Penalty Clauses: The new rules and how these impact on commercial contracts

In late 2015 the Supreme Court gave its judgment on the joint cases of Cavendish Square Holding BV v Talal El Makdessi (“El Makdessi”) and ParkingEye Ltd v Beavis (“ParkingEye”)  [2015] UKSC 67. In these cases the Court considered the long standing rules and principles in relation to penalty clauses contained in commercial contracts. The decision is considered to be one of the most important in English Common Law for the last 100 years.

A penalty is a sum specified in a contract to be payable by a party in breach of contract as a consequence of that breach. Liquidated damages are also a pre-specified sum payable in the event of breach but which are a “genuine pre-estimate” of the loss that would arise from that breach.

Prior to the recent judgment, the law distinguished between penalty clauses, which were unenforceable, and liquidated damages which were enforceable. The court held in El Makdessi and ParkingEye that this test had been applied too rigidly in the past and there may be circumstances in which there is a clear justification for the imposition of a penalty and where a penalty clause would be enforceable.

The cases in question had very different facts. El Makdessi concerned the sale of a Middle Eastern media business. The relevant share purchase and shareholders’ agreements stipulated that if the seller was in breach of certain non-compete provisions then he would lose his entitlement to deferred consideration that would otherwise have been due to him, and he would be obliged to sell his remaining shares to the buyer at a price which excluded any value for goodwill. The Court of Appeal considered these provisions to be a penalty as they sought to deter the seller from acting in a certain way, rather than to compensate the buyer for any genuine loss suffered.

ParkingEye related to an £85 parking fine which was given to Mr Beavis as a result of him overstaying the two hour parking limit at a privately owned car park. Mr Beavis tried to argue that the fine was a penalty and therefore unenforceable. The Court of Appeal disagreed but granted Mr Beavis leave to appeal.

The decision of the Supreme Court has widened the previously applied tests in relation to the enforceability of penalty clauses. Lord Hodge stated 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”.

In El Makdessi, the court held that the provisions contained in the agreements were there to protect the legitimate interests of the buyer and did not go beyond protecting those interests. In ParkingEye it was held that although £85 may have been perceived to be an unreasonably high sum, there were clear legitimate commercial interests that were to be protected by the fine, which included efficient use of parking spaces, and the generation of income to maintain the car park. Furthermore, it was held that the fine was not an unfair, term under the Unfair Terms in Consumer Contracts Regulations 1999 and was therefore enforceable.

As well considering primary and secondary obligations, and the proportionality of the penalty, the Supreme Court touched on the importance of considering the comparable bargaining power of the parties, and whether they have been properly advised when negotiating the terms of the contract.

Under the new test, the party seeking to rely on a penalty clause must be able to show that the clause is to protect a legitimate interest, and that the penalty is not exorbitant or unconscionable. The following principles will also apply:

• The penalty no longer has to be a genuine pre-estimate of loss.
• The party seeking to rely on the clause does not have to have suffered loss.
• The purpose of the clause can be to act as a deterrent against a specific breach of contract.
• The penalty does not have to be financial.
• The penalty can only apply to a breach of a primary obligation, not a secondary one, like not paying a contractual penalty.

This significantly widens the position in relation to the enforceability of penalty clauses. In determining whether such a clause is enforceable the court will be obliged to consider the wider commercial context of the agreement. If it can be shown that there is a legitimate reason why breach of contract damages would not be sufficient in the case in question, then even if the amount stated in the penalty clause seems to have no correlation to the actual loss suffered, it may be enforceable.

When negotiating the terms of a contract, the parties may now want to:

• include provisions linking standards of performance to the protection of “legitimate interests”;
• include financial penalties for certain breaches of contract;
• review post-termination restrictions and the consequences of breaching those restrictions;
• remove references to “genuine pre-estimate of loss”; and
• expressly state which provisions are considered primary obligations, and therefore subject to a penalty.

Where the contract has been negotiated by parties of comparable bargaining power who have each sought appropriate professional advice, it will now be much harder for one party to challenge the validity of a penalty clause.

ENDS

This is for information purposes only and is no substitute for, and should not be interpreted as, legal advice.  All content was correct at the time of publishing and we cannot be held responsible for any changes that may invalidate this article.