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New penalty test

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The Supreme Court has provided a new test on penalties, which replaces the old test of whether a clause was a "genuine pre-estimate of loss". The court ruled in Cavendish v Makdessi; ParkingEye v Beavis [2015] UKSC 67 that the new test is whether the clause is a secondary obligation which imposes a detriment which is out of all proportion to the legitimate interest of the innocent party. If so it will be penal and therefore unenforceable. The ruling helpfully acknowledges that a party can, in some circumstances, have a legitimate interest in enforcing performance which goes beyond simply being compensated for losses.

New test
The new test for whether a provision is an unenforceable penalty 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."
This is taken from the majority judgments of Lord Neuberger and Lord Sumption (with whom Lord Clarke and Lord Carnwath agreed on this point). Lord Mance and Lord Hodge (with whom Lord Toulson agreed on this point) each chose, rather than agreeing with the majority, to put the test in their own words using phrases such as "extravagant disproportion" and "extravagant, exorbitant or unconscionable". It is unclear the extent to which their differences are of substance or form.
Facts – restrictive covenants and parking charges
Makdessi v Cavendish: Mr Makdessi agreed to sell to Cavendish a stake in a company. The contract provided that if Makdessi was in breach of certain restrictive covenants against competing activities, he would not be entitled to receive the final two instalments of the price paid by Cavendish (clause 5.1). Further, Makdessi could be required to sell his remaining shares to Cavendish, at a price that excluded the value of the goodwill of the business (clause 5.6). Makdessi breached the covenants but argued that clauses 5.1 and 5.6 were unenforceable penalty clauses.
ParkingEye v Beavis: ParkingEye managed a car park for the owners of a retail park. Numerous notices stated that a failure to comply with a two hour time limit would result in a parking charge of GBP 85. Mr Beavis parked in the car park, but overstayed the two hour limit. ParkingEye demanded payment of the GBP 85 charge. Mr Beavis argued that the GBP 85 charge was unenforceable as a penalty.
New test applied to the facts
Makdessi v Cavendish
All Supreme Court Justices came to the same answer ‑ that clauses 5.1 and 5.56 were not penalties, but they arrived there via different routes.
Clause 5.1 – a price adjustment clause
Lord Neuberger and Lord Sumption (with whom Lord Carnwarth agreed) (their Lordships) held that clause 5.1 was in reality a price adjustment clause. Although the occasion for its operation was a breach of contract it was in no sense a secondary provision.
It was not a liquidated damages clause, it was not concerned with regulating the measure of compensation for breach of the restrictive covenants, nor was it a contractual alternative to damages at law.
Although their Lordships acknowledged that clause 5.1 had no relationship with the measure of loss attributable to the breach, Cavendish had a legitimate interest in the observance of the restrictive covenants which extended beyond the recovery of that loss. It had an interest in relating the price of the business to its value. The goodwill of the business was critical to its value to Cavendish.
There were no juridical standards by which the court could assess how much less the business was worth if the restrictive covenants were breached, instead this was a matter for the parties, who were sophisticated, successful and experienced commercial people bargaining on equal terms over a long period with expert legal advice. They were the best judges of the degree to which each of them should recognise the proper commercial interests of the other.
However, their Lordships did not sanction absolutely any price adjustment clause: "We do not doubt that price adjustment clauses are open to abuse, and if clause 5.1 were a disguised punishment for the Sellers' breach, it would make no difference that it was expressed as part of the formula for determining the consideration".
Clause 5.6: reduced price for remaining shares
Their Lordships held that the logic of the price formula for the sale of the retained shares under clause 5.6 was similar to that of the price adjustment achieved by clause 5.1 for the sale of the transferred shares. The same legitimate interest which justified clause 5.1 justified clause 5.6 also. More fundamentally, a contractual provision conferring an option to acquire shares, not by way of compensation for a breach of contract, but for distinct commercial reasons, belonged, in the eyes of their Lordships, among the parties' primary obligations, even if the occasion for its operation was a breach of contract.
Their Lordships were, perhaps, rather opaque on why they felt the need to look at the legitimate interests if the clauses were creating primary and not secondary obligations according to their test.
On this question Lord Hodge (with whom Lord Clarke agreed on this point) was clearer. He held that there was clearly a strong argument that in substance clause 5.1 was a primary obligation which made payment of the interim and final payments conditional upon the seller's performance of certain other of his obligations. But even if it were correct to analyse clause 5.1 as a secondary provision operating on breach of the seller's primary obligation, Lord Hodge was satisfied that it was not an unenforceable penalty clause. In relation to clause 5.6, Lord Hodge construed the clause as a secondary obligation but one which was not an unenforceable penalty.
ParkingEye v Beavis
Their Lordships held that while the penalty rule was plainly engaged, the GBP85 charge was not a penalty. Although ParkingEye was not liable to suffer loss as a result of overstaying motorists, it had a legitimate interest in charging them which extended beyond the recovery of any loss. The scheme in operation here (and in many similar car parks) was that the landowner authorised ParkingEye to control access to the car park and to impose the agreed charges, with a view to managing the car park in the interests of the retail outlets, their customers and the public at large. That was an interest of the landowners because; (i) they received a fee from ParkingEye for the right to operate the scheme; and (ii) they leased sites on the retail park to various retailers, for whom the availability of customer parking was a valuable facility. It was an interest of ParkingEye, because it sold its services as the managers of such schemes and met the costs of doing so from charges for breach of the terms (and if the scheme was run directly by the landowners, the analysis would be no different).
This is a lengthy judgment and one in which it is not always easy to reconcile the approaches taken by the Supreme Court Justices. However it is clear we have a new test which is more flexible as it may take into account, in certain cases, not just what loss is likely to result from the breach, but instead broader considerations (perhaps, for example, reputational risk, public interest in providing a service) in deciding whether an interest is legitimate and what is proportionate to protect that interest.
Deciding on what losses may flow from a breach (such as a delay or failure to pay), can be very difficult, so it is also helpful that a number of members of the court acknowledged that sophisticated and well–advised commercial parties are in the best position to decide on what certain aspects of their relationship/promises are worth. It is likely therefore that parties of equal bargaining power, with specialist advisors, may find it more difficult to challenge a clause as a penalty following this decision.
There remain a number of areas for debate:
  • The difficult distinction as to whether a provision is a primary or secondary obligation. The members of the court did not agree on this point on the facts.
  • In what circumstances, even where one is concerned with a primary obligation, it can nevertheless be viewed as a disguised punishment? It is hoped that this will only operate as a safety valve in exceptional circumstances.
  • What legitimate interests can be protected? This itself may by intertwined with whether the clause is a primary obligation and parties are advised to consider this aspect of the test in any event.
  • How the courts are going to apply the test of whether or not a clause is "out of all proportion" to that legitimate interest. It is hoped that they will be loath to second-guess the parties' own judgment on that issue, especially in a heavily negotiated commercial contract.
In terms of drafting solutions, some or all of the following are worth considering:
  • Try to identify precisely what the legitimate interests in a clause that operates on breach may be and even consider setting those interests out the recitals.
  • Try to ensure that, where possible, key clauses operating on breach are drafted so as to highlight their importance to the overall package. The idea is to maximise the chances of such a clause being identified as primary obligations. An alternative would be to draft in a way which makes the obligation conditional.
  • Where appropriate include within an agreement that that each side was of comparable bargaining power and each side had been fully advised by solicitors.
Further information
For more information please contact Sarah Garvey, or tel +44 20 3088 3710.

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