Test for 'penalty' clauses reviewed
CAVENDISH SQUARE HOLDING v EL MAKDESSI and PARKINGEYE v BEAVIS (SC) [2015]
The Supreme Court (SC) has decided that the clauses challenged in the combined appeals of these two cases, which involved very different facts and financial sums, were not penalties and were consequently enforceable. In doing so, it questioned the ‘genuine pre-estimate of loss’ test previously used to determine whether a contractual provision is a penalty.
The ‘penalty rule’
The law relating to contractual penalty clauses essentially provides that if a term in a contract is considered to be a penalty, then it will be unenforceable and cannot be relied upon (penalty rule). This is not only a long-standing principle of English law which has existed since the 16th century but is common to many legal systems.
The penalty rule is generally applied in relation to liquidated damages clauses (also referred to as service credits in services agreements) which typically provide for an agreed sum to be payable if one of the contracting parties breaches a particular provision of the contract. The injured party only has to prove that the breach occurred not any actual loss, which is a major plus factor so far as a customer is concerned.
The law has developed over time such that to be enforceable, a liquidated damages provision must be a genuine pre-estimate of the likely loss and the amount stipulated must not be ‘extravagant and unconscionable’ compared with the greatest loss that could be proved to have resulted from the breach. Also, the purpose of the clause should be to compensate for any actual loss that may be suffered rather than to predominantly act as a deterrent to breach. Otherwise the clause may be considered a penalty and be invalid.
CAVENDISH SQUARE HOLDING v EL MAKDESSI
Facts:
- Cavendish Square Holding (C) entered into a sale and purchase agreement (SPA) under which it became the majority shareholder of a holding company for an advertising and marketing group. Mr Makdessi (M) was one of the selling shareholders and retained a minority shareholding in the holding company.
- The SPA provided that the money for the sale of M’s shares was to be paid in instalments linked to the group’s operating profits. He was also entitled to additional earn-out payments for the sold shares and a ‘put’ option in respect of his retained shareholding. The SPA contained extensive restrictive covenants which:
- prohibited M from competing with the group following the sale and provided that if M became a defaulting shareholder, including breaching any of these covenants, he would forfeit his rights to the earn-out payments and the put option; and
- required M to sell his remaining shares at a price ignoring the value of goodwill (ie at a much lower price).
- After the sale C claimed that M had breached the restrictive covenants because he was involved and interested in a competitor company. M argued that the forfeiture provisions in the SPA were unenforceable penalty clauses which would deprive him of millions of dollars when C had suffered no losses recoverable at law. C contended that the clauses were “commercially justified” in the circumstances.
- The High Court (HC) held that the defaulting provisions were not a penalty as their purpose was not to deter breach but to decouple the parties quickly and to adjust the consideration between them by reducing the price, which was substantially based on goodwill. The HC said the clauses had a commercial purpose and a commercial justification.
- M appealed to the Court of Appeal (CA) which overturned the HC decision and unanimously found that the relevant provisions in the SPA were unenforceable penalties.
- C then appealed to the SC.
PARKINGEYE v BEAVIS
Facts:
- ParkingEye (P) managed a car park in a retail shopping area. There were many signs around the car park clearly stating that if a driver stayed over the permitted two hours of free parking, there would be a charge of £85.
- Mr Beavis (B) parked his car for nearly three hours and when P charged him the £85 fee, he refused to pay. He was given the opportunity to get a discount in return for prompt payment and also to appeal. B declined to do either but instead argued that the parking charge was unenforceable as it was a penalty.
- B’s argument failed in the HC and the CA, which both found that the applicable provision was not a penalty and so P was entitled to charge the fee.
- B then appealed to the SC.
Decisions:
Despite the facts of the two cases varying significantly, the SC ruled on them both in a combined judgment and whilst C’s appeal was allowed, B’s was dismissed: neither of the relevant clauses was found to constitute a penalty and so they were both valid and enforceable.
Both appeals
- The SC stated that the penalty rule is "an ancient, haphazardly constructed edifice which has not weathered well" and that it was originally formulated for relatively simple transactions but that it has not kept up with the more complex commercial agreements that we often see today.
