When is a Penalty Not A Penalty?
Considering the recent Supreme Court decision in Cavendish Square Holding BV v El Makdessi and ParkingEye Ltd v Beavis  UKSC 67
The Supreme Court handed down judgment in the El Makdessi and ParkingEye consolidated appeals on 4 November 2015. In doing so, it provided a restatement of the rule against penalties, which will be of importance to any Northern Irish business seeking either: (a) to rely on a contractual provision for fixed damages; or (b) to challenge the enforceability of a provision for fixed damages to which it is subject.
Contractual obligations. Parties to any legal contract, written or unwritten, will be bound by certain obligations. By way of example, a party (X) to a services contract might be obliged to provide certain services to another party (Y). If X fails to provide the services (or fails to provide the services properly) and Y suffers loss as a result, damages will be payable to Y as a matter of law. Those damages will generally be calculated so as to put Y in the position he would have been in if the services had been provided (or provided properly) by X.
Rule against penalties. In some cases, however, the contract will include provisions for certain agreed amounts to be paid in the event of non-performance, i.e. rather than relying on default damages assessed as a matter of law. These provisions will be enforceable by Y to the extent that they are not construed as ‘penalties’: the so-called ‘rule against penalties’. Where a provision is found to be a penalty, it will be struck down by the court and Y will have to rely on his default legal remedies.
Penalties. To determine whether or not a provision amounts to a ‘penalty’, the following short-hand test had been developed (prior to the recent Supreme Court decision), based on case law dating back to 1915:
- Does the contractually agreed amount represent a genuine pre-estimate of loss?
- If so, the clause should be enforceable.
- If not, the clause should be struck down as a penalty.
In fact, the case law from which the short-hand test was developed actually set out four ‘