England’s Supreme Court changes the test for determining whether a contractual provision is a “penalty” and therefore unenforceable

In its judgment of 4 November 2015, England’s Supreme Court, for the first time in a century, considered the principles underlying the law relating to contractual penalty clauses, in two appeals before it. One appeal involved a share purchase and shareholders’ agreement (Cavendish Square Holding BV v Talal El Makdessi) and the other a charge imposed on an individual for overstaying a two hour free parking period (ParkingEye Limited v Beavis). Both appeals gave rise to the same question, namely what is the ambit of the penalty rule in English law? The judgment changes the test under English law for determining whether a contractual clause, which takes effect upon breach of contract, is a penalty and therefore unenforceable.

The old test

Parties to a contract may agree that breach of contract will have certain specified consequences. They might agree, for example, that the party in breach will pay the innocent party a specified sum. Until now, courts in England and Wales (as they do in Hong Kong) would uphold such clauses if the consequence specified was a genuine pre-estimate of the loss that would be suffered by the innocent party in the event of breach. If, however, the court considered the clause to be a penalty clause i.e. a way of punishing the contract breaker rather than compensating the innocent party (for example, by specifying an amount payable out of all proportion to any damages liable to be suffered as a result of breach) then it would be held to be unenforceable.  

The new test

Rather than abolishing the “penalty rule” altogether, the Supreme Court decided to reformulate the test to be applied where a contractual clause is challenged as being a penalty clause. The Supreme Court said that the real question is whether the clause is penal and not whether it is a genuine pre-estimate of loss, since the fact that a clause is not a genuine pre-estimate of loss does not, without more, make it penal.

The Supreme Court noted the difference between “primary” and “secondary” obligations under a contract and made it clear that the “penalty rule” regulates only the remedies available for breach of a party’s primary obligations under a contract and not the fairness of the primary obligations themselves.

The Court explained it in this way:

“… where a contract contains an obligation on one party to perform an act, and also provides that, if he does not perform it, he will pay the other party a specified sum of money, the obligation to pay the specified sum is a secondary obligation which is capable of being a penalty; but if the contract does not impose (expressly or impliedly) an obligation to perform an act, but simply provides that, if one party does not perform, he will pay the other party a specified sum, the obligation to pay the specified sum is not a conditional primary obligation and cannot be a penalty.”     

Accordingly, the “penalty rule” only comes into play where a contractual provision provides what the remedy is for breach of the contract. The true test of whether a clause is a penalty clause, the Supreme Court said, is whether the impugned clause 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 the performance of the contract or in some appropriate alternative to performance. In the case of a straightforward damages clause, the Supreme Court said, such interest will rarely extend beyond compensation for the breach, although compensation may not necessarily be the only legitimate interest that an innocent party may have in the performance of the defaulter’s primary obligations.

New test applied to the facts

Makdessi appeal

Mr Makdessi sold his controlling interest in an advertising agency and the buyer, Cavendish, agreed to pay up to US$147million, depending on a calculation of the profits. The contract provided that for a period after the sale, Mr Makdessi was not to compete with his old business and that if he did he would lose the right to the final instalment of the purchase price and would have to sell his remaining shares to Cavendish at a price that disregarded goodwill and was therefore relatively low. Mr Makdessi argued that those consequences were excessive.  

The Supreme Court held that the clauses complained of, were in reality, price adjustment clauses and part of the parties’ primary obligations and were not secondary obligations under the contract or a contractual alternative to damages. The Supreme Court held that Cavendish had purchased Mr Makdessi’s business on terms that he would not undermine its value by being involved in a competing business and that those terms were fundamental to the commercial basis of the deal. Cavendish had a legitimate interest in enforcing the covenants, in order to protect the goodwill of the business, and the parties themselves were the best judges of how that interest should be reflected in the agreement. They were entitled, the Supreme Court said, to agree that if Mr Makdessi competed with the business, the price that Cavendish was prepared to pay would be smaller. Likewise, the forfeiture of Mr Makdessi’s remaining shares at a price which included nothing for goodwill reflected the fact that the goodwill had originally been priced on the assumption that Mr Makdessi would observe the non-competition clauses. Although commercially, these were tough clauses, it could not be said that Cavandish had no sufficient or legitimate interest in including and enforcing them, the Supreme Court said.

ParkingEye Appeal

Mr Beavis had parked his car in a privately owned carpark in a shopping centre. Twenty prominently placed notices on the premises stated that parking was free for up to two hours, but that after that, £85 would be charged. Mr Beavis stayed an hour over the two hour time limit and received a bill for £85. Mr Beavis argued that this was excessive and unenforceable.

The Supreme Court held that the provisions in question were not penal and the owners/operators of the carpark had a legitimate interest in the efficient use of the parking spaces for the benefit of other users of the shopping centre. That interest could only be served by deterring people from occupying parking spaces for long periods to the detriment of other members of the public and the £85 charge was no greater than was necessary to achieve that result and was not unreasonable by comparison with public sector parking facilities. Accordingly, the provision in question was not penal and was valid.

Effect of the judgment

The judgment changes the test under English law for determining whether a contractual clause is a penalty and therefore unenforceable. Under the new test, the first question is whether the clause is a primary or secondary obligation under the contract. If the latter, it may be unenforceable if it 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. Although, the Supreme Court made it clear that classification of a contractual term will depend on substance rather than mere form, this means that it may be possible to avoid application of the penalty rule with careful drafting. The Supreme Court made it clear that in relation to a negotiated contract between properly advised parties of comparable bargaining power, the strong initial presumption must be that the parties are themselves the best judges of what is legitimate in a provision dealing with the consequences of a breach. Accordingly, the new test will probably result in less clauses falling foul of the penalty rule if they are properly drafted and the parties can show that the clause in question can be commercially justified and is not unconscionable and extravagant and out of all proportion to the interest which it seeks to protect.

The judgment made it clear that the penalty rule applies not only to clauses providing for the payment of money upon breach of contract, but also providing for other consequences. The Supreme Court said that there was no reason why it should not apply, for example, to an obligation to transfer assets (either for nothing or at an undervalue).  

In Hong Kong, it remains to be seen whether the courts will follow the new test under the Cavendish and Beavis judgments or will continue to apply the “genuine pre-estimate of loss” test to determine whether a contractual clause is penal and therefore unenforceable. 

Comment in respect of construction cases

Construction contracts invariably include “liquidated damages clauses” for late completion of construction projects. Such clause usually provides that the contractor shall pay liquidated damages for each day of delay in completing the project beyond the original or extended completion date, at a specified daily rate. Such rate can be very high in the case of commercial projects.

Assuming that the above Supreme Court judgment is adopted by the Hong Kong Courts, such liquidated damages clause should be regarded as a “secondary obligation” and it will therefore still be necessary to consider whether the liquidated damages are a penalty. If a liquidated damages clause is challenged, it is quite common to mount such challenge on the ground that the daily rate of liquidated damages is not a genuine pre-estimate of the loss that would be suffered for delayed completion. In order to counter such challenge, the employer typically produces a breakdown for calculation of the daily rate of liquidated damages. Such challenges seldom succeed. The general attitude of the Hong Kong Courts is that the liquidated damages clause is a bargain between the parties to the contract which the Courts should not interfere with without compelling reasons. If this new Supreme Court judgment is applied in Hong Kong, it will be even more difficult to set aside a liquidated damages clause.