23 November 2015
The penalty rule after Cavendish and ParkingEye
At the start of its judgment of 4 November 2015, the Supreme Court addressed Lord Dunedin’s speech in Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd  AC 79, which set out four tests for deciding if a clause was a penalty, of which the most often quoted one is the ‘genuine pre-estimate of loss’. Lord Neuberger and Lord Sumption state in the judgment that Lord Dunedin’s tests had become quasi-statutory code in subsequent case-law, which in their view was unfortunate since he proposed his tests not as rules but as considerations, and did not suggest that they were applicable to every case in which the law of penalties was engaged.
In their opinion, the fact that a clause is not a pre-estimate of loss does not mean that it is a penalty and neither does it being a deterrent, or in terrorem, make it inherently penal. For them, the enforceability of such a clause depends on whether the means by which the contracting party’s conduct is to be influenced are ‘unconscionable’ or ‘extravagant’ by reference to some norm.
This of course leads to the question of what that norm is and, as Lord Toulson states, ‘it is impossible to lay down abstract rules about what may or may not be “extravagant or unconscionable”, because it depends on the particular facts’.
What the judgment in Cavendish does clarify is that the test that should be applied now is this:
Is the provision a secondary obligation that 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 court recognised that with a straightforward damages clause such interest is likely to take the form of compensation for breach of the primary obligation, therefore Lord Dunedin’s four tests ought to suffice in testing its enforceability. However, compensation is not necessarily what an innocent party is after, in requiring the performance of the primary obligation, whether in a complex commercial arrangement or retail consumer setting, as illustrated by the facts of the two cases.
Cavendish Square Holding BV v Talal El Makdessi
In February 2008, Mr Makdessi and another shareholder sold the majority of the shares in Team Y & R Holdings Hong Kong Ltd, and through a series of contracts those shares came into the ownership of Cavendish Square Holdings BV. The agreement for the sale of the shares was extensively negotiated over six months, with both sides represented by highly experienced commercial law firms.
Clause 5.1 of the agreement stipulated that if a seller breached clause 11.2 – that contained restrictive covenants requiring the sellers to refrain from carrying out certain activities in specified regions, which competed with Team Y & R Holdings Hong Kong Ltd’s business – then the seller would not be entitled to receive the remaining payments for the shares, and under clause 5.6 Cavendish Square Holdings BV would be entitled to require the defaulting seller to sell all of his shares at net asset value within 30 days’ notice.
Mr Makdessi breached clause 11.2 by his active involvement in the affairs of a competitor business.
The court considered that the background behind clause 5 is of some importance, namely that a large proportion of the share purchase price represented goodwill, as reflected in the maximum price agreed to be payable by Cavendish Square Holdings BV, and the express recognition by the sellers in clause 11.1 that the restrictive covenants in clause 11.2 reflected the importance of the goodwill.
In monetary terms, clause 5.1 had the effect of reducing the amount payable to the sellers jointly by up to US$82 million. This was neither a liquidated damages clause nor a contractual alternative to damages, and the court categorised it as a price adjustment clause.
Although the occasion for the operation of clause 5.1 is breach of contract, according to Lord Neuberger and Lord Sumption it is not a secondary provision. The payments made by Cavendish Square Holdings BV were said in clause 3.1 to be payable in consideration of the shares ‘and the obligations of the sellers herein’, which Lord Neuberger and Lord Sumption held to include the restrictive covenants contained in clause 11.2. They held that clause 5.1 is not intended to compensate for loss, but rather Cavendish Square Holdings BV had a legitimate interest in the observance of the restrictive covenants.
The court emphasised that the nature of the clause being one of price adjustment does not in itself prevent it from being penal, but that it depends on the nature of the right of which the contract-breaker is being deprived and the basis on which he is being deprived of it. In this case, the court was satisfied that the clause was not intended to be a punishment. Lord Mance explained that the price adjustment was not extravagant, exorbitant or unconscionable, in the context of a carefully negotiated agreement between informed and legally advised parties at arm’s length.
Lord Hodge decided that even if Lord Neuberger and Lord Sumption’s analysis was wrong and clause 5.1 were a secondary provision operating on breach of the seller’s primary obligations in clause 11.2, it was in any case not an unenforceable penalty because the nature of the obligation was to prevent the sellers from derogating from what they had sold. Namely shares in the company, with a high value attributed to its goodwill.
