CONTRACT — Penalty — Enforceability — Common law rule that contractual penalty clause not enforceable — Circumstances in which rule engaged — Test for determining whether provision penal — Whether rule should be abolished, restricted or extended
Cavendish Square Holding BV v El Makdessi
ParkingEye Ltd v Beavis
 UKSC 67;  WLR (D) 439
SC: Lord Neuberger of Abbotsbury PSC, Lord Mance, Lord Clarke of Stone-cum-Ebony, Lord Sumption, Lord Carnwath, Lord Toulson, Lord Hodge JJSC: 4 November 2015
There was no justification for abolishing, restricting or extending the rule that a contractual penalty clause was unenforceable.
A contractual clause was penal if it was a secondary obligation which imposed 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 Supreme Court so held in (1) allowing an appeal by the claimant, Cavendish Square Holding BV, against the decision of the Court of Appeal (Patten, Tomlinson and Christopher Clarke LJJ)  EWCA Civ 1539 which had overturnedd declarations granted by Burton J  EWHC 3582 (Comm) that the defendant, Talal El Makdessi, was not entitled to further payment under an agreement for the sale of shares in a company to the claimant and was obliged to sell his remaining shares in the company to the claimant as a result of breaching a non-competition clause in the agreement; and (2) dismissing an appeal (Lord Toulson JSC dissenting) by the defendant, Barry Beavis, against the decision of the Court of Appeal (Moore-Bick, Patten and Lloyd LJJ)  EWCA Civ 402 to uphold the decision of Judge Moloney QC, sitting in the County Court at Chelmsford on 19 May 2014, that the claimant, ParkingEye Ltd, could recover a charge of £85 imposed on the defendant for overstaying the permitted period of free parking in a car park which it managed.
LORD NEUBERGER OF ABBOTSBURY PSC and LORD SUMPTION JSC said that the appeals raised an issue which had not been considered by the Supreme Court or by the House of Lords for a century, namely the principles underlying the law relating to contractual penalty clauses (“the penalty rule”). The first appeal raised the issue in relation to two clauses in a substantial commercial contract. The second appeal raised the issue at a consumer level. The penalty rule as it had been developed by the judges gave rise to two questions: (i) in what circumstances was the rule engaged at all? (ii) what made a contractual provision penal? As to the first issue, a provision could not be a penalty unless it provided an exorbitant alternative to common law damages. That meant that it had to be a provision operating upon a breach of contract. There was a fundamental difference between a jurisdiction to review the fairness of a contractual obligation and a jurisdiction to regulate the remedy for its breach. Leaving aside challenges going to the reality of consent, the courts did not review the fairness of men’s bargains either at law or in equity. The penalty rule regulated only the remedies available for breach of a party’s primary obligations, not the primary obligations themselves. That meant that in some cases the application of the penalty rule might depend on how the relevant obligation was framed in the instrument, ie whether as a conditional primary obligation or a secondary obligation providing a contractual alternative to damages at law. However, the capricious consequences of that state of affairs were mitigated by the fact that the classification of terms for the purpose of the penalty rule depended on the substance of the term and not on its form or on the label which the parties had chosen to attach to it. As to the second issue, the law relating to penalties had become the prisoner of artificial categorisation, itself the result of unsatisfactory distinctions: between a penalty and genuine pre-estimate of loss, and between a genuine pre-estimate of loss and a deterrent. Those distinctions originated in an over-literal reading of Lord Dunedin’s four tests in Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd  AC 79 and a tendency to treat them as almost immutable rules of general application which exhausted the field. However, the real question when a contractual provision was challenged as a penalty was whether it was penal, not whether it was a pre-estimate of loss. Those were not natural opposites or mutually exclusive categories. The fact that the clause was not a pre-estimate of loss did not therefore, at any rate without more, mean that it was penal. To describe it as a deterrent (or in terrorem) did not add anything. A deterrent provision in a contract was simply one species of provision designed to influence the conduct of the party potentially affected. It was no different in that respect from a contractual inducement. Neither was inherently penal or contrary to the policy of the law. The question whether it was enforceable should depend on whether the means by which the contracting party’s conduct was to be influenced were “unconscionable” or (which would usually amount to the same thing) “extravagant” by reference to some norm. The true test was whether the impugned provision was a secondary obligation which imposed 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 could have no proper interest in simply punishing the defaulter. His interest was in performance or in some appropriate alternative to performance. In the