The much anticipated judgment of the Supreme Court in the conjoined appeals of Cavendish Square Holdings BV v Talal El Makdessi and ParkingEye Ltd v Barry Beavis  was handed down last month. Both cases were concerned with the proper application of the penalty rule. The rule is easily expressed: where a contractual term providing specified remedies for breach is penal in nature, it will not be enforceable. However, with conflicting approaches taken by the Courts in the huge body of relevant case law, it had become increasingly difficult to determine how the rule should be applied in practice. This, in turn, led to uncertainty as to the outcome of cases that turned on the principle and consternation among draftsmen as to how damages clauses should be crafted to ensure enforceability.
This judgment provides definitive guidance as to the relevant questions to be asked and brings an end to the application of tests proposed by the House of Lords over a century ago, which have no useful application in the highly complex commercial contracts that are so often before the Courts today.
THE PENALTY RULE
In their joint lead judgment, Lords Neuberger and Sumption characterised the penalty rule ‘as an ancient, haphazardly constructed edifice which has not weathered well’, noting that:
‘… for many years, the courts have struggled to apply standard tests formulated more than a century ago for relatively simple transactions to altogether more complex situations. The application of the rule is often adventitious. The test for distinguishing penal from other principles is unclear.’
Having set out an illuminating history of the origins of the rule, their Lordships started their analysis of what it is that makes a contractual provision penal with reference to Lord Halsbury’s judgment in Clydebank Engineering & Shipbuilding Co Ltd v Don Jose Ramos Yzquierdo y Castaneda , in which he explained that a penalty clause may be distinguished from an enforceable liquidated damages clause by establishing:
‘… whether it is…unconscionable and extravagant, and one which no court ought to allow to be enforced.’
They then turned to Lord Dunedin’s judgment in Dunlop Pneumatic Tyre Co Ltd v New Garage & Motor Co Ltd , in which he formulated four tests to determine the true nature of a provision:
- the provision would be penal if the sum stipulated for is extravagant and unconscionable in amount in comparison with the greatest loss that could conceivably be proved to have followed from the breach;
- the provision would be penal if the breach consisted only in the non-payment of money and it provided for the payment of a larger sum;
- there was a presumption (but no more) that it would be penal if it was payable in a number of events of varying gravity; and
- it would not be treated as penal by reason only of the impossibility of precisely pre-estimating the true loss.
Their Lordships traced the problems subsequently faced by the Courts to the fact that these tests ‘achieved the status of quasi-statutory code’, when they were in fact not rules but considerations ‘that may prove helpful or conclusive’. While Lord Dunedin’s tests could be helpfully applied to straightforward contracts, they are less easily or appropriately applied in complex cases where the interests of the parties cannot easily be boiled down to a pecuniary sum. The distinction between a penalty and a genuine pre-estimate of loss, and a genuine pre-estimate of loss and a deterrent, is unhelpful. In their opinion:
‘… [a] damages clause may properly be justified by some other consideration than the desire to recover compensation for a breach. This must depend on whether the innocent party has a legitimate interest in performance extending beyond the prospect of pecuniary compensation flowing directly from the breach in question.’
In recent years, the Courts have demonstrated a willingness to recognise the importance of such considerations and to apply a broader test in complex cases, looking instead at the possible commercial justification for clauses which might otherwise be regarded as penal. While commercially sensible, this has of course led to significant uncertainties. It is these uncertainties that this judgment addresses.
Cavendish Square v El Makdessi
This case was concerned with the sale of a group of companies by Messrs Makdessi and Ghossoub (the sellers) to Cavendish Square Holding BV (Cavendish). Under the terms of the contract, Cavendish was to purchase 60% of the shares of the holding company while the sellers retained the remaining 40%. The contract provided for a series of four payments by way of consideration: a ‘completion payment’ due on execution of the contract; a ‘second payment’ to be paid into escrow and released in instalments as restructuring took place; an ‘interim payment’; and a ‘final payment’. In addition to the sale of their respective shareholdings, the contract imposed additional obligations on the sellers including a number of non-compete restrictive covenants. In the event the sellers breached those covenants, the interim and final payments would not be payable (clause 5.1) and Cavendish would have the option to buy the sellers’ remaining shareholding at a 20% discount (clause 5.6). This discount represented the value of the goodwill in the company.
