What amounts to Penalty Law?
What amounts to a penalty in law?
The Supreme Court has published its judgment in 2 cases that relate to whether certain contractual clauses amounted to penalties. The general rule in English law is that penalties are unenforceable but the test that determines this has evolved over time.
What were the facts
In the first case, Mr Makdessi agreed to sell to Cavendish a controlling stake in a Middle East advertising and marketing company. The sales contract stated that if he were in breach of certain restrictive covenants preventing competitive activities, Mr Makdessi would not be entitled to receive the final instalments of the sale price and could be required to sell the balance of his shares to Cavendish at a reduced price. Mr Makdessi then breached the covenants. He sought to argue that the clauses setting out the consequences of not keeping to the covenants were unenforceable penalties. In the second case, ParkingEye Limited operated a shopping car park. It published various notices throughout the car park stating that a failure to comply with a 2 hour parking limit would "result in a Parking Charge of £85". Mr Beavis parked in the car park and overstayed his welcome by almost an hour. Mr Beavis then sought to argue that the £85 was an unenforceable penalty.
What did the Supreme Court decide?
The Supreme Court decided that neither the covenants in Mr Makdessi's case nor the charge in Mr Beavis' case were unenforceable penalties. In both cases, the provisions in question could be enforced.
It is important to understand what the penalty rule is. Since at least the early 18th century, English law has stated that any contractual term that constitutes a penalty is unenforceable. The test as to what constitutes a penalty has however evolved over time. To paraphrase the Court, it is an "ancient, haphazardly formed" rule that "has not weathered well". It protects those contracts that are not regulated in any other way, so serves a valuable purpose.
The Court, in reaching its decision, spent a significant amount of time analysing the history of the penalty rule. At the end, it decided that the rule needed reformulating. The enforceability of a provision should turn on whether the person seeking to enforce the relevant provisions has a legitimate interest that it was seeking to protect. The previous test of whether a clause that takes effect on a breach of another clause was a "genuine pre-estimate of loss" and therefore compensatory was rejected.
The updated test has 2 limbs:
- Is there a legitimate business interest that is being protected by the provision?
- If so, is the provision "extravagant, exorbitant or unconscionable"?
If the answers are yes, then the provision will fail the test and be construed as a penalty. The new test will also only apply to secondary obligations (in other words, a duty to do something as a result of failing to do something else).
In Mr Makdessi's case, essentially the Court decided that Cavendish had a legitimate interest to protect. Also, both clauses were primary, not secondary obligations as they were not drafted to be contractual alternatives to a damages claim. The penalty rule could not therefore apply.
In Mr Beavis' case, the Court decided that that penalty test should be applied, as the charge was a consequence of not complying with the parking rules. £85 was not viewed as a penalty on the basis that ParkingEye had a legitimate interest in charging overstaying motorists, which went beyond the recovery of any loss that it suffered. ParkingEye and the landowner needed to provide efficient parking management and obtain an income, including a profit margin, from those operations. Based on other car park operators' charges, the car park in question, and that there was an abundance of signage, the charge was neither extortionate nor unconscionable.
The Court also discounted Mr Beavis' argument that his parking charge was unenforceable as it was an unfair term under the Unfair Terms in Consumer Contracts Regulations 1999 (now replaced by the Consumer Rights Act 2015).
What does this mean for me?
There will inevitably be much debate over whether a clause is seeking to protect a legitimate interest and whether the consequences are extravagant or unconscionable. However, the underlying issues are two fold. Firstly, you need to ensure that any provision in your contracts that you might want to enforce and that sets out the consequences of not complying with another provision does not fail the new penalty test. Previous rules that may have applied when the contract was drafted are no longer good law. Secondly, you may well be hoping to rely on a provision in a contract being found to be a penalty. Be aware that this may no longer be the case following these judgments.
For more information, contact James Geary.
Case: Cavendish Square Holding BV v Talal El Makdessi; ParkingEye Limited v Beavis  UKSC 67.