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The rule on penalties: a new more flexible test
Practical Law UK Articles 9-620-4058 (Approx. 4 pages)
The rule on penalties: a new more flexible test
by David Nitek and Maura McIntosh, Herbert Smith Freehills LLP
| Published on 26 Nov 2015 • United Kingdom |
In a landmark decision that has been welcomed by commercial parties, the Supreme Court has introduced a new test for when a contractual provision will be considered penal and therefore unenforceable. The decision is likely to mean less interference in contracts freely negotiated between properly advised commercial parties of similar bargaining power.
In a landmark decision that has been welcomed by commercial parties, the Supreme Court has introduced a new test for when a contractual provision will be considered penal and therefore unenforceable (Cavendish Square Holding BV v Talal El Makdessi; ParkingEye Limited v Beavis [2015] UKSC 67).
The court has taken the opportunity to re-examine the principles underlying the rule against penalties, which had not been considered by the Supreme Court or the House of Lords for a century. Declining either to abolish the rule entirely or to expand its scope, the court rejected the traditional distinction between a clause aimed at compensating the innocent party, which is enforceable, and one aimed at deterring a breach, which is penal.
The new hallmark for a penalty clause is the provision of a remedy that is out of all proportion to the innocent party's legitimate interest in enforcing the counterparty's obligations under the contract. The decision is likely to mean less interference in contracts freely negotiated between properly advised commercial parties of similar bargaining power.
The underlying disputes
The court heard two appeals that both raised questions as to whether contractual provisions were penal.
Makdessi concerned provisions of a share purchase and shareholders' agreement. These provided that if the seller was in breach of certain non-compete restrictions, he lost his entitlement to deferred consideration that would otherwise be payable and was required to sell his remaining shares at a price that excluded the value of goodwill. The Court of Appeal held that the provisions were penal, as their purpose was deterrence rather than compensation (www.practicallaw.com/6-555-4134).
ParkingEye related to a charge of £85 imposed on an individual, Mr Beavis, for overstaying a two-hour permitted period of free parking at a car park. The Court of Appeal held that the charge was not a penalty (www.practicallaw.com/2-614-2506).
Supreme Court decision
The Supreme Court allowed the appeal in Makdessi but dismissed the appeal in ParkingEye, in each case finding that the provisions in question were not penal.
In Makdessi, the court considered that the relevant provisions protected the buyer's legitimate interest in enforcing the non-compete restrictions in order to protect the goodwill of the business. That had nothing to do with punishing the seller and everything to do with achieving the buyer's commercial objective in acquiring the business. The parties were the best judges of how the value of those interests should be reflected in the agreement (see box "Interference with contracts").
In ParkingEye, the court considered that the charge was justified by the car park operator's legitimate interest in managing the efficient use of the car park and obtaining an income stream to meet its costs and make a profit. The charge was not out of proportion to that interest and so it was not penal.
A more flexible approach
The court's decision means that a clause will not necessarily be penal simply because it is not a genuine pre-estimate of loss or because it is aimed at deterrence rather than compensation. The new test, which focuses on legitimate interests, is significantly more flexible. This should not, however, be taken too far. The court commented that, in a straightforward damages clause, the innocent party's interest will rarely extend beyond compensation for breach, and so the traditional test will usually be adequate to determine the validity of the clause.
The circumstances in which the court will recognise a legitimate interest that goes beyond compensation for financial losses are not necessarily straightforward to predict with any certainty. However, the new test introduces welcome flexibility and is likely to mean that fewer clauses are struck down as penal. It may be particularly significant where the innocent party will not suffer an obvious financial loss as a result of the breach, as in ParkingEye.
In the construction sector, for example, liquidated damages for delay might be set by government entities, which do not necessarily suffer financial losses in the same way as commercial parties, or which may desire the liquidated damages regime to reflect, at least in part, the public utility of a particular service. The new test provides a more workable starting point in that context.
The scope of the rule
The court considered whether the rule should be extended so that it could apply to provisions that take effect other than on a breach of contract, as the Australian courts have done, but it declined to do so. The rule will not apply to primary obligations under a contract, but only secondary obligations that provide a contractual alternative to common law damages.
It may therefore be possible to avoid the application of the rule altogether with careful drafting; for example, by providing for a payment that is conditional on performance rather than an entitlement to liquidated damages in the event of breach. However, the court emphasised that the classification of terms for the purposes of the penalty rule depends on the substance of the term and not mere form.
In Makdessi, for example, the court allowed the appeal also on the basis that the relevant provisions were primary, rather than secondary, obligations and therefore the rule against penalties was not engaged. Although they operated in the event of the seller's breach, they were, in reality, price adjustment clauses and did not provide a contractual alternative to damages.
This focus on substance rather than form could, on the other hand, muddy the waters for those seeking to draft contractual provisions so as to escape the application of the rule. The court commented that if a price adjustment clause is a disguised punishment for the seller's breach, it would make no difference that it was expressed as part of the formula for determining the consideration. So if parties wish to avoid the application of the rule altogether, they will need to ensure that the provisions in question do not, in substance, provide a contractual alternative to damages for breach.
In addition, it is clear from the judgment that the rule is not restricted to clauses requiring payment of money on breach. It will apply to obligations to transfer assets, either for nothing or at an undervalue, and probably also to clauses preventing a party from recovering instalments paid or payable. However, this last point, and the interaction between penalties and forfeiture, is a matter of some debate and disagreement in the different judges' judgments.
In any event, the safe course must be to assume that the rule cannot be avoided by providing for a more creative alternative to liquidated damages. If the clause is, in reality, a secondary obligation that arises on breach, it should be considered carefully to ensure that it will not fall foul of the new rule on penalties.
David Nitek is a partner, and Maura McIntosh is a professional support consultant, at Herbert Smith Freehills LLP.
Interference with contracts
It has long been recognised that the penalty rule is an interference with freedom of contract, and therefore the courts should not be too quick to strike down a clause as penal. The new rule on penalties established by the Supreme Court in Makdessi and ParkingEye supports that approach, both by providing greater flexibility and also by recognising that the circumstances in which a contract was made and the nature of the parties are relevant in considering the application of the rule. The court also said that in a negotiated contract between properly advised parties of comparable bargaining power, the strong initial presumption must be that the parties are the best judges of what is legitimate in a provision dealing with the consequences of breach.