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After a century, the Supreme Court has reset and clarified the penalty rule

View profile for Christopher Buck
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Many contracts include liquidated damages provisions agreed upon by all parties to the contract.

Liquidated damages are an agreed sum which becomes payable upon breach of the contract by one of the parties to it. The general rule is that the agreed sum is recoverable upon breach as liquidated damages clauses are enforceable. However, liquidated damages clauses are unenforceable if they constitute a penalty.

The Supreme Court has recently reset and clarified the penalty rule. This has been eagerly anticipated for a century since the ruling of Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd [1915] which was the previous case governing the rules on penalty clauses.

This case set out the traditional test so as to distinguish between liquidated damages and penalty clauses. It is this test which has been reviewed by the Supreme Court in the joint appeals of Cavendish Square Holding BV v Talal El Makdessi and ParkingEye Ltd v Beavis [2015]. The Supreme Court declined abolishing or extending the test, but rather decided to reset and clarify it.

Cavendish Square Holding BV v Talal El Makdessi

Mr Makdessi, and his co-owner Mr Ghossoub, entered into a sale and purchase agreement with Cavendish. The agreement stipulated that Mr Makdessi and Mr Ghossoub, who had held the majority shareholding, would sell a significant amount of their shares so that Cavendish would hold the majority shareholding. Upon completion of the sale, the sale and purchase agreement stipulated that, dependant on the operating costs of the Group, an interim and a final payment would be made to Mr Makdessi and Mr Ghossoub.

Clause 11.2 of the sale and purchase agreement stipulated that there were certain activities which Mr Makdessi was prohibited from carrying out. The prohibited activities were any that would potentially compete with the interests of the Group. Should clause 11.2 be breached, then clauses 5.1 and 5.6 stated that:

  • “He would not be entitled to the Interim and Final Payments.
  • He could be required to sell to Cavendish the remainder of his shares in the Group at a default price, based solely on asset value and without reference to goodwill (to which significant value had been attached in the sale price).”

Mr Makdessi confirmed that he had breached clause 11.2 but stated that clauses 5.1 and 5.6 could not be enforced as they were penalty clauses. At first instance, Cavendish was successful in arguing the enforceability of the clauses, however, this was overturned and the appeal was held in favour of Mr Makdessi.

ParkingEye Ltd v Beavis

Mr Beavis parked his car in a car park where ParkingEye were employed by the car park owner to manage the use of the car park and provide a “traffic space maximisation scheme”. Notices stipulating the length of stay permitted in the car park were displayed stating “2 hour max stay” and “Parking limited to 2 hours” and, importantly, “Failure to comply… will result in a parking charge of £85″.

ParkingEye notified Mr Beavis that it had been recorded on camera that he had exceeded the maximum stay of 2 hours. Mr Beavis was therefore fined the £85 as stipulated on the signs displayed in the car park. The fine, if paid within 14 days, could be reduced to £50. Mr Beavis neither paid the fine, nor did he dispute the fine using the appeals process. In response to ParkingEye commencing proceedings against him, Mr Beavis argued that the £85 fine was unenforceable as it was a penalty or that he would look to rely on the terms of the Unfair Terms in Consumer Contracts Regulations 1999 to show that the fine was unfair and invalid.

The Court dismissed Mr Beavis’ appeal and found that the £85 fine did not constitute a penalty as ParkingEye, in looking to manage the car park’s efficiency, had a legitimate aim and therefore were entitled to claim for the outstanding fine. The £85 fine was also found not to be extravagant or unconscionable in relation to other UK car parking fines and was also not in breach of the Unfair Terms in Consumer Contracts Regulations 1999.

The effect of the recent case law

The recent case law identifies that the true test in determining whether a clause is unenforceable due to being a penalty clause is whether there is a secondary obligation in the clause which is to the detriment of the party who has breached the clause and out of proportion in relation to the innocent party’s legitimate interest in enforcing the primary obligation.

The previous test would determine whether a clause was in relation to liquidated damages or a penalty clause. The new test recognises that it is not whether there has been a pre-estimate of loss, but rather whether the clause is penal. Determining that a clause is to be a deterrent does not establish that it is a penalty. The enforceability of clauses depends in part on whether the clause is deemed unconscionable or extravagant.

Expert advice

Companies should now consider reviewing their terms of business with their legal advisers in light of Cavendish to ensure that they contain clauses which are valid and can be enforced. Such reviews will determine the likelihood of clauses being deemed as penal, namely as unconscionable or extravagant, and as such will allow any necessary amendments to ensure they are not likely to be considered as unenforceable penalties.

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