Supreme Court shifts the goalposts to reframe the test for penalty clauses

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The Supreme Court has handed down its long awaited judgment in the combined cases of Cavendish Square Holding BV v Talal El Makdessi and ParkingEye Limited v Beavis [2015] UKSC 67.  The decision provides some welcome clarity as to the circumstances where the law against penalty clauses will apply, and advises on when a clause will be deemed to be a penalty and therefore held to be unenforceable.

Background

The verdict brings to a conclusion two cases with significantly different factual backgrounds.  The Cavendish case involved clauses in a sale and purchase agreement (SPA) negotiated between two major multinational companies, whereas the dispute in ParkingEye related to the non-payment of an £85 parking fine.  The new tests set out by the Supreme Court are therefore likely to have significant precedence and will be applicable to a wide range of commercial contracts.

In Cavendish, clause 11.2 of the SPA prohibited Mr Makedessi and Mr Ghossoub, who were selling a significant proportion of their shares in a company, from undertaking certain activities that could potentially compete with the interests of the Cavendish Group.  Upon a breach of clause 11.2, clauses 5.1 and 5.6 came into play and provided respectively that:

  • The Sellers would not be entitled to the post sale interim and final payments
  • The Sellers could be required to sell their remaining holding in the Group to Cavendish for a sum that ignored any value for goodwill.

Mr Makedessi admitted a breach of clause 11.2 however argued that clauses 5.1 and 5.6 were unenforceable penalty clauses, a stance which Cavendish contested.

The Parking Eye case was rather more straightforward and concerned a fine issued to a motorist who had overstayed the prescribed 2 hour limit by 56 minutes.  As with most modern parking enforcement operations prominent notices were displayed that informed patrons of the 2 hour window and warned of the potential £85 fine.  Mr Beavis, however, sought to contest the charge on the basis that it constituted an unenforceable penalty and also an unfair contractual term.

The Decision

Prior to the Supreme Court’s intervention in the cases at hand, the law relating to contractual penalty clauses stemmed from a century old decision by the House of Lords in Dunlop Tyres [1915] AC 79, whereby clauses that provided for the payment of a sum that was extravagant and unconscionable in comparison with the greatest conceivable loss were deemed penalty clauses and therefore unenforceable.  Although the old principles have not been completely demolished, it was quickly acknowledged in the Supreme Court’s joint judgement that they were “ancient” and required resetting and clarification.

The new test therefore maintains that certain clauses can still be unenforceable penalty clauses, but shifts the requirements of a penalty clause in a manner that allows the parties greater scope to decide between themselves, in the contract, what is appropriate.

A penalty clause is therefore defined as:

 “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 Court further commented that a failure to reflect a genuine pre estimate of loss was not enough, on its own, to make a clause unenforceable, and that there was a “strong initial presumption that the parties themselves are the best judges of what is legitimate”.

In Cavendish, the Court not only held that the buyer had a legitimate interest in the observance of the non-compete provisions, but also that both clauses 5.1 and 5.6, in adjusting the sale price and conferring an option to buy shares, formed part of Mr Makdessi’s primary obligations and did not therefore engage the penalty rule.

The ParkingEye clause was held to be a secondary obligation as it imposes a separate obligation to pay a fine following a failure to observe the primary obligation of not exceeding the allotted time. However the Court held that ParkingEye had a legitimate interest in charging a sum higher than the actual loss, as the funds from charges were required to effectively provide their service to the landowner.  The £85 charge was further held to be not out of all proportions to this legitimate interest when compared to charges enforced elsewhere and recommended by the industry body.

The relevant clauses in both cases were therefore held, under the new principles, to be valid and enforceable.

Comment

The Supreme Court’s judgment provides some welcome clarification of the rules surrounding penalty clauses and will significantly assist certainty in a wide variety of commercial contracts, particularly where the parties, as in Cavendish, had access to professional advice when forming the contract.

Parties no longer need to be overly concerned as to whether a clause represents a genuine pre-estimate of loss, but will instead need to consider whether a clause constitutes a primary or secondary obligation, what legitimate interests a party is seeking to protect in its contract, and whether the remedy is disproportionate in that context.

If you have any questions about how the Supreme Court’s decision might impact on your existing commercial agreements or would like assistance on any other Corporate and Restructuring matter, please do not hesitate to contact me at Nick.Pickup@forbessolicitors.co.uk or on 0800 321 3258.

Nick Pickup

About Nick Pickup

Nick Pickup is a Solicitor within the Corporate and Restructuring team at Forbes Solicitors. Nick’s blogs cover his specialism of work on mergers and acquisitions, business start up’s, joint ventures, shareholder issues, company restructures and general company advice.
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