Charles Edwin Edwards MSt(Cantab) MSc(Lond) FCInstCES Barrister
“…The essence of a penalty is a payment of money stipulated as in terrorem of the offending party; the essence of liquidated damages is a genuine covenanted pre-estimate of damage…” Lord Dunedin at page 86 in Dunlop Pneumatic Tyre Co Ltd v New Garage & Motor Co Ltd [1915] AC 79…”
Charles Edwards, a Barrister and TECBAR Adjudicator, reviews two recent judgments of the UK Supreme Court, Cavendish Square Holding BV v Talal El Makdessi; ParkingEye Limited v Beavis [2015] UKSC 67, which have far reaching consequences for those determining what the difference is between a penalty clause and liquidated damages. By way of background, the first appeal involved an agreement between Mr Makdessi and Cavendish, whereby Mr Makdessi had agreed to sell Cavendish, a controlling stake in the holding company of the largest advertising and marketing communications group in the Middle East. The agreement between the parties provided for amongst other things that:
“…if he was in breach of certain restrictive covenants against competing activities, Mr Makdessi would not be entitled to receive the final two instalments of the price paid by Cavendish (clause 5.1) and could be required to sell his remaining shares to Cavendish, at a price excluding the value of the goodwill of the business (clause 5.6). Mr Makdessi subsequently breached these covenants. Mr Makdessi argued that clauses 5.1 and 5.6 were unenforceable penalty clauses. The Court of Appeal, overturning Burton J at first instance, held that the clauses were unenforceable penalties under the penalty rule as traditionally understood…”
The second appeal by way of background involved ParkingEye Ltd who had agreed with the owners of Riverside Retail Park to manage the car park. Mr Beavis incurred a parking charge of £85 for his failure to comply with a time limit. Mr Beavis submitted that the charge was unenforceable at common law as it was a penalty and/or it was unfair and unenforceable pursuant to the Unfair Terms in Consumer Contracts Regulations 1999.
The Supreme Court considered both appeals and allowed the appeal in Cavendish Square Holding BV v Talal El Makdessi whilst dimissing the appeal in ParkingEye Limited v Beavis. Therefore, the Supreme Court upheld the validity of the disputed clauses in both appeals. The Court reviewed the law applicable to penalty clauses generally dating back to over 100 years. The Court stated amongst things that:
“…The penalty rule in England is 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. For many years, the courts have struggled to apply standard tests formulated more than a century ago for relatively simple transactions to altogether more complex situations. The application of the rule is often adventitious. The test for distinguishing penal from other principles is unclear. As early as 1801, in Astley v Weldon (1801) 2 Bos & Pul 346, 350 Lord Eldon confessed himself, not for the first time, “much embarrassed in ascertaining the principle on which [the rule was] founded”. Eighty years later, in Wallis v Smith (1882) 21 Ch D 243, 256, Sir George Jessel MR, not a judge noted for confessing ignorance, observed that “The ground of that doctrine I do not know”. In 1966 Diplock LJ, not a judge given to recognising defeat, declared that he could “make no attempt, where so many others have failed, to rationalise this common law rule”: Robophone Facilities Ltd v Blank [1966] 1 WLR 1428, 1446. The task is no easier today. But unless the rule is to be abolished or substantially extended, its application to any but the clearest cases requires some underlying principle to be identified…”.
The difference between a clause providing a genuine pre-estimate of damages and a penalty clause as stated in the judgment is fundamental to the modern law. This is a question which is normally decided by the Courts as a matter of construction: “…Public Works Comr v Hills [1906] AC 368, 376; Webster v Bosanquet [1912] AC 394; Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd [1915] AC 79, at pp 86-87 (Lord Dunedin); and Cooden Engineering Co Ltd v Stanford [1953] 1 QB 86, 94 (Somervell LJ)…”.
Lord Dunedin at page 86 in Dunlop Pneumatic Tyre Co Ltd v New Garage & Motor Co Ltd [1915] AC 79 where the Court had to consider whether a clause was a penalty or liquidated damages stated that:
“…The essence of a penalty is a payment of money stipulated as in terrorem of the offending party; the essence of liquidated damages is a genuine covenanted pre-estimate of damage…”. Lord Dunedin further stated at page 87 that: “It will be held to be a penalty if the sum stipulated for is extravagant and unconscionable in amount in comparison with the greatest loss that could conceivably be proved to have followed from the breach…”.
The Court, having reviewed the law over the last hundred years on penalty clauses, decided amongst other things that:
“…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. 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, and we therefore expect that Lord Dunedin’s four tests would usually be perfectly adequate to determine its validity…”.
The Court was of the view that the innocent party had no proper interest in simply punishing the defaulter and that his interest was in performance or in some appropriate alternative to performance and therefore in a case which involved a straightforward damages clause, that interest will rarely extend beyond compensation for the breach. Therefore the Court expected that Lord Dunedin’s four tests would usually be perfectly adequate to determine the validity of the clause.
Conclusion
In conclusion, this case will have far reaching consequences for those determining whether a contractual provision is a penalty clause and therefore unenforceable. As stated by the Court, the true test was whether the impugned provision was 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 above is for general information only and to encourage discussion and does not constitute legal advice. The author does not assume any responsibility for the accuracy of any statements made and appropriate legal advice should be taken and relied upon before taking or omitting to take any action in respect of any specific matter. If the facts and matters referred to above are relevant to you or your organisation, then please do not hesitate to contact me in chambers to see how I can assist you or your organisation.
Charles Edwin Edwards MSt(Cantab) MSc(Lond) FCInstCES Barrister
(Head of Chambers)
Gray’s Inn Construction Chambers
344-354 Grays Inn Road
London
WC1X 8BP
