In Cavendish Square Holding BV v Talal El Makdessi and ParkingEye Limited v Beavis  UKSC 67 (see Legal update, Supreme Court restates penalty rule), the Supreme Court gave its first judgment on contractual penalty clauses in 100 years.
Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd  AC 79 had remained the classic statement principle, supplemented by a century of haphazard development. The result, according to Lords Sumption and Neuberger, was that the penalty rule had become:
“An ancient, haphazardly constructed edifice which has not weathered well, and which in the opinion of some should simply be demolished, and in the opinion of others should be reconstructed and extended.”
The penalty rule has been frequently raised in commercial disputes, partly because of the confusion surrounding its application. No wonder when it was messy and uncertain, and had the power to render unenforceable clauses requiring a breaching party to pay (or be deprived of) potentially huge sums.
The new 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.”
The question now is whether the Cavendish judgment will help.
The penalty rule and the Cavendish and ParkingEye Limited judgment
Cavendish concerned an agreement for the sale of a controlling stake in a holding company. In ParkingEye Limited, it was argued that an advertised excess parking charge was unenforceable at common law as a penalty. The facts in these cases alone demonstrate the variety of contexts in which the penalty rule arises. The judgment will have consequences in almost any contractual area, including (but not limited to):
- Employment contracts that specify draconian consequences on breach.
- Financial services.
- Media and entertainment.
- General commerce.
Penalty clauses are traditionally contrasted with liquidated damages clauses, which are perfectly enforceable and provide a pre-estimate of the loss payable upon breach (see Standard clauses, Liquidated damages). Penalty clauses require the breaching party to pay (or be deprived of) a sum (or some other benefit) to deter them from breach. Although the main underlying principle is that the law generally seeks to uphold and enforce the bargain that the parties have made for themselves, as Lord Browne-Wilkinson held in Workers Trust Bank Ltd v Dojap Investments Ltd  AC 573 (PC) 578 :
“In general a contractual provision which requires one party in the event of his breach of the contract to pay or forfeit a sum of money to the other party may be unlawful as being a penalty, unless such provision is a genuine pre-estimate of the loss which the innocent party will incur by reason of the breach.”
In their joint judgment, Lords Neuberger and Sumption rejected two binary distinctions (between genuine pre-estimate of loss and a punishment, and between a genuine pre-estimate of loss and a deterrent) as artificial and unsatisfactory. Attempting to cut through the mass of common law rules, they suggested that what is important is whether the provision is “unconscionable” or (which will usually amount to the same thing) “extravagant” by reference to some norm. This suggested a return to the simplicity of the House of Lords’ decisions in Clydebank Engineering & Shipbuilding Co Ltd v. Don Jose Ramos Yzquierdo y Castaneda  AC 6 and Dunlop.
However, they also accepted that in assessing whether a provision is unconscionable or extravagant, there may be a legitimate commercial interest in performance, which would not be adequately covered by direct financial loss (for example, goodwill in a business). Courts should therefore accept that clauses compensating these broader interests (and thus imposing a higher penalty than merely direct financial loss) still serve a compensatory function. Nevertheless, there are limits, and where the penalty is out of all proportion to the broader commercial interest, it will be unenforceable. These principles were translated into the new test that looks at whether the detriment imposed on the breaching party is out of all proportion to the innocent’s party’s interest in performance.
Consequences of the Cavendish and ParkingEye Limited judgment
The concepts of “legitimate interest” and “proportionality” are at the heart of the new Sumption/Neuberger test.
It will be interesting to see whether public law principles are used in determining the proper scope of these concepts. The need for measures to be taken in pursuit of legitimate interests and for such measures to be proportionate to those legitimate interests is a central feature of human rights law. Proportionality is also an important feature of modern administrative law. Deference (another important public law concept) is contested and complex but, in one of its forms, it reflects the fact that the original decision-maker may have greater expertise than the courts, and therefore the courts should defer on those issues. The concept of deference is said to mediate the intensity of review that the courts engage in under proportionality analysis.
There are, perhaps, some similarities in the framing of the Cavendish test. In determining whether the provision is out of all proportion, the court seems to envisage that one of the factors mediating the standard of review could be the need to respect contractual arrangements and the relative bargaining position of the parties. However, there are some important differences between public law principles and contract. For example, in public law cases:
- The courts have to consider the broader public interest, not just the interests of the parties before them (although note their Lordships’ view that the availability of remedies, even for breach of contractual duty, “engages broader social and economic considerations”).
- There is generally vast inequality of bargaining power between the parties.
- The test is whether an interference with a right is proportionate to the legitimate aim pursued. The Cavendish test of “out of all proportion” arguably produces a higher threshold.
Public law also has well-developed guiding principles that specify what may count as a legitimate interest, and that guide decision-making on proportionality. There is no such firm guidance as to what may count as a legitimate interest in the commercial world, or on what counts as “out of all proportion” to it. The civil law systems in Belgium, France, Italy and Switzerland all assess contractual penalties using tests such as “manifestly excessive”, “disproportionately high”, or “excessive”. Perhaps these may be relevant?
Given these differences, it will be interesting to see whether the courts turn to public law concepts and how this will affect the courts’ propensity to intervene. The result is that the outcome of penalty arguments remains uncertain, and the frequency with which such arguments appear is unlikely to diminish. In the meantime, contract lawyers have new concepts to grapple with. In Braganza v BP Shipping  1 WLR 1661, the Supreme Court held that a decision of a contractual fact-finder had to be rational in the Wednesbury sense. Recent decisions like these, combined with the onward march of consumer protection law, show that contract lawyers will need to understand public law principles. No longer is freedom of contract the only guiding principle; the world of agreements is no longer (and has in truth not been for some time) red in tooth and claw.
Cavendish has real consequences for drafting. In practice, it may be difficult for a court to assess whether a penalty is out of all proportion to, for example, loss of goodwill. Parties should therefore carefully consider whether provisions are justifiable. A strict application of the “out of all proportion” element would suggest that judicial intervention is necessary even where the innocent party legitimately benefited from the inclusion of the clause. Judicial intervention is most likely where there is an inequality of bargaining power between the parties. In such cases, the argument for deference to the agreement of parties would be weaker. The balance of bargaining power between the parties may be a factor that will calibrate the degree of scrutiny, in a similar fashion to the way that deference calibrates proportionality in public law.
Finally, although their Lordships declined explicitly to expand the scope of the penalty rule, the question is also raised as to whether a contractual provision could serve an illegitimate interest which is different from deterring the other party from breaching the clause. If so, a clause might be struck down under this new test that would have survived the older penalty rule. On balance, it seems unlikely that the courts will uproot contractual provisions in all but exceptional cases. However, the possibility of yet further litigation while the parameters of the test are identified cannot be excluded.
The author would like to thank Dr Kirsty Hughes (University Lecturer in Public Law, University of Cambridge and member of Blackstone Chambers’ Academic Panel) for her assistance in the publication of this post.