In a recent landmark case, the UK’s Supreme Court has restated the law on contractual penalties (the Penalty Rule) and attempted to clarify it for modern use. This rule is important because it makes certain types of contractual provisions unenforceable so it interferes with the ability of parties to set their own bargains in some respects.
What sort of provisions can be unenforceable penalties under the Penalty Rule?
Any contractual provision which is triggered by a breach of contract and imposes an adverse consequence of the party in default can potentially be a penalty. The purpose of the Penalty Rule is to prevent disproportionate and unreasonable remedies being imposed in a breach situation. The significance of the rule, therefore, is in how it distinguishes between terms triggered by breach which are acceptable and those which are not and therefore will not be enforced.
What was the problem with the existing law?
The Penalty Rule has been evolving for well over a hundred years. During that period, different courts have formulated any number of tests, definitions, and factors to be taken into account when determining whether something is a penalty or not. In particular, because many of the cases dealt with identifying and setting the permissible scope of liquidated damages provisions (where, to create certainty, parties agree up front the level of damages to flow from certain breaches based on their estimate of the possible loss) many of the guidelines established did not sit well with other types of provision. Further, uncertainty arose as to what other justifications (than the reasonableness of a pre-estimate of loss) could be led in support of clauses triggered by breach.
What was the Supreme Court asked to decide?
The Supreme Court had two cases before it. The facts in each were at opposite ends of the spectrum but the issue was the same. Two individuals were in breach of their respective contracts. Each contract contained severe financial consequences.
In the first case (Cavendish), Mr Makdessi had agreed to sell Cavendish a controlling stake in a large marketing and communications group. The contract contained restrictive covenants prohibiting Mr Makdessi from competing after the sale. If Mr Makdessi breached the restrictive covenants:
- he would not be entitled to receive the final two instalments of the purchase price; and
- under a call option, he could be required to sell his remaining shares at a price which excluded the value of goodwill.
Mr Makdessi breached the restrictions.
In the second case (ParkingEye), ParkingEye managed a car park for a retail park. On the site there were numerous notices warning of a £85 charge for parking beyond the permitted two hour time limit. Mr Beavis overstayed the allotted time.
Mr Makdessi and Mr Beavis alleged that the above provisions were unenforceable penalties.
The Supreme Court’s decision
The Supreme Court upheld the provisions in both cases.
It explained two key points which had become rather lost in the existing case law:
- The purpose of the law on penalties is solely to regulate the remedies available to the innocent party for breach of primary obligations (a contract’s main terms). It is not there to limit or regulate the content of the primary obligations that parties can agree. The leading judgement in the case considered the Makdessi terms to be in the nature of a primary price adjustment and therefore not within the scope of the Penalty Rule at all. However, they warned that the test was one of substance rather than form and the decision was a fine one, the two minority judges were not in complete agreement on this classification of the Makdessi terms.
- Secondly, even where the relevant provision is secondary in nature (i.e. it simply sets out the remedy/consequences of breach of a primary obligation), it will only be unenforceable as a penalty if the remedy is out of all proportion to any legitimate interest of the innocent party in enforcing the primary obligation that has been breached.
The court also indicated that judges should be slow to interfere in a negotiated contract between properly advised parties of comparable bargaining power. The strong initial presumption in such a case should be that the parties themselves were the best judges of what is legitimate in a provision dealing with the consequences of breach.
The guidance in Cavendish and ParkingEye is welcome news for those concerned to ensure that negotiated contractual terms can be relied upon in modern commercial contracts.
Key points for those who negotiate commercial contracts:
- Care should still be taken when including and drafting terms triggered by breach of contract. Sometimes there will be other ways to achieve the same end and it is worth discussing this with your advisers.
- It will always be helpful if any particular term activated on a breach can be characterised as “primary” – and therefore outside the scope of the Penalty Rule. However there will often be scope for doubt and therefore care should also be taken to evidence the legitimate interest of the parties.
- It will be important to reflect on whether the parties had an equal bargaining power and access to advice and to note the commercial purpose and justification for the term.
On January 20, 2016