The Supreme Court’s decisions in Cavendish Square Holding BV (Appellant) v Talal El Makdessi (Respondent), ParkingEye Limited (Respondent) v Beavis (Appellant)1 Freedom of contract is at the very heart of English civil law. The rationale is that parties should be free to make their own bargains and be held to them without Court interference. However, as with many closely held principles, English law’s
commitment to freedom of contract is not absolute.
One of the more controversial exceptions is the common law “rule against
penalties”, which may typically be engaged when a contract provides that a party in breach must pay a pre-determined sum of money to the innocent party (otherwise known as “liquidated damages”) or provide some other compensation to the innocent party (for example, where a contract provides that rights will be lost or assets transferred at an undervalue).
The traditional approach of the English Courts has been that, if the relevant terms of the contract are intended to be a deterrent to breach rather than a genuine pre- estimate of the loss that might be suffered by the innocent party upon breach, the contractual provision may be held to be unenforceable as a penalty.
Since the turn of the millennium a different tack has been taken by the Courts, such that even if the liquidated damages are not a genuine pre-estimation of loss, the clause providing for them may not be penal (and therefore unenforceable) if it can
1 [2015] UKSC 67
● ON 4 NOVEMBER 2015 THE RULE AGAINST PENALTIES IN COMMERCIAL CONTRACTS CAME UNDER THE
SCRUTINY OF A SEVEN JUDGE PANEL OF THE SUPREME COURT.
● THIS BRIEFING CONSIDERS THE SUPREME COURT’S JUDGMENT IN THOSE CASES AND THE
CONSEQUENCES FOR THE
LAW ON PENALTIES.
be otherwise commercially justified. Examples of clauses which have been held to be enforceable because they are commercially justified include a clause charging increased interest on a defaulting loan, a clause requiring the payment of the costs of the original litigation between the parties in the event of a breach of the settlement agreement and a clause awarding the innocent party a generous measure of damages for wrongful dismissal.
On 4 November 2015 the rule against penalties came under the scrutiny of a seven judge panel of the Supreme Court in a landmark judgment of two cases raising similar issues. The questions to be considered were not limited to whether the clauses in issue constituted penalties, but whether the rule against penalties should be reformed or even scrapped in its entirety. The Supreme Court’s judgment in those cases, and the consequences for the law on penalties, are considered in detail below.
Cavendish and ParkingEye
The two cases gave the Supreme Court the opportunity to address the role of the rule against penalties first in a commercial contract of sale and second in a consumer contract. In summary, the relevant facts were:
a) In Cavendish, Mr Makdessi had sold a majority interest in his business to Cavendish. The contract of sale allocated a very large payment for goodwill but clauses 5.1 and 5.6 respectively provided that if Mr Makdessi breached contractual restrictive covenants relating to non-competition (regardless of the severity of the breach) he would no longer be entitled to around US$44 million in unpaid instalments otherwise owed to him and Cavendish could exercise an option to purchase Mr Makdessi’s remaining
shareholding at a price which did not apportion any value to goodwill. Mr Makdessi breached the non-competition covenants and, when Cavendish sought to rely on clauses 5.1 and 5.6, alleged that those clauses were unenforceable as penalties. The High Court found in favour of Cavendish under the commercial justification test, but the Court of Appeal found in favour of Mr Makdessi, relying more closely on the traditional rule against penalties.
b) In ParkingEye, Mr Beavis had parked at a car-park which permitted free parking for a stay of up to two hours, but imposed a fine of £85 for any overstay. Mr Beavis left his car there for 2 hours and 56 minutes, was fined
£85 and appealed the fine as a penalty under common law and as contrary to the Unfair Terms in Consumer Contracts Regulations 1999 (although this note only addresses the penalty question). Both the High Court and the Court of Appeal rejected Mr Beavis’ case and upheld the fine.
The Supreme Court held (with no dissent on this point) that the relevant clauses in both cases were not penalties and were enforceable.
Further, the judges of the Supreme Court were unanimous in declining to abolish or to expressly modify the scope of the rule against penalties. Instead, the judgments were each based on what the judges supposed to be the true meaning of the previous authorities. In particular, the Court recognised that the rule has a useful role in protecting parties against oppressive bargains, particularly where a statutory
“THE TWO CASES GAVE THE SUPREME COURT THE OPPORTUNITY TO
ADDRESS THE ROLE OF THE RULE AGAINST PENALTIES FIRST IN A COMMERCIAL CONTRACT OF SALE AND SECOND IN A CONSUMER
CONTRACT.”
regime is not in place to offer that protection and that many jurisdictions (both common law and civil law) have recognised such a rule.
The test for a penalty clause
The Supreme Court judges took subtly different approaches to this question, although were unanimous in their view that the test is not limited to the binary question of whether a clause is a genuine pre-estimate of loss or a deterrent.
In the leading judgment, Lords Neuberger and Sumption (with whom Lord Carnwath agreed) held that the test is whether the relevant clause “imposes a detriment on the contract-breaker out of all proportion to any legitimate interest of the innocent party in the enforcement” of its primary obligation. Lord Hodge and Lord Mance (with whom Lord Toulson agreed) found the test to be that (in Lord Hodge’s words) “the correct test for a penalty is whether the sum or remedy stipulated as a consequence of a breach of contract is exorbitant or unconscionable when regard is had to the innocent party’s interest in the performance of the contract.” It is unclear whether there was intended to be a distinction between a remedy “out of all proportion” and one which is “exorbitant and unconscionable”, but in any case Lord Clarke appears not to have thought so as he agreed with each of Lord Sumption, Lord Neuberger, Lord Hodge and Lord Mance.
Whether or not there is ultimately found to be any difference in these tests, it is apparent that there will still be straightforward cases where the innocent party has no interest in the performance of the primary obligation beyond the receipt of liquidated damages so that the required analysis may be limited to whether those specified damages are a genuine pre-estimate of the loss of the innocent party.
However, in more complex cases, compensation is now clearly not necessarily the only legitimate interest that the innocent party might have in the performance of the defaulting party’s primary obligations. Such cases will require a detailed analysis of the interests of the innocent party, at the time the contract was made, in requiring performance of the primary obligation by its counterparty.
Application to the facts
Applying that test to the Cavendish case, the Supreme Court found that Cavendish had a “substantial” and “legitimate interest” in protecting the goodwill of the business it was purchasing, because that goodwill was critical to its value to Cavendish and Mr Makdessi’s loyalty was critical to the goodwill. Cavendish obtained that protection by providing a strong financial incentive to Mr Makdessi to remain loyal to the company and not to compete with it. Similarly, Cavendish had a legitimate interest in matching the price of the shares to the value that Mr Makdessi was contributing to the business. Clauses 5.1 and 5.6 were therefore found to be legitimately “addressing the disloyalty of a seller who was prepared to attack the company’s goodwill”. That loyalty was found to be entirely undermined when Mr Makdessi breached a restrictive covenant not to compete with the business he was selling, regardless of the severity of the breach. Despite the very significant financial consequences to Mr Makdessi, the Supreme Court were not satisfied that the effect of clause 5.1 and 5.6 was “out of all proportion” to or “exorbitant or unconscionable”
in light of that legitimate interest of Cavendish.
In ParkingEye, even though it was accepted that the fine of £85 was not a genuine pre-estimate of loss (in fact there was found to be no financial loss whatsoever), it
“...COMPENSATION IS
NOW CLEARLY NOT
NECESSARILY THE ONLY
LEGITIMATE INTEREST THAT
THE INNOCENT PARTY
MIGHT HAVE IN THE
PERFORMANCE OF THE
DEFAULTING PARTY’S
PRIMARY OBLIGATIONS.”
was held not to be a penalty. The fine was found to be an “understandable
ingredient” of a parking scheme serving the legitimate interests of the operator of the car-park to: (i) manage the use of available parking space and (ii) provide the only income stream available to the operator which allowed it to offer two hours of free parking to its customers.
The future of penalty clauses
The decisions of the Supreme Court emphasise the desire of the English Courts to hold parties to the bargains that they have willingly made and extend the
circumstances in which the contract terms will be enforced far beyond those under the traditional test. From the point of view of certainty of contractual relations, this is to be welcomed.
However, it is difficult to predict precisely how the various tests expounded by the judges will be interpreted in future. In a case of such importance to commercial parties, it would have been preferable for the judges to have agreed upon a single formulation of the relevant principles, particularly in circumstances where there is (apparently) no dispute in substance. After all, much of the previous uncertainty concerning the law on penalties arose from a decision given by the House of Lords 100 years ago in which a number of different judgments were given.
A final point of note is that Lords Sumption and Neuberger placed some emphasis on the context in which the contract was made in reaching their decision, stating 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…”. The other judges also relied (apparently to a lesser extent) on these principles.
A further outcome of this decision may therefore be that whilst the rule on penalties will continue to apply to commercial contracts (which Cavendish argued
unsuccessfully against in principle), in practice where the parties had equal bargaining power and reputable advice when the contract was made, the hurdle which must be surmounted to prove a clause a penalty will be a very high, if not unreachable, one. In those transactions, the lesson to be taken from the Supreme Court’s judgment is that parties need to be increasingly wary of agreeing to clauses providing for pre-determined remedies for breach of contract, given that the scope for later arguing that those clauses are penalties may be greatly reduced.
“THE DECISIONS OF THE SUPREME COURT
EMPHASISE THE DESIRE OF
THE ENGLISH COURTS TO
HOLD PARTIES TO THE
BARGAINS THAT THEY
HAVE WILLINGLY MADE...”
Should you like to discuss any of the matters raised in this Briefing, please speak with the authors below or your regular contact at Watson Farley & Williams.
ANDREW WATERS Partner
London
+44 20 3036 9815 awaters@wfw.com
BEN LAMBLE Senior Associate London
+44 20 3036 9848 blamble@wfw.com
Publication code number: 57152751v1© Watson Farley & Williams 2015
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