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Supreme Court reformulates the penalty rule in Cavendish v Makdessi

This post considers the implications of the Supreme Court’s ruling on penalty clauses in Cavendish Square Holding BV v El Makdessi and ParkingEye Ltd v Beavis but first, the background to the penalty rule.

The penalty rule: the background

Rather than leaving the common law to dictate the level of damages payable for breach of contract, contracting parties often choose to make express provision for payment of a specified sum by the guilty party. When faced with such a provision, a court may well be tasked with determining whether it ought to be enforced, as a liquidated damages clause, or held unenforceable, as a penalty clause. In the latter case (where the “penalty rule” is invoked), the innocent party is left to prove its entitlement to damages at common law.

One might expect there to be a clear and long-understood principle underlying the court’s power to interfere with contracting parties’ freedom of contract, by invoking the penalty rule. However, that is not the case. Historically, a succession of judges have tried and failed to elucidate the juridical basis for the penalty rule.

No doubt because the principle underlying the penalty rule has been unclear for so long, the test for what constitutes a penalty clause has shifted somewhat over time. The classic common law distinction between a liquidated damages clause and a penalty clause cast:

  • A liquidated damages clause as a clause providing for payment of a genuine pre-estimate of the damage that may conceivably flow from the breach in question.
  • A penalty clause as a clause providing for payment of a sum held in terrorem over a guilty party, in the sense that it was extravagant and unconscionable in amount in comparison with the greatest loss that could conceivably be proved to have flowed from the breach in question.

In recent years, the penalty rule has changed, not just in linguistic terms, but also in substance. Of particular importance, the courts have suggested that a clause may be enforceable even if it does not constitute a genuine pre-estimate of loss, provided that the sum stated therein is “commercially justifiable”.

As will become evident, the Supreme Court has not only accepted the notion that commercial justifiability has some part to play in the relevant test, but has replaced much of the traditional common law penalty rule with a reformulated test that marks a significant retreat from judicial interference in parties’ freedom of contract.

Cavendish Square Holding BV v El Makdessi and ParkingEye Ltd v Beavis

In July 2015, the Supreme Court heard two appeals together, both of which raised issues surrounding the penalty rule. The principal difference between the two was that the first appeal, Cavendish Square Holding BV v Talal El Makdessi, concerned a commercial contract, while the second appeal, ParkingEye Ltd v Beavis, concerned a consumer contract.

Judgment was handed down in November 2015. The first judgment was given by Lord Neuberger and Lord Sumption, with whom Lord Carnwath agreed in full and Lord Clarke agreed in very large part. The judgments of Lord Hodge (with whom Lord Clarke and Lord Toulson agreed almost universally) and Lord Mance were also strongly supportive of the new test proposed by the first judgment, albeit with slight differences in formulation.

Presaging a reformulation of the penalty rule test, the first judgment began by describing the penalty rule as:

“…an ancient, haphazardly constructed edifice which has not weathered well.”

As the first judgment then made clear:

  • The penalty rule had its roots in the equitable jurisdiction to relieve from defeasible bonds. That jurisdiction was invoked, not on public policy grounds, but on the basis that the party seeking to rely on the bond only ever intended the bond to be security for its right to claim a debt or damages, such that it should be restrained from claiming under the bond and instead prove its claim in debt or damages.
  • It was only when the common law altered the penalty rule, as born in equity, that the penalty rule started being invoked on what were essentially public policy grounds. From the outset, the test laid down by the common law was one that essentially drew a binary distinction between, on the one hand, genuine pre-estimates of loss and, on the other, sums extravagant and unconscionable in comparison with conceivable losses.

In summarising the hangover from that traditional, binary distinction in the modern law, Lord Neuberger and Lord Sumption noted that in their view:

“…the law relating to penalties has become the prisoner of artificial categorisation, itself the result of unsatisfactory distinctions: between a penalty and genuine pre-estimate of loss, and between a genuine pre-estimate of loss and a deterrent.”

Lord Carnwath and Lord Clarke shared that view. Lord Hodge, in a very similar vein, noted that the law risked being placed in a straightjacket:

“…by an over-rigorous emphasis on a dichotomy between a genuine pre-estimate of damages on the one hand and a penalty on the other.”

