What is a penalty clause? Perhaps no longer what you think it is…

Posted by Sheilah Mackie on

The Supreme Court handed down its much anticipated judgment on 4th November 2015 in the conjoined appeals of Cavendish Square Holding BV v Talal El Makdessi and ParkingEye Limited v Beavis. The judgment is important, not only because of its in-depth analysis of the correct test to decide what is and is not a penalty clause in a business to business context, but also due to its analysis of how to interpret provisions of a similar nature in a business to consumer context (also considering at the same time the application of Unfair Terms in Consumer Contracts Regulations 1999).

Looking at the business to business implications first, the facts of Cavendish Square Holding BV v Talal El Makdessi involved a complex set of calculations relating to the purchase price for the transfer of shares in the Middle East’s largest advertising and marketing communications group to WPP (one of the world's largest advertising and communications group). The main question to be addressed, was whether or not certain provisions in the transfer agreement, that would have significantly discounted the price that would have been received by the sellers, were enforceable or were penalties and so unenforceable. Before their Lordships considered the application of the law to the facts before them, they first conducted a detailed analysis of what that law actually was.

To some readers, it might seem a slightly unnecessary analysis (the judgment runs to some 124 pages) for it is trite law that, if a clause providing for certain sums to be paid upon a breach of contract by one party (or for the transfer of some assets or similar) does not represent a genuine pre-estimate of the loss that the non-breaching party will suffer, then the clause is a penalty and so unenforceable in its entirety. However, their Lordships were of the view that this statement of the test was, in fact, a misstatement of the conditions set out in the original case that gave rise to the current (incorrect) test. The 'genuine pre-estimate of loss' test was but one of four conditions, set out by Lord Dunedin, in Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd, with the other three conditions having become over-looked in the application of the law in subsequent cases and practice. The law had also become subject to an "artificial categorisation", that had led to Lord Dunedin's conditions being treated as the be-all and end-all of the test, with parties and judges not looking beyond a weighing up of whether or not a clause providing for the payment of liquidated damages, for example, could be said to be comparable to what a party would otherwise have received, in the form of damages for breach of contract.

So, what is the correct test? Lords Neuberger and Sumption, in their combined judgment, said that the true test was:

"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 obligations."
While Lord Hodge stated it in a similar vein as:
"the correct test of a penalty is whether the sum or remedy stipulated as a consequence of a breach of contract is exorbitant or unconscionable when regard is had to the innocent party's interest in the performance of the contract".

The difference between those tests and the current application of the 'genuine pre-estimate of loss' test, was that the interests of the innocent party could, in certain circumstances, be much wider than simply ensuring compliance with the obligations in the clause that triggered the 'penalty' or receiving payment of a sum to reflect the losses that flowed from non-compliance. Instead, those interests could include maintaining the overall integrity of a series of contracts, or maintaining brand reputation or even enabling the innocent party to receive sums from the other party, that reflected a greater level of risk, the innocent party might face whilst the other party was in breach of its obligations.

Applying this test to the facts before them, in Cavendish Square Holding BV v Talal El Makdessi, their Lordships were of the view that the law on penalty clauses was not engaged and the clauses in question, were primary obligations that were enforceable and operating as price adjustment provisions, rather than liquidated damages. Moreover, Cavendish had wider legitimate interests to be protected through the inclusion of those clauses.

The practical consequences of the restatement of the test are that, while in many cases a clause may be found to be out of proportion and the only legitimate interest of the innocent party is to receive a sum to compensate it for the losses it has suffered through non-compliance. But in other cases, it will be much harder for a party to have a clause struck out as an unenforceable penalty, if the clause reflects the need for the other party to protect much wider legitimate interests, in the overall commercial reality.

Turning now to the business to consumer implications, the case of ParkingEye Limited v Beavis involved the highly contentious issue of parking charges that are commonly levied following an over-stay by a driver in certain car parks. This is an issue close to many people's hearts and also a case that has had much attention in the press.

It was common ground, before the Court, that there was a contract between the parties – a contractual licence allowing Mr Beavis to park for two hours free of charge, in the car park managed by ParkingEye, subject to the other conditions set out on the notices dotted around the car park e.g. only those with blue badges could park within disabled parking bays, cars to be parked within the white lines etc - and that a breach of those conditions would result in the levying of a parking charge of £85. As such, that parking charge engaged the rules on penalty clauses given that it was a sum levied upon the breach of the terms of the contractual licence.

ParkingEye conceded that £85 was not a genuine pre-estimate of the loss that it would suffer through a breach of the parking conditions; indeed, it would have had a very limited claim in damages given that it only managed the car park and did not own it. However, their Lordships fell upon the notion that, as ParkingEye was engaged to operate a 'traffic space maximisation scheme' on behalf of the owners and the owner's interests included, amongst other things, ensuring a regular turn-over of spaces, attracting customer to the retail stores and preventing 'misuse' of the parking spaces, the main objectives of the £85 charge were (1) to manage the efficient use of space and (2) generate some income from the car park (parking otherwise being free for drivers).

Their Lordships thought that these objectives were perfectly reasonable and that the imposition of a charge to deter over-stayers was a reasonable means of achieving then. Thus, while the penalty rule was engaged, the charge was reasonable and so not a penalty and Mr Beavis would not be relived from paying it. Applying the analysis set out earlier in the judgment, the view of the Court was that in Mr Beavis' case "deterrence is not penal if there is a legitimate interest in influencing the conduct of the contracting party which is not satisfied by the mere right to recover damages for breach of contract".
However, that was not the end of the matter for Mr Beavis as he was also able to deploy the argument that the £85 charge was unfair under the Unfair Terms in Consumer Contracts Regulations 1999. Under the Regulations, a term in a contract between a supplier and a consumer that is unfair is not binding on the consumer with the test to be applied being "a contractual term which has not been individually negotiated shall be regarded as unfair if, contrary to the requirement of good faith, it causes a significant imbalance in the parties’ rights and obligations arising under the contract, to the detriment of the consumer". NB the causes of action in ParkingEye Limited v Beavis pre-dated the Consumer Rights Act 2015, which has now replaced the Unfair Terms in Consumer Contracts Regulations 1999 – see our article on the Act here.

Again, a detailed analysis of the wording of the EU Directive underlying the Regulations was carried by their Lordships out along with consideration given to relevant European cases that had applied the wording in practice but, having done so, the majority of the Court did not think that the parking charge was unfair or caused a significant imbalance in the parties' rights. It was said not to be in bad faith because it was a simple and familiar provision of which clear notice was given to drivers and not to cause an imbalance in rights because drivers had the benefit of two free hours of parking. The charge was also reflective of the wider interests of the car park owners that should be protected against.

Despite some strong interventions by the Consumers Association, that were considered telling by Lord Toulson (who dissented on this part of the appeal), a somewhat surprising view proffered by the Court was that the charge couldn't be unfair because it was a frequent occurrence across many car parks that drivers obviously accepted. To the majority of readers, it would seem plainly absurd that simply because such charges are encountered with unfailing regularity that does not automatically render them fair or not levied in bad faith but, with the decision being made by the highest court in the UK, there is going to be little if any scope in future for a further successful challenge to be made against these dreaded charges. So, the moral of the story? Always assume you'll take longer than you need and plan accordingly; particularly with Christmas on its way.

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Sheilah gives her clients practical commercial advice on a range of issues including IP/IT, franchising, data protection and FOI.

Sheilah Mackie
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