Penalty clauses in contracts: changing the rules of the game?

Posted: 22/01/2016

The Supreme Court has re-examined the rule against penalties in contracts. Its judgment in the joined cases of Cavendish Square Holding BV v Tala El Makdessi; ParkingEye Limited v Beavis has been widely welcomed as introducing greater clarity and flexibility to this somewhat opaque principle. Just how much certainty will be gained in practice remains to be seen. What is clear is the Supreme Court’s continued determination to protect the sanctity of contracts and minimise judicial interference in freely negotiated agreements after the event (see also Arnold v Britton). 

In drafting terms, the main objective will be framing a clause as a primary obligation rather than a secondary one, whilst bearing in mind that the courts will ultimately look to the substance rather than the form. Although parties have been warned that the courts will not be fooled by labels, the position of the Supreme Court is clear: “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 a breach” (para 35). 

History of the building 

In their leading judgment, Lords Neuberger and Sumption described the law relating to contractual penalty clauses as “an ancient, haphazardly constructed edifice which has not weathered well” (para 3). In order to decide whether to demolish it or to reconstruct and/or extend it, their Lordships undertook a comprehensive structural survey of the legal history: the first in the Supreme Court or House of Lords for a century. 

Parties to commercial contracts may agree that, if a contractual provision is breached, the defaulting party must pay the innocent party a specified sum of money. The penalty rule probably developed to protect the weaker contracting party from oppression by its stronger counterpart (para 257). The courts have long differentiated between a sum representing a genuine pre-estimate of damages (an enforceable liquidated damages clause), and a sum which is out of all proportion to any damages liable to be suffered (an unenforceable penalty clause).

In the seminal case of Dunlop Pneumatic Tyre Co Ltd the court described the difference as “The essence of a penalty is a payment of money stipulated as in terrorem of the offending party; the essence of liquidated damages is a genuine covenanted pre-estimate of damage”. Lord Dunedin also set out four considerations which “may prove helpful, or even conclusive” in determining whether or not a clause is penal. These tests, which have been relied on routinely since, have proved extremely influential. Indeed, their Lordships made their views on the overzealous application of these tests known in no uncertain terms. 

Abolition or extension? 

Counsel for Cavendish argued that their Lordships should abolish the judicially constructed penalty rule. Despite noting their “doubt that the courts would have invented the rule today if their predecessors had not done so three centuries ago”, the Supreme Court did not consider this to be an appropriate route for the courts to take, for three main reasons (para 36). 

First, the penalty rule “is not only a long-standing principle of English law, but is common to almost all major systems of law, at least in the Western world” (para 37). Secondly, although there is much greater statutory protection for consumers now, non-consumer contracts remain unregulated. Parties such as professionals and small businesses “may share many of the characteristicsof consumers, which are thought to make the latter worthy of legal protection” (para 38). Finally, the penalty rule is consistent with other well-established principles which involve the court refusing to give full force to contractual provisions: relief from forfeiture, equity of redemption and refusal to grant specific performance. 

Counsel for Mr Makdessi submitted that the Supreme Court should extend the penalty rule so that it applied more generally, as the High Court of Australia had done recently in Andrews v Australia and New Zealand Banking Group. This would make it “less formalistic in its application”, and prevent people from circumventing it by dint of careful drafting. Their Lordships found the Australian redefinition of a penalty difficult to apply, and considered that their decision “did not address the major legal and commercial implications of transforming a rule for controlling remedies for breach of contract into a jurisdiction to review the content of the substantive obligations which the parties have agreed” (para 42). 

Reconstruction, rather than demolition or extension, was the order of the day. The Supreme Court looked at two main questions: when is the penalty rule engaged, and what makes a contractual provision penal? 

When is the penalty rule engaged? 