case of a straightforward damages clause, that interest would rarely extend beyond compensation for the breach, and their Lordships would therefore expect that Lord Dunedin’s four tests would usually be perfectly adequate to determine its validity. But compensation was not necessarily the only legitimate interest which the innocent party might have in the performance of the defaulter’s primary obligations. In a negotiated contract between properly advised parties of comparable bargaining power, the strong initial presumption had to be that the parties themselves were the best judges of what was legitimate in a provision dealing with the consequences of breach. The claimant in the first case had contended that the penalty rule should now be regarded as antiquated, anomalous and unnecessary, and that it was the creation of the judges and the judges should now take the opportunity to abolish it. Their Lordships rather doubted that the courts would have invented the rule today if their predecessors had not done so three centuries ago. But that was not the way in which English law developed and judicial abolition would not be a proper course for the court to take. The defendant in the first case suggested that, as an alternative to confirming or abrogating the penalty rule, the court could extend it, so that it applied more generally—the course taken by the High Court of Australia in Andrews v Australia and New Zealand Banking Group Ltd (2012) 247 CLR 205. Any decision of the High Court of Australia had strong persuasive force but their Lordships could not accept that English law should take the same path, quite apart from its inconsistency with established and unchallenged House of Lords authority.
In the first case, the defendant, who had co-founded the largest advertising and marketing communications group in the Middle East, had agreed to sell his shares in the holding company to the claimant. The agreement had been the subject of extensive negotiations over six months, and both sides had been represented by highly experienced commercial lawyers. A large proportion of the purchase price, which was to be paid by instalments, represented goodwill. Subsequently, the claimant had claimed that the defendant was in breach of a non-competition clause in the agreement and sought a declaration that he was, therefore, not entitled to further payments under the agreement as a result of clause 5.1 and was obliged to sell to the claimant all his shares in the company at the price specified in the agreement as a result of clause 5.6. The issue was whether clauses 5.1 and 5.6 were void and unenforceable because they constituted penalties. Burton J had concluded that the two provisions were valid and enforceable. However, the Court of Appeal had held that the two provisions were unenforceable penalties under the penalty rule as traditionally understood, essentially because it felt bound by the traditional explanation of the rule as being directed against deterrent clauses as such. Having considered all the facts, their Lordships concluded that neither clause was avoided by the penalty rule.
In the second case, the defendant had had a contractual licence to park his car in the retail park on the terms of the notice posted at the entrance, which he had accepted by entering the site. Those terms were that he would stay for not more than two hours, that he would park only within the marked bays, that he would not park in bays reserved for blue badge holders, and that on breach of any of those terms he would pay £85. The £85 charge had two main objects. One was to manage the efficient use of parking space in the interests of the retail outlets and of the users of those outlets. That was to be achieved by deterring commuters or other long-stay motorists from occupying parking spaces for long periods or engaging in other inconsiderate parking practices. The other purpose was to provide an income stream to enable the claimant to meet the costs of operating the scheme and make a profit from its services, without which those services would not be available. While the penalty rule was plainly engaged, the £85 charge was not a penalty. Although the claimant 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. There was no reason to suppose that £85 was out of all proportion to the claimant’s interests. The charge was neither extravagant nor unconscionable.
LORD CARNWATH JSC agreed.
LORD MANCE, LORD CLARKE OF STONE-CUM-EBONY and LORD HODGE JJSC gave concurring judgments.
LORD TOULSON JSC gave a judgment concurring on the applicable principles but dissenting on the outcome of the appeal in the second case.
Joanna Smith QC, Richard Leiper, James McCreath and Edwin Peel (instructed by Squire Patton Boggs) for thye claimant in the first case.
Michael Bloch QC and Camilla Bingham QC (instructed by Clifford Chance LLP) for the defendant in the first case.
John de Waal QC and David Lewis (instructed by Harcus Sinclair UK Ltd) for the defendant in the second case.
Jonathan Kirk QC, David Altaras and Thomas Samuels (instructed by Cubism Law) for the claimant in the second case.
Christopher Butcher QC (instructed by Solicitor, Consumers’ Association) for the Consumers’ Association, intervening.
Reported by: Jill Sutherland, Barrister.
© 2015. The Incorporated Council of Law Reporting for England and Wales.