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Restatement of the Penalty Rule
On 23 September 2015, we provided a note on the Enforceability of Agreed Remedy Provisions centred around the Court of Appeal’s decision in Makdessi v Cavendish Square Holdings BV  EWCA Civ 1539. On 4 November 2015, the Supreme Court overturned this decision, unanimously allowing the appeal in Makdessi v Cavendish Square Holding BV and ParkingEye v Beavis  UKSC 67 and restating the rule on penalties.
To recap, the rule against penalties applies to the not uncommon situation where parties to commercial contracts agree to a specific remedy for breach of a contractual provision. The most common being a “Liquidated Damages” clause which provides that a specified sum is to be paid (or forfeited) upon breach. The traditional test of whether a clause constituted an unenforceable penalty was established in Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd  AC 79. This test was considered and applied in Makdessi :
- the expression used by the parties in not conclusive;
- the essence of a penalty is to deter the offending party from breaching the contract, while a liquidated damages clause is a genuine pre-estimate of damage;
- whether or not clause represents a penalty is a question of construction decided on terms and circumstances of the contract, at time of making of the contract, not at the time of the breach;
- to assist with construction, the following tests may be helpful (or even conclusive):
- the provision may be penal if the sum stipulated 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 will be penal if the breach consisted only in the non-payment of money and it provided for the payment of a larger sum;
- a single lump sum is payable on occurrence of one or more or all of several events, some of which occasion serious and others trifling damage; and
- the provision will not be treated as penal by reason only of the impossibility of precisely pre-estimating the true loss.
The Supreme Court considered and overturned the decisions in both Makdessi  and ParkingEye Ltd v Beavis  EWCA Civ 402. The facts of these cases are summarised as follows.
Mr Makdessi and his co-owner entered into a sale and purchase agreement (“SPA”) to sell to Cavendish a significant portion of their shares in the holding company for the largest advertising and marketing group in the Middle East (the “Group”). The SPA included various non-compete provisions as regards Makdessi (who remained as a director and continued to hold shares) on the basis that the goodwill in the company was considerable and dependent upon Makdessi's prominence in the relevant market. Clause 5 of the SPA, in essence, provided that a breach of any of the various non-compete provisions by Mr Makdessi would make him a defaulting shareholder, triggering:
- the forfeit of any unpaid portions of deferred consideration (which was to be paid in stages, calculated by reference to profit) (clause 5.1); and
- a call option pursuant to which Makdessi could be required to sell all of his remaining shares in the Group to Cavendish at a default value based on asset value (without taking into account goodwill) (clause 5.6).
Mr Beavis overstayed (by 56 minutes) in a carparking space that was clearly signposted as having a two hour free-parking time limit and an £85 charge for non-compliance. ParkingEye, the carpark manager, notified Mr Beavis that the £85 charge was payable. Mr Beavis did not pay the charge (or use the appeals process) and argued in proceedings that the £85 charge was an unenforceable penalty.
Decisions and reasoning
The Supreme Court upheld the validity of the clauses in question and restated the law on penalties. Lords Neuberger and Sumption held that:
"The true test 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. The innocent party can have no proper interest in simply punishing the defaulter. His interest is in performance or in some appropriate alternative to performance."
The commercial background to clause 5 of the Makdessi SPA was important in determining the enforceability of clause 5, in particular that:
- the SPA was negotiated in detail, over a considerable period of time, between parties dealing on equal terms with the benefit of professional advice (indicates the significance of party autonomy in commercial contracts).
- a significant proportion of the purchase price to be paid for the shares represented the value of goodwill in the business. The goodwill was critical to the business and the loyalty of Mr Makdessi was critical to the success of the business (Cavendish had a significant interest in Makdessi’s performance of the non-compete provisions).
Their Lordships held that clause 5.1 (forfeit of deferred consideration) was a price adjustment and clause 5.6 (call option), an option to acquire shares. Both clauses formed part of Makdessi’s primary obligations even though they were triggered by a breach of contract.
Their Lordships held that ParkingEye “had a legitimate interest in charging them [a sum] which extended beyond the recovery of any loss”. That legitimate interest included providing a service to the landowner to manage the carpark in the interest of the retail outlets (to whom the landowner leased the property), their customers and the wider public. The charges in question met the costs of providing such service and thus underpinned the business model which enabled free parking for two hours. Furthermore, their Lordships held that £85 was neither extravagant nor unconscionable, being comparable to the costs of on-street and local authority parking as well-being below the maximum charge suggested by the British Parking Association.
The decision in Makdessi restores the ability of commercial parties to make their own bargains, and confirms the court’s role in enforcing those bargains.
When negotiating clauses which impose a sanction for breach, contracting parties and their representatives should carefully consider the commercial context and the following questions:
Is the provision 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? If possible, the provision should be drafted in a manner which makes it clear that the relevant obligation forms part of a primary obligation e.g. a price adjustment or option triggered by breach. Where the provision is, or may be interpreted as, a secondary obligation then there must be some legitimate commercial justification relevant to the innocent party’s legitimate interest in the primary obligation.
Is the provision penal? A secondary obligation that is a genuine pre-estimate of loss will be valid. Where the secondary obligation is not a pre-estimate of loss there will need to be some other commercial justification for any additional burden – Lord Mance provided some useful examples which may justify financial burden going beyond compensation for loss: the maintenance of a system of trade, which only functions if all trading partners adhere to it; terms of settlement which provide on default for payment of costs, which a party was willing to forgo if the settlement is honoured; and the revision of financial terms to match circumstances disclosed or brought about by a breach.
Is the sanction beyond a “norm” and therefore potentially “unconscionable” or “extravagant”? Consideration should be given to what is currently charged as an “industry norm” in similar circumstances.
For further information, please contact Charles Claisse, Head of Corporate.
The article above, current at the dates of publication, is for reference purposes only.It does not constitute legal advice and should not be relied upon as such. Specific legal advice about your specific circumstances should always be sought separately before taking any action.