The Supreme Court was clear that “the rule against penalties applies only in the context of a breach of contract” (para 239).  Its main purpose, according to the authorities, is to prevent a claimant from recovering a sum of money which bears little or no relationship to the loss actually suffered by the claimant as a result of the defendant’s breach. The courts have no jurisdiction to review the fairness of a contractual obligation, but they do have jurisdiction to regulate the remedy for its breach: “Leaving aside challenges going to the reality of consent, the courts do not review the fairness of men’s bargains… The penalty rule regulates only the remedies available for breach of a party’s primary obligations, not the obligations themselves” (para 13). 

Consequently, the application of the penalty rule may depend on how the obligation is framed in the contract: ie as a conditional primary obligation, or a secondary obligation providing a contractual alternative to common law damages. For example, a contract obliges party A to perform act Z, and further provides that if party A does not perform act Z, he will pay party B sum X. The obligation to pay sum X is a secondary obligation, capable of being a penalty. If the contract simply provides that if party A does not perform act Z he will pay party B sum X, that is a conditional primary obligation and cannot be a penalty.

All clear? Their Lordships acknowledged the “capricious consequences of this state of affairs”, but emphasised that  “the classification of terms for the purposes of the penalty rule depends on the substance of the term and not on its form or on the label the parties have chosen to attach to it” (para 16).  This is presumably to discourage parties from trying to draft round the penalty rule, although the jury is still out on how effective this will prove. 

Finally, Lords Neuberger and Sumption clarified that although payment of money is the typical obligation under a penalty clause, an obligation to transfer assets (either for nothing or at an undervalue), or clauses where one party forfeits a deposit following its own breach of contract could also constitute a penalty (para 16). Lord Hodge held that a deposit may be a penalty where it is not reasonable as earnest money, or where it exceeds the percentage set by long established practice without justification (para 238). Clauses that allow the innocent party to withhold monies which are otherwise due can also be penalties (para 226). 

When is a clause penal? 

The Supreme Court held that it was “unfortunate” that Lord Dunedin’s Dunlop tests had “achieved the status of a quasi-statutory code”. He had suggested the tests as potentially helpful considerations rather than rules, and had himself acknowledged that the crux of the matter was whether the clause was unconscionable or extravagant. Finally, none of the other three Law Lords had expressly agreed with the four tests, or indeed mentioned them in their judgments. 

Lords Neuberger and Sumption found the distinctions between penalties, deterrents and genuine pre-estimates of loss to be “unsatisfactory” (para 31). The real question is whether a contract is penal, not whether it is a pre-estimate of loss. “These are not natural opposites or mutually exclusive categories… The fact that a clause is not a pre-estimate of loss does not, at any rate without more, mean that it is penal”. 

Equally, labelling a clause as a deterrent is not determinative. A deterrent is simply the flipside of a contractual inducement: it is a provision designed to influence the conduct of the affected party. As such it is neither inherently penal nor contrary to the policy of the law. The question of its enforceability should depend on whether the means of influencing that party’s behaviour is “’unconscionable’ or (which usually amount to the same thing) ‘extravagant’ by reference to some norm” (para 31).  

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 innocent party can have no proper interest in simply punishing the defaulter. His interest is in performance or in some appropriate alternative (para 32)”.   

The Dunlop tests remain useful for a straightforward damages clause, because that interest will rarely extend beyond compensation for the breach, but they do not lend themselves well to more complex cases. 

Theory in practice: Makdessi 

Makdessi involved the sale of shares in the largest advertising and marketing communications group in the Middle East. Mr Makdessi (one of two vendors) was an extremely influential business man, and his name was closely identified with the group. Preservation of the goodwill in the business was central to the agreement. 

Two clauses came before the courts for consideration. Clause 5.1 provided that if Mr Makdessi breached certain non-compete clauses, he would lose his entitlement to the deferred payments which would otherwise have been due to him. Clause 5.6 provided that if Mr Makdessi became a defaulting shareholder, Cavendish would be entitled to require him to sell his remaining shares to them at a price that excluded the value of the goodwill. 

