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Contracts and penalty clauses: can you enforce an obligation that arises on breach?

If you make a contract, you should always know the consequences of breach. How will the parties’ relationship change as a result of breach and how do…

Introduction

If you make a contract, you should always know the consequences of breach. How will the parties’ relationship change as a result of breach and how do you quantify the loss that you may incur?

A penalty clause imposes on the defaulting party a (secondary) obligation which arises only following breach of another, primary, obligation. For the past 100 years, since the court’s decision in Dunlop Pneumatic Tyre Co Limited v New Garage & Motor Co Limited, a secondary liability has been treated as a penalty if it is extravagant and unconscionable and does not reflect the innocent party’s losses.

Unlike penalty payments, liquidated damages are damages which reflect a genuine estimate of the losses of the innocent party. Liquidated damages clauses are usually enforceable, whereas penalty clauses are unenforceable beyond the claimant’s actual loss.

Solicitors have since Dunlop advised their clients to follow the traditional tests set out in that case, which in essence require damages to reflect the likely financial losses incurred.

Current position

The position was challenged in two recent cases, namely Cavendish Square Holding BV v Talal El Makdessi and ParkingEye Limited v Beavis.

Cavendish v L Makdessi

Mr Makdessi and his co-owner Mr Ghossoub were the majority shareholders in a large advertising and marketing communications group in the Middle East. They sold the majority of their shares to Cavendish. Under the terms of the sale and purchase agreement the payments were to be in two instalments. The agreement also included a restrictive covenant which prohibited Mr Makdessi from carrying out certain activities which would compete with the group. If he breached the restriction, he would lose the right to the deferred payments and the remaining shares he continued to hold would be bought at asset value without any reference to goodwill (which clearly reduced the value). Mr Makdessi admitted breach of the restrictions but asserted that the clauses dealing with the consequences were unenforceable as a penalty.

Mr Makdessi’s argument was accepted by the Court of Appeal, although they declined to extend their position to other clauses which had an effect other than on a breach of contract.

ParkingEye v Beavis

This case relates to a motorist, Mr Beavis, who parked his car in a city centre car park in Chelmsford. ParkingEye had been appointed to manage the car park. Notices within the car park explained that the maximum stay was two hours and failure to comply would result in an £85 fine. Mr Beavis parked for nearly three hours and argued that the £85 charge was a penalty.

The court was of the opinion that the £85 charge protected a legitimate interest as it went beyond just losses from additional parking; ParkingEye was there to manage effective use of the car parking space on behalf of nearby retail outlets, their customers and the wider public. Also in comparison to the charges imposed by other car parks it was not extravagant or unconscionable.

Impact of the Court of Appeal decision

The Court of Appeal decided in relation to Makdessi that the key issue was whether the clause was extravagant and unconscionable. In addition, as part of the test of unconscionability the court raised the issue that such a clause must not predominantly be intended to deter a breach.

Following the Court of Appeal decision, to avoid clauses being construed as penalty clauses, solicitors have:

  • drafted clauses so they did not relate specifically to a breach of contract (for example, a payment would be due if a particular condition was satisfied rather than as a consequence of breach);
  • to ensure that the parties were able to make a claim, included covenants in favour of those who may not suffer any direct loss (in Makdessi, the claimant shareholder had not suffered any loss (whereas the company had) and so its claim had no commercial justification); and
  • as the sanction should be commensurate with the legally recoverable loss caused by the breach, provided different levels of consequence depending on the severity of the breach.

Supreme Court

The Makdessi case was this month appealed to the Supreme Court and thankfully common sense prevailed. Their Lordships, by majority granted the appeal on the following grounds:

  • The change to the deferred consideration was deemed a primary obligation as it was a price adjustment, so penalties were irrelevant. That said, the court did consider whether Cavendish had a legitimate interest as they had paid a considerable price for goodwill. It was decided that it did.
  • Equally, in relation to the purchase of the remaining shares, for commercial reasons the deal would not proceed without this provision, which was therefore a primary obligation, even if its operation was as a result of a breach.

On this basis the court allowed the Makdessi appeal and dismissed the appeal in ParkingEye.

Key things to consider

The key questions to consider in relation to such clauses are:

  • Is the offending obligation a primary or a secondary obligation?
  • If a secondary obligation, does it impose a detriment on the breaching party out of all proportion to any legitimate interests of the innocent party?
  • Is the outcome of the remedy clause unconscionable and extravagant by reference to the norm in that industry?

Summary

Provided the clause is either a primary obligation or a secondary obligation intended to protect a legitimate interest which is not unconscionable or extravagant but which follows an industry norm (i.e. it can be shown as a commercially justifiable or reflecting a genuine estimate of loss), it is unlikely to be a penalty and will be enforceable.