UK: Important Changes To The English Law Rule On Penalty Clauses - What Does It Mean For Franchising?

Last Updated: 4 March 2016
Article by Gordon Drakes and Tim Rickard

In a recent landmark decision, the highest court in England and Wales, the Supreme Court, considered the long established principles underlying the law relating to contractual penalty clauses (the penalty rule). The Supreme Court issued a joint judgment in the cases of Cavendish Square Holding BV v Talal El Makdessi (El Makdessi) and ParkingEye Ltd v Beavis [2015] UKSC 67 (ParkingEye), which is one of the most important decisions in English common law for the last 100 years.

The Supreme Court judgment sets out a new, progressive test for determining whether or not a contractual provision will be considered penal and therefore unenforceable. The judgment is relevant to all franchise systems which operate under English law agreements, as it re-calibrates the application of the penalty rule and potentially gives franchisors greater scope to deter certain types of behaviour and impose contractual penalties for certain types of breaches.

What was the penalty rule?

The origins of the penalty rule can be traced back as far as the 16th century, and originates in the concern of the Courts to prevent exploitation in an age when credit was scarce and borrowers were particularly vulnerable. Essentially, a penalty is a payment of money stipulated in the contract and is unenforceable against the offending party if it is an exorbitant alternative to common law damages.

At the beginning of the 20th century, the judgment in the case of Dunlop Pneumatic Tyre Co Ltd v New Garage & Motor Co. Ltd [1915] A.C. 847 (Dunlop) sought to restate the law on the penalty rule by providing four tests which were designed to be "helpful, or even conclusive" in determining whether or not a clause was an unenforceable penalty. The Dunlop judgment distinguished between penalty clauses (which are unenforceable) and "liquidated damages" clauses, which are enforceable provided that the specified sum is "a genuine pre-estimate of loss" – wording which has since appeared in many English law commercial contracts over the last 100 years.

However, in El Makdessi and ParkingEye the Supreme Court noted that the Dunlop tests had taken on the status of a "quasi-statutory code", which was never the intention, and the Dunlop test has been applied too rigidly, particularly in cases where there is a clear commercial justification for including a penalty clause, or where there may be interests beyond the compensatory which justify the imposition on a party in breach of an additional financial burden.

What were the cases about?

The El Makdessi case related to the sale of a Middle Eastern media business and the provisions of a share purchase and shareholders' agreement.  The agreements provided that if the seller was in breach of certain non-compete restrictions, then he lost his entitlement to deferred consideration that would otherwise have been payable, and he must sell his remaining shares at a price that excluded the value of the goodwill (which would have been diminished by his breach of the covenants). The Court of Appeal held that these provisions were penal, as their purpose was to deter an act rather than to compensate the loss suffered by the innocent party.

The ParkingEye case related to a parking fine of £85 imposed after a driver overstayed the two-hour limit in a privately-run car park. The driver, Mr Beavis, attempted to argue that this was a penalty (as the owner of the car park had not suffered any clear loss) and therefore unenforceable. The Court of Appeal disagreed but granted Mr Beavis permission to appeal, and it is testament to the integrity and impartiality of the English court system that the Supreme Court gave such a detailed judgment on a case involving a £85 fine.

The new test

The Supreme Court's judgment has moved the law on contractual penalties away from the narrowly applied tests in Dunlop and has re-cast the test as follows: "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 [32]".

Lord Hodge expanded on this, stating that the "correct test for a penalty is whether the sum or remedy stipulated as a consequence of a breach of contract is exorbitant or unconscionable when regard is had to the innocent party's interest in the performance of the contract [255]".

In El Makdessi, the Court concluded that the provisions in the agreements protected the buyer's legitimate interest in enforcing the non-compete restrictions so that the goodwill of the business was protected.   The goodwill of the business was critical to its value to the buyer.  The provisions therefore did not go beyond protecting the buyer's legitimate interests.

In ParkingEye, it was clear that whilst the £85 charge may have been perceived understandably by users of the car park as a deterrent from over-staying the two-hour limit, there were also clear legitimate commercial interests that it was seeking to protect by imposing the charge. These included preserving the traffic management system and efficient use of parking space in the surrounding outlets and their users by deterring long-stay parking.  The charge was also relied upon to generate the income needed to run the scheme.  As a result, the charge was held not to be "out of all proportion" to those interests and therefore not penal.

In addition to the principles of primary versus secondary obligations, proportionality and the legitimacy of a deterrent, the Supreme Court judgment in respect of El Makdessi also referred to the importance of considering the circumstances in which the parties entered into the contract – "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 [35]". This is relevant to franchise agreements, which can appear across this spectrum depending on whether it is an international deal, a domestic multi-unit or high value deal or a domestic business format unit franchise deal. 

