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Supreme Court judgment on penalty clauses in the Cavendish and ParkingEye cases

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

Introduction
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

Facts
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.

Application
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

Facts
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.

Application
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.

Comment
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.

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