Case Law Update: A Tale of Two Clauses

In the recent joint judgment of Cavendish Square Holding BV v Talal El Makdessi ("El Makdessi") and ParkingEye Limited v Beavis ("ParkingEye") [2015] UKSC 67 the Supreme Court reviewed the law on penalty clauses for the first time in a century. The result was a slight refashioning of the test for determining whether a penalty clause is unenforceable in order to provide for its effective application in more complex contractual cases.

Setting the scenes

The plotline of El Makdessi can be summarised as follows: Mr Makdessi entered into a share purchase agreement which contained various clauses imposing consequences on Mr Makdessi should he breach any of the restrictive covenants in the agreement. Clause 5.1 stated that he would not receive the final two instalments of the purchase price of the shares whilst clause 5.6 stated that he could be forced to sell his shares for a reduced sum that excluded the goodwill value of the business. Having then gone on to breach the non-compete restrictive covenant in the agreement, Mr Makdessi tried to argue that clauses 5.1 and 5.6 were unenforceable penalty clauses.

In ParkingEye Mr Beavis incurred an £85 parking charge for failing to keep to the two-hour time limit laid down by a parking operator in Chelmsford. He similarly went on to try and argue that this was an unenforceable penalty clause.

Contrasting defeats

Both Mr Makdessi and Mr Beavis lost their cases, but for differing reasons.

In the case of El Makdessi, the application of the penalty rule as first established in the case of Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd was not called into question with regards to clause 5.6 as it was decided that the rule had not been engaged at all. This is because the penalty rule only applies to secondary obligations of a contract whereas clause 5.6 was a conditional primary obligation (it was effectively a price adjustment clause which belonged alongside the other provisions setting out primary obligations). The judges were more divided as to whether clause 5.1 amounted to a primary or secondary obligation, but all judges agreed that, regardless of its status, this clause was not a penalty because Cavendish had a legitimate interest in Mr Makdessi's observance of the restrictive covenants which went beyond the measure of loss attributable to the breach.

In ParkingEye meanwhile the Supreme Court decided that although the penalty rule was engaged the charge in question did not amount to a penalty firstly because it served to further legitimate interests of the parking operator (i.e. the costs of operating the car park were met through the imposition of such fines), and secondly because the value of the fine was not considered extravagant or unconscionable when compared with other similar parking facilities.

Revolutionising the penalty test

The result of El Makdessi and ParkingEye is that the penalty test now has three distinct elements to it:

1. the clause in question must be a secondary obligation;
2. there must be a legitimate reason behind imposing a charge which is higher than the loss that the imposing party has actually suffered; and
3. there should be some other wider commercial or socio-economic justification for the inclusion of the clause.

If all three elements are met then the charge will not be considered a penalty and the clause will be enforceable.

Impact on public contracts

With public contracts, just as with private sector contracts, the result of this joint judgment should be taken into consideration when drafting secondary obligations. The third limb of the revised penalty test in particular provides food-for-thought for public sector contracting authorities.

In the case of public contracts the foremost objective is not profit but public good. The third limb of the new penalty test could therefore potentially be a useful tool when considering the validity of any secondary obligations.  In such circumstances wider socio-economic justification for a significant fine may be more readily available than in private sector contracts where profit for shareholders is the primary objective.

Similarly in PFI/ PPP projects, where many different contracting parties form a complex web of obligations through numerous agreements, failure to perform an obligation could easily impact on multiple parties rather than simply one. A seemingly extravagant charge in this context could perhaps have wider commercial justification given the domino effect that a breach could have on the entire project.

This article was jointly written by Elizabeth Gibson and Rachel Maddocks.