Penalty clauses in M&A and commercial contracts: Supreme Court redefines the test

Written on 4 Nov 2015

The Supreme Court has today handed down judgment in two cases concerning the enforceability of alleged penalty clauses: Cavendish Square Holding BV v Talal El Makdessi and ParkingEye Ltd v Beavis. In both cases the Supreme Court upheld the validity of the disputed clauses.

The decision redefines the test for determining whether a contractual term is a penalty. The two cases, which raised similar issues and so were heard together, mark the first time in over a century that the Supreme Court (or, its predecessor, the House of Lords) has considered the ambit of the rule against penalties in English law.

The Supreme Court had a number of questions to address.

Should the penalty rule be abolished?

The Court was asked, on behalf of Cavendish Square Holding BV, to take this opportunity to abolish the penalty rule in its entirety. The rule has been criticised as being technical, largely superseded by statutory regulation, and one that unnecessarily interferes with legitimate commercial arrangements commonly entered into by sophisticated, experienced business people.

The Supreme Court declined to abolish the penalty rule. The rule is a long standing principle of English law and is common to almost all major systems of law in the western world. Few would have wagered that abolishing the rule in its entirety was a course the Supreme Court would take.

Should the penalty rule be extended?

The Supreme Court was also asked to consider whether to extend the penalty rule to clauses which impose onerous obligations on a party even where no breach of contract is involved. The Court declined to take this step on the grounds that the rule is an in-road upon freedom of contract and ought not to be extended by judge-made law (as opposed to Parliament).

Given the penalty rule remains, to what extent can parties now agree financial consequences for a breach of contract?

The Supreme Court has restated the rule against penalties and said that the concepts of “deterrence” and “genuine pre-estimate of loss” are “unhelpful”!

The true test is now 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”.

What does the test mean?

1. Does the clause impose a primary or secondary obligation?

This stage was a key factor in Cavendish v El Makdessi. Lords Sumption and Neuberger considered that the clause in question should be viewed as a price adjustment clause, adjusting the purchase price to take into account the purchaser’s legitimate interests. Despite the sum being payable on breach of contract, the Court said that the clause was in no sense a secondary obligation – instead it was a primary contractual obligation (which the Courts do not have a power at common law to regulate), rather than a secondary obligation (or a remedy payable on breach) which is capable of being a penalty.

We discuss Makdessi in more detail here.

2. Does the clause relate to a legitimate interest of the innocent party?

In the majority of commercial cases, the answer to this question will be straightforward. Where the innocent party will suffer financial loss as a result of a breach by the other party, there is clearly a legitimate interest to be protected.

An innocent party can have no proper interest in simply punishing the other party. But compensation for loss is not the only legitimate interest that an innocent party may have in the other party’s performance of its obligations – and these legitimate interests may extend well beyond compensation for loss. 

In the ParkingEye case, the £85 charge imposed on Mr Beavis for over-staying the free 2 hour parking period was designed to deter him from overstaying his allotted time. But the Court has made clear that deterrence is only objectionable if it is penal (i.e. if the object is to punish) – and deterrence is not penal if there is a legitimate interest in influencing the conduct of the other party which is not satisfied by the mere right to recover damages for breach of contract. Here, ParkingEye had a legitimate interest in charging motorists which overstayed which was greater than the recovery of its loss, for example, it had an interest in generating income in order to run the scheme.

3. Is the detriment to be imposed on the contract-breaker out of all proportion to the innocent party’s legitimate interest?

This part of the test will be more familiar. In contracts that specify an amount to be paid in the event of a breach of a contractual provision, the question will be whether that amount is “out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation” or “extravagant, exorbitant or unconscionable”. 

Lords Neuberger and Sumption confirmed that this did not mean that the amount to be paid needed to be a “genuine pre-estimate of loss”. But, as Lord Hodge put it, where there is “an extravagant disproportion between the stipulated sum and the highest level of damages that could possibly arise from the breach”, this will amount to a penalty and be unenforceable. In considering what is extravagant, exorbitant or unconscionable, Lord Mance considered that the extent to which the parties were negotiating at arm’s length, on the basis of legal advice, and having every opportunity to appreciate what they were agreeing, must at least be a relevant factor.

Osborne Clarke comment

In recent cases, the Courts have been moving away from the dichotomy between an enforceable “genuine pre-estimate of loss” and an unenforceable penalty, saying it is too rigid. In this landmark decision, the Supreme Court has held that the much-quoted concept of “genuine pre-estimate of loss” is unhelpful. Importantly, there may be interests beyond the compensatory which justify the imposition of an additional financial burden on a defaulting party. What is necessary now is to consider what legitimate interest is being served by the clause and, if such an interest exists, whether the provision made for that interest is nevertheless extravagant, exorbitant or unconscionable.

While a “genuine pre-estimate of loss” is not a part of the restated test, if the parties have considered the likely financial consequences of a breach and agreed a corresponding sum payable for breach, it will be more difficult later to claim that that sum is extravagant, exorbitant or unconscionable.

This judgment will be of particular interest where the sum to be paid does not relate to any obvious financial loss on the part of the innocent party. It may be, however, that more case law is needed to shape exactly what might be a legitimate interest in those circumstances.

It is clear that the question of whether a provision is a penalty clause has moved away from asking whether the financial consequence is a “genuine pre-estimate of loss” likely to be suffered. Our view is that this decision is likely to give businesses greater freedom to impose financial consequences on contract-breakers without such provisions being held to be a penalty and therefore unenforceable. The key issue is establishing the legitimate interest of the party, and ensuring that any financial consequence payable on breach is in proportion to that interest. In the Makdessi case, the Court said that the parties themselves were the best judges of the extent to which they should recognise the proper commercial interests of the other and that this was a matter for negotiation, not forensic assessment by the Court.

This decision is likely to give businesses greater freedom to impose financial consequences on contract-breakers.

Paul Gardner, Partner, Commercial