Cavendish claimed that Mr Makdessi had breached the restrictive covenants and sought a declaration that he was therefore not entitled to the interim or final payments and was obliged to sell his remaining shares to Cavendish at the discounted price. The combined result was a reduction of $44m in the amount to be paid to Mr Makdessi for his total shareholding.
By the time the case came to trial it was common ground that Mr Makdessi was in breach of the restrictive covenants. However, he submitted that clauses 5.1 and 5.6 were unenforceable on the grounds that they constituted penalties.
The Court of First Instance upheld Cavendish’s claim, finding that the clauses did not amount to extravagant or oppressive penalties but acted as reasonable protection to Cavendish as the purchaser of a company whose value was largely dependant on goodwill.
The Court of Appeal overturned the decision and held instead that the provisions were out of all proportion to the loss attributable to the breaches and were therefore unenforceable.
ParkingEye v Beavis
This case was concerned with a parking charge of £85 levied on Mr Beavis, who had parked in a private car park and subsequently overstayed the period of free parking.
The charge was imposed by ParkingEye, a company engaged by the owner of the property to provide a traffic space maximisation scheme.
ParkingEye conceded that the charge was payable as a result of a breach of contract and that it was not a pre-estimate of damages. As it was not the owner of the property, Parkingeye had not (and could not have) in fact incurred any damage as a result of Mr Beavis’s overstay.
Both the Court of First Instance and the Court of Appeal held that the charge did not amount to a penalty: although ParkingEye suffered no direct financial loss, it was contractually bound to the owner to provide limited free parking and thus had a commercial interest in ensuring the limits were adhered to. In the circumstances, the amount charged was not extravagant or unconscionable.
THE SUPREME COURT’S JUDGMENT
Cavendish Square v El Makdessi
Before looking at the question of what makes a contractual provision penal, Lords Neuberger and Sumption highlighted the importance of establishing the circumstances in which the rule is engaged at all. The rule can only be engaged where the relevant provision operates upon a breach of contract. Unless the provision is in fact a remedy for a breach of contract, the Courts have no jurisdiction to impose the rule. As their Lordships noted, this can result in the application being dependent on how the provision is framed in the contract: where a contract provides that a specified sum should be paid in the event that a party has failed to perform a primary obligation, that clause is a secondary obligation that is capable of being a penalty; however, if a contract provides that in the event that one party does not perform an obligation it must instead pay a specified sum, the payment of the specified sum is also a primary obligation that cannot be a penalty. They noted, however, that devious draftsman would not get away with simply dressing up what was in reality a primary obligation/remedy relationship as dual primary obligations, as equity requires the Courts to determine the substance of a term not its form or the label the parties chose to give it.
Their Lordships first considered whether clause 5.1, was in fact a forfeiture clause and thus not subject to the application of the penalty rule but concluded that they were:
‘… prepared to assume, without deciding, that a contractual provision may in some circumstances be a penalty if it disentitles the contract-breaker from receiving a sum of money which would otherwise have been due to him.’
Whether or not the penalty rule will in fact apply:
‘… depends 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.’
As the payments were payable in consideration of the share sale and the fulfillment of the sellers’ obligations, it was determined that clause 5.1 was, in reality, a price adjustment clause and thus not a secondary obligation. However, their Lordships noted that if the clause was in fact a disguised punishment for the sellers’ breach, it would make no difference that it was expressed as part of the formula for determining the consideration and could potentially be subject to the penalty rule. They therefore went on to consider whether the clause represented such a punishment.
Considering the relationship between clause 5.1 and the potential damage that may be occasioned by the breach of the restrictive covenants, their Lordships found that the clause: ‘has no relationship, even approximate, with the measure of loss attributable to the breach’. Nevertheless, they went on to recognise that Cavendish had a legitimate interest in the observance of the restrictive covenants which extended beyond the recovery of that loss: the goodwill (which was dependent on the behaviour of the sellers) was critical to the value of the company. On that basis, they held that:
‘… the fact that some breaches of the restrictive covenants would cause very little in the way of recoverable loss to Cavendish is therefore beside the point.’
