Supreme Court clarifies the rules on penalty clauses
13th November, 2015
Recent Supreme Court judgments in two cases have sought to clarify the law on liquidated damages clauses in commercial contracts and the circumstances in which such clauses will be deemed to be unenforceable as a "penalty".
The rulings in both cases have important implications for a range of different contracts.
What happened in ParkingEye?
The first of these cases – ParkingEye Limited v Beavis – was regarding an £85 charge levied by ParkingEye Limited to a Mr Barry Beavis for overstaying his welcome in a car park.
Mr Beavis overstayed the 2 hour maximum by 56 minutes, but refused to pay the £85 charge on the basis that the charge was:
- unenforceable at common law as a penalty; and
- unfair and unenforceable by virtue of the Unfair Contract Terms in Consumer Contracts Regulations 1999.
What happened in Cavendish?
In the second case – Cavendish v Talal al Makdessi – the matter in issue was whether the consequences of a breach of restrictive covenants in a Share Purchase Agreement constituted unenforceable penalties.
The contract contained restrictive covenants together with provisions to the effect that in the event of a breach of the restrictive covenants, Mr Makdessi would (i) forfeit his right to the remaining instalment payments in consideration for his shares; and (ii) Mr Makdessi would be required to sell his remaining 20% shareholding to Cavendish. The effect on Mr Makdessi being that he could receive up to US$44,181,600 less for his share of the group, if he breached the restrictive covenant provisions.
By the time of trial, the fact that Mr Makdessi had breached the restrictive covenants was not in dispute. However, Mr Makdessi alleged that the wording of the non-compete provisions meant that they were penalties at common law and were therefore unenforceable.
What did the Supreme Court say?
The Supreme Court rejected arguments advanced to the effect that the penalty clause rule was “antiquated, anomalous and unnecessary” and should be abandoned entirely. Instead the Supreme Court sought to clarify the law on penalty clauses, in light of what they recognised as confusion in the existing common law position in respect of the categorisation of penalties, deterrents and “genuine pre-estimates” of loss.
In seeking to clarify the test as to whether a clause is an unenforceable penalty, the Supreme Court explained that: “The true test is whether the impugned provision is 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.”
Although, in a simple case, the legitimate interest might be compensation for the breach, the Supreme Court recognised that the innocent party may have other legitimate interests to protect, for example based on commercial justification.
In ParkingEye Limited v Beavis, the Supreme Court considered that ParkingEye had a legitimate business interest in enforcing the £85 charge and that the charge was not an unenforceable penalty. The court considered that the legitimate objectives, amongst others, included the fact that one of the main objectives was to manage the efficient use of parking space in the interest of the retail units and their customers, as well as providing an income to ParkingEye so that they could provide this service.
The Supreme Court also found that the term imposing the £85 charge was not unfair under the Unfair Terms in Consumer Contracts Regulations. Although it could be said that there was a significant imbalance between the term and the position under trespass laws, it was not contrary to the requirement of good faith. Further, clear signage had been displayed and consumers still continued to use the car park.
This contract pre-dated the implementation of the Consumer Rights Act 2015 though the same provisions regarding unfairness are incorporated into the 2015 Act and therefore there is nothing to suggest that the Supreme Court would have taken a different view as to the fairness of the term.
In Cavendish v Talal al Makdessi, the Court held that the clauses within the contract were not unenforceable as penalties because Cavendish had a legitimate interest in the observance of the non-compete provisions, in order to protect the goodwill of the business generally.
The goodwill of the business (which required Mr Makdessi’s loyalty) was critical to Cavendish and therefore the non-compete provisions were considered to be a legitimate way of protecting Cavendish’s interests. The Supreme Court also noted that the contract was a “carefully negotiated agreement between informed and legally advised parties” and was not considered to be “extravagant, exorbitant or unconscionable”.
The Supreme Court noted that it was not the function of the penalty rule to allow the courts to review the fairness of the parties’ primary obligations.
What does this mean for me?
The Supreme Court made clear in both cases that in order to be enforceable, a liquidated damages clause must be proportionate to a legitimate interest.
When drafting commercial contracts, the current test as to whether the clause is a “genuine pre-estimate of loss”, will remain a good starting point for consideration of the clause, as an assessment of the likely damage to the innocent party remains a relevant factor in considering whether the liquidated damages provision is excessive.
However, parties seeking to rely on the benefit of a liquidated damages provision should also consider including an express provision to state that it is agreed that the liquidated damages are to protect legitimate business interests, and where possible the clause should state what those interests are (for example, in Cavendish, the clause could have referred expressly to the importance of goodwill).
How can Ward Hadaway help?
We can assist you when drafting or negotiating liquidated damages provisions within your customer or supply contracts and also advise on enforceability of such provisions.
If you would like further information or guidance on the implications of this case then please contact us.
Please note that this briefing is designed to be informative, not advisory and represents our understanding of English law and practice as at the date indicated. We would always recommend that you should seek specific guidance on any particular legal issue.
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