A penalty shoot out

One of the significant differences between civil and common law jurisdictions is that whereas the former generally see no objection to fixed sums being paid in the event of a breach that may not reflect a loss that is incurred, common law jurisdictions will strike down such clauses where they amount to a penalty rather an a genuine pre-estimate of a loss likely to flow from a breach.

In a recent judgment relating to two cases the Supreme Court has reformulated the rules relating to penalty clauses under English law and in doing so has narrowed the differences between civil and common law jurisdictions.

Cavendish Square and ParkingEye

The first case, Cavendish Square (Cavendish Square Holdings BV v Talal El Makdessi), concerned a commercial contract where a seller, Mr El Makdessi, had breached certain restrictive covenants under a share purchase agreement. The agreement provided that in the event of a breach the seller would not be entitled to receive the final instalments of the purchase price and that the seller would be required to sell his remaining shares at a price that excluded the goodwill. Mr El Makdessi claimed that this amounted to a penalty and should not be enforced.

In the second case ParkingEye (ParkingEye Limited v Beavis [2015] UKSC 67) Mr Beavis had parked his car in a car park managed by ParkingEye for more than the two hour limit and as a result he received a fine of £85. Mr Beavis disputed the fine claiming it was an unenforceable penalty.

In both cases the Supreme Court held that neither claimant was correct and the rule against penalties could not be invoked.

The penalty rule

The Supreme Court approached the cases by first asking two questions:

  • in what circumstances is the penalty rule engaged; and
  • if engaged, what makes a contractual provision penal?

As to the first question as to when the penalty rule is engaged the Supreme Court decided that it only applied in circumstances where the compensation agreement appears in the contract as an alternative to the usual rule on damages for breach. Thus agreement to pay compensation is a secondary term, which only comes into effect once a main or primary obligation has been breached.

The Supreme Court held that the rule against penalties does not apply to a clause which obliges a party to pay a monetary sum that is not a secondary or compensatory term, but a main or primary obligation. In the Cavendish Square the price adjustment term which prevented a shareholder from receiving interim payments was held not to be a secondary term even though it was triggered by a breach of restrictive covenants. The rationale for this was that the inclusion of the price adjustment was part of the commercial bargain and related to the importance of the covenants to the company’s goodwill. Its primary purpose was not to provide compensation for any breach.

By a majority the Supreme Court also considered that the same reasoning applied to the associated term that required the seller to sell his remaining shares at a lower price that excluded goodwill. A minority of the judges considered this to be a secondary compensatory term designed to deter a breach of contract, although they also considered that it was neither exorbitant nor unenforceable.

The task of identifying whether a particular term alleged to be a penalty is a primary or secondary term is unlikely to be easy. Further the Supreme Court recognised that primary terms can still be exorbitant, particularly if there is inequality of bargaining power, so that extreme examples could still be held to be unenforceable as a penalty.

With regard to the second question, which is what makes a contractual term penal, the established test is whether the clause is “compensatory or a deterrent”. The Supreme Court did not depart from this rule but it clearly thought it was of limited application since its view was that a damages clause may be justified by some other consideration rather than simple compensation.

The Court noted that case law has developed much more sensitive criteria for cases where the liquidated damages were set relatively high with the aim of deterring breaches of contract which would have a detrimental impact on the innocent party’s trade as a whole or where the breaches did not give rise to an immediate and measurable monetary loss. In such cases, it must be asked whether the innocent party’s interest in protecting its trade as a whole gave rise to a “commercial justification” for the specified liquidated damages. The Court therefore reformulated the test as “…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”.

In the Cavendish Square, it was considered that even if the price adjustment term was a secondary term, it was still not a penalty because it was carefully negotiated and reflected the importance of the non-competing covenants where the loss could be greater than monetary value attributable to a breach. Similarly, in the ParkingEye, the charge of £85 for staying more than two hours in the car park was not considered a reasonable pre-estimate of the car park’s loss, but the commercial reasons for the charge, which were to help pay for the operation of the car park for the benefit of the retail outlet it belonged to, were considered sufficient to justify it.

The Supreme Court also took the opportunity to restate what is a continuing theme of judgments from this Court which is that in construing any contractual provision there is a strong initial presumption that contracting parties are the best judges of what they intend to be the legitimate consequence of a breach of contract.

Practical implications

Time will tell but the Supreme Court’s decisions suggest that in the future there may be far fewer challenges to compensation clauses on the grounds that they amount to a penalty and that it will be much easier to enforce well drafted liquidated damages clauses.

When drafting these types of clauses it will be helpful to bear in mind that:

A primary obligation is generally to be exempt from the penalty rules, so ensure that the payment term is expressed as a primary term.

Where a party is seeking to include a straightforward pre-estimation of loss, ensure that this pre-estimate is genuine and not “unconscionable” or “extravagant” (reference can be made to industry practices/sums).
Where a liquidated damages clause goes beyond a pre-estimate of loss, then identify the “legitimate interest” that justifies it in the preamble to the contract or in the clause itself, and define the criteria by which it will be deemed to be proportionate.