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Supreme Court re-examines penalty clauses in commercial contracts

If you wish to agree on the level of payment for a breach of contract, it is more likely now that such provisions will be enforceable provided that such payments are not “extravagant, exorbitant or unconscionable” and the benefitting party has a legitimate interest in preventing the breach.

The background

The law in this area dates back to 1915 and the case of Dunlop.  The original test in Dunlop considered whether a clause was a genuine pre-estimate of a party’s loss or had a deterrent effect.

If it was a genuine pre-estimate – it was enforceable.

If it bore no relation to the maximum loss a party could have realistically suffered, and its purpose was to act as a deterrent – it was a penalty.

The latest developments

The Supreme Court recently re-examined the rules as part of the judgment in two cases (Cavendish Square Holding BV v Tala El Makdessi and ParkingEye Limited v Beavis).  The Court’s decision has been widely welcomed as introducing greater clarity and flexibility in this complex area.

What does this mean?

If you’re involved in negotiating or drafting commercial contracts – this is news for you.

It is important to note that the Supreme Court has not abolished the principles of the historic Dunlop case, but it has created a new test.

Under the new test, the Court will analyse whether the clause is too harsh when measured against the innocent party’s interest in ensuring that the others fulfil their obligations.  There are three points to consider when analysing whether a clause is enforceable:

  • Does the innocent party have a legitimate interest in enforcing the clause?
  • Does the clause have an adverse impact that exceeds the innocent party’s legitimate interest?
  • Is the clause a primary provision of the contract?

Key questions

Key questions to ask yourself in relation to any potential penalty clauses include:

  • Are you seeking to protect your client relationships or safeguard confidential information and trade secrets?
  • What will be the impact in the event of a breach and are the consequences of such a breach served and protected by the clause?
  • Does the clause go further than necessary to protect the company’s legitimate interests?

Summary

The new test is a welcome change to the law on penalty clauses and it appears that the previous test of a ‘genuine pre-estimate of loss’ is no longer relevant save for determining the validity of a simple payment of damages clause.  However, the new test is still not straightforward and there may be more litigation on the horizon in relation to the interpretation of the new test.

This is good news for businesses as the Court will now consider the wider commercial context of a transaction and has emphasised its reluctance to get involved where the parties are of equal bargaining power and have entered into a contract on the basis of sound legal advice.

Case Details

In the case Cavendish Square Holding BV v Talal El Makdessi, Cavendish received a controlling stake in a holding company from Makdessi and subsequently became the majority shareholder.  Under the terms of the contract between the parties, Makdessi was prohibited from competing with the company.  If he did, he would forfeit the right to an interim and final payment under the staged payment provisions of the SPA upon sale and he could have also been required to sell his remaining shares in the company.  Makdessi began to compete and when the action was taken as a result of the breach, he argued that the clauses were in fact penalties and were unenforceable.

In an entirely different set of circumstances, the Supreme Court considered ParkingEye v Beavis in which the Court of Appeal had previously held that a parking charge was not a penalty clause as it protected the legitimate interests of the company.  ParkingEye owned and operated a car park located outside retail premises and provided free parking for a maximum period of 2 hours.  However, the conditions of parking imposed an £85 payment if a vehicle overstayed this allocated time.  Mr Beavis stayed for a period of 2 hours 56 mins and was duly presented with an £85 charge.  Mr Beavis resisted payment stating that the charge was unenforceable at common law as it constituted a penalty.

Posted on April 7, 2016

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