The changing law of penalty clauses

11 August, 2017
by: Cripps Pemberton Greenish

This week the Cripps Pemberton Greenish’s trainee solicitor blog team caught up with Alex Aristodemou, currently in his second seat with the commercial dispute resolution team, to review the law of penalty clauses.

The longstanding rule on penalty clauses

For over a century, the position has been that penalty clauses in contracts will not be enforceable. But what is a penalty clause? The 1914 case of Dunlop Pneumatic Tyre Co Ltd v New Garage & Motor Co Ltd essentially stated the key test.

The test was whether a clause provided for compensation as a genuine pre-estimate of loss or whether it was exorbitantly penal in nature, designed to deter breach of contract. In the latter case, this was deemed to be a penalty clause and therefore unenforceable.

The law has moved on

In the 2015 Supreme Court decision of Makdessi v Cavendish SquareHoldings BV the court took a different approach. The sanctions for breach of restrictive covenants of a seller of shares in a share purchase agreement were held to be a conditional primary obligation which were construed as being entirely outside the penalty clause rule.

The clauses in question provided that part of the purchase price would not be paid to the seller if he conducted competing activities, further requiring the sale of the seller’s remaining shares to the buyer, at a price excluding the goodwill of the company. The Supreme Court said that this type of primary obligation designed to ensure that contracting parties keep to the terms of their bargain was not to be subjected to the penalty clause test.

The clause was adjudged to be a price adjustment mechanism for the price of the shares. These had been devalued owing to the damage caused to the goodwill of the business arising from breach of the restrictive covenants, whilst the commercial reality was recognised that both parties were negotiating at arm’s-length and properly advised.

An extended stay…

In its joint judgement, the Supreme Court also heard the case of ParkingEye Limited v Beavis. Mr Beavis had overstayed his welcome when parking his car by 56 minutes over the 2 hour stipulated time limit. When fined £85 for doing so, he argued that this was a penalty and therefore unenforceable, as it was not a genuine pre-estimate of loss.

Failure to remove his car from the parking space within the 2 hour time limit was deemed to be a failure to perform his side of the contract by the Court, for which a specified sum of money was payable.  In this instance, the provision demanding payment of £85 was deemed to be a secondary obligation arising from a breach of the primary obligation which was to stay no longer than 2 hours.

In coming to this conclusion, the Court looked at the amount of the fine, deciding that it was reasonable when considering the protection of the legitimate interest of the car park operators in operating the site whilst meeting operating costs and making a profit.

Is it a primary or secondary obligation?

The position therefore seems to be that a distinction must be made between primary and secondary obligations in contracts, which will not always be a simple exercise. If expressed as a primary obligation, the rules on penalty clauses will not apply, whilst if it is a secondary obligation considerations of whether the clause amounts to a breach of the penalty rule will depend on whether it protects the legitimate interests of the innocent party to deter breach, or whether it goes beyond this.

The Supreme Court is essentially saying that certain contractual provisions can still be held to be penalties and therefore unenforceable. However, the test to be applied when judging if they are so is whether the remedy stipulated as a consequence of the breach is exorbitant when considering the innocent party’s interest in correct performance of the contract.  Where the compensation payable is wholly disproportionate to the highest level of damages which could arise from the breach it could still be held to be an unenforceable penalty clause.

The law on penalty clauses restated

These principles effectively mean that a clause will not be deemed a penalty and therefore unenforceable simply because it is not a genuine pre-estimate of loss as long as it can be rationalised. This will particularly apply in commercial arrangements where the aim is to deter breach in the first place.

The limits of this rationale remain to be tested, and whilst flexibility in the application of the rigid penalty rule is welcome, this recent decision has most certainly added further ambiguity to the limits of the application of the rule, requiring expert drafting of compensation clauses and an ability to understand the commercial justification for arguing them either way.