REUTERS | Eric Thayer

Spotlight on the rule against penalties

Exciting times for commercial lawyers advising on liquidated damages clauses. The Supreme Court is to consider the rule against penalties for the first time since Lord Dunedin did so, one hundred years ago, in Dunlop Pneumatic Tyre v New Garage Motor. Due to the way in which the rule has developed over the years, contractual parties negotiating liquidated damages clauses may struggle to understand their position in relation to the law on penalties. Hopefully, the Supreme Court will take advantage of this opportunity to deliver much needed guidance.

In Dunlop, Lord Dunedin explained that the underlying rationale of the rule is that the court will not enforce a contractual provision for payment (or the loss of rights or compulsory transfer of property at an undervalue) in the event of breach of contract, where the amount to be paid or lost is out of all proportion to the loss caused by the breach. Traditionally, the essence of the rule was that if a liquidated damages clause, instead of being a genuine pre-estimate of loss, required excessive payment in the event of breach, it was likely to be penal because its function was to act as a deterrent and not to compensate the innocent party.

The rule has been reformulated since Dunlop and courts are now unlikely to approach the issue on the basis of a simple dichotomy between clauses that are a genuine pre-estimate of loss on the one hand, and a penalty on the other. The courts have shown a willingness to adopt a more flexible approach to the enforceability of liquidated damages clauses, by applying a broader test which, generally speaking, consists of asking whether there is any commercial justification for a discrepancy between the sum in the clause and the amount the innocent party would have received if damages had been assessed at common law. Until recently, two common threads could be seen running through the various decisions (whether the traditional or modern approach was used):

  • The rule against penalties is an interference with freedom of contract, so courts are predisposed to uphold liquidated damages clauses, especially in the case of commercial contracts entered into between parties of comparable bargaining power.
  • If the principal purpose of a liquidated damages clause is to deter a party from breaching the contract, the clause is likely to be a penalty and therefore unenforceable.

These common threads are now harder to identify following the decisions of the Court of Appeal in El Makdessi v Cavendish Square Holdings and ParkingEye Ltd v Beavis. The Supreme Court is due to hear the appeal in El Makdessi this summer, and may hear the appeal in ParkingEye in the not too distant future, as the individual in that case, Mr Beavis, was given permission to appeal to the Supreme Court and is raising funds through crowdfunding to pursue it.

El Makdessi

The decision in El Makdessi demonstrates the inherent uncertainty in the approach to assessing commercial justification, which requires the court to examine the contract as a whole, in the circumstances and context in which it was made. In that case, the Court of Appeal (Christopher Clarke LJ), held that clauses in a share purchase agreement that provided that if the sellers breached certain restrictive covenants, the buyer did not have to pay any future installments of the price, and that the sellers would lose their put options, were unenforceable penalties. In my view, it was somewhat surprising that the court chose to interfere with the parties’ commercial bargain by deciding not to enforce the relevant clauses, as they had been freely and extensively negotiated between sophisticated parties, with the benefit of advice from experienced lawyers. I think that even though the clauses would have deprived the sellers of US$82 million between them if they had been found to be valid, they could arguably be commercially justified, as the adjustment in consideration between the parties was based on substantial loss of goodwill following breach of the covenants (as originally held at first instance by the High Court).

ParkingEye

In ParkingEye, however, the Court of Appeal (Moore-Bick LJ) appeared to water down the rule against penalties, by holding that a parking charge for overstaying the period of free parking was not a penalty, while accepting that it bore no direct relationship to the loss that the parking management company could suffer (in fact, the claimant would receive a financial gain from the breach) and, more significantly in my view, recognising that its predominant purpose was to deter individuals from overstaying the period of free parking. In that case, Mr Beavis overstayed a period of free parking by 56 minutes and was required to pay £85 to the claimant management company (or £50 if he paid promptly). Mr Beavis refused to pay and the claimant sued him. The court justified its decision on the basis that an £85 charge was not extravagant and, in any event, there were social and commercial reasons for upholding the clause. The court stressed the unusual features of the contract, so it may be that the decision is confined to its facts and that the rule as it applies to more mainstream commercial contracts is unchanged.

We must wait and see what the Supreme Court decides.

Practical Law Dispute Resolution Martha Castaneda Wilcox

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