The relevant questions were therefore:
Mr Makdessi’s objection to this clause was its exclusion of the value of goodwill from the calculation of the shares subject to the ‘forced’ sale. A substantial part of the purchase consideration comprised goodwill, potentially up to US$114 million, or 77 per cent of the aggregate purchase consideration.
There was a difference in opinion as to whether clause 5.6 was a primary obligation (Lord Neuberger and Lord Sumption) with a legitimate requirement for the defaulting seller to sell his shares, and which therefore required a formula for the share price to be negotiated and agreed, or a secondary obligation (Lord Hodge) designed to deter the sellers from breaching clause 11.2. A slightly different take from Lord Mance was that the clause was a reshaping of the parties’ primary relationship necessarily resulting from the seller’s default.
Ultimately, the court agreed that clause 5.6 was a legitimate means of protecting Cavendish Square Holdings BV‘s interest in the value of Team Y & R Holdings Hong Kong Ltd, and was neither exorbitant nor unconscionable in light of that interest. The negotiation of the contract by parties with equal bargaining power was also a factor.
ParkingEye v Beavis
Mr Beavis was served with a parking charge notice for overstaying the two-hour limit in a retail car park managed by ParkingEye. He refused to pay it on the basis that it was:
The Supreme Court held that on the facts, Mr Beavis had a contractual licence to park his car on the terms of the notice posted at the entrance, which he accepted by entering the site. One of the terms was that he would stay for not more than two hours. The £85 payable on breach of such term was a charge for contravening the terms of the contractual licence.
It is common ground that the main purpose of the £85 parking charge was to deter motorists from overstaying. Also, since ParkingEye suffered no loss as a result of Mr Beavis’ overstay, the £85 cannot be said to be a pre-estimate of any loss.
The court decided that the penalty rule was relevant here but that on the facts, the charge is not a penalty because ParkingEye had a legitimate interest that was ‘commercially justifiable’, in charging overstaying motorists, which extended beyond the recovery of any loss. The fact that the term was intended to deter overstaying motorists does not make it penal if there is a legitimate interest in influencing the conduct of the contracting party that goes beyond compensation.
The court emphasised that this did not mean that ParkingEye could charge overstayers a sum that was out of all proportion to its interest. However, in the circumstances it found that £85 was neither extravagant nor unconscionable, having regard to the level of charges imposed by local authorities for overstaying in public car parks.
For similar reasons the term was not held to be unfair under the 1999 Regulations, Lord Toulson dissenting.
An end to the debate?
The judgment mentions recent decisions in the Australian High Court that have extended the penalty doctrine giving the court equitable jurisdiction to relieve a party against an onerous provision, whether or not that failure was a breach of contract. The Supreme Court unanimously disagreed with this approach, finding that the ‘somewhat formal distinctions’ between a breach and non-breach situation, in the context of the penalty rule, are important because the rule is an ‘inroad upon freedom of contract’ and should not be extended by the judiciary.
Cavendish Square Holdings BV’s primary contention was that the doctrine of penalties should be either abolished or restricted so as not to applying in ‘commercial’ contracts. The Supreme Court declined to abolish the rule, which it considered was based on public policy and consistent with other English, and Western, legal principles. Furthermore, as discussed above, it found that there were better ways of dealing with the difficulties arising from the rule rather than to abolish it entirely. Also, Lord Mance pointed out that there remain significant imbalances in negotiating power in the commercial world. Also, that it was not desirable for the courts to be made to rule on issues of fact about the bargaining power of the parties and the calibre of their legal advisers.
At the other end of the spectrum, the Supreme Court rejected the suggestion by Mr Makdessi’s legal team that the penalty doctrine should be confined to cases of payment of money, for example liquidated damages. They held that the doctrine could apply to clauses entitling the withholding of sums otherwise due to the contract-breaker, and to clauses that provide for the transfer of property from the contract-breaker to the innocent party.
It is evident from the historical background and analysis of the correct application of the penalty rule covered in its 123-page judgment, that the Supreme Court wishes to clarify that the penalty doctrine is alive and kicking, and needs neither extension nor restriction. The reworded test set out in its judgment is a pragmatic one, consistent with the tendency of the courts in recent years when interpreting contract clauses, to look at the commercial justification behind the agreed words.
This article is for general awareness only and does not constitute legal or professional advice. The law may have changed since this page was first published.
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