Contract Update - A Case of the Lesser Spotted Penalty Clause

Contracts may contain terms which set out what remedy the innocent party may claim in the event of breach by another. This is normally financial but may include the transfer of property or some other transaction of value to the innocent party.

In English contract law liquidated damages clauses are enforceable but penalty clauses are not. This has caused many difficulties to contracting parties when negotiating contracts. It follows that it is therefore a fertile ground for disputes.

The two appeal cases of Cavendish Square Holding BV v Talal El Makdessi and ParkingEye Lmited v Beavis were heard together and gave the Supreme Court the opportunity to consider the rule against penalties and its application in a modern, commercial context.

Why the case is important

The decision is the first of the Supreme Court and its predecessor, the House of Lords, on the scope and application of the rule against penalties for almost a century. Contractual terms susceptible to being penalties are very commonly found in commercial agreements so the case has far reaching implications for contracts generally.

Common examples of terms that may be considered as being penalties include:

Liquidated damages clauses;
Exit provisions in a joint venture/shareholders' agreement where a non-defaulting party can buy out a defaulting party at a discount;
Provisions in sale and purchase agreements where deferred consideration is not to be paid where the seller is in breach of contract; and
Liquidated damages provisions in commercial contracts used as agreed financial remedies for breaches of late delivery or minimum commitment (take-or-pay) provisions in supply contracts.

It is worth noting that given the similarities between English law and the law of other common law countries, this decision is expected to reverberate globally.

Classic Test

The rule against penalties is based on the position in English law that on breach of a contract an innocent party should be compensated for loss and that clauses which are penal or exist to act as a deterrent for breach of contract are not valid.

The classic test of whether a clause is a "genuine pre-estimates of loss" – if it is it will be enforceable, if not, it will be a penalty – has stood for a century.

Supreme Court Decision

The Supreme Court re-affirmed that the rule against penalties still has a place in the modern world of commercial contracts. This is despite some calling for its abolition. However, the classic test of whether a clause is a "genuine pre-estimates of loss" has been substantially modified.

Seven of the Lord Justices heard the case with five of the seven providing written decisions highlighting the importance of the case. The Court was unanimous that the doctrine of penalties should not be abolished, but was divided on its scope and the relevant test to be applied. The shift in focus from the classic test is towards a test of "extravagance", "unreasonableness and deterrence", and a greater emphasis on "legitimate interests" and "punishment".‎

Very briefly (the judgment runs to 124 pages and is available here) the judges held:

In Makdessi, the price formula in the sale and purchase agreement had a genuine function which had nothing to do with punishment and everything to do with achieving Cavendish's commercial objective of acquiring the business. The amount in question was not 'excessive' in its nature. They had a substantial legitimate interest to protect which depended on the continued loyalty of the seller through his compliance with the terms of the agreement. The Court was further convinced by the fact that the parties were highly experienced in commercial affairs and had been advised by reputable solicitors.

In ParkingEye, the Supreme Court held that a £85 fine levied for a parking ticket had two purposes. The first was to manage the efficient use of parking spaces in the interest of retail outlets and other consumers and secondly to provide an income stream to enable ParkingEye to meet the costs of operating their legitimate business scheme.

In holding the above, the Court has accepted and confirmed that liquidated damages can be more than a genuine pre-estimate of loss and can in fact protect a legitimate commercial interest. Therefore, when drafting, be clear as to what is to be compensated and if possible the commercial interest being protected.

The judgment will give more leeway to commercial parties negotiating contracts to decide what the consequence of a breach should be with greater confidence that what they agree will be enforceable. However, the test is as vague as it was previously and will be subject to the specific facts of each individual case. As a result there is little likelihood that this is the end of the fertile ground for disputes and further cases on interpretation of the new, expanded test is sure to follow.

The official Supreme Court summary which at 3 pages is substantially shorter than the 124 judgement, can be viewed here.