When a contract includes a provision for payment on breach of contract, that payment may well be liable to challenge by the breaching party as falling foul of the legal rule protecting parties against penalty clauses, which are unenforceable.
Until a recent decision of the Supreme Court in Cavendish Square Holding BV v Talal El Makdessi and ParkingEye Limited v Beavis 2015 UKSC 67, the century-old leading case on penalty clauses had been Dunlop Pneumatic Tyre Co Ltd v New Garage & Motor Co Limited  AC 79. Dunlop sets out a test to determine whether a clause is an unenforceable penalty clause or an enforceable liquidated damages clause. According to that test, a clause will most likely be considered as a penalty if the sum specified falls into one of the three following categories:
In addition to the above, the key consideration was whether the specified sum was intended to be a compensatory damages clause (i.e. whether it was a genuine pre-estimation of anticipated loss) or whether it was intended to be a deterrent (i.e. a penalty). If, however, a genuine pre-estimation of loss was impossible, that alone would not suffice to make a clause a penalty. This dichotomy between compensatory and deterrent clauses has been the standard approach of the courts for the last century.
However, more recently the courts have become more open to considering the contract as a whole and whether there is any commercial justification to support the conclusion that the clause is compensatory, not a deterrent, particularly where the contract has been negotiated between two commercial parties.
In the first instance decision of El Makdessi, the High Court found the clause in question to be enforceable because it considered that it should very rarely interfere in freely negotiated and commercially justified clauses, particularly where both parties were sophisticated and of equal bargaining power. This case related to clauses in a share sale agreement which placed restrictions on competition by the selling shareholders, the breach of which would result in the sellers not being entitled to all of their deferred payment. This decision was overturned by the Court of Appeal where it was held that, because the effect of the clause went far beyond a compensatory figure (the sellers stood to lose up to $44 million) and into the territory of deterrence, the clause was a penalty and therefore not enforceable.
The concept was further considered in the ParkingEye case. This involved a breach of contract where the maximum time limit in a pay and display car park was exceeded and a charge of £85 for overstaying the time limit was levied. The motorist challenged the charge under the Unfair Terms in Consumer Contracts Regulations 1999. The High Court rejected that challenge and the motorist appealed to the Court of Appeal. The court examined the position from several different perspectives, including the proportionality of the charge to the loss, the deterrence factor and commercial justification, although it was noted that this was not to be a normal contract between commercial parties of equal bargaining power. Whilst the court held that the charge was clearly a deterrent, the fact that it was not extravagant or excessive meant that the court upheld the charge as liquidated damages and therefore enforceable.
Both the buyers in El Makdessi and the motorist in ParkingEye appealed to the Supreme Court and the appeals were heard together. Judgment was handed down on 4 November 2015 where the appeal in El Makdessi was allowed and the appeal in ParkingEye was dismissed, so both clauses were upheld as valid liquidated damages clauses.
In El Makdessi, the Supreme Court found the clauses in question to be primary obligations and, because the rule against penalties determines the enforceability of remedies available for breach of primary obligations and not the primary obligations themselves, the rule did not apply. Accordingly the clauses were not capable of being penalties and the parties were, as commercial parties, free to contract on the terms they wished to.
In ParkingEye, the Supreme Court observed that the owner of the car park was not liable to suffer a loss as a result of an overstaying motorist. Accordingly, it had a legitimate interest in levying a charge that extended beyond the recovery of loss in order to properly manage the car park and deter motorists from long stay occupation. It was free to do so as long as the charge was neither extravagant nor unconscionable, which £85 was not. The court noted that deterrence is not penal if there is a legitimate interest in deterring a breach which would not be satisfactorily compensated by the mere right to recover damages for that breach.
It is clear that, as a result of the Supreme Court’s decision, the courts will now take a more modern approach to the question of penalty clauses and will look at the contractual circumstances as a whole. While a provision for payment on breach of contract can still be “extravagant and unconscionable” and therefore a penalty, ParkingEye demonstrates that this is no longer always the case and some payments will be enforceable. The old dichotomy has been modernised to include a degree of flexibility by the courts where deterrent payments are not extravagant or unconscionable or where the parties are commercial and of comparable bargaining power and, in particular, where they obtain legal advice.
So, when drafting these clauses parties should carefully consider whether the sum due is commercially justifiable as well as whether it could be viewed as excessive or disproportionate to the loss. If it could fall within the latter then it will be at risk of being deemed unenforceable. Similarly, where commercial parties enter freely into contracts containing potential penalty clauses they will in the future find it more difficult to legitimately challenge their unenforceability.