The Doctrine of Penalties Survives

04 Nov 2015

For the first time in a century the principles underlying the law relating to contractual penalty clauses were considered by the Supreme Court. The review was long overdue and most certainly needed. In their joint judgment Lord Neuberger PSC and Lord Sumption JSC (with whom Lord Clarke JSC and Lord Carnwath JSC agreed) observed that:

“The penalty rule in England is an ancient, haphazardly constructed edifice which has not weathered well.” [3]

The two appeals lie at opposite ends of a financial spectrum. The first appeal, Cavendish Square Holding BV v Talal El Makdessi, raised the issue in relation to two clauses in a substantial commercial contract. The second appeal, ParkingEye Ltd v Beavis, raised the issue at a consumer level.

The penalty rule as traditionally understood was directed against deterrent clauses, provisions for payment in the event of breach where the amount to be paid or lost is out of all proportion to the loss attributable to the breach.

“The essence of a penalty is a payment of money stipulated in terrorem of the offending party; the essence of liquidated damages is a genuine pre-estimate of the damage.” Lord Dunedin in Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd [1915] AC 67

More recently the courts introduced "commercial justification" as part of the test. (Lordsvale Finance plc v Bank of Zambia [1996] QB 752 approved in Cine Bes Filmcilik ve Yapimcilik v United International Pictures [2004] 1 CLC 401; Murray v Leisureplay plc [2005] IRLR 946). The assumption being (which the Supreme Court found “to be questionable” [28]) that a provision cannot have a deterrent purpose if there is a commercial justification.

Lord Neuberger and Lord Sumption observed that 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.

Whilst recognising that there is a case to be made for abolition of the doctrine, and casting “doubt that the courts would have invented the rule today if their predecessors had not done so three centuries ago” [36], the court declined to abrogate or extend the doctrine, preferring reformulation.

The court held that the real question when a contractual provision is challenged as a penalty is whether it is penal, not whether it is a pre-estimate of loss. The fact that the clause is not a pre-estimate of loss does not therefore, at any rate without more, mean that it is penal. 

“The question whether it is enforceable should depend on whether the means by which the contracting party’s conduct is to be influenced are ‘unconscionable’ or (which will usually amount to the same thing) ‘extravagant’ by reference to some norm” [31].

“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” [32].

The first step is to consider whether any (and if so what) legitimate business interest is served and protected by the clause, and if so and secondly, whether the provision made for that interest is extravagant, exorbitant or unconscionable – Lord Mance [152].

The scope of "legitimate interest" appears to be broader than "commercial justification", including social as well as economic considerations. Compensation is not the only legitimate interest that the innocent party may have in the performance of the defaulter’s primary obligation.

In the Beavis appeal the penalty rule was engaged, but, applying the reformulated test the court held that the charge does not contravene the rule.

In short summary, ParkingEye operates the car park on Riverside Retail Park in Chelmsford. The first two hours of parking was free to customers of the Retail Park. Thereafter, a "parking charge" of £85 was imposed on overstayers. Mr Beavis overstayed. He contended the charge was an unlawful penalty charge.

It was common ground before the Supreme Court that there was a contract between Mr Beavis and ParkingEye. The court accepted that as a matter of contractual analysis the ‘parking charge’ was not a charge for the right to park or to overstay but was a charge for contravening the terms of the contractual licence. It was common ground that the £85 was payable upon a breach of contract and was not a pre-estimate of damages.

However, the charge had two main objectives, which were held to be perfectly reasonable. First, to manage the efficient use of parking space in the interests of the retail outlets, and of the users of those outlets who wish to find spaces in which to park their cars. This was to be achieved by deterring long-stay motorists from occupying parking spaces for long periods. Second, to provide an income stream to enable ParkingEye to meet the costs of operating the scheme and make a profit from its services, without which those services would not be available.

The court held that ParkingEye had a legitimate interest in charging which extended beyond the recovery of any loss. “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” [99].

In my view this seminal judgment provides welcome clarity as to the applicable test, yet the introduction of a legitimate interest test enlarges the scope of enforceable deterrence to include what would otherwise, and conventionally, have been an unlawful penalty clause.

David Lewis of Hardwicke was Junior Counsel for Barry Beavis in the Supreme Court.


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