UK Supreme Court upholds ban on excessive contractual 'penalty clauses' while dismissing two appeals

Rejecting a line of argument that the penalty clause rule was "antiquated, anomalous and unnecessary", seven Supreme Court judges held that it remained good law but re-considered the circumstances in which it should apply. They found that the clauses in dispute in two related cases were not penalty clauses.

In their leading judgment, Lords Neuberger and Sumption said that the law had become "the prisoner of artificial categorisation" over the years, due to confusion over the distinctions between a penalty, a deterrent and a "genuine pre-estimate of loss".

"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," they said.

"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. In the case of a straightforward damages clause, that interest will rarely extend beyond compensation for the breach .... But compensation is not necessarily the only legitimate interest that the innocent party may have in the performance of the defaulter's primary obligations … [This] is recognised in the more recent decisions about commercial justification," they said.

In the first of two cases decided by the Supreme Court, the judges were asked to rule on the validity of an agreement between Talal El Makdessi, a Middle Eastern entrepreneur, and a company, Cavendish Square. Makdessi had agreed to sell to Cavendish a controlling stake in his company. The contract provided that if he was in breach of certain restrictive covenants against competing activities, Makdessi would not be entitled to around $44 million in payments which he would otherwise be due and that Cavendish would have the option to purchase his remaining shares at a reduced value. When Makdessi breached the terms of the contract, Cavendish attempted to enforce these terms.

Cavendish attempted to argue that the penalty rule should be abolished altogether and the contract be allowed to stand, especially given the growing importance of statutory regulation in relation to unfair contract terms. Although the judges acknowledged that contemporary judges would not have invented the rule "if their predecessors had not done so three centuries ago", judicial abolition was "not the way in which English law develops". Instead, the judges found that the clauses in dispute were not in fact penalties at all.

In the leading judgment, the judges said that they were "prepared to assume" that a contractual provision may in some circumstances be a penalty if it deprived the contract-breaker of a sum of money that would otherwise have been due, and that clauses forcing the transfer of assets (e.g. the option over shares) could be penalties. But whether the provision would actually be a penalty "must depend 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", they said.

"It is not a proper function of the penalty rule to empower the courts to review the fairness of the parties' primary obligations, such as the consideration promised for a given standard of performance," they said.

"Although [the clause in this case] has no relationship, even approximate, 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 measuring the price of the business to its value. The goodwill of this business was critical to its value to Cavendish, and the loyalty of [Makdessi] was critical to the goodwill. The fact that some breaches of the restrictive covenants would cause very little in the way of recoverable loss to Cavendish is therefore beside the point," they said.

Commercial litigation expert Michael Fletcher of Pinsent Masons, the law firm behind Out-Law.com, said that the court's approach may create "greater flexibility" for contracting parties, as it had effectively established a test based "not on whether a clause is intended to be a deterrent, but on legitimate interest: does the innocent party have a legitimate interest to protect and, bearing this in mind, whether the clause is extravagant, exorbitant or unconscionable", he said.

"Parties should assume that, if they are drafting liquidated damages clauses, that the traditional test still applies - that is, as a starting point, they should seek to ensure that damages are a genuine pre-estimate of loss in order to ensure that the clause will be enforceable, simply because damages which do not genuinely pre-estimate loss and which exceed the loss that would be claimable as damages may be extravagant, and therefore unenforceable" he said.

"When agreeing these clauses, parties will often expressly agree that the damages are a genuine pre-estimate of loss in order to avoid the law of penalties applying. Practically, where a contracting party seeks to introduce a clause which seeks to prevent certain conduct, and creates rights if that conduct occurs, it may now be sensible to draft a provision which states that the parties agree that the clause protects the legitimate business interests of the party that would receive the benefit, perhaps even setting out those legitimate business interests, and that it is agreed that the clause is neither extravagant nor unconscionable," he said.

Liquidated damages clauses are used in the majority of construction contracts to establish financial consequences if a contractor or sub-contractor breaches its obligation to complete works in accordance with the requirements of the contract for reasons which are its contractual responsibility. Construction disputes expert Neal Morris of Pinsent Masons said that many of these clauses could be caught by the new rules, because the figures quoted in the contract rarely represented the loss that the employer would actually suffer.

"The Cavendish case is a long overdue clarification of how the courts will from now on approach the question of whether a clause in a contract can be reviewed by the courts and whether it can be struck down as penal or not," he said. "For the construction industry, it is important that both employers and contractors review the level of liquidated damages in every contract and consider how the figure relates, if at all, to the impact of works being delayed."

"The principle is a rare example of where the courts will consider altering the terms of a contract entered into by commercial parties. The decision also results, unusually, in English and Australian law differing in their approach to a key contract law issue," he said.

The second case decided by the Supreme Court as part of the same judgment was an appeal against a parking fine of £85 imposed after a driver overstayed the two-hour limit in a privately-run car park. The driver, a Mr Beavis, attempted to argue that this was an unenforceable penalty, but the majority of the judges disagreed as the car park operator had a "legitimate interest" in charging those that overstayed the time limits which "extended beyond the recovery of any loss".

"Parking schemes similar to this one are in place at retail parks across the country, so this was a real test case," said retail property expert Alicia Foo of Pinsent Masons.

"However, while the decision will be welcomed by centre owners, managers and car parking operators alike, it does not give them carte blanche to charge whatever they like of those who overstay in breach of the rules. Truly exorbitant charges will be unenforceable, either as a penalty at common law and/or under the 1999 Unfair Terms in Consumer Contracts Regulations, so a balance still has to be struck."