In a recent judgment, the Supreme Court has clarified the law relating to contractual penalty clauses – the first time the penalty rule has been considered by the Supreme Court or the House of Lords for a century.
The penalty rule
The penalty rule is potentially engaged where a contract, as well as specifying the parties’ primary obligations, also sets out the consequences for a party that fails to perform an obligation. For example, a contract could provide that a party in breach would have to pay a specified sum of money to the innocent party in compensation. Such a provision, known as a liquidated damages clause or a secondary obligation, may be a helpful way of avoiding litigation over damages.
Liquidated damages clauses are commonly used in contracts for the supply of goods to provide an agreed remedy for late delivery, and in construction contracts to avoid disputes over late performance. The penalty rule may be engaged by a share purchase or asset purchase agreement, where the purchase price is payable in instalments and post-completion payments may be withheld if the seller is in breach. Also relevant would be exit provisions in a shareholders’ agreement requiring a party in default to sell their shares in the company at a discounted value.
In general, the courts will uphold such provisions if the sum payable by the party in breach of the contract is a genuine pre-estimate of the loss to be suffered by the innocent party. A sanction will also be upheld if it is considered to be part of a primary obligation (for example, where a payment to be made by one party is conditional on the other party’s compliance). However, it has long been the law that, where a secondary obligation is so far in excess of the innocent party’s likely loss as to amount to a penalty, the provision is not enforceable. The penalty rule thus operates as a limit to the doctrine of freedom of contract: the courts will not enforce a provision amounting to a penalty, even where it has been agreed by the contracting parties.
In practice, the distinction between a clause providing for liquidated damages and a penalty clause has not always been easy to draw, especially in cases where the consequences of breach for the innocent party may be more wide-ranging than the immediate financial loss suffered. In some cases, the courts have upheld provisions that were considered to be commercially justifiable even if the sum to be paid by the party in breach could not be described as simply a pre-estimate of the innocent party’s loss.
The Supreme Court has now reconsidered the penalty rule in its decision on two conjoined cases, Cavendish Square Holding BV v El Makdessi and ParkingEye Ltd v Beavis  UKSC 67. Their Lordships declined the opportunity to abolish the rule, noting that most jurisdictions have some means by which a party in breach of contract is protected from having to pay excessive compensation to the innocent party. They have, however, affirmed the principle that a provision does not need to be a genuine pre-estimate of loss to be upheld as commercially justifiable and not a penalty.
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Cavendish v El Makdessi
The first case, Cavendish Square Holding BV v El Makdessi, concerned the sale of shares in a group of companies which formed the largest advertising agency in the Middle East. The contract for the purchase of the shares provided that Mr El Makdessi and Mr Ghossoub, the sellers, would sell some of their shares in the group to Cavendish, giving Cavendish a majority stake in the group. The price payable for the shares comprised initial and second payments amounting to a total of $65.5 million and interim and final payments amounting to a possible further maximum of $82 million, depending on the group’s profits.
The contract also provided that the sellers must comply with restrictive covenants preventing them from competing with the group for a certain period. A seller in breach of the restrictive covenants would not be entitled to receive the interim or final payments (which in Mr El Makdessi’s case would have amounted to about $44 million), and would have to sell all their remaining shares in the group to Cavendish for a price to be determined in accordance with the group’s net asset value, which ignored the significant goodwill in the group.
Mr El Makdessi breached the restricted covenants and admitted he had done so, but argued that the provisions in the contract denying him the interim and final payments and requiring him to sell his remaining shares to Cavendish at a value ignoring goodwill should not be enforced because they were penalties.
The Supreme Court disagreed, upholding the provisions in question, even though those provisions went far beyond recovery of a genuine pre-estimate of loss. Their Lordships found that the effect of Mr El Makdessi’s breach of the restrictive covenants on the group’s business was likely to be very significant, since he had founded the group, was closely identified with it, and had very strong relationships with its clients and employees. Consequently, the provisions applying in the event of breach "had a legitimate function which had nothing to do with punishment and everything to do with achieving Cavendish’s commercial objective in acquiring the business" (Lord Neuberger and Lord Sumption).
ParkingEye v Beavis
The second case, ParkingEye Ltd v Beavis, was quite different. It concerned a charge imposed for parking in a car park for longer than the time permitted. Mr Beavis parked his car in a car park provided for shoppers at a retail park in Chelmsford. The car park was managed by ParkingEye, and notices explained that users could park for up to two hours without charge but would have to pay a parking charge of £85 if they parked for longer than two hours. Mr Beavis parked for nearly three hours, and ParkingEye sought to recover the parking charge from him. Mr Beavis argued that the charge was a penalty and so unenforceable.
The Supreme Court upheld the parking charge, considering that it did not infringe the penalty rule. The purpose of the charge was to manage the use of the parking space efficiently in the interests of the shops in the retail park and their customers, and to provide an income to enable ParkingEye to operate the car park. Consequently, ParkingEye had a legitimate interest in making the charge, which was not excessive, even though there was no direct relationship between a motorist’s overstaying the two-hour limit and any loss sustained by ParkingEye. Since the scheme served a legitimate interest, any deterrent effect was not penal and so permissible. It was also held that the £85 charge did not infringe the Unfair Terms in Consumer Contracts Regulations 1999, although Lord Toulson dissented on this point.
The Supreme Court has confirmed that the penalty rule is still good law and, in simpler cases, the question of whether the payment concerned represents a genuine pre-estimate of loss will still be relevant. In more complex cases, however, the test will be "first, whether any (and if so what) legitimate business interest is served and protected by the clause, and, second, whether, assuming such an interest to exist, the provision made for the interest is nevertheless in the circumstances extravagant, exorbitant or unconscionable" (Lord Mance). As Lord Neuberger and Lord Sumption put it, the question is whether the provision "imposes a detriment on the contract breaker that is out of all proportion to the legitimate interest of the innocent party".
When parties are negotiating a liquidated damages clause in a contract, it will be advisable for the party seeking inclusion of the clause to provide a brief explanation of why the amount specified is a reasonable protection of a legitimate commercial interest. This will assist in defending the clause as enforceable against any future litigation alleging that it is a penalty.