The Supreme Court on the penalties doctrine: recast and restricted but not rejected in full
12 Thursday Nov 2015
Last week’s highly anticipated and seminal Supreme Court judgment in the joined cases of Cavendish Square Holding BV v Makdessi and ParkingEye v Beavis  UKSC 67 marked the first time in a century that the highest court of England and Wales has considered the penalties doctrine. The Supreme Court Justices made the most of this opportunity by restating the law on penalties and thereby creating a new leading authority for this doctrine, to replace the early 20th Century authority of Dunlop Pneumatic Tyre Company v New Garage and Motor Company  AC 79.
The long-cited test of whether a liquidated damages clause is a “genuine pre-estimate of loss” designed to compensate the innocent party rather than deter the defaulting party from committing the breach is no longer conclusive (nor is it completely redundant – indeed, it still may have applicability in the simplest of cases).
The test which has replaced it is whether a stated remedy in a contract is proportionate to the legitimate interests of the innocent party. In addition to this, the Supreme Court has somewhat clarified the types of clauses which fall within the penalties regime, holding that the regime is restricted to secondary obligations only (broadly, those obligations that arise upon breach of a primary obligation, the paradigm example being a provision for payment of a sum of money upon a breach of contract).
Whilst this is helpful clarification, the Supreme Court has still left wide open the questions of:
- what is a primary or secondary obligation (which may not be clear in certain cases);
- what constitutes a party’s legitimate interests;
- how to apply the test of whether a stated remedy is proportionate to a party’s legitimate interests; and
- whether the doctrine applies to “withholding clauses” (that is, those that permit the innocent party to withhold a sum which would otherwise be due under the contract, such as deferred consideration clauses).
Cavendish Square Holding BV v Makdessi
Mr Makdessi contracted to sell to Cavendish his controlling stake in the holding company of the largest advertising and marketing communications group in the Middle East. The sale and purchase agreement contained restrictive covenants prohibiting Mr Makdessi from certain activities in competition with the group. If Mr Makdessi breached those covenants, the contract provided that he:
- would not be entitled to receive the final two instalments of the price paid by Cavendish (described as the “withholding clause”, at Clause 5.1); and
- could be required to sell his remaining shares to Cavendish at a price that reflected the net asset value of the shares but excluded the value of the goodwill of the business (the “share transfer clause”, at Clause 5.6).
Mr Makdessi breached the restrictive covenants, but argued that the two clauses were penalty clauses and therefore unenforceable. At first instance, Mr Justice Burton found that the clauses were not penal and had a legitimate commercial purpose, but he was overturned by the Court of Appeal, which held that they were unenforceable penalties.
ParkingEye v Beavis
ParkingEye Ltd managed a car park at a retail park in Essex. The car park had a two-hour limit during which time users could park for free, and ParkingEye displayed a number of notices to the effect that overstayers would be subject to a “parking charge” of £85. Mr Beavis overstayed the time limit and ParkingEye demanded payment of the £85 charge. Mr Beavis argued that the charge was either unenforceable as a penalty, or was unfair and therefore unenforceable under the Unfair Terms in Consumer Contracts Regulations 1999. His arguments were rejected both at first instance and by the Court of Appeal.
Should the penalties doctrine be abolished or extended?
Counsel for Cavendish argued before the Supreme Court that the penalties doctrine was antiquated and unnecessary, and should therefore be abolished, or at the very least not apply to “commercial” contracts (i.e. contracts at arm’s length between equally balanced parties). This in our view would be more consistent with the approach the Supreme Court has recently taken in the area of contractual construction (for example, in the case earlier this year of Arnold v Britton  UKSC 36, where the Supreme Court held that where the words of a contract are clear, those words will be upheld even if the result appears to be contrary to commercial common sense).
Although Lord Neuberger and Lord Sumption (who jointly gave the leading judgment in the Supreme Court) described the penalties doctrine as “an ancient, haphazardly constructed edifice which has not weathered well, and which in the opinion of some should simply be demolished, and in the opinion of others should be reconstructed and extended”, the Supreme Court refused to abolish it. Although the Court doubted that the courts today would have invented such a rule, they accepted that the doctrine is a long-standing principle of English law, is common to almost all major systems of law, and that judicial abolishment would be inconsistent with the way the English common law system works. However, they also rejected any argument that the doctrine should be extended to cover clauses which are triggered other than by material breach of contract (as has happened in Australia).
The Supreme Court also rejected the suggestion that the penalties doctrine should not apply at all to commercial contracts. However, they acknowledged that as the doctrine is an interference with parties’ freedom of contract, courts must be careful before intervening in their arrangements. As Lord Neuberger and Lord Sumption stated, “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”.
