Penalty clauses in Commercial Contracts now valid and enforceable

25 December 2015

The Supreme Court recently considered a joint appealin the cases of Cavendish Square Holding BV v El Makdessi and ParkingEye Ltd v Beavis [2015] UKSC 67.

Both cases involved commercial clauses which the claimants argued were penalty clauses. Prior to these cases, penalty clauses would be held as invalid. However, the Supreme Court upheld the clauses in both cases to be valid and enforceable.

Traditionally, the courts followed the rule that if a commercial contract contained a clause for liquidated damages in the event of a breach of contract, then this would only be held to be reasonable and enforceable if it was a "genuine covenanted pre-estimate of damage". This means only the actual loss of the claimant will be recoverable and the clause cannot be used as a way to punish the party that breached the contract. 

The decision from these two recent cases has caused some confusion as to when penalty clauses will be valid and enforceable and when they will be held invalid. The Supreme Court judges provided further clarification in giving their judgement on the joint case, which is summarised below.

Cavendish Square Holding BV v El Makdessi

Mr Makdessi and his co-owner were the majority shareholders of a group of companies. They sold a large proportion of their shares to Cavendish making Cavendish the majority shareholder. The Share Purchase Agreement (SPA) contained provisions dealing with the payment for the shares which meant that the payment would be split into an interim payment and a final payment. Both payments were based on the profits of the group of companies purchased by Cavendish. 

The SPA contained a non-compete clause which stopped Mr Makdessi from competing with the group of companies sold to Cavendish. This non-compete clause stated that if Mr Makdessi or his co-owner breached the clause then they would (1) not be entitled to the interim or final payments, and (2) be forced to sell the remainder of their shares in the group of companies to Cavendish without the value of their shares taking into account any goodwill. This would have the effect of significantly reducing the value of the shares when forced to sell to Cavendish.

Mr Makdessi breached the non-compete clause and claimed that it should be unenforceable because it was a penalty clause. Cavendish was successful in the first instance but this was appealed. When the appeal was heard in the Supreme Court, the judges held that the first decision should be upheld and Cavendish should be allowed to rely on those clauses. 

The Supreme Court judges stated in making their decision that, the non-compete clause was not a penalty clause, it was a price adjustment clause. The Supreme Court judges held that both parties had a legitimate interest in the observance of the covenants and the clauses for non-payment and forcing a share sale was not compensation; it was a necessary consequence of a breach to protect the interests of the group of companies. 

ParkingEye Ltd v Beavis

Mr Beavis parked his car in a car park close to Chelmsford City Centre which contained many notices to inform customers that they would be fined £85.00 if they parked for longer than 2 hours. ParkingEye Ltd was the company hired by the landowner to manage the car park and to ensure that customers did not overstay the 2 hour maximum parking time. Mr Beavis overstayed the two hour limit by 56 minutes and ParkingEye Ltd issued him with an £85.00 fine. As Mr Beavis did not pay the fine or appeal it, ParkingEye Ltd brought proceedings against him to recover the costs.

Mr Beavis claimed that the £85.00 fine was an invalid penalty clause and he claimed that the clause breached the Unfair Terms in Consumer Contracts Regulations 1999 (UTCCRs). Mr Beavis lost in the first instance and the court held that the clause was enforceable. The Supreme Court judges also upheld this decision. 

The Supreme Court judges did recognise this clause as a penalty clause but still allowed it to be enforced. They stated that, although ParkingEye Ltd did not directly suffer any loss, they still had a legitimate interest in charging a sum which was compensatory. ParkingEye Ltd had an interest because it was providing a service to the landowner and the charges allowed them to continue to do this. Also, the amount which they charged was not considered to be disproportionate as this is the amount which similar companies charge as a parking fine. As the Supreme Court judges decided that the clause did not breach the penalty rules, they said it would not breach the UTCCRs as it is not unreasonable.

The Supreme Court judges also stated that the rules which were set out in the previous case of Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd [1915] AC 79 may still be relevant.

Dunlop Pneumatic Tyre Co Ltd v New Garage & Motor Co Ltd

Dunlop sued its tyre retailer, New Garage, for breaching an agreement to not resell Dunlop tyres at a price lower than that listed in the contract. The agreement stated that, if that did happen, New Garage would pay £5 per tyre ‘by way of liquidated damages and not as a penalty’. The judge held the £5 sum was liquidated damages and enforceable. The Court of Appeal held the clause was a penalty and Dunlop could only get nominal damages. Dunlop appealed.

In the House of Lords, Lord Dunedin stated that the question of whether a sum stipulated is a penalty or liquidated damages is a question of construction to be decided upon the terms and inherent circumstances of each particular contract, judged of as at the time of the making of the contract, not as at the time of the breach. To assist this task of construction, various tests have been suggested, which if applicable to the case under consideration may prove helpful.

Firstly, a clause will be held to be penalty 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. Secondly, a clause will be held to be a penalty if the breach consists only in not paying a sum of money, and the sum stipulated is a sum greater than the sum which ought to have been paid. Thirdly, there is a presumption that it is penalty when "a single lump sum is made payable by way of compensation, on the occurrence of one or more or all of several events, some of which may occasion serious and others but trifling damage". On the other hand, it is no obstacle to the sum stipulated being a genuine pre-estimate of damage, that the consequences of the breach are such as to make precise pre-estimation almost an impossibility. On the contrary, that is just the situation when it is probable that pre-estimated damage was the true bargain between the parties.

In summary, the three cases discussed above share a common thread. Cavendish is considering the breach of an agreed covenant that quite reasonably could devalue an interest in a business sale; Dunlop was similar since New Garage was ostensibly under-cutting Dunlop itself. Beavis perhapshas an element of public policy about it as, if parking restrictions are not reasonably enforced, there might be a free for all; and/or perhaps protecting the legitimate/competing interests of land owners. These are all sensible and relevant considerations quite different to where, for example, a service contract states that if a supplier is in breach, there is some additional charge disguised as a genuine pre-estimate of loss that simply finds its way into their 'perks' tin. 

Guidance – When will a penalty clause be held valid and enforceable?

If you are considering using a clause in a commercial contract which could appear, on the face of it, to be a penalty clause, you should contemplate the following points:

  • The penalty clause should not be secondary to the primary clause. For example, if the main clause places an obligation on a party to specifically do something and the second clause is triggered on a breach of this, then this could be seen as a penalty clause and invalid. Also, the secondary clause should not impose a detriment on the contract-breaker which is out of proportion to the primary clause or this will be seen as penal.
  • To work out if the secondary clause is penal you should focus on whether the clause is a genuine pre-estimation of loss or if it is more then compensatory. If the secondary clause is completely disproportionate to the obligations set out in the primary clause then which will be seen as penal and unenforceable. Also, you should consider the industry standards as in the ParkingEye case. The clause should not extend beyond the "norm" or be "unconscionable" or "extravagant". 

This is not legal advice; it is intended to provide information of general interest about current legal issues.