Mr Makdessi admitted that he had breached the non-compete clauses but argued that they were unenforceable penalty clauses. The Court of Appeal agreed with Mr Makdessi; the Supreme Court did not. Instead, Lords Sumption and Neuberger held that clause 5.1 was a price adjustment clause: it was therefore a primary, rather than a secondary, obligation, and penalty rule was not engaged. That said, they proceeded to analyse the clause anyway, finding that although clause 5.1 had no relationship with the measure of loss flowing from the breach, Cavendish had a legitimate interest in the observance of the restrictive covenants in order to protect the business critical goodwill of the Group. 

Clause 5.6 presented more of a challenge, but their Lordships held that a similar analysis applied. It did not represent the estimated loss attributable to the breach, but it did reflect the reduced consideration with Cavendish would have been prepared to pay for the business without Mr Makdessi’s loyalty. The other judges concurred. 

Theory in practice: ParkingEye 

In ParkingEye, Mr Beavis parked his car in a car park in Chelmsford. Parking was stated (on large, prominent, legible signs) to be free for two hours. Failure to comply with this (and various other conditions) would result in a parking charge of £85. Mr Beavis left his car in the car park for two hours and 56 minutes. He did not accept the offer of a reduced charge of £50 for prompt payment; nor did he engage with the appeals process. Mr Beavis maintained through the High Court and Court of Appeal that this was an unenforceable penalty clause.

The Supreme Court dismissed his appeal by a majority of six to one.  Although the penalty rule was engaged, the clause was not a penalty. Both the car park operators and the landowners had a legitimate interest in charging non-compliant motorists, and the charge was neither extravagant nor unconscionable, given the circumstances, the signage, and the fact that charges of a similar level are found throughout the UK. “In short, commercial interests may justify the imposition upon a breach of contract of a financial burden which cannot be related directly to loss caused by the breach or justified by reference to the impossibility of assessing such loss” (para 145).   

Mr Beavis also argued that the charge was unfair for the purposes of the Unfair Terms in Consumer Contracts Regulations 1999. The majority of their Lordships held that, although the charge might fall under the description of potentially unfair terms, it did not come within the basic test of unfairness as any imbalance in the parties’ rights did not arise contrary to the requirements of good faith (the legitimate interest argument). 

Lord Toulson dissented: in his view, the burden was on the operator to show that the consumer would have agreed to the terms in individual negotiations on level terms. ParkingEye had not produced sufficient evidence to that effect, and it was not reasonable to make that assumption. 

Structurally sound? 

The Makdessi judgment has its difficulties. Their Lordships were, broadly, in agreement (save for Lord Toulson on the regulations point in Parking Eye). That said, they reached their conclusions in a variety of different ways: Lords Neuberger and Sumption in Makdessi held that the rule against penalties was not engaged because the relevant clause was a primary obligation; Lord Carnwath agreed; Lord Mance appears to go straight to whether the clause is penal; and Lords Hodge, Toulson and Clarke acknowledged the “strong argument” that it was a primary obligation but preferred to keep an open mind, instead analysing the reasons why the clause was not an unenforceable penalty. 

Equally, there are a number of subtle variations on the theme of the “true test” given by Lords  Sumption and Neuberger. Lord Mance provides a two stage test, which requires firstly, consideration of whether the clause serves or protects any legitimate business interest; if so, consideration of whether the provision made for that interest is extravagant, exorbitant or unconscionable (para 152). Per Lord Hodge, the test is whether the sum or remedy triggered by the breach is exorbitant or unconscionable in relation to the innocent party’s interest in the contract being performed: if there is an “extravagant disproportion” between the stipulated sum and the highest potential level of damages, the clause will be a penalty (para 255). 

Given the criticism made by their Lordships of the courts’ slavish adherence to tests set out in one of four House of Lords judgments, it will be interesting to see how (and which of) these tests are applied. There may also be some interesting satellite litigation around what constitutes a legitimate interest; when a term might be extravagant, exorbitant or unconscionable; against which “norm” it is to be compared, and finally, around proportionality of the relevant sum. 

This article was published in Procurement & Outsourcing Journal in January 2016. 

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