The new test for whether a contractual clause is penal and therefore unenforceable
The majority of the Supreme Court held that the new test for penalties 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”. This can be broken down into the following questions:
- Is the provision a secondary obligation rather than a primary obligation (a secondary obligation generally being one that arises on the breach of a party’s primary obligation under the contract)?
- If it is a secondary obligation, is it within the innocent party’s legitimate interests to impose that obligation?
- Is the result out of proportion with the party’s legitimate interests? In assessing this, the court must consider whether the clause is unconscionable, exorbitant or extravagant (which were terms used in the judgments of Lord Mance and Lord Hodge, and are used interchangeably throughout).
The Court also made the following observations:
- For the innocent party’s interest to be legitimate it must extend beyond simply punishing the defaulting party – the interest must be in the performance of the contract or some appropriate alternative. However, compensation is not necessarily the only legitimate interest that the innocent party may have in the performance of the defaulting party’s primary obligations.
- The real question is whether a clause is penal, not whether it is a genuine pre-estimate of loss. The fact that a clause is not a genuine pre-estimate of loss does not, without more, mean that it is penal.
- A clause that is a deterrent is not inherently penal. A deterrent provision in a contract is just one type of contractual provision that is designed to influence the conduct of the party potentially affected. Its enforceability will depend on whether it is exorbitant, unconscionable or (which will usually amount to the same thing) extravagant.
In the light of this, Lord Dunedin’s judgment in Dunlop (which introduced the long-standing test of whether a clause was a genuine pre-estimate of loss as opposed to a clause designed to deter breach) will be of much less importance in determining whether a clause is a penalty. However, it is not necessarily redundant – the Supreme Court accepted it might still be of use in considering simple damages clauses in standard contracts (although one could argue that the new test would work equally as well in justifying a classic “liquidated damages” clause). It cannot though be easily applied to more complex commercial cases – as can be seen from the development in recent years of the “commercial justification” test as a means of finding that a clause is not a penalty even if it is not a genuine pre-estimate of of loss.
Application to the cases
Cavendish Square Holding BV v Makdessi
The Supreme Court was unanimous in finding that the clauses were intended to protect Cavendish’s legitimate interest in Mr Makdessi’s observance of the restrictive covenants. His continued loyalty to the group was critical to the success of the transaction, in particular to the value of the goodwill in the business.
More importantly, the majority held that the clauses were primary obligations and therefore did not engage the penalties doctrine in the first place.
The “withholding clause” was in fact a price adjustment clause, which made payment of the final instalments to Mr Makdessi conditional on his performance of the contract. However, Lord Mance and Lord Hodge expressed doubt about whether withholding clauses would always be primary obligations, Lord Hodge in particular saying “I see no principled reason why the law on penalties should be confined to clauses that require the contract-breaker to pay money in the event of breach and not extend to clauses that in the same circumstances allow the innocent party to withhold moneys which are otherwise due”.
The “share transfer clause”, in the view of the majority, was “a contractual provision conferring an option to acquire shares, not by way of compensation for a breach of contract but for strict commercial reasons, and therefore belongs among the parties’ primary obligations, even if the occasion for its operation is a breach of contract”. However, not all the Justices agreed on this point – Lord Mance accepted that a forced transfer for no consideration or for consideration that did not reflect the value of the asset transferred may constitute a penalty within the scope of the doctrine, and Lord Hodge considered the share transfer clause to be a secondary obligation.
Given that the Court of Appeal also found both clauses to be secondary obligations, this is obviously not a clear-cut test, and whether a withholding clause or share transfer clause is a primary or secondary obligation would have to be considered in the context of the contract and arrangement as a whole.
In any event, the Supreme Court held that neither clause was designed to punish Mr Makdessi; Cavendish had a legitimate interest in Mr Makdessi’s adherence to the restrictive covenants which extended beyond the recovery of the loss to Cavendish, since Cavendish had an interest in measuring the price it had paid for the business to its value. The goodwill of the business was critical to its value to Cavendish, and the loyalty of Mr Makdessi was critical to that goodwill. In addition, the share transfer clause was intended to protect Cavendish’s commercial interests by severing Mr Makdessi’s connection with the group if he tried to compete against them.
ParkingEye v Beavis
Mr Beavis had a licence to park in the car park for two hours for free, subject to the terms displayed on the notice. The £85 charge was payable on breach of contract and was therefore a secondary obligation which engaged the penalties doctrine. ParkingEye conceded that it was not a pre-estimate of damages since it was not the owner of the car park and therefore could not recover damages, and accordingly did not lose anything by Mr Beavis’ unauthorised overstay. ParkingEye also conceded that the charge was intended to have a deterrent effect on motorists.
