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Penalty Clauses: A Fresh Approach

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About The Author

Monish Kulkarni (Guest Contributor)

Monish is a recent GDL graduate from City University, and prior to that, studied History at Lincoln College, Oxford. He has a particular interest in commercial law, having observed a number of cases relating to contract and trusts law at the Commercial Court in London. In his spare time, Monish likes to travel, learn new languages and enjoys following cricket and boxing.

The penalty rule has long been a complex and controversial area of contract law. The rule applies to contractual provisions which call for a particular sum to be paid by the contract breaker to the innocent party in the event of a breach. In essence, provisions which require the payment of a sum so extravagant that they seek to deter the party from breach are considered penalties. They are unenforceable by the court. On the other hand, a provision requiring payment of a reasonable pre-estimate of loss, allowing the parties to easily calculate and predict damage, can be an enforceable liquidated damages clause.

The approach followed until now can be summarised by Lord Dunedin’s statements in Dunlop Pneumatic Tyre Co Ltd v New Garage & Motor Co. Ltd [1915] A.C. 847: a ‘penalty is a payment of money stipulated in terrorem of [i.e. to deter] the offending party; the essence of liquidated damages is a genuine pre-estimate of the damage’. He then defined the penalty clause in more detail:

  1. A clause is penal if the sum stipulated to be paid upon breach is extravagant or unconscionable compared to the greatest loss reasonably provable following from the breach.
  2. A clause is penal if the breach consisted only in the non-payment of money, yet the clause provides for a larger sum.
  3. There is a presumption that the clause is penal if its provision are engaged in a number of events of varying extent of damage, from trifling to serious.
  4. The impossibility of calculating a precise pre-estimate of loss does not automatically render the provision a penalty.

In November 2015, the Supreme Court handed down judgement on the joined cases of Cavendish Square Holdings BV v Talal El Makdessi and ParkingEye Ltd v Beavis [2015] UKSC 67. In its judgment, the Court reconsidered the law on penalties after almost a century since Dunlop. By the admission of Lords Sumption and Neuberger, the penalty rule was ‘an ancient, haphazardly constructed edifice’ that courts have struggled to apply over the last century.

But what has changed and does the alteration represent good policy? There is concern over what the effect on commercial contracts will be, particularly in engineering and construction agreements where such provisions are frequently used. The Court must maintain a difficult balancing act between preventing the innocent party unfairly seeking a disproportionate sum following breach and respecting parties’ freedom of contract.

The Penalty Rule following Cavendish and ParkingEye

The Supreme Court found the distinction between pre-estimate of loss and deterrent unsatisfactory, for reasons considered below. The true test, they said, 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 (para 32).

The Court is effectively asking three things. Firstly, is the provision a secondary obligation i.e. one that arises upon breach of a primary obligation? The Court made clear only secondary obligations are capable of being a penalty. Secondly, does the innocent party have a legitimate interest in enforcing performance of the clause beyond compensatory damages for breach? If so, thirdly, is the provision out of all proportion to the legitimate interest of the innocent party?

The result is that, even if a provision obliges a sum greater than a genuine pre-estimate of loss to be paid out on breach, the provision will be saved if (i) it is justified by a legitimate interest, and (ii) the sum is proportionate to that interest.

Application of the rule to Cavendish and ParkingEye

The Court then applied this new test to the combined cases before them.

In Cavendish v El Makdessi, Mr Makdessi (the ‘Seller’) sold a controlling stake in a large advertising and marketing communications company to Cavendish (the ‘Buyer’), subject to non-compete restrictive covenants that if breached (i) deprived the Seller of two large instalment payments, and (ii) obliged the Seller to sell his remaining shares at a reduced price. The covenants were breached and the issue before the Court was whether the clauses should be regarded as penalties, and therefore be unenforceable. In total, the operation of the clauses would have deprived the Seller of approximately $44m USD.

The Seller was one of the mostly highly regarded Lebanese businessmen whose name was very closely associated with the sold company at which he had very strong relationships with clients and senior employees.

Applying the above test, the Court found that even if clause (i) was a secondary obligation that did not represent a pre-estimate of loss, the Buyer had a legitimate interest in enforcing it to protect the goodwill of the company: the loyalty of the Seller and the goodwill of the business were fundamentally linked and were critical to the Buyer, thus justifying  the provision. While the Court could not measure goodwill on any tangible scale, it held that as both were commercial parties, they were the best judges of how that value should be reflected financially, especially as both parties had the benefit of legal advice from well-regarded firms. Clause (i) was not a penalty and could be enforced.

Similarly, clause (ii) was held not to be a pre-estimate of loss. The right to buy the remainder of the Seller’s shares for a reduced price reflected the new situation in which the goodwill and loyalty of the Sseller was lost. There was a legitimate interest and the clause was not out of proportion to that interest. As such, even if a secondary obligation, the provision would be enforceable.

In any case, the Court found that both clauses were primary obligations and were therefore not capable of engaging the penalty rule.

In ParkingEye v Beavis, the issue was whether an £85 parking charge for overstaying at a car park was penal. Applying the test, the Court decided that whilst the penalty rule was engaged as an £85 parking charge was clearly not a genuine pre-estimate of loss, ParkingEye possessed a legitimate interest that justified the charge: the effective management of customer parking in a town centre and meeting the running costs of the scheme, plus profits. In essence, if customers were not deterred from moving their cars on time, the car park would rarely have spaces and would be unable to operate effectively. Finally, the charge of £85 was proportionate to ParkingEye’s legitimate interest because the overstay price was clearly advertised and consistent with car park operator charges across the UK. 

Analysis of the judgement

The decision has much to recommend in it. Firstly, it recognises a clause will not necessarily be a penalty simply because it is aimed at deterrence and not compensation.  Both Cavendish and ParkingEye illustrate this point. The old Dunlop approach focused exclusively on financial loss flowing from breach and failed to consider the practical socio-economic and wider policy justifications that might support any given provision.

Moreover, the Court made clear that a clause will only be regulated by the penalty rule if it is a secondary obligation and engaged in the breach. This approach narrows the court’s jurisdiction to intervene, respecting the freedom of contract between the two parties.

The removal of the rigid dichotomy between a genuine pre-estimate of loss and deterrence is also welcome. The approach originated, the Court argues, from too close a reading of Lord Dunedin’s Dunlop judgement at the expense of other speeches in the Appellate Committee. In scrutinising Dunlop’s clause that charged distributor £5 for every tyre re-sold, Lord Atkinson justified enforcing the provision as it protected Dunlop’s goodwill and reputation: a very similar formulation to Cavendish, a century on.

The judgement also reflects a general trend in the last two decades towards greater flexibility in scrutinising penalty clauses. In Lordsvale Finance Ltd v Bank of Zambia [1996] QB 752, Coleman J found that a provision increasing the interest rate on a loan in default was out of proportion to the greatest estimable loss. But it was commercially justifiable as it reflected the greater credit risk associated with a borrower in default and could, therefore, be given effect. This ‘commercial justification’ approach was adopted by Mance LJ in Cine Bes Filmcilik ve Yapimcilik v United International Pictures [2004] 1 CLC 401 and by Arden LJ in Murray v Leisureplay plc [2005] IRLR 946. It is instructive to see that the Supreme Court’s judgment in Cavendish – ParkingEye as part of a more recent acknowledgement that prima facie penalty clauses can be enforced if commercial justification is established.

This new approach is finally more flexible. It has already been applied robustly to two polar opposite issues: an £85 car parking charge and a $44 million share acquisition. The judges noted the difficulty with which the old test applied to ‘relatively simply transactions to altogether more complex situations’ [para 3]. By centring the test on ‘legitimate interest’, wider considerations to the specific agreement are considered each time.

But the decision has also created uncertainty. There is no clear guidance at this stage regarding what constitutes a legitimate interest. As this interest can be non-financial (e.g. maintaining goodwill or reputation) it is difficult to know how ‘legitimate’ the interest need be before it justifies a provision extending beyond a pre-estimate of loss. To then measure whether the interest is proportionate to the severity of the provision is equally problematic. While the Court might say the parties themselves, well-advised and of equal bargaining power, are the best judges of whether a provision is proportionate to the interest, a more sophisticated test will most likely be required to bring real certainty for commercial bodies.

Finally, while the Court has provided clarity in deciding only secondary obligations will fall foul of the penalty rule, this might encourage well-advised parties to carefully incorporate penalty provisions into primary obligations. It remains to be seen how sternly courts treat this practice. Helpfully, Lord Neuberger and Sumption have indicated that categorising a clause as either primary or secondary depends on the clause’s substance, not form. They cite Lord Radcliffe’s speech in Campbell Discount Co Ltd v Bridge [1962] AC 600, 622: ‘the intention of the parties themselves is never conclusive and may be overruled or ignored if the court considered that even its clear expression does not represent the real nature of the transaction’. The probable outcome is that courts will be able to bar flagrantly penal secondary obligations disguised as primary provisions. However, where provisions are more ambiguous in classification, there is still much uncertainty for commercial parties whose intentions as to the classification of a clause might well be overruled by the court.

Effect on future commercial arrangements

Recognition that a party can have a non-financial legitimate interest in enforcing a provision beyond monetary compensation for breach has made it harder to render a clause penal. Yet in industries such as construction and engineering, where liquidated damages clauses are commonly used, employers may err on the side of caution and ensure that liquidated damages clauses still reflect a genuine pre-estimate of loss. This might be where there is an element of loss that is not easily quantified, such as damage to goodwill or reputation.

The Supreme Court also made clear that provisions agreed upon by two properly-advised, commercial parties, will be strongly presumed to be proportionate to the legitimate interest. In practice, it has become harder for the contract breaker to prove the provision in question is penal.

Furthermore, ParkingEye v Beavis has made it harder for ordinary consumers faced with charges to successfully challenge them. It is not clear at what value beyond £85, to take the facts of ParkingEye, a charge would have to be to become disproportionate to the car park operator’s legitimate interest.

Conclusion

The Supreme Court was given the opportunity in Cavendish – ParkingEye to alter the basis of the penalty rule. They took it, moving its rationale away from the pre-estimate calculation to whether the provision is out of proportion to a legitimate interest. This change allows courts to appreciate a wider number of commercial, yet not necessarily financial considerations that reflect the true basis of the agreement. Yet we cannot ignore the uncertainty which the legitimate interest approach brings. Defining a legitimate interest will, in the final assessment, be a matter for the courts: a potentially unfortunate situation that may give rise to higher levels of litigation and court activity. Nonetheless, the decision will be welcomed by parties proffering such clauses: they are no longer, given the correct circumstances, to be penalised for inserting contractual provisions that extract more than a pre-estimate of loss from the contract breaker upon breach. 

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Tagged: Commercial Law, Contract Law

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