Today the Supreme Court has given judgment in the combined cases of Cavendish Square Holding BV v Talal El Makdessi and ParkingEye Ltd v Beavis  UKSC 67.
These appeals gave the Supreme Court the first opportunity to review the law on penalties since the famous case of Dunlop Pneumatic Tyre Co Ltd v New Garage & Motor Co. Ltd  A.C. 847 decided almost exactly 100 years ago.
The review was needed. As Lord Neuberger PSC observed at the commencement of his joint judgment with Lord Sumption JSC (with which Lord Clarke JSC and Lord Carnwath JSC agreed):
“The penalty rule in England is an ancient, haphazardly constructed edifice which has not weathered well, and which in the opinion of some should simply be demolished, and in the opinion of others should be reconstructed and extended. For many years, the courts have struggled to apply standard tests formulated more than a century ago for relatively simple transactions to altogether more complex situations.” (para. 3)
That last sentence is of course a reference to the four well-known propositions set out by Lord Dunedin in Dunlop at pp86-88, the key one being the second one:
“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.”
It was this proposition that Mr Beavis relied upon to argue that the £85 parking charge imposed upon him by ParkingEye for overstaying in a car park in a retail shopping centre in Chelmsford was a penalty – it was, he said, far too high to be a genuine pre-estimate of the loss that ParkingEye suffered as a result of his breach of contract. Both the trial judge and the Court of Appeal disagreed. The Supreme Court has now also dismissed Mr Beavis’s appeal and, in a decision of immense significance for commercial lawyers and their clients, in doing so explained and updated the law on penalties for the 21st century.
Mr Beavis’s case was linked with the appeal in Cavendish Square Holding BV v Talal El Makdessi, a $100m+ claim arising out of the sale of an advertising agency. The parties to that appeal made mirror submissions – in the case of the appellant Cavendish that the rule against penalties was outdated and should be abrogated, and in the case of Mr El Makdessi, that it should be extended as it was recently by the High Court in Australia in Andrews v Australia and New Zealand Banking Group Ltd (2012) 247 CLR 205 in which the High Court concluded that there subsisted, independently of the common law rule, an equitable jurisdiction to relieve against any sufficiently onerous provision which was conditional upon a failure to observe some other provision, whether or not that failure was a breach of contract.
In the event the Supreme Court decided that judicial abolition would not be the proper course for a principle that is common to almost all major systems of common law; nor did they extend it. However their reappraisal of the doctrine has made it looser and effectively abolished the dichotomy between penalty and genuine pre-estimate of loss that Mr Beavis relied on.
They did this, as appellate courts tend to do, by going back to the beginning (well, the 16th century) and to first principles. The essence of the analysis is that the rule against penalties originally formed part of the court’s equitable jurisdiction but by the end of the 18th century it became a common law rule. They explained that the common law on penalties was developed almost entirely in the context of damages clauses – if the agreed sum was a penalty it was treated as unenforceable and, until now, the distinction between a clause providing for a genuine pre-estimate of damages and a penalty clause has remained fundamental to the modern law, to be decided as a matter of construction at the time it is agreed.
The Justices then posed themselves two questions: (1) In what circumstances is the rule engaged at all? and (2) What makes a contractual provision penal?
As to the first point, there is a fundamental difference between a jurisdiction to review the fairness of a contractual obligation and a jurisdiction to regulate the remedy for breach. The penalty rule regulates only the remedies available for breach of a party’s primary obligations, not the primary obligations themselves. As they explained at para. 14:
“Thus, where a contract contains an obligation on one party to perform an act, and also provides that, if he does not perform it, he will pay the other party a specified sum of money, the obligation to pay the specified sum is a secondary obligation which is capable of being a penalty; but if the contract does not impose (expressly or impliedly) an obligation to perform the act, but simply provides that, if one party does not perform, he will pay the other party a specified sum, the obligation to pay the specified sum is a conditional primary obligation and cannot be a penalty.”
As to the second, what makes a contractual provision penal, they reminded themselves of an earlier decision of the House of Lords in Clydebank Engineering & Shipbuilding Co Ltd v Don Jose Ramos Yzquierdo y Castenada  AC 6 and referred to Lord Halsbury’s observation (at p10) that the distinction between a penalty and a valid liquidated damages clause depended upon whether the agreement was “unconscionable and extravagant”.
They went on to say that Lord Dunedin’s four tests were a useful tool for deciding whether these expressions can be properly applied to simple damages clauses in standard contracts, but were not easily applied to more complex cases. Critically, the concept of a penalty and a pre-estimate of loss was not mutually exclusive. The fact that the clause is not a genuine pre-estimate of loss does not therefore mean that it is penal.
