the agreed charges, with a view to managing the car park in the interests of the retail outlets, their customers and the public at large. That was an interest of the landowners because: (i) they received a fee from ParkingEye for the right to operate the scheme; and (ii) they leased sites on the retail park to various retailers, for whom the availability of customer parking was a valuable facility. It was an interest of ParkingEye, because it sold its services as the managers of such schemes and met the costs of doing so from charges for breach of the terms. The Court emphasised that “[d]eterrence is not penal where 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.”
These cases indicate that a slightly less prescriptive approach may need to be taken by parties and their lawyers to interpreting potential penalty clauses and that a fuller, more rounded appreciation of the parties’ intentions, objectives and bargaining positions needs to be borne in mind when making any assessment of these clauses. Just as importantly, particular care and attention needs to be paid to the way in which these provisions are drafted to ensure that they accurately and adequately reflect what the parties are hoping or intending to achieve.
It remains to be seen exactly how the reformulated and clarified test will be applied but there would appear to be at least a number of practical points that ought to be borne in mind.
· The courts will always looks very closely at the commercial context of a contract in interpreting it and ruling on its effect and a draftsman would be well-advised to ensure that, where the relevant provision sets out to a achieve a legitimate business objective, that legitimate business objective can be discerned from reading the contract.
· Building on that theme, a party seeking to include, and rely on, a liquidated damages clause should consider the inclusion of a brief description of how the amount specified justifies protection of the party’s legitimate commercial interest.
· It would be advisable to frame provisions of this nature as primary obligations reflecting the key or principal purposes of the parties rather than secondary or collateral purposes. This case indicates that the penalty rule will be confined to those obligations considered by the courts to constitute secondary or collateral obligations only.
· The courts will be loathe to interfere with the apparent intentions of the parties when faced with a negotiated contract between properly advised parties of comparable bargaining power; the Supreme Court stated that “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 traditional test of whether or not a provision provides a genuine pre-estimate of loss will remain relevant in straightforward cases but the new formulation of the test allows courts to explore and recognise the commercial realities of parties’ intentions and business relationships.