UK - Supreme Court unveils new, narrow rule on penalties

The Supreme Court has now completed a comprehensive review of the contractual penalty rule and unveiled a new test that makes the law simpler and clearer. There are two key changes:

  • the penalty rule applies where the consequence of a breach of contract is out of all proportion to the legitimate interests of the innocent party. In other words, this is not just a narrow question of whether the provision is a genuine pre-estimate of loss. The innocent party’s wider interests are also relevant; and
  • the scope of the rule is narrowly confined to provisions triggered by a breach of contract. It does not apply to primary obligations, such as price adjustment clauses. In some cases, it will be possible to draft around the rule.

We consider the judgment in more detail below. 

The new penalty rule

The general rule of English contract law is that parties are “masters of their own contractual fate”. However, there are limits to this freedom. One is when the consequences of a breach of contract are fixed in advance and are oppressive. If so, the provision is subject to the penalty rule and will not be enforced by the courts.

The penalty rule in its current form has been around for over 100 years and had become, in the words of Lord Sumption, “an ancient, haphazardly constructed edifice which has not weathered well”. Confronted with these difficulties, the Supreme Court was asked to consider a range of options including abolishing the rule on penalties or extending it to apply more widely. The Supreme Court rejected both and instead reformulated the test. The true test for a penalty is now:

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 new test provides a much clearer and simpler test for a penalty. Determining if a provision is a penalty is not just a narrow assessment of whether it is a genuine pre-estimate of loss. Instead, it allows a much broader consideration of the innocent party’s wider interests.

Makdessi v Cavendish - Is it even a penalty?

The Supreme Court has also narrowly confined the penalty rule to secondary obligations, i.e. obligations triggered by breach of contract. It does not apply to primary obligations.

This point is illustrated by the first of the cases before the Supreme Court. Mr Makdessi sold a controlling stake in his advertising and marketing company to Cavendish. The sale contract contained a restrictive covenant against competing activities. Breach of that covenant entitled Cavendish to:

  • withhold the final two instalments of the purchase price; and
  • acquire Mr Makdessi’s remaining stake in the company at a reduced price that did not take account of goodwill.

The Supreme Court accepted that a provision that disentitles a party to something otherwise due might be a penalty. However, in this case the Court decided both of these provisions were, in effect, price adjustment clauses. They did not represent the estimated loss attributable to the breach. Instead, they reflected the reduced consideration which Cavendish would have been prepared to pay for the business without the loyalty of Mr Makdessi.

As such, the provisions are primary obligations and are not even subject to the penalty rule. The penalty rule only applies to secondary obligations triggered by breach of contract.

In practice - Drafting is important

The Supreme Court acknowledged this approach “can still turn on questions of drafting, even where a realistic approach is taken to the substance of the transaction and not just its form”. However, the penalty rule is an inroad into freedom to contract. It may be “inflexible” but ought not to be extended.

This means it may be possible to structure a contractual provision to be a primary, rather than secondary obligation. If so, it avoids the penalty rule.

Beavis v ParkingEye – Wider interests justify parking charge

The second case illustrates the application of the new penalty rule in practice. It arose after Mr Beavis parked at the Riverside Retail Park in Chelmsford. There were clear signs notifying him that the first two hours’ parking were free but overstaying that time limit would result in a parking charge of £85.

The owner of the retail park contracted with ParkingEye Limited to provide management services for the car park. When Mr Beavis left his car in the car park for two hours and 56 minutes, ParkingEye issued him with an invoice for £85.

This charge was subject to the penalty rule. It was clearly a secondary obligation consequent on breaching the two hour parking rule. Moreover, ParkingEye conceded that it was not a genuine pre-estimate of damages (as it had in fact suffered little or no damage). However, the Supreme Court decided the £85 charge was not a penalty because it was neither extravagant nor unconscionable. In particular:

  • the charge was comparable with the level of charges imposed by local authorities for parking infringements;
  • the charge was prominently displayed in large letters at the entrance to the car park and at frequent intervals within it; 
  • ParkingEye had a legitimate interest in obtaining an income stream to meet its costs; and 
  • the landowner had a legitimate interest in ensuring the efficient use of parking spaces in the car park to ensure a good turnover of customers in the retail outlets. The approach taken of charging those who overstayed was common practice in the UK.

Mr Beavis also challenged the charge as being unfair under the Unfair Terms in Consumer Contracts Regulations 1999. However, the Supreme Court dismissed that claim for much the same reasons.

In practice – Greater flexibility and certainty

The decision is welcome as it provides greater certainty over the penalty rule. Like the Supreme Court’s decision in Arnold v Britton, it shows the importance their Lordships place on contractual freedom.

The rule on penalties will continue to provide a useful safety valve in cases of obvious oppression. However, the presumption is that properly advised parties with comparable bargaining power will be the best judges of what is a legitimate response to a breach of contract.

The decision in Cavendish Square Holding BV v Talal El Makdessi; ParkingEye Limited v Beavis [2015] UKSC 67 is available here.