The Supreme Court may have rewritten the rulebook on penalty clauses, but what difference will the decision have in practice? Stuart Pemble, Isabel Teare and Miranda Whiteley offer some deep thought on the matter
The Greek philosopher Heraclitus is famous for suggesting that the only thing permanent about human existence was ever-present change. However, that conclusion ignores the fact that some things seem to be more immutable than others. Penalty shoot-outs, for example. Followers of the beautiful game in England will know only too well that penalties will always end in heartbreak and disappointment.
And it seems that the Weeping Philosopher’s best-known idea might face another penalty-related exception. Because, notwithstanding the excitement at the end of 2015 around the Supreme Court’s rewriting of the rule against penalties in Cavendish Square Holding BV v El Makdessi; Parkingeye Ltd v Beavis [2015] UKSC 67; [2015] PLSCS 309, the suspicion is that, from a practical perspective, little has actually changed. Establishing that a clause is a penalty has always been a hard ask for any litigant. Once the dust has settled and the new test is considered by the courts, the judgment may simply mean that it is a harder ask than before.
Allyson Colby has already summarised both cases (see her practice point and legal note, Penalty kicks, in EG, 28 November 2015, p108 and p111), but it is possible to delve a little deeper into the detail and draw some practical conclusions that practitioners should keep in mind when considering penalty clauses in contracts.
Penalty!
The question as to whether or not a clause is a penalty tends to arise when the parties agree that an amount of damages (often – and especially in construction contracts – known as liquidated, or liquidated and ascertained, damages) shall be payable as a result of a breach of contract. The question also arises where an alternative agreed consequence (such as the transfer of shares to the innocent party at an undervalue) happens as a result of the breach. Previously, if the agreed amount of damages (or other consequence) was a genuine estimate of the innocent party’s loss, then the clause was upheld irrespective of whether or not it represented the actual loss suffered.
Alternatively, if the clause was deemed not to be a genuine estimate of loss, the courts treated it as an unenforceable penalty. Although the principle sounds easy in theory, it has proved difficult to apply in practice; and so practitioners awaited the decisions in Cavendish and ParkingEye with considerable anticipation.
The Supreme Court’s thinking
Lords Neuberger and Sumption (who gave the joint leading judgment and with whom Lords Clarke and Carnwath agreed) provide a detailed analysis of the rule’s origin and historical development. And, although they traced it to an equitable doctrine that was well established by the beginning of the 16th century, their historical analysis inevitably centres around Lord Dunedin’s famous judgment in Dunlop Pneumatic Tyre Co Ltd v New Garage & Motor Co Ltd [1915] AC 79. Lord Dunedin emphasised four key principles to be considered when trying to decide whether or not a clause is a penalty. Most practising lawyers looking to get their heads around penalty clauses would, until the Supreme Court’s judgment, have turned to these principles as the key tests for deciding the issue:
- A sum would have been be a penalty if it was an extravagant or unconscionable amount when compared to the greatest loss which could actually have been suffered by the innocent party.
- It would also have been a penalty if the breach of contract was the non-payment of a sum of money and the amount of damages payable for that breach exceeded the original contractual obligation.
- There was a presumption (but not a hard and fast rule) that a clause was a penalty if a single lump sum was payable on the occurrence of one or more events, some of which were serious but others of which were trivial.
- A sum could be a genuine pre-estimate of loss even where it was almost impossible to provide an accurate estimate of the innocent party’s likely loss.
Despite the importance Lord Dunedin’s principles have played in the century since they were first applied, Lords Neuberger and Sumption gave them relatively short shrift. Having first described the rule itself as “an ancient, haphazardly constructed edifice which has not weathered well” and then concluded that it had grown more by accident than design, their Lordships bemoaned the fact that Lord Dunedin’s principles had “achieved the status of a quasi-statutory code in the subsequent case law”, despite his four tests not actually being agreed with (or mentioned) by the other members of the House of Lords in Dunlop.
The new rule
Notwithstanding their obvious misgivings about the rule’s history and legacy and the undue importance given to Lord Dunedin’s principles, the Supreme Court was not prepared to cast it aside, not least because it has played an important role in English jurisprudence and in a number of other common law countries. Instead, the judges felt that it should be reset, partly better to reflect its equitable origins and partly to recognise that the courts should consider the full “nature and extent of the innocent party’s interest in the performance of the relevant obligation”.
Lords Neuberger and Sumption stressed that the rule had to recognise cases where the innocent party’s interest extended beyond monetary compensation. In Dunlop, for example, the claimant’s wider commercial goal (in addition to receiving damages) was to avoid being undercut in the sales of its tyres and other products when it supplied them to individual garages.
This is now the rule:
“The true test is 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.”
Legal consequences
First, and most importantly, the rule against penalties does not apply to primary obligations but to secondary ones. Primary obligations are those terms of the contract which govern the parties’ actual obligations. Secondary obligations are ones which are consequential upon those primary obligations. The rule against penalties considers whether the secondary obligation (most obviously, the damages payable as a result of the breach of the primary one) is out of all proportion to the legitimate interest of the innocent party enforcing the primary obligation.
This can be a difficult distinction to apply in practice. The rule “can still turn on questions of drafting, even where a realistic approach is taken to the substance of the transaction and not just its form”. For example, in Cavendish, the court decided that the clause in question was a price adjustment clause and therefore a primary obligation; as such, it could not be a penalty.
Secondly, the question of whether the clause is a genuine pre-estimate of loss remains important, but in a slightly different way than before. The test is now whether the clause is penal. It follows that simply not being a genuine pre-estimate will not, on its own, decide whether or not a clause is penal. Conversely, if the clause is a genuine pre-estimate of loss, it will be difficult to see how it can be penal.
Thirdly, Lords Sumption and Neuberger acknowledged that the rule against penalties infringes parties’ freedom to contract. There is a difficult hurdle to be overcome before applying the rule in a commercial context:
“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.”
Fourthly, the courts will be interested in whether the alleged penalty can be said to be extravagant or unconscionable by reference to some norm (such as an industry standard). In ParkingEye, the damages payable by the defendant for staying too long in a car park were comparable with other charges and less than the maximum suggested by an industry body.
Finally, and of particular interest to property lawyers, Lords Mance, Hodgson and Clarke considered the relationship between the penalty rule and the courts’ ability to grant relief from forfeiture. Their Lordships agreed that the courts should first consider whether a forfeiture clause is penal before considering whether or not it should be enforced. If the clause is penal, there is no need to consider the question of relief from forfeiture.
Practical consequences
Although the rule has been reset, the practical consequences (especially in a commercial contract where the parties have received professional advice) are likely to be limited. It has always been difficult to persuade a court that a clause is a penalty. Arguably, Cavendish and ParkingEye make that an even harder hurdle to overcome, especially where the parties explain (perhaps in a recital) the commercial interests that justify the inclusion of the clause in the contract. Parties may also start drafting clauses that might otherwise be penal as primary rather than secondary obligations.
Penalty shoot-out: the key points
- The Supreme Court has arguably made it even more difficult for a litigant successful to argue that a contractual clause is a penalty
- Commercial parties taking independent advice should have confidence that the courts will be unlikely to interfere with their contracts
- If a clause might otherwise be penal, parties should consider expressing it as a primary obligation (such as a price adjustment) rather than a secondary one; only secondary obligations can fall foul of the rule
- However, the court admitted that it could all boil down to the drafting
Stuart Pemble is a partner and Isabel Teare and Miranda Whiteley are professional support lawyers at Mills & Reeve LLP