What then is it that makes a provision for the consequences of breach ‘unconscionable’ and by comparison with what is a penalty clause said to be ‘extravagant’?
The broader test the Court propounded lies in the context of commercial justification for clauses that might otherwise be regarded as penal – is there some other reason which justifies the discrepancy between the amount payable under the clause and the amount payable by way of damages at common law?
“A damages clause may properly be justified by some other consideration than the desire to recover compensation for a breach.” (para. 28).
The principle engages broader social and economic considerations, one of which is that the law will not generally make a remedy available to a party whose adverse impact on the defaulter significantly exceeds any legitimate interest of the innocent party.
The true test, the Court held at para. 32, is whether:
“the impugned provision is a secondary obligation which imposes a detriment on the contract breaker out of all proportion to any legitimate interests of the innocent party in the enforcement of the primary obligation”.
Applying these principles to Mr Beavis’s case, they decided that whilst the penalty rule was engaged, the £85 charge was not a penalty since ParkingEye had a legitimate interest in charging overstaying motorists which extended beyond the recovery of any loss. The company was managing car parks in the interests of the retail outlets, their customers and the public at large and had 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. ParkingEye could not charge a sum out of all proportion to its interests but there was no reason to suppose that £85 was out of all proportion. There was no suggestion about what an unreasonable charge might be.
Lord Mance, at para. 198 of his judgment acknowledged that the charge had a deterrent effect but concluded that it has to be and was set at a level which enables managers to recover the cost of operating the scheme. It is hence commercially justifiable.
The new principles explained by the Supreme Court mean that it is no longer possible for contract breakers to argue that a secondary charge payable upon breach of agreement is a penalty and unenforceable simply because it is not a genuine pre-estimate of loss. If this clause is tested the fact that it may be a penalty is not the end of the argument. If there is some commercial justification then deterrence is permitted. But what that commercial justification is and – dare we say it – whose commercial interest – remains to be worked out on a case by case basis.
To summarise this, the position as to whether or not a clause in a contract is unenforceable as a penalty seems now to follow these lines:
- Does the clause engage the penalty rule? (Or, to put it another way, is the clause under scrutiny a genuine pre-estimate of the innocent party’s loss? If yes, then the penalty rule is not engaged; if no, then it is engaged.) So if yes…
- Does the innocent party have a legitimate interest in charging the defaulting party a sum which extends beyond the loss the innocent party has actually suffered? (ParkingEye’s legitimate interest was deemed to be that it sells its services as the manager of car parks and meets the costs of doing so from charges for breach of the terms.) If yes, and …
- There is some other wider commercial or socio-economic justification for the clause, then it does not contravene the penalty rule.
By way of example, apply these principles to this rudimentary scenario which was the cause of some debate at the times of the hearing in the Supreme Court and below: a person has a 12 month contract for a ‘pay as you go’ mobile phone with a mobile phone company which is payable on a monthly basis at, say, £10 per month. There is a clause in the contract that if the person switches to a different contract with a different mobile phone company at any point during the contract, the mobile phone company can charge a sum of, say, £150. If the person switches after 6 months, the mobile phone provider has lost £60 but is charging its customer £90 more than the loss caused by the customer’s default. Here, the clause would engage the penalty rule (because it is not a genuine pre-estimate of loss). Although arguable, it might not be deemed to be out of all proportion to the mobile phone company’s loss. But the mobile phone company will struggle to clear the hurdle in points 2 (because it will generate revenue and profit from elsewhere in its business – it is not solely reliant on the breach assuming that it also generates profit from the user’s telephone calls, etc.) and 3 (because there would not seem to be any wider commercial justification for the penalty clause: the only beneficiary is the mobile phone company).
Looking at the position overall, it seems to us that in deciding to abandon the admittedly over-rigid categorisation of penalty clauses in Dunlop the Supreme Court has, in the course of explaining and updating the law in this fascinating decision, created some uncertainty in the commercial world – in the case of an individually negotiated bilateral contract, we ask, from whose standpoint do you consider the ‘commercial justification’ test? From the point of view of the consumer and the ‘take it or leave it’ contracts we make every day when we buy goods or services (or drive into a car park) we consider that the decision is something of a setback making it more difficult to defend claims for deterrent charges when the consumer is in breach.
John de Waal QC of Hardwicke and Henry Hickman of Harcus Sinclair acted, pro bono, for Barry Beavis in the Supreme Court.