Penalties - Supreme Court reviews the law

In two contrasting cases, one concerning an arm’s length professionally negotiated commercial contract, and another concerning a consumer contract, the Supreme Court has delivered its judgment representing a fundamental review of the law regarding penalties.

The law of penalties applies to contractual clauses operating on a breach of contract by the other party to the contract.  We summarise two recent cases:

Cavendish Square Holdings BV v Talal El Makdessi:  Mr Makdessi had agreed to sell his shares to Cavendish.  The contract contained a clause (5.1) under which, if Mr Makdessi became a “defaulting shareholder” by being in breach of restrictive covenants or having been summarily dismissed, he would lose his entitlement to the final two instalments of the price paid by Cavendish.  He would also, under another clause (clause 5.6), be obliged to sell his remaining shares to Cavendish at a price significantly below the true value (excluding the value of the goodwill of the business).  In the High Court, the clauses were held not to be penalties, but this was overturned in the Court of Appeal which held that the clauses were unenforceable penalties.  Cavendish appealed.

ParkingEye Ltd v Barry Beavis:  ParkingEye was a car park operator.  It displayed notices in its car park saying that a failure to comply with a two hour time limit for free parking would result in a parking charge of £85.  Having overstayed the time limit by almost an hour, Mr Beavis resisted payment of the £85 charge and argued it was unenforceable at law as a penalty.  He also argued that it was unfair and unenforceable by virtue of the Unfair Terms in Consumer Contracts Regulations 1999.  Both the first instance decision and Court of Appeal held that the charge was not a penalty and was therefore enforceable.  Mr Beavis appealed.

The Supreme Court held:

  • In the Cavendish case, neither clauses 5.1 nor 5.6 were held to be unenforceable penalty clauses.  The Supreme Court placed great emphasis on the fact that in a negotiated contract between professionally 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 consequences of breach of the contract.  The Court was prepared to assume, without deciding, that a clause such as 5.1, which disentitled a contract-breaker from a sum of money to which it would otherwise be entitled, was capable of being a penalty.  Primary obligations would not normally engage the penalties rule.  Cavendish had a legitimate interest in the observance of the restrictive covenants which extended beyond the recovery of loss for breach.  The goodwill of the business was critical to its value to Cavendish.  Likewise, clause 5.6 was justified by the same legitimate interest in that it reflected the reduced price which Cavendish would have been prepared to pay for the business if it had not been able to count on the loyalty of Mr Makdessi.  Both clauses were legitimate clauses designed to achieve Cavendish’s commercial objective in acquiring the business.
     
  • In ParkingEye, the Supreme Court held that the charge did not contravene the rule against penalties nor did it contravene the Unfair Terms in Consumer Contracts Regulations 1999.  While the penalty rule was plainly engaged, the £85 charge was not a penalty.  The imposition of the charge had two main commercial objectives: to deter commuters from abusing the provision of parking spaces, and to provide an income stream to ParkingEye to meet the costs of operating the scheme and make a profit from its services.  This did not mean that ParkingEye could charge exorbitant amounts to overstayers.  The test was whether the sum was extravagant or unconscionable.  The Supreme Court agreed with the trial judge and with the Court of Appeal that £85 was neither extravagant nor unconscionable having regard to the level of charges imposed by local authorities for overstaying in car parks on public land.  The mere fact that motorists chose to use the car park on those terms was evidence of its reasonableness.  They were not constrained to do so (as they might be in other cases, such as railway stations).  The Court also held that the same considerations which showed that the charge was not a penalty demonstrated that it was not unfair for the purpose of the Unfair Terms in Consumer Contracts Regulations 1999.

Comment: The Supreme Court has updated and clarified the law on penalties.  The Court distinguished between secondary obligations (those triggered on breach of contract) which would engage the penalties rule, and primary obligations which would ordinarily not.  The old test for penalties involved assessing whether a payment triggered by breach of contract was a “genuine pre-estimate of loss” and therefore compensatory and enforceable, or whether it was aimed at deterring a breach of contract and was therefore penal and unenforceable.  Under the new test, a payment that is not a genuine pre-estimate of loss will not automatically be penal  The test should be whether the innocent party has a legitimate interest in enforcement of the contract going beyond recovery of compensation for breach.  Account may be taken of commercial interests and there is more of a focus on proportionality and whether the sum payable is unconscionable or extravagant.

The judgment in Cavendish v Talal El Makdessi provides comfort that primary obligations such as price adjustment clauses are not liable to be attacked as penalties, particularly in the context of a negotiated contract between properly advised parties of comparable bargaining power.  As for ParkingEye, the judgment does not give car parking operators carte blanche to charge exorbitant fees for overstaying.  The Court recognised that any such fee has to be proportionate to the operator’s or landowner’s interests.  But the Court was not sympathetic to Mr Beavis’s arguments that the charge was unfair.  As Lords Neuberger and Sumption commented: “The risk of having to pay it was wholly under the motorist’s own control.  All that he needed was a watch.”

(Cavendish Square Holdings BV v Talal El Makdessi: ParkingEye Ltd v Barry Beavis [2015] UKSC 67)

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