The reformulated penalty rule

Following the decision in Cavendish Square Holding BV v El Makdessi and ParkingEye Ltd v Beavis [2015] when drafting liquidated damages provisions, parties should identify and document the applicable legitimate business interest that necessitates liquidated damages. Parties should then consider whether the remedy for breach is ‘extravagant, exorbitant or unconscionable’.

The penalty rule

Construction contracts often include a liquidated damages clause and they can be found in standard form and bespoke contracts. Liquidated damages are used to provide an employer with a contractual right to a liquidated sum from a contractor or consultant often in respect of contractor/consultant culpable delay to the contract works/services.  

In a previous article we summarised the court’s changing approach in relation to liquidated damages and penalties. This article looks at recent case law which suggests that providing there was a commercial justification for the liquidated damages clause, a clause which does not represent a genuine pre-estimate of the loss suffered may still be enforced.

The Supreme Court has recently reformulated the penalty rule test in a combined judgement which covers two cases; Cavendish Square Holding BV v El Makdessi and ParkingEye Ltd v Beavis [2015] UKSC 67. The Supreme Court has confirmed that the principle of penalty clauses will remain; however, a new approach to the identification of penalty clauses has been followed, which moves away from the concept of genuine pre-estimate of loss.  

The cases

Cavendish Square Holding BV v El Makdessi concerned a commercial contract. Makdessi entered into a sale and purchase agreement to sell Cavendish a significant portion of its shares. The sale and purchase agreement contained stage payment provisions. Makdessi was granted an option in respect of his remaining 20% shareholding. The sale and purchase agreement also contained restrictive covenants preventing Makdessi from competing with the group after the sale and provided that if Makdessi breached the restrictive covenants he would forgo the instalments linked to future profits and the option, as well as being required to sell his remaining 20% stake at a discounted value.

ParkingEye Ltd v Beavis concerned a consumer contract. Mr Beavis overstayed a two hour free period of parking in a car park by 56 minutes and occured an £85 charge for doing so.

The question to be determined in both cases was whether a contractual provision constituted a penalty and was therefore invalid.

The Judgment

Lord Neuberger and Lord Sumption in their Judgment (at paragraph 3) described the penalty rule as:

“an ancient, haphazardly constructed edifice which has not weathered well, and which in the opinion of some should simply be demolished, and in the opinion of others should be reconstructed and extended.”

In their Judgment they analysed the development of the penalty rule, noting that the law on penalties has developed into damages based clauses providing for payment of a specified sum instead of common law damages. In particular, Lord Neuberger and Lord Sumption noted that in their view (at paragraph 31):

“… the law relating to penalties has become the prisoner of artificial categorisation, itself the result of unsatisfactory distinctions: between a penalty and genuine pre-estimate of loss, and between a genuine pre-estimate of loss and a deterrent”.

Lord Neuberger and Lord Sumption held (at paragraph 28) that:

“a damages clause may properly be justified by some other consideration than the desire to recover compensation for a breach. This must depend on whether the innocent party has a legitimate interest in performance extending beyond the prospect of pecuniary compensation flowing directly from the breach in question.”

Lord Neuberger and Lord Sumption held (at paragraph 32) that the new test for whether a clause is a liquidated damages clause or a penalty clause should be:

“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 new test for penalties

Lord Mance suggested a two-fold test:

1. Consider whether a legitimate business interest is served and protected by the clause breached; and
2. Consider whether the provision to protect such interest is extravagant, exorbitant or unconscionable.

As a result of the new test:

• there is no need to consider whether the liquidated damages clause is a genuine pre-estimate of the employers’ loss. The fact that a clause is not a pre-estimate of loss does not mean that it is penal;
• to determine whether a liquidated damages clause is penal requires a broad understanding of the innocent party’s legitimate interest in the performance of the contract, for example taking into account protection of brand, reputation or good-will, not just considering the compensation awarded by the clause;
• if a clause is a deterrent against breach, it does not mean that the clause is penal;
• if a clause makes a provision for a sum that is out of all proportion (for example it is unconscionable, exorbitant or extravagant) to the legitimate interest of the innocent party in enforcing the obligation breached, it will be unenforceable.

The test reinforces the ability of parties to agree their own commercial terms and conditions and confirms the court’s role in enforcing such terms and conditions. Lord Neuberger and Lord Sumption acknowledged that the court should recognise that:

“In a negotiated contract between properly advised parties of comparable bargaining power, the strong initial presumption must be that the parties themselves are the best judges of what is legitimate in a provision dealing with the consequences of breach.”

The decision

In both cases, the Supreme Court upheld the validity of the clauses and the clauses were not penalty clauses.

In Cavendish the clauses in the sale and purchase agreement were seen as a package and were intended to protect the business as a whole.

In ParkingEye the parking charge was seen as an understandable feature in a scheme serving legitimate interests. The £85 charge was not out of all proportion to the car park owner’s interests and was therefore neither extravagant nor unconscionable.

Practical considerations

When drafting / agreeing liquidated damages clauses:

• consider setting out specific details of the legitimate interest which the clause serves to protect, taking into account the commercial justification of the clause; and
• care should be taken to ensure that the amount of the liquidated damages is not unconscionable or extravagant by reference to the industry norm. For example, consider what others charge in similar circumstances.

Employers will be able to justify the sums stipulated by way of liquidated damages in the wider commercial context to the contract. However, contractors or consultants may face increased difficulties in striking down a liquidated damages clause by persuading an adjudicator, arbitrator or the courts that the clause is an unenforceable penalty clause.

Following this case, it is likely that fewer liquidated damages clauses will be considered as unenforceable penalty clauses.