However, applying its restated test, the Supreme Court held that the provision was not an enforceable penalty because ParkingEye had legitimate interests in making the charge. These included providing an efficient parking service to the owner of the car park, the retailers and the general public and meeting the costs of doing so from the charges. This did not mean that ParkingEye could charge what it liked, but £85 was not out of all proportion to its interests and not extravagant or unconscionable in relation to charges imposed in local authority car parks.
In addition, the majority held that the charge was not unfair under the Unfair Terms in Consumer Contracts Regulations 1999. Lord Toulson dissented on this point.
Areas of uncertainty
In recasting the penalties test, the Supreme Court judgment has left open a number of areas within that test which are likely to lead to uncertainty as to how it should be applied, and open up new avenues for challenging the validity of clauses:
Primary or secondary obligation?
Cavendish v Makdessi demonstrates that it is not always clear what is a primary or secondary obligation – there, the majority of the Supreme Court and the Court of Appeal (and Lords Mance and Hodge) reached conflicting conclusions. What is clear is that the courts will look at the substance of the provision, not its form, and will still intervene if it considers the provision to be a disguised penalty.
Meaning of “legitimate interest” and “proportionate”
It may not always be easy to work out what constitutes an innocent party’s legitimate interest and whether the remedy is proportionate to that interest. This will open up two areas of challenge to the validity of such clauses: whether an interest is genuinely legitimate and if the sanction designed to protect it is truly proportionate. Contracting parties will need to consider (and communicate) these carefully from the outset.
We can at least take some comfort from Lord Neuberger and Lord Sumption’s statement that “the strong initial presumption must be that the parties themselves are the best judges of what is legitimate” where the parties are properly advised and of comparable bargaining power. In addition, guidance can be taken from Lord Mance’s view that in judging what would be extravagant, exorbitant or unconscionable, “the extent to which the parties were negotiating at arm’s length on the basis of legal advice and had every opportunity to appreciate what they were agreeing must at least be a relevant factor”.
However, there does not seem to be much further guidance from the Supreme Court as to how this balancing exercise would work in practice (although clearly where one has facts similar to these two cases, guidance can be taken from the facts of the judgments themselves).
Does the doctrine apply to “withholding clauses”?
The majority’s finding that the “withholding clause” in Cavendish v Makdessi was in fact a primary obligation and did not engage the penalties doctrine meant that the Supreme Court left open the question whether the doctrine applies to such clauses. Lord Neuberger and Lord Sumption were “prepared to assume, without deciding” that a withholding clause might in some circumstances be a penalty, although that would very much depend on “the nature of the right of which the contract breaker is being deprived and the basis on which he is being deprived of it”. Lord Mance and Lord Hodge were more clearly in favour of applying the doctrine, with Lord Mance considering it “absurd” to draw a distinction between clauses requiring the payment of money and those withholding money.
The position remains unclear, but as Cavendish v Makdessi demonstrates, it is possible to argue that a withholding clause, if drafted as a price adjustment clause which makes payment conditional on proper performance of the contract, is a primary obligation and not even caught by the doctrine in the first place.
These areas of uncertainty mean that contracts will need to be carefully thought through and drafted to minimise the risk of clauses being held unenforceable. Sensible precautions parties can take include:
- Wording clauses to make payments conditional on a party’s proper performance of its obligations under the contract (rather than imposing payment of a sum on breach of contract), so it is arguable that the obligation is a primary one. Note, however, that the court will look at the substance of the provision, not its form, and will still intervene if it considers the provision to be a disguised penalty.
- Identifying and setting out in the contract (for example, in recitals) why the sanction is commercially justifiable in terms of the innocent party’s legitimate interests.
- Highlighting the importance of the clauses to the overall contractual package (such as the fundamental importance in Cavendish v Makdessi of Mr Makdessi’s continued loyalty and how this translated into the calculation of the purchase price).
- Keeping any clauses which tie the purchase price to a party’s proper performance of its obligations together in the contract.
- Considering how the parties can show that the sanction is not unconscionable or extravagant and out of proportion to the legitimate interest of the innocent party. In Beavis v ParkingEye this was demonstrated by reference to the industry “norm” for parking charges. A helpful question to be asked by the drafters could therefore be whether there is a comparable norm in the parties’ industry that could be relied upon in showing that a sanction was not exorbitant, extravagant or unconscionable.
- If applicable to the circumstances, making it clear in the contract that the parties are operating at arms’ length and have equal or comparable bargaining power, that the contract has been carefully negotiated and that the parties have been advised by independent and experienced solicitors.