The Supreme Court has clarified the rule against penalties in its recent judgment ParkingEye Limited v Beavis and Cavendish Square Holdings v Talal el Makdessi  UKSC 67.
This is the first time in a century that the Supreme Court has addressed the rule, with the judgment both confirming the existence of the doctrine of penalties and providing welcome guidance in a modern commercial context.
The rule against penalties is longstanding in English law and the general principle is that if a clause is a penalty, it will not be enforced beyond the actual loss of the claimant.
The traditional test to distinguish unenforceable penalty clauses originates from the judgment in Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd (1915), which focused on whether the clause constituted a “genuine pre-estimate of damage”. This has been reformulated by the Supreme Court, who criticised the law as becoming “the prisoner of artificial categorisation”. The Court has in turn moved the focus away from the traditional “genuine pre-estimate of damage” to placing a greater emphasis on the innocent party’s “legitimate interests”.
The appeals heard by the Court arose in very different contexts; however the validity of the disputed clauses was upheld in both cases.
ParkingEye Limited v Beavis related to an £85 penalty charge imposed on Mr Beavis for overstaying the free two-hour parking limit. The penalty charge was held to be enforceable, despite being a secondary obligation (see below) as the car park operator had a legitimate interest in ensuring there was available parking for other potential customers and to generate a profit margin.
Cavendish Square Holdings v Talal el Makdessi concerned a price adjustment clause in a share purchase agreement which took effect if the seller, Mr Makdessi, breached certain restrictive covenants. The clause in dispute was held to be enforceable as it was a primary and not a secondary obligation. The buyer, Cavendish, had a legitimate interest in the observance of the restrictive covenants, in order to protect the goodwill of the business. The Court recognised that the contract had been negotiated in detail between commercial parties of similar bargaining power.
The Supreme Court reformulated the test for an unenforceable penalty clause and found that the true test is whether the disputed 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 Court in this approach drew a distinction between primary obligations (i.e. the terms to be performed under the contract) and secondary obligations (i.e. those that come into play once a breach occurs). It was determined that the penalty rule will only apply to secondary obligations and will allow the innocent party to protect its legitimate interests in a proportionate manner.
The resulting true test can therefore be divided into two parts:
- Is the obligation secondary? If so,
- Does the provision protect a legitimate interest in an exorbitant or unconscionable way?
This judgment has provided some welcome clarification in the area of penalty clauses.
The Supreme Court has confirmed that to avoid the penalties rule, commercial parties should focus on whether the relevant clause proportionately protects a legitimate business interest that is not extravagant or unconscionable. The judgment has also provided commercial parties with relative confidence that their negotiated agreements will be enforced, meaning that commercial negotiation and drafting will be increasingly important.
There is still room for further clarification, and it will be interesting to see the approach of the lower courts. In particular, the interpretation of what constitutes a proportionate legitimate interest and manoeuvering around the penalty rule on the basis of primary and secondary obligations will undoubtedly cause difficulties. As a result, the increased flexibility of the true test may in fact hinder commercial negotiations and make it difficult for parties to predict when the penalty rule will apply.
In approaching clauses concerning liquidated damages, price adjustments and “take or pay” obligations (an obligation to pay for goods or services even if no longer required), commercial parties may be best advised to set out an explanation of what their legitimate interest is to justify a particular charge in the contractual bargain reached.
It should also be noted that the Supreme Court has advised that they will assess the substance of the parties’ agreement and not simply the form, such that any attempt to avoid the penalty rule through a cleverly structured clause making payment conditional upon the main terms to be performed under the contract (a primary obligation) will be of limited assistance.
Ultimately, it should be remembered that following this judgment, where parties with equal bargaining power have negotiated contractual terms, it will be harder to challenge the validity of those provisions if a dispute should arise.
Author - Lucinda Burgoine
For further information on this subject, please contact Craig Chaplin.This information is intended as a general discussion surrounding the topics covered and is for guidance purposes only. It does not constitute legal advice and should not be regarded as a substitute for taking legal advice. DWF is not responsible for any activity undertaken based on this information.