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Penalty Clauses – A change in the law

Historically the law surrounding penalty clauses was based on there being a genuine pre-estimate of loss.  Clauses of this nature were often found in contracts by reference to liquidated damages; a transfer in property, a deposit being forfeited and/or payment being withheld.

The cases of Cavendish Square Holding BV v Talal El Makdessi and ParkingEye Limited v Beavis [2015] UKSC 67 were brought jointly before the Supreme Court to consider and revisit the law on penalty clauses.

The question before the Supreme Court in both cases was not whether the clause operated fairly but whether at the time in which the contract had concluded if the remedy sought by the enforcing party was so unfair it should fail.

Factual Background

Cavendish Square v El Makdessi

Mr Makdessi was a very successful businessman in the advertising and marketing profession.  In 2008 he agreed to sell 474 shares to Cavendish.  In consideration of the shares Cavendish were required to make 4 substantial instalment payments, subject to various conditions.  One of the conditions imposed on Mr Makdessi was that he was not permitted to compete against, to solicit or accept orders or enquiries associated with the Group of companies for which the shares were being purchased, to divert trade, to employ or solicit any senior employee or consult from the Group of companies.  If Mr Makdessi defaulted on any of these conditions (among others) then Cavendish was entitlement to withhold Mr Makdessi’s Interim Payment and/or Final Payment.  Mr Makdessi breached his obligations and Cavendish sought to withhold payment.

Parking Eye v Beavis

Mr Beavis parked his car, for free, at a shopping centre thereby entering into a contract with ParkingEye.  The terms and conditions of parking were clearly displayed at a variety of locations in the car park.  One of the key terms stated that he could only park there for a 2 hour period failing which he would incur a charge of £85. Mr Beavis overstayed by 56 minutes and the charge of £85 applied.

The ‘Old Test’

In accordance with the Dunlop Pneumatic Tyre Co. Ltd v New Grange and Motor Ltd [1915] A.C.79 case an enforcing party had to demonstrate that the remedy sought represented a ‘genuine pre estimate of loss’.  However, in Cavendish the loss suffered was intangible (being the Goodwill of the Group of Companies) and in ParkingEye no loss was suffered and/or the charge incurred by Mr Beavis could not be clearly identified given that he could park there for free for the first 2 hours.

The Submissions

Cavendish argued that the price paid for the shares represented the goodwill of the Group of Companies which was at risk of serious damage if Mr Makdessi undertook the prohibited activities (identified above and in other clauses set out in the share transfer).  As a result the breaches committed by Mr Makdessi had a substantial effect on the goodwill of the Group of Companies. 

In ParkingEye it was asserted that the reason for the charge was to deter those who overstayed and to provide an income stream to meet the costs associated with administration and management.  The charge of £85 was also in line with the advisory regulatory code for the British Parking Association which recommended charges up to £100. 

The Decision

The Supreme Court concluded that neither were penalty clauses.  The Court’s view was that the enforcing parties (Cavendish and ParkingEye) were merely protecting their commercial interests and therefore the remedy sought was merely to deter the breach in the first place.  

Lord Hodge stated at Paragraph 255 of the Judgment that

“the correct test for a penalty is whether the sum or remedy stipulated as a consequence of a breach of contract is exorbitant or unconscionable when regard is had to the innocent party’s interest in the performance of the contract. Where the test is to be applied to a clause fixing the level of damages to be paid on breach, an extravagant disproportion between the stipulated sum and the highest level of damages that could possibly arise from the breach would amount to a penalty and thus be unenforceable. In other circumstances the contractual provision that applies on breach is measured against the interest of the innocent party which is protected by the contract and the court asks whether the remedy is exorbitant or unconscionable

In the circumstances the ‘new’ test is whether the Clause is extravagant, exorbitant and/or unconscionable having regard to the commercial and legitimate interests of the business.   The type of factors the Courts will consider include whether the parties were negotiating the contract at arm’s length, whether they had the opportunity to understand what was being agreed, whether they had the benefit of legal advice and whether they had equal bargaining power. 

Whilst the Courts do not wish to interfere or limit the freedom of contracts there is a sense that there may be more litigation to come…

Added: 18 Apr 2019 13:54

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