UK: The Supreme Court Has Reformulated The Rule Against Penalties

Last Updated: 23 February 2016
Article by Robert Turner, John Woolley, Jane Miles and Shaun Tame

In November 2015, in a widely anticipated judgment, the Supreme Court reviewed the operation of the rule on penalties for the first time in a century. The court's decisions in two very different cases: Cavendish Square Holdings BV v. Makdessi and ParkingEye Ltd v. Beavis were reported at [2015] UKSC 67 and, together, they clarify the test for ascertaining whether a clause is a penalty and therefore unenforceable.

All the judges rejected a submission to either abolish the rule on penalties (at least in relation to commercial cases) or expand its operation, in particular to clauses other than those that are triggered by breach. All the judges also agreed that the current state of the authorities was unsatisfactory. There were, however, some differences of detail between the approach of the seven-judge Supreme Court panel to the reformulation of the rule (on which you might want to refer to our more detailed briefing). In summary, Lord Neuberger and Lord Sumption, in a joint judgment, held the true test for a penalty is whether the clause is a secondary obligation which imposes an obligation on the contract-breaker out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation. A clause is not penal merely because it is not a genuine pre-estimate of loss, even if it operates as a deterrent.

Further analysis of the decision

A detailed analysis of the two decisions by Tracey Petter can be accessed here: " Supreme Court unshackles the rule on penalties". It should be noted that a late amendment by two of the Lords did not change the decisions but did, unfortunately, make it less clear whether the view held by the Lords majority (that the clauses in each case were primary obligations) prevails.

Joanna Smith QC's talk on the Cavendish/Beavis decisions

We were delighted to welcome Joanna Smith Q.C. of Wilberforce Chambers to a seminar at our London offices on 14 December 2015 to give us a first-hand account of the issues involved in the Cavendish and Beavis decisions. Joanna Smith QC was counsel for the claimant in the Cavendish case. If you would like a copy of her hand-out or access to a recording of the seminar, please contact Alastair Young.

How do the Cavendish/Beavis decisions affect the way construction contracts are drafted?

Construction contracts usually include a provision for liquidated and ascertained damages (LADs). Such provisions provide for a payment – a liquidated sum – to be made in the event of certain defined breaches. Before the Cavendish case, drafters would ensure that this sanction had a commercial justification, was not merely a deterrent, was calculated as a genuine pre-estimate of the losses that might flow from the breach and was not a figure that could be said to be extravagant and unconscionable when compared to the maximum loss that might flow from that breach.

These elements of the rule against penalties have, however, shifted over the years making the doctrine unclear. The Supreme Court judges therefore wanted to both clarify the rule and allow the parties freedom to make their own bargains when contracting provided such bargains could be justified based on a legitimate interest. So, for example, in the Beavis case, the £75 parking fine might have seemed penal to the claimant compared to the small parking charge. However, from the innocent car park owner's point of view, the fine was justifiable to deter people from exceeding their paid time allowance on their parking.

Following Cavendish, those who negotiate construction contracts should bear in mind the key drafting points below:

  • When construing an allegedly penal clause, the courts prefer to adopt an approach that respects the parties' freedom of contract whenever possible. Therefore, where commercially aware parties, dealing as equals and supported by specialist, experienced and expert legal advice, have fully negotiated their contract terms, the court is less likely to find a clause to be a penalty.
  • Emphasis is now placed on the innocent party's legitimate interest in performance of the contractual obligations. Deterrence is no longer an essential component, nor is the assessment of whether the clause constitutes a genuine pre-estimate of loss.
  • The Supreme Court confirmed that the rule against penalties (as reformulated) can also apply to complex clauses that for example withhold payment on breach. When drafting such clauses, care must now be taken not to engage or to contravene the rule by, for example:
  • drafting a provision as a primary obligation which forms part of the parties' substantive obligations (rather than a secondary obligation which sets out a remedy for a breach of a primary obligation);
  • drafting the clause so the remedy specified is not triggered by a breach.
  • If there is no way to avoid the application of the rule of penalties to a clause, take steps to ensure the clause does not infringe the rule. This can be done by considering whether (as Lord Hodge said) "the sum or remedy stipulated as a consequence of breach of contract is exorbitant or unconscionable when regard is had to the innocent party's interest in performance of the contract". You might want to record what the legitimate interest in performance is and why the remedy is proportionate (unless it is obvious).
  • If the remedy provided by the clause is the withholding of moneys otherwise due, ensure the clause does not fall foul of the forfeiture rules by ensuring that the remedy is not out of all proportion to the loss suffered by the innocent party either in money terms or in respect of damage to other interests which that party justifiably needs to protect.
  • The court will not modify a clause: it will either find the clause to be a penalty or not.

Practical questions to consider when drafting

Following the Supreme Court decision, the questions you should ask when drafting a liquidated damages provision are as follows:

  • Have you considered your and the other party's commercial interests in the deal or project?
  • Are those interests set out clearly in the contract?
  • What would be the effect of any potential breach on the innocent party's operation? For example, what effect would a delay to completion on this particular project have on the employer's business? What would it cost the employer?
  • What is the relative bargaining power between the contracting parties? Is it evenly balanced? Are your legal advisers of comparable weight? Have you acknowledged the parties' bargaining position in the contract?
  • Is the sanction in proportion to the potential breach and the effect on the innocent party's commercial operation? (It is still a good starting point to calculate the financial consequences as a genuine pre-estimate of loss but note that some consequential sanctions which extend beyond compensation for such a genuine pre-estimate may still be justified on the basis that they are legitimately required to protect the innocent party's commercial position.)
  • In setting the sanction, consider: what is normal in the industry and have you guarded against the chosen sanction being "unconscionable" or "extravagant"?

Remember that in reaching their decision on the Cavendish and Beavis claims, the Supreme Court judges wanted to ensure that parties in the future are free to agree sanctions which are appropriate to their commercial position and the deal/project – provided they are based on a legitimate interest.

Contractors in particular should be aware that the decisions will make it harder to argue that LAD clauses are penal and should ensure they are fully engaged in drafting LAD provisions so that they fully understand the consequences of any breach.

Dentons is the world's first polycentric global law firm. A top 20 firm on the Acritas 2015 Global Elite Brand Index, the Firm is committed to challenging the status quo in delivering consistent and uncompromising quality and value in new and inventive ways. Driven to provide clients a competitive edge, and connected to the communities where its clients want to do business, Dentons knows that understanding local cultures is crucial to successfully completing a deal, resolving a dispute or solving a business challenge. Now the world's largest law firm, Dentons' global team builds agile, tailored solutions to meet the local, national and global needs of private and public clients of any size in more than 125 locations serving 50-plus countries.

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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