In proposing a new test, Lord Neuberger and Lord Sumption noted that the four principles set out by Lord Dunedin in Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd would usually be adequate to determine the validity of a given clause. Lord Carnwath agreed with that proposition, as did Lord Clarke. Those principles are that:

  • A provision will be penal 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.”

  • A provision will be penal if the breach consists only in the non-payment of money and it provides for the payment of a larger sum.
  • There is “a presumption (but no more)” that a provision will be penal if it is payable in a number of events of varying gravity.
  • A provision will not be treated as penal by reason only of the impossibility of precisely pre-estimating the true loss.

However, Lord Neuberger and Lord Sumption also noted that, for over a century, the case-law referred to a broader and more nuanced set of criteria for drawing a line between liquidated damages clauses and penalty clauses, which emphasised that:

  • Liquidated damages clauses may be set at a relatively high level with a view to deterring breaches of contract that would prejudice the innocent party’s trade holistically, even if the breaches in question would not give rise to a direct, immediate and measurable monetary loss.
  • Viewed from that perspective, liquidated damages clauses are not always concerned with the recovery of compensation for losses flowing directly and measurably from the specific breach with which they are concerned.
  • Recent authorities were correct to ask whether the innocent party’s interest in protecting its trade holistically gave rise to a “commercial justification” for the sum stipulated.

In effect, summarising the import of those references in the earlier case-law, Lord Neuberger and Lord Sumption held that:

“…a damages clause may properly be justified by some other consideration than the desire to recover compensation for a breach. This must depend on whether the innocent party has a legitimate interest in performance extending beyond the prospect of pecuniary compensation flowing directly from the breach in question.”

That opinion was shared by Lord Carnwath and Lord Clarke, and shared in terms by Lord Mance, Lord Hodge and Lord Toulson.

On that basis, Lord Neuberger and Lord Sumption held that the new test for whether a clause is a liquidated damages clause or a penalty clause should be:

“…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.”

That sentiment was supported by Lord Carnwath and Lord Clarke, thus making that formulation of the test the formulation supported by the majority.

It is noteworthy that Lord Hodge formulated essentially the same test in a similarly succinct manner when he said that a sum would be a penalty if it was:

“…exorbitant or unconscionable when regard is had to the innocent party’s interest in the performance of the contract.”

Lord Mance also formulated what was essentially the same test.

What is the test for a penalty clause?

In light of the degree of concord between the judgments, it is to be expected that, in determining what constitutes a penalty in the future, Lord Dunedin’s four principles will be used in conjunction with the “legitimate interest” test put forward in subtly different ways by Lords Neuberger, Sumption, Hodge and Mance.

The newly reformulated test for penalty clauses differs from its early common law predecessor in the following fundamental ways:

  • There is no longer any need to consider whether the sum stipulated is a “genuine pre-estimate of loss”, or a sum held in terrorem over a guilty party.
  • In determining whether a sum is exorbitant or unconscionable, regard must now be had to the innocent party’s legitimate interest in the performance of the contract on a broad basis, not just to the level of damages that the innocent party could have expected to flow directly and measurably from the breach.
  • The fact that a clause is a deterrent against breach no longer necessarily means (at least of itself) that it will be unenforceable, not least because the prospect of liability in common law damages can itself readily be described as a spur to performance.
  • It is only when a clause makes provision for a sum that is out of all proportion to (it is unconscionably high or exorbitant by reference to) the innocent party’s legitimate interest in the performance of the contract (and/or intended to punish the guilty party) that it will be struck down.

Consequences

Liquidated damages provisions are commonly found in standard form and bespoke contracts in the construction, engineering and energy sectors, where they are most often intended to provide an employer with a contractual right to a liquidated sum from a contractor in respect of contractor-culpable delay to the contract works.

The consequences of the Supreme Court’s decision in Cavendish are likely to be significant in those sectors, especially where the parties are properly advised and of comparable bargaining power. For example:

  • Employers can expect to be given greater scope to contend that their interest in performance of the contract, in the wider commercial context to the contract, serves to justify the sums stipulated by way of liquidated damages.
  • By contrast, contractors can expect to face greater difficulties than ever before in seeking to persuade courts, arbitrators and adjudicators that a damages clause constitutes a penalty that should be struck down in favour of a common law damages assessment.
Keating Chambers Matthew Finn

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