As to clause 5.6, their Lordships agreed with Mr Makdessi that the formula that excludes the value of the goodwill from the reduced price at which the sellers would be forced to sell their remaining shareholding did not and could not be suggested to compensate for the estimated loss attributable to the breach. However, they held that similar considerations that applied to clause 5.1 should be applied to the reduction of the purchase price. In this case, the reduction reflected the price that Cavendish was prepared to pay for the acquisition of the company in circumstances where it could not count on the loyalty of the sellers. Their Lordships concluded that:
‘… there is a perfectly respectable commercial case for saying that Cavendish should not be required to pay the value of goodwill in circumstances where the defaulting shareholder’s efforts and connections are no longer available to the company, and indeed are being deployed to the benefit of the company’s competitors, and where goodwill going forward would be attributable to the efforts and connections of others.’
While the effect of clause 5.6 may have been (and may have been designed to be) a deterrent to breach, that would only be objectionable if the overall objective was to punish. In this case it was not as:
‘… the price formula in clause 5.6 had a legitimate function which had nothing to do with punishment and everything to do with achieving Cavendish’s commercial objective in acquiring the business’.
ParkingEye v Beavis
Their Lordships found that the £85 charge had two main objects: (i) to manage the efficient use of parking space, which was to be achieved by deterring commuters or other long-stay motorists from occupying parking spaces for long periods; and (ii) to provide an income stream to enable ParkingEye to meet the costs of operating the scheme and make a profit from its services, without which those services would not be available.
As a sum payable for breach of contract, the penalty rule was plainly engaged in this case. However, despite the fact that it bore no relation to the damage that could be incurred by such breach, their Lordships deemed that it was not in fact a penalty as ParkingEye had a legitimate interest in imposing the charge which extended beyond the recovery of any loss, namely the proper management of the parking scheme.
While the charge was undoubtedly designed to act as a deterrent, their Lordships reiterated that deterrence is not penal if there is a legitimate interest in influencing the conduct of the contracting party which is not satisfied by the mere right to recover damages for breach. In reaching this conclusion their Lordships emphasised that it should not be understood that ParkingEye could charge overstayers whatever it liked:
‘… it could not charge a sum which would be out of all proportion to its interest or that of the landowner for whom it is providing the service.’
In the circumstance, particularly having regard to the charges imposed by local authorities for overstaying in car parks on public land, the £85 charge was not disproportionate.
This judgment is a line in the sand: the Dunlop tests are to be rejected in favour of the fundamental question: does the impugned provision impose 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?
Whether or not there is a relationship between the potential damage that may be incurred in the event of breach and the damages payable is irrelevant and the fact that the provision may be designed to act as a deterrent to breach is not evidence of it being penal.
While this undoubtedly resolves the growing tensions in the case law between the traditional Dunlop approach and the commercial justification approach, it does not mean the application of the rule will be any easier: the myriad of arguments that may be proffered as to a party’s legitimate interests in complex contractual relationships are easily imaginable.
What is clear is that this judgment will result in a significant reduction in the success of defences based on the penalty rule. In keeping with a growing number of Supreme Court decisions, the Courts are showing themselves increasingly unwilling to interfere in parties’ freedom of contract, even in circumstances where there is precedent to do so. As we have discussed in previous articles, the Courts cannot be looked to to rescue parties from bad bargains.
By Alex Radcliffe, associate, and Erin Vickers, trainee, Cooley (UK) LLP.
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Cavendish Square Holding BV (appellant) v Talal El Makdessi (respondent) & ParkingEye Ltd (respondent) v Beavis (appellant)  UKSC 67
Clydebank Engineering & Shipbuilding Co Ltd v Don Jose Ramos Yzquierdo y Castaneda  AC 6, 9, 10
Dunlop Pneumatic Tyre Co Ltd v New Garage & Motor Co Ltd  UKHL 1 (1 July 1914)