UK: Enforcement Of Contractual Provisions: The Supreme Court Reviews The Law On Unenforceable Penalty Clauses

Cavendish Square Holding BV (Appellant) v Talal El Makdessi (Respondent); ParkingEye Limited (Respondent) v Beavis (Appellant) [2015] UKSC 67

The Supreme Court has upheld the validity of two disputed penalty clauses, by allowing an appeal in Cavendish v El Makdessi and dismissing an appeal in ParkingEye v Beavis.

Background

In Cavendish v El Makdessi, the contract for the sale of Mr Makdessi's controlling stake in a company provided that if Mr Makdessi was in breach of certain restrictive covenants, he would be a Defaulting Shareholder, meaning that (a) he would not be entitled to receive the final two instalments of the purchase price and (b) he could be required to sell his remaining shares to Cavendish at a price which excluded the value of the goodwill of the business. Following Mr Makdessi's breach of the restrictive covenants, Cavendish sought to have him declared a Defaulting Shareholder, and succeeded at first instance. The first instance judgment was overturned by the Court of Appeal, however, which held that the relevant clauses were unenforceable penalty clauses. Cavendish appealed.

In ParkingEye v Beavis, Mr Beavis parked in a car park in Chelmsford managed by ParkingEye for longer than the two-hour limit permitted, and as a result, ParkingEye demanded payment of the clearly publicised £85 parking charge. The parking charge was upheld at first instance and in the Court of Appeal, despite Mr Beavis' arguments that it was an unenforceable penalty clause. Mr Beavis appealed.

These two appeals were heard by the Supreme Court in July and the judgment has been eagerly anticipated, as it was felt likely to clarify the law in relation to the rule against penalties.

The Supreme Court judgment

When considering whether a contractual provision is penal, the modern law was set out a century ago in Dunlop Pneumatic Tyre Company Ltd v New Garage and Motor Company Ltd [1915] where, as generations of law students can confirm, the House of Lords held that the test was whether the predominant purpose of the clause was (a) deterrence (not enforceable) or (b) compensation with a genuine pre-estimate of loss (enforceable).

The Court in El Makdessi/ParkingEye reflected that the approach in Dunlop was restrictive, and that the concepts of 'deterrence' and a 'genuine pre-estimate of loss' were unhelpful. The Court considered that the penalty rule was one which had "not weathered well", but that it was a very well-established principle in the United Kingdom, Europe and other common law jurisdictions. While the Unfair Terms in Consumer Contracts Regulations 1999 now govern consumer contracts, the rule still serves a purpose in regulating otherwise unregulated contracts and it should not, therefore, be abolished, but nor should it be extended.

In a joint judgment by Lord Sumption and Lord Neuberger, the Court reformulated the test for an unenforceable penalty clause, holding that the validity of such a clause turned on whether the innocent party could claim a legitimate interest in the enforcement of the clause:

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 resulting test can be divided into two elements:

  1. Is any legitimate business-interest protected by the clause; and, if so,
  2. Is the provision made in the clause extravagant, exorbitant or unconscionable?

The Court held that the penalty rule only applies to secondary obligations; that is, those triggered by breach of a primary obligation, and noted that in addition to the simple payment of money, this could encompass the withholding of payments, a requirement to transfer property, or a requirement to repay a non-refundable deposit.

In applying their revised test to Cavendish, the Court held that both the withholding of the final instalments and the requirement to sell Mr Makdessi's shares were primary, rather than secondary, obligations, and the penalty rule was not, therefore, engaged.

In ParkingEye v Beavis, the Court found that the penalty rule was engaged, but that the £85 charge was not a penalty. ParkingEye and the landowners had a legitimate interest in the provision and efficient management of customer parking, and the income from the charge, as part of a legitimate scheme plus a profit margin. Further, the Court found that the charge imposed by ParkingEye and the landowners was no higher than was necessary to induce Mr Beavis not to overstay, in order efficiently to manage the car park.

Implications of the judgment and points to note

Courts have historically been reluctant to intervene in parties' commercial bargains, and the received wisdom is that the rule against penalties should be used sparingly. In both these cases, the clause which had been challenged as a penalty was upheld. This is perhaps less surprising in the case of Cavendish, which involved two sophisticated, legally advised parties, and where it was accepted that Mr Makdessi had breached the relevant restrictive covenants.

Although many commentators have pointed to a gradual refining of the courts' approach to the rule against penalties, with recent cases showing an increasingly flexible approach (including, in the Court of Appeal in the ParkingEye case, "broader social and economic considerations"), the mantra of "genuine pre-estimate of loss" was still commonly heard and understood to apply.

When drafting contracts, it is still important to look at all provisions and determine whether they might fall to be assessed as penalty clauses, noting that it is not only clauses providing for specific payments upon breach that are potentially caught by this definition, but also those providing for the withholding of a benefit or a requirement to transfer shares or other property.

The judgment at paragraph 14 points to what is likely to be the best way to avoid engaging the rule on penalties at all:

where a contract contains an obligation on one party to perform an act, and also provides that, if he does not perform it, he will pay the other party a specified sum of money, the obligation to pay the specified sum is a secondary obligation which is capable of being a penalty; but if the contract does not impose (expressly or impliedly) an obligation to perform the act, but simply provides that, if one party does not perform, he will pay the other party a specified sum, the obligation to pay the specified sum is a conditional primary obligation and cannot be a penalty. [emphasis added]

The new test ("legitimate interest" rather than "genuine pre-estimate of loss") does not appear likely to dramatically increase or reduce the number of clauses which are found to be penalties. Parties seeking to refute an allegation that a contractual provision is a penalty will still need to adduce evidence of what their legitimate interests are and how they are reflected in the relevant clauses.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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