What's changed? Some practical implications

The Supreme Court has set a new test which recognises that a contractual party will often have a legitimate interest which can be protected by a contractual penalty which does not have to be a genuine pre-estimate of loss.

Provided that a contracting party can demonstrate that it is using a penalty clause to protect a legitimate interest and the penalty is not exorbitant or unconscionable, the following principles now apply:

  • It is no longer necessary for the penalty to be a genuine pre-estimate of loss.
  • A party relying on the penalty clause does not have to suffer a loss.
  • The predominant purpose of a clause can be to act as a deterrent against a certain breach of contract.
  • The penalty does not just have to be a specified financial amount. A party can, for example, withhold deferred consideration or require the transfer of certain property as the consequence for breach.
  • Generally, parties have a greater freedom to contract for the consequences for breach.

It is also worth noting that the penalty rule only operates on and regulates against breaches of "primary obligations". For example, if the contract provides that Party A shall perform an act (the primary obligation) and goes on to state that if Party A does not perform that act, Party A is obliged to pay Party B a specified sum of money, the obligation to pay is a "secondary obligation" and is capable of being a penalty. If an obligation to pay a penalty can be expressed as a primary obligation, this would circumvent the application of the penalty rule. However, the Supreme Court judges had differing views on what constituted a primary and a secondary obligation, so clever drafting will not always guarantee that the penalty rule can be avoided by framing a penalty as a primary obligation.

What does this mean for English law franchise agreements?

Franchise agreements typically fall into two categories:

  • those which are issued on a "take it or leave it" basis, which is common in domestic business format franchising, when the parties are not of comparable bargaining position and the franchisee may not even take proper legal advice; or
  • those which are negotiated freely between well-advised parties of comparable bargaining positions, which is common in larger scale, often multi-unit domestic franchising and international franchising.

It therefore seems like a fair assumption that the greater freedoms conferred by the Supreme Court will have most impact on English law large scale domestic and international franchise agreements, as opposed to smaller scale domestic agreements.

Nevertheless, all franchisors have a number of legitimate interests to protect and contractual penalties can therefore play an important role in focussing the mind of the franchisee on the franchisor's key interests and the types of behaviours and breaches which cannot be tolerated. For example:

  • Franchisors must protect the goodwill and reputation of the brand and the system, both for themselves and their other franchisees. The goodwill and reputation is essential to maintaining and attracting franchisees and customers to the business.
  • Franchisors are vulnerable when a franchisee decides to leave the network, as each franchisee has the potential to become a direct competitor of the franchisor, having benefitted from training, support and access to know-how.
  • Franchisors have a legitimate interest in maintaining a high degree of contractual power and discretion so that they can effectively monitor and police their franchise networks and introduce innovations into the system.

This judgment is welcome news for franchisors, who may have previously hesitated from including deterrents and specified financial consequences for certain breaches. There may be more scope now to charge penalties for repeated operational breaches, breaches of audit protocols and breaches of in-term and post-term covenants. The approach to franchise sales could also be revised in light of El Makadessi.

However, the new test does raise a number of queries which will no doubt be tested in the Courts in the years to come. At what point does a specified sum become exorbitant? In Parkingeye, £85 was proportional, but would the court take the same view to a fine of £250? There is a degree of uncertainty over what constitutes a primary and secondary obligation and the extent to which it is therefore possible to "draft around" the whole issue of contractual penalties.

In terms of practical steps, franchisors should consider taking legal advice and reviewing carefully the terms of their template agreements with a view to:

  • weaving in the thread of "legitimate interests" and linking it to certain standards of performance
  • including more financial consequences for certain breaches
  • reviewing restrictive covenants and franchise sale provisions in light of El Makadessi
  • replacing references to "genuine pre-estimates of loss"
  • framing certain clauses as primary obligations

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.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
Gordon Drakes
 
In association with
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Check to state you have read and
agree to our Terms and Conditions

Terms & Conditions and Privacy Statement

Mondaq.com (the Website) is owned and managed by Mondaq Ltd and as a user you are granted a non-exclusive, revocable license to access the Website under its terms and conditions of use. Your use of the Website constitutes your agreement to the following terms and conditions of use. Mondaq Ltd may terminate your use of the Website if you are in breach of these terms and conditions or if Mondaq Ltd decides to terminate your license of use for whatever reason.

Use of www.mondaq.com

You may use the Website but are required to register as a user if you wish to read the full text of the content and articles available (the Content). You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these terms & conditions or with the prior written consent of Mondaq Ltd. You may not use electronic or other means to extract details or information about Mondaq.com’s content, users or contributors in order to offer them any services or products which compete directly or indirectly with Mondaq Ltd’s services and products.

