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Supreme Court clarifies law on penalties

The Supreme Court has handed down its much awaited decision in the consolidated appeals of Cavendish v El Makdessi (Cavendish) and ParkingEye v Beavis (ParkingEye) (2015). The two (very different) appeals gave the Supreme Court an opportunity to review the law on penalties, which was established 100 years ago.

In 1915, Dunlop Pneumatic Tyre Co Ltd v New Garage & Motor Co Ltd found that if a penalty is a genuine pre-estimate of the innocent party's loss on breach, then it is enforceable. But, if the penalty for breaching the contract is "extravagant, exorbitant or unconscionable", in other words is excessive and has no relation to the total losses that the innocent party could have suffered on breach, then it is a penalty and is unenforceable. 

For the past century, there has been a general policy against contractual penalty clauses. The courts have often made great efforts to ensure that penalties are not enforced, even if they reflect the negotiated position of two parties of equal bargaining power. 

Many have argued that this approach should be abolished. They feel it does not reflect the modern commercial world and that parties should be free to negotiate and agree whatever terms they like. A review of the penalty rule has therefore been eagerly anticipated.

Below we summarise the Supreme Court’s recent decision and set out its implications for the law on penalties.

Background to the appeals 

Cavendish

Cavendish concerned two clauses in a substantial commercial contract that meant Mr Makdessi would forfeit his entitlement to deferred payments from Cavendish and be required to sell his shares at a reduced price, if he breached some of the restrictive covenants in the contract. 

Mr Makdessi breached the covenant and when Cavendish sued, he argued that the clauses were penalties and not enforceable.

Cavendish decision

The Supreme Court held that the penalty rule did not apply but if it did, then the clauses were not enforceable. 

The penalty rule did not apply because the clauses were just a way of adjusting the price of the shares and they had no relation to the loss suffered by Cavendish on Mr Makdessi's breach. 

The aim of the clauses was to encourage Mr Makdessi's loyalty and Cavendish had a legitimate interest to ensure that the restrictive covenants were observed by Mr Makdessi. 

The contract had been carefully negotiated between informed and legally advised parties at arm's length and the clauses should not be regarded as being "extravagant, exorbitant or unconscionable" as a consequence. 

The court could not know what the deal would have been had the covenant not been given. As such, it must defer to the parties who were the best judges of their interests. The court would not interfere in such circumstances. 

ParkingEye

ParkingEye concerned an £85 parking charge that had been imposed on Mr Beavis after he overstayed at the car park by one hour. Mr Beavis contested his liability to pay the charge on the basis that it was a penalty and/or was contrary to the Unfair Terms in Consumer Contracts Regulations 1999. 

ParkingEye decision

The Supreme Court held that the parking charge was not a penalty and that there had not been a breach of the Unfair Terms Consumer Contracts Regulations 1999 because:

  • ParkingEye has a legitimate interest in charging overstaying motorists. The charge deterred users of the cark park from staying in the parking spaces for long periods, thereby reducing the space available to other members of the public. The charge also provided an income stream to enable ParkingEye to meet the costs of operating the scheme. 
  • The £85 charge was not unreasonable when compared to the charges of other car parking providers and the car park was well used despite the charge. This was evidence of the reasonableness of the charge. 

Revised penalty clause test to protect ‘legitimate interests’ of innocent party

The Supreme Court has reviewed the law on penalties. 

The test is now whether the clause imposes a detriment to the party breaching the contract that is out of proportion to the legitimate interests of the innocent party.

You should consider:

  • whether any (and if so what) legitimate business interest is served and protected by the clause;
  • whether that clause can be justified; and
  • if it can be justified, whether the clause is "extravagant, exorbitant or unconscionable".

You must identify what the innocent party's interests are in ensuring performance. Is the penalty disproportionate when compared to those interests?

The test will be fact dependent and the answers will depend on the circumstances of each individual case.

What next? The practical considerations

The Supreme Court decision has wider implications: 

  • The above test should be considered when drafting individually negotiated commercial contracts, construction contracts as well as your every day non-negotiated consumer agreements. 
  • You should keep a contemporaneous note of negotiations and you should explain why a particular clause protects your legitimate commercial interests. 
  • Consider whether your negotiated contract should say that certain clauses are included to protect the legitimate business interests of both parties or a particular party and that the parties regard that clause as proportionate to those interests.
  • If your aim is to deter a party from breaching the contract, then that deterrence will not necessarily be penal, and therefore unenforceable. This is good news and you may wish to review your existing contracts.
  • The court is less likely to interfere where the contract has been negotiated between parties of equal bargaining power. This is good news. However, the question of what will amount to a legitimate interest and whether the protection of that legitimate interest can be justified is likely to be the subject of much debate and will need to be considered on a case by case basis. We recommend that you seek legal advice as soon as this issue arises. 

This publication is intended for general guidance and represents our understanding of the relevant law and practice as at November 2015. Specific advice should be sought for specific cases. For more information see our terms & conditions on www.TLTsolicitors.com

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