Tue 17 Nov 2015

Penalty Clauses: reinventing the ancient and haphazard

In a recent decision of the Supreme Court in the cases of Cavendish Square Holding BV v Talel Makdessi and Parking Eye Limited v Beavis the court has clarified the rule relating to contractual penalty clauses - a rule which Lord Neuberger and Lord Sumption described in the opening paragraphs of their decision as "an ancient, haphazardly constructed edifice which has not weather well".   Although both cases before the court concerned penalties, they proceeded on the basis of very different facts.  Cavendish related to penalties in the context of a commercial contract while Parking Eye dealt with the consumer law side of penalties and unfair contract terms imposed in the context of private parking restrictions.

The Penalty Rule

Penalty clauses in contracts are unenforceable because they are a contractual substitution for damages at common law.  When one person breaches their contract with another, causing them loss, the innocent party should, generally speaking, be entitled to recover their actual loss and nothing more. Accordingly, if the contract provides for a penalty payment to be made in the event of breach, that penalty is unenforceable.  For that reason the law has, for a long time, made a distinction between a penalty (which bears no relation to the loss actually sustained by the innocent party) and a genuine pre-estimate of loss (where the parties have tried, at least, to provide for payment of a contractual sum which more accurately reflects the loss suffered).

In looking at the test in a modern context, the court in the present cases started by considering the scope of the rule against penalties. The rule only regulates remedies available for a party on breach of contract, or secondary obligations.  It does not regulate the parties' primary contractual obligations. Further, while penalty clauses typically set out a figure payable in damages for breach, the rule against penalties also applies against clauses which set out other consequences for a breach, for example: clauses which provide for withholding payments on breach (which may also be contrary to rules on forfeiture); clauses regulating the transfer of property on breach; or, clauses requiring a purchaser to pay an extravagant or non-refundable deposit on breach. 

With the scope of the penalty rule determined, the Supreme Court then moved on to look at the true test for a penalty clause.  The court was unanimous in agreeing that, as Lord Neuberger and Lord Sumption put it, "The law relating to penalties has become the prisoner of an artificial categorisation, itself the result of an unsatisfactory distinction: between a penalty and a genuine pre-estimate of loss; and between a genuine pre-estimate of loss and a deterrent" largely due to an overliteral reading of previous authorities. Whether a clause was a genuine pre-estimate or whether it was a deterrent was not relevant. The only question that needs to be asked is whether it is penal. The test formulated by Lord Neuberger and Lord Sumption was whether the impugned provision is a secondary obligation (i.e. one which applies on breach of contract) which imposes a detriment on the contract breaker out of all proportion to the legitimate interest of the innocent party in the enforcement of the primary contractual obligation.  Lord Hodge, while agreeing with the majority, expressed the rule slightly differently and his succinct formulation of it found favour with other members of the court. He said that: "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 interests in the performance of the contract".

Despite the slight difference in formulation of the test, the Supreme Court's clarification of the application of penalty clauses is very welcome.  The court also resisted calls from certain parties to the appeal to abrogate penalty clauses entirely and declined an invite to judicially to abolish them primarily on the bases that: parties are free to contract as they please; that abolition will not cure disparities in the negotiating position of the parties; and, that in other jurisdictions the scope of penalty clauses is expanding.  Against that background, the actual results of the two cases are perhaps of less general importance but it's still interesting to see the application of the penalty rule in practice.

The Cavendish Case

Mr Cavendish had bought a business from Mr Makdessi who had entered into restrictive covenants undertaking not to compete with the sold business. The contract between the parties provided that if Mr Makdessi breached his restrictive covenants he would: (a) not be entitled to the two final instalments of the price paid by Cavendish and; (b)  would be required to sell his remaining shares to Cavendish at the price which excluded the value of the goodwill of the business.  Mr Makdessi breached his covenants but argued in court that these clauses were unenforceable penalties. 

The court took the view that there was a strong argument that the clauses were in fact primary obligations and that the penalty rule was not applicable at all. However, if the rule did apply, the court held that the clauses were not unenforceable. The clauses were just a method of price adjustment so, although what was provided in the contract bore no relation, even an approximate one, with the loss which Cavendish suffered on breach, Cavendish still had a legitimate interest in these restrictions being observed which went beyond the recovery loss.  They were designed to encourage "loyalty" and as Lord Neuberger and Lord Sumption explained: "Loyalty is indivisible.  Its absence in a business like this introduces a very significant business risk whose impact cannot be measured simply by reference to the known and provable consequences of particular breaches.  It is clear that this business was worth considerably less to Cavendish if that risk existed and it did not."

The court took the view that the value that was to be put on that loyalty was a matter for the parties. Both parties were sophisticated, successful and experienced commercial business people bargaining on equal terms over a long period with the benefit of expert legal advice and, therefore, the parties themselves were the best judges of the degree to which each of them should recognise the proper commercial interests of the other.  Cavendish had a legitimate commercial interest to protect by making the deferred consideration and the sale of shares dependent on the continued loyalty of Makdessi through compliance with the covenants.  The clauses were not exorbitant nor unconscionable and were consistent with the protection of Cavendish's legitimate business interest.

The Parking Eye case

The Parking Eye matter was more straightforward.  Parking Eye was a private car park business which regulated parking on certain private land not owned by them. It was accepted by all the parties that Parking Eye suffered no loss when a car overstayed in one of the car parks under their control.  Nonetheless, Parking Eye did have a legitimate interest to protect and that interest would justify the levy of a charge albeit one which was not exorbitant.  When deciding whether a charge was exorbitant (and therefore a penalty) the question was ultimately a value judgment for the court and in the present case the sum of £85 for overstaying was not regarded as such.

The majority of the court also found that the charges did not contravene the Unfair Contract Terms for Consumers Regulations 1999 primarily because there was no significant imbalance between the parties when a motorist was given the privilege to park free for 2 hours in return for a promise to pay a reasonable sum for overstaying.  Lord Toulson, however, did not agree with the majority on the unfair contract terms point.  He considered that the majority had substituted its own view on reasonableness for the true question which should have been asked, namely, whether Parking Eye could reasonably have assumed that the customer would have agreed to the terms when they parked if the contract between the parties had been individually negotiated with both parties taking the benefit of legal advice. 

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