Disclaimer

Mondaq Ltd and/or its respective suppliers make no representations about the suitability of the information contained in the documents and related graphics published on this server for any purpose. All such documents and related graphics are provided "as is" without warranty of any kind. Mondaq Ltd and/or its respective suppliers hereby disclaim all warranties and conditions with regard to this information, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. In no event shall Mondaq Ltd and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use or performance of information available from this server.

The documents and related graphics published on this server could include technical inaccuracies or typographical errors. Changes are periodically added to the information herein. Mondaq Ltd and/or its respective suppliers may make improvements and/or changes in the product(s) and/or the program(s) described herein at any time.

Registration

Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:

  • To allow you to personalize the Mondaq websites you are visiting.
  • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our information providers who provide information free for your use.

Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.

If you do not want us to provide your name and email address you may opt out by clicking here .

If you do not wish to receive any future announcements of products and services offered by Mondaq by clicking here .

Information Collection and Use

We require site users to register with Mondaq (and its affiliate sites) to view the free information on the site. We also collect information from our users at several different points on the websites: this is so that we can customise the sites according to individual usage, provide 'session-aware' functionality, and ensure that content is acquired and developed appropriately. This gives us an overall picture of our user profiles, which in turn shows to our Editorial Contributors the type of person they are reaching by posting articles on Mondaq (and its affiliate sites) – meaning more free content for registered users.

We are only able to provide the material on the Mondaq (and its affiliate sites) site free to site visitors because we can pass on information about the pages that users are viewing and the personal information users provide to us (e.g. email addresses) to reputable contributing firms such as law firms who author those pages. We do not sell or rent information to anyone else other than the authors of those pages, who may change from time to time. Should you wish us not to disclose your details to any of these parties, please tick the box above or tick the box marked "Opt out of Registration Information Disclosure" on the Your Profile page. We and our author organisations may only contact you via email or other means if you allow us to do so. Users can opt out of contact when they register on the site, or send an email to unsubscribe@mondaq.com with “no disclosure” in the subject heading

Mondaq News Alerts

In order to receive Mondaq News Alerts, users have to complete a separate registration form. This is a personalised service where users choose regions and topics of interest and we send it only to those users who have requested it. Users can stop receiving these Alerts by going to the Mondaq News Alerts page and deselecting all interest areas. In the same way users can amend their personal preferences to add or remove subject areas.

Cookies

A cookie is a small text file written to a user’s hard drive that contains an identifying user number. The cookies do not contain any personal information about users. We use the cookie so users do not have to log in every time they use the service and the cookie will automatically expire if you do not visit the Mondaq website (or its affiliate sites) for 12 months. We also use the cookie to personalise a user's experience of the site (for example to show information specific to a user's region). As the Mondaq sites are fully personalised and cookies are essential to its core technology the site will function unpredictably with browsers that do not support cookies - or where cookies are disabled (in these circumstances we advise you to attempt to locate the information you require elsewhere on the web). However if you are concerned about the presence of a Mondaq cookie on your machine you can also choose to expire the cookie immediately (remove it) by selecting the 'Log Off' menu option as the last thing you do when you use the site.

Some of our business partners may use cookies on our site (for example, advertisers). However, we have no access to or control over these cookies and we are not aware of any at present that do so.

Log Files

We use IP addresses to analyse trends, administer the site, track movement, and gather broad demographic information for aggregate use. IP addresses are not linked to personally identifiable information.

Links

This web site contains links to other sites. Please be aware that Mondaq (or its affiliate sites) are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of these third party sites. This privacy statement applies solely to information collected by this Web site.

Surveys & Contests

From time-to-time our site requests information from users via surveys or contests. Participation in these surveys or contests is completely voluntary and the user therefore has a choice whether or not to disclose any information requested. Information requested may include contact information (such as name and delivery address), and demographic information (such as postcode, age level). Contact information will be used to notify the winners and award prizes. Survey information will be used for purposes of monitoring or improving the functionality of the site.

Mail-A-Friend

If a user elects to use our referral service for informing a friend about our site, we ask them for the friend’s name and email address. Mondaq stores this information and may contact the friend to invite them to register with Mondaq, but they will not be contacted more than once. The friend may contact Mondaq to request the removal of this information from our database.

Security

This website takes every reasonable precaution to protect our users’ information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to webmaster@mondaq.com.

Correcting/Updating Personal Information

If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to EditorialAdvisor@mondaq.com.

Notification of Changes

If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

How to contact Mondaq

You can contact us with comments or queries at enquiries@mondaq.com.

If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at problems@mondaq.com and we will use commercially reasonable efforts to determine and correct the problem promptly.