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Nicholas Goodfellow and David Lascelles discuss the Supreme Court judgment on penalty clauses in the Cavendish and ParkingEye cases.

The Supreme Court has handed down judgment ([2015] UKSC 67) in two appeals concerning the law relating to contractual penalty clauses. Firstly, in the context of a substantial commercial contract relating to the sale of shares: Cavendish Square Holding BV v Makdesssi. Secondly, in a case arising in the consumer context relating to a charge imposed for overstaying in a retail car park: ParkingEye Ltd v Beavis.

The majority judgment was given by Lord Neuberger and Lord Sumption (with whom Lord Clarke and Lord Carnwarth agreed).

Legal principles
Whilst the penalty rule was described as "an ancient, haphazardly constructed edifice which has not weathered well…” (see [3]) arguments that it should abolished (or extended) were both rejected. The focus of the Supreme Court was on refining the test.

Two key questions arise:

  1. In what circumstances is the penalty rule engaged? (see [12]-[18])
  2. What makes a contractual provision penal? (see [19]-[35])

In what circumstances is the penalty rule engaged?
Whether the penalty rule applies may depend on how the relevant obligation is framed in the instrument (see [14]). A distinction is drawn between (a) a secondary obligation providing a contractual alternative to damages, and (b) a conditional primary obligation. As to this:

  • Secondary obligation providing alternative to damages: a contract contains an obligation on one party to perform an act, and also provides that, if he does not perform it, he will pay the other party a specified sum of money; this is capable of being a penalty.
  • Conditional primary obligation: the contract does not impose (expressly or impliedly) an obligation to perform the act, but simply provides that, if one party does not perform, he will pay the other party a specified sum; this cannotbe a penalty.

What makes a contractual provision penal?

"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. 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…” (see [32])

In applying this test it will be necessary to identify where the innocent party’s ‘interests’ lie.

In the case of a straightforward damages clause, that interest will rarely extend beyond compensation for the breach. In such a case the four tests per Lord Dunedin in the leading case of Dunlop [1915] AC 79 will "usually be perfectly adequate to determine [the clause’s] validity…”.

However compensation is not the only legitimate interest that the innocent party may have (see the analysis of facts of Cavendishand ParkingEye below).

The question of whether a clause is a penalty falls to be determined as a matter of construction at the time it was agreed (see [9]). The circumstances in which the contract was made may be relevant. For example, "In a negotiated contract between properly advised parties of comparable bargaining power, the strong initial presumption must be that the parties themselves are the best judges of what is legitimate in a provision dealing with the consequences of breach…” (see [35]).

Cavendish v Makdessi

The case concerned a share sale agreement in which the sellers agreed to sell a majority stake in a particular company. These shares were transferred to Cavendish, who was substituted as a party to the agreement, and came to hold 60% of the shares in the company, while the sellers retained 40%.

The agreement had been the subject of extensive negotiations over six months, and both sides were represented by highly experienced and respected commercial lawyers (see [47]).

The agreement contained a clause entitled ‘Default’ (clause 5) which was engaged if one of the Sellers breached a clause containing restrictive covenants against competitive activities (clause 11.2; see [52] for the precise wording) and provided that:

  1. The ‘Defaulting Shareholder’ (defined to include a seller who had breached clause 11.2) would not receive the last two tranches of the price paid by Cavendish for the shares in the company (clause 5.1);
  2. Cavendish could also require the Defaulting Shareholder to sell all of his remaining shares at a price based on asset value, but ignoring any goodwill (clause 5.6).

One of the sellers, Mr Makdessi, breached clause 11.2, and Cavendish brought proceedings seeking a declaration that he was a Defaulting Shareholder and not entitled to the last two tranches of payment for the shares, and sought specific performance of clause 5.6.

The Court held that Clauses 5.1 and 5.6 were not unenforceable penalty clauses.

Clause 5.1
This was a price adjustment clause, and not a contractual alternative to common law damages (see [74]). Therefore, it was a primary obligation.

In any event, despite there being no relationship between clause 5.1 and the loss attributable to breach of clause 11.2, Cavendish had "a legitimate interest in the observance of the restrictive covenants which extended beyond the recovery of that loss…” on the basis that the goodwill of the company’s business was critical to its value to Cavendish (see [75]).

Clause 5.6
This was also a primary obligation (see [83]), and justified by the same legitimate interest as clause 5.1 (see [82]). The price formula for Cavendish acquiring the shares had nothing to do with punishment, and everything to do with achieving Cavendish’s commercial objective in acquiring the business.

In respect of both clauses 5.1 and 5.9, emphasis was placed on the fact that the parties were on an equal footing with experienced legal representation on both sides over a long period of time in negotiating the agreement (see [75] and [82]).

ParkingEye v Beavis

This case was more straightforward on the facts. ParkingEye managed a car park at a retail site which provided free parking for customers for 2 hours, and a fine of £85 for customers who overstayed. Notice of the charge was displayed in large prominent signs throughout the car park. Mr Beavis overstayed for almost one hour, and when Mr Beavis did not pay the £85 ParkingEye commenced proceedings against him. As part of his defence, Mr Beavis argued that the charge was unenforceable as a penalty. It was common ground that a contract existed between ParkingEye and Mr Beavis.

The Court held the charge was not a penalty.

Whilst ParkingEye was not liable to suffer loss as a result of overstaying motorists, it had a legitimate interest in charging which extended beyond the recovery of any loss (see [99]). The charge had two main purposes. Firstly, to manage the efficient use of parking space in the interests of the retail outlets (by deterring customers from overstaying). Secondly, to provide an income stream to enable ParkingEye to meet the costs of operating the scheme and make a profit from its services.

The ‘true test’ of whether a clause is a penalty requires a careful analysis of:

  1. The precise nature of the obligation under challenge, and whether it can properly be classified as ‘secondary’;
  2. The ‘legitimate interests’ of the innocent party in seeking performance of the primary obligation.

These cases illustrate that clauses which provide for amounts to be paid (or not paid) and which bear no relationship between the breach in question and the loss may nonetheless be upheld if they are supported by a legitimate interest.

In assessing what may comprise such an interest, the commercial objectives of the innocent party are likely to be all important. Commercial parties in breach, who have been represented by experienced lawyers when negotiating the agreement in question are likely to be in a weaker position. In such cases, the Court may well conclude that the parties themselves were best placed to judge the commercial interests of each other.

Posted: 05.11.2015 at 09:42
Tags:  Comments  Commercial Law
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