- It went on to refer to the ‘true test’ of whether a provision is a penalty. It said this is whether the disputed clause is a secondary obligation which makes the defaulting party suffer a detriment out of all proportion to any “legitimate interest of the innocent party” in relation to enforcing the primary obligation. Simply punishing the defaulting party is not a proper interest but the performance of the contract or some appropriate alternative to performance would be.
C’s appeal
- The SC made a distinction between ‘primary’ and ‘secondary’ contractual obligations:
- primary obligations are main requirements to do something under the contract (eg A shall do X);
- secondary obligations are those whose only purpose is to set out the compensation for the breach of a primary obligation, as an alternative to a standard claim for damages (eg A shall do X. If A does not do X, it will pay Y);
- a ‘conditional primary’ obligation is then one which may become effective on the breach of a primary obligation but is not necessarily compensation for that breach (eg A shall do X or pay Y).
- Having drawn this distinction, the SC said that a primary or conditional primary obligation cannot be treated as a penalty but a secondary obligation can.
- The restrictive covenants in the SPA were found to be primary rather than secondary obligations (akin to ‘price adjustment’ clauses) and so the penalty rule did not apply (although query whether that is actually an accurate analysis?). In any event, the object of the clauses was not to punish M – C had a legitimate interest in making sure the restrictive covenants were observed to protect the goodwill of the business, which extended beyond merely recovering loss resulting from their breach. The SC said the parties who were, "sophisticated, successful and experienced commercial people bargaining on equal terms over a long period with expert legal advice", were the best judges of how their proper commercial interests should be recognised in the contract.
B’s appeal
- The SC found that the requirement to pay the £85 charge was a secondary obligation and although the penalty rule applied, the fee was not considered to be a punishment and so it was upheld.
- In commenting on this, the SC said there were two main purposes of the overstay charge:
- to enable P to manage the efficient use of parking spaces and facilitate customers of the retail outlets being able to find parking spaces by deterring long-stay motorists from occupying spaces for lengthy periods; and
- to provide income for P so that it could meet the costs of operating the parking scheme and make a profit, without which the parking services would not be available.
- These two objectives appeared perfectly reasonable to the judges and P therefore had a legitimate interest in levying the charge which extended beyond simply the recovery of any loss which would have been minimal or even non-existent. In addition, the charge was not ‘unconscionable or extravagant’ in light of other car park practices around the UK and there were alternative parking areas that motorists could utilise. As a result, the £85 fee was not considered to be a penalty.
Points to note:
- The previous test of a 'genuine pre-estimate of loss' has been replaced with looking at whether the disputed provision results in the defaulting party suffering a detriment which is disproportionate to the injured party’s legitimate interest. Even if the amount set out does not strictly relate to the loss incurred due to the breach, it will not necessarily be a penalty if the innocent party can show that there is a justified reason why compensation for the actual loss suffered would be insufficient. Also, compensation may not necessarily be the only legitimate interest that the innocent party may have with respect to the performance of a defaulting party's primary obligations.
- The decision also confirms that the terminology used in the contract will not determine whether a provision will be held to be a penalty – this will depend on the substance of the provision and not on its form or on the label which the parties have chosen to attach to it.
- Where the contracting parties are both commercial entities, historically it has been comparatively rare for the Courts to declare a liquidated damages provision unenforceable for being a penalty. The outcome in El Makdessi confirms that this approach is likely to continue. Many commentators have suggested that the law on penalties has been radically re-written but we would argue that, in reality, although there has been a re-formulation of the law (and even then the SC still endorsed the test of whether a provision is ‘extravagant or unconscionable’ which the Courts have used for some time), the outcome in most cases will be much the same. In that sense the law has really just caught up with the conclusions that the Courts have been reaching for some time now. The reality is that it will continue to be extremely rare for provisions to be struck down for being a penalty.
- It was interesting that the Court did not find it objectionable that the charging regime operated by P allowed revenue to be generated to enable it to make a profit. It was also noteworthy that favourable comparisons with other car park operators’ practices were thought relevant in assessing the penal nature of the clause.