No more dodgy penalties

In the case of Cavendish Square Holding BV v El Makdessi and ParkingEye Ltd v Beavis, the Supreme Court has reset and clarified the contractual penalty rule. The classic “quasi-statutory” test established one hundred years ago in Dunlop will still “usually be perfectly adequate” to determine the validity of a straight-forward damages clause, but the Supreme Court has now specified that that key legal test when considering a penalty clause 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”. Sanction clauses will now have to be drafted with this test in mind to avoid unenforceability.

Background

The Cavendish Square case concerned an agreement for the sale of a controlling stake in a holding company.  The contract stipulated that if the Seller was in contractual breach post-sale, two further payments could be withheld by the Buyer.  The Seller admitted he was in breach of contract (namely, in breach of restrictive covenants), but argued the clauses withholding the two further payments were unenforceable penalty clauses.

In the ParkingEye case, it was argued that an advertised £85 excess parking charge amounted to a penalty at common law and was also not enforceable.

Common Law

A penalty clause is unenforceable – where a clause is deemed to be a penalty, the court will assess damages according to the usual principles of measure of damages, remoteness and mitigation.  In Dunlop it was held that “the essence of a penalty is a payment of money stipulated in terrorem of the offending party; the essence of liquidated damages is a genuine covenanted pre-estimate of damage”.  Lord Dunedin referred to four tests to determine whether a clause is a penalty:

• The provision would be a penalty if the sum stipulated is extravagant and unconscionable in amount compared with the greatest conceivable financial loss.
• The provision would be a penalty if the breach consisted only in the non-payment of money and it provided for the payment of a larger sum.
• There was a presumption (but no more) that it would be penal if it was payable in a number of events of varying gravity.
• The provision would not be treated as a penalty by reason of it being difficult or impossible to pre-estimate precisely the loss which might be caused by the breach.

Decision

In both Cavendish and ParkingEye, the Supreme Court upheld the validity of the clauses and restated the law on penalties.  Lords Neuberger and Sumption held that: “The true test 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”.

The meaning of primary and secondary obligations was highlighted in the Cavendish case.  The Seller admitted to committing a breach of his primary obligations (under the restrictive covenants) – it was held that the clauses withholding the two further payments in the wake of this breach were price adjustment clauses operating as part of these  primary obligations under the contract (rather than as secondary, punitive payment clauses).

In reaching their decision, the court observed that the key question is whether a clause is penal, not whether it is a pre-estimate of loss.  In other words, if a clause is not a specified damage clause this does not mean it is a penalty clause by default.  They also observed that the enforceability of a clause will partly depend on whether it is extravagant and unconscionable, affirming the continued relevance of the Dunlop tests.

The decision recognised that a penalty ruling is always “an interference with freedom of contract”, and that the court should not strive to identify a clause as penal.  “In a negotiated contract between properly advised parties of comparable bargaining power, the strong initial presumption must be that the parties themselves are the best judges of what is legitimate in a provision dealing with the consequences of breach”.

Comment

The concept of “legitimate interest” (and what is out of all proportion to that legitimate interest) is now central to the interpretation of penalty clauses, and it will have consequences in almost every contractual area.

Whilst application of the new legal test is still unchartered territory, a clause which imposes a sanction for breach should be drafted in a manner to make it sufficiently clear that it forms part of the parties’ primary obligations, and thus minimise the risk of a court construing it as a secondary obligation capable of being a penalty.

Karim Amijee, Trainee Solicitor, Michael Simkins LLP