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Enforcement of Contractual Penalty Clauses

Freedom of contract lies at the heart of English law and parties are “masters of their own contractual fate”. The question is how, if at all, does the law intervene when a contract imposes consequences which are fixed in advance and are oppressive such as the payment of a large sum payable on breach? The argument is that such clauses act as a ‘penalty’ and are commonly used by financially stronger parties as a tool for discouraging breach. These sums are usually excessive and are disproportionate to the parties’ actual losses. Such provisions will be subject to the ‘penalty rule’ and will not be enforced if certain tests fail.

Traditional Test

A liquidated damage clause is one which fixes in advance a sum of money to be paid by the defaulting party to the innocent party in the event of breach. As a general rule liquidated damages clauses are enforceable and the sums due recoverable if they represent a genuine pre-estimate of loss. Conversely, if a clause is deemed to be a ‘penalty’ it will not be enforceable beyond the actual loss suffered.

The traditional test on penalty clauses was set out by the House of Lords in the case of Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd (1915). Lord Dunedin referred to the following 4 tests to determine if a clause is an unenforceable penalty:

  1. The provision would be penal if the sum stipulated for is extravagant and unconscionable in amount when compared to the greatest loss that could conceivably be proved to have followed from the breach;
  2. The provision would be penal if the breach consisted only the non-payment of money but provided for payment of a larger sum;
  3. There is a presumption that the provision would be penal if the sum is payable in a number of events of varying gravity; and
  4. The provision would not be penal by reason only of the impossibility of precisely pre-estimating the true loss.

Therefore, if the amount of liquidated damages is extravagant, unconscionable, bears no resemblance to the loss and is intended to deter breach the court is likely to construe it as a penalty. The above 100 year old rule in Dunlop is still of relevance today but is no longer the primary authority.

Cavendish Square Holding BV v Talal El Makdessi (2015)

In the above case the defendant had agreed to sell his controlling stake in the largest advertising group in the Middle East to the claimant in stage payments. The Share Sale Agreement contained non-compete covenants breach of which would entitle the claimant to forfeit the balance of the price payable by the claimant to the defendant for his shares and would require the defendant to transfer all his remaining shares to the claimant for a price which excluded the goodwill. The defendant accepted the breach of covenant but alleged that the clauses were penalties and therefore unenforceable.

At First Instance the court held these were not penalty clauses as their was not to deter breach but to adjust the consideration between the parties. On the facts, there was potential for substantial impact on goodwill if the defendant’s covenants were breached. The claimant was entitled to assess the value of the breach of covenant by reference to the greatest loss that could conceivably be proven to have followed from the breach.

On appeal the Court of Appeal reviewed the penalty rule by repeating the principles in Dunlop but focused on a more flexible approach adopted in more recent cases. The court clarified that where the dominant purpose of a clause is to deter breach and the amount is commercially justified then it would not be a penalty. The defendant’s appeal was upheld as the court held that the clauses in question were intended to deter breach, did not reflect a genuine pre-estimate of loss, were extravagant and unreasonable when compared to the likely damage from the breach with no commercial justification. The claimant appealed to the Supreme Court the decision of which is explored below.

ParkingEye Ltd v Beavis (2015)

In the above case the defendant parked in a car park that was operated by the claimant. The car park’s signs stated that the maximum stay was 2 hours after which an £85 charge would apply. The defendant overstayed for almost 1 hour and was charged £85 which he refused to pay claiming it was a penalty.

At First Instance the court stated that motorists park in accordance with the Terms and Conditions at the entrance of the car park and on the noticeboards thus entering into a contract. The contract in question included an obligation to leave within 2 hours which if the motorist did not comply with amounts to an agreement to incur the charge. This term has the features of a penalty as the claimant does not suffer any actual loss if the obligation is breached. The court held that the predominant purpose of the term is to deter but is a commercially justifiable term that is not improper or excessive in amount and not unfair under the Unfair Terms in Consumer Contracts Regulations 1999.

The defendant appealed to the Court of Appeal which reflected the First Instance decision that the charge was not a genuine pre-estimate of loss, aimed at deterring motorists from overstaying but was not extravagant or unconscionable and was justified commercially and socially. The defendant appealed to the Supreme Court.

Supreme Court

The Supreme Court delivered a joint decision in the above 2 cases. The court was asked to consider a range of options including the abolition of the penalty rule or extending it to apply more broadly. The court rejected the traditional test in Dunlop and the following test was laid out – in paragraph 32:

“…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. The innocent party can have no proper interest in simply punishing the defaulter. His interest is in performance or in some appropriate alternative to performance.”

The real question therefore is if a clause is truly penal and not if it is a pre-estimate of loss. If it is not a true pre-estimate of loss this does not without more render the clause penal. Describing the clause as a deterrent simply means that it is designed to influence a party’s conduct but it does not mean that it is fundamentally penal or contrary to public policy. The enforceability of clauses of such nature will to some extent depend on whether they are unconscionable or extravagant.

The decision also draws a distinction between primary and secondary obligations in determining the validity and enforceability of such clauses. If a contract does not impose an obligation to perform an act and only provides that if a party does not perform the contract it will pay a sum to the other party, such an obligation is primary in nature and cannot be a penalty. A secondary obligation is an obligation to perform an act which if not performed imposes an obligation on the defaulting party to pay the innocent party a specified sum. The obligation to pay is a secondary obligation which is capable of being a penalty.

Cavendish Decision

The Supreme Court held that the 2 clauses were not penal in nature as they were primary obligations which provided for an adjustment to the purchase price equivalent to the other primary price calculation clauses. The clauses were also commercially justified by the claimant’s rightful interest in protecting the goodwill of the company and the parties were the best judges as to how this was to be achieved and reflected in the contract.

ParkingEye Decision

The Supreme Court held that the £85 charge was a secondary obligation with the aim of deterring breach but was not penalty. The claimant and owner both had legitimate interests in deterring breach. For the owner this was the provision and efficient management of customer parking for nearby retail outlets and for the claimant it was a source of income to cover costs of operating the car park in accordance with its business model and a small profit. In light of the above, it was not a penalty as the charge was reasonable and proportional to their commercial interests.

Practical Considerations

If a sanction is intended to form part of a primary obligation it is worth ensuring that it is drafted clearly so as to avoid the risk of being interpreted as secondary and possibly a penalty. Even then, the court will be able to distinguish between substance and form and in some cases this will ultimately depend on how the provision is framed.

If an obligation is in fact intended to be secondary it is advisable to consider its background and any commercial justifications and what the primary obligations are based on. The overall effect of breach should also be taken into account. A clause will not be a penalty for example where its purpose is to maintain a system of trade. Simultaneously, the sanction should not be beyond the norm or in other words extravagant or unconscionable. Industry norms ought to be considered if there are any and what others charge in similar situations. If there is no direct comparable norm it may simply be a matter of ‘feel’.

Conclusion

The Supreme Court has offered a much-needed clarification of the law and practical guidance in modern commercial contracts. It has re-affirmed the principle of contractual freedom and the court’s respective role. It is likely that further guidance will follow as legitimate interests and their proportionality are not easily identifiable.

Although there is a diversity of approaches in European private law there is general consensus that some form of protection is necessary with some differences in degree and extent. In general the courts of European jurisdictions tend to accept the validity of liquidated damages clauses unless they cause unacceptable consequences. For example, the payment of the sum due under the contract may be amended if equity so requires under Dutch law, if unconscionable under Swedish law, if unreasonably high or manifestly excessive under German, Italian and Polish law and the amount may be decreased or increased if excessive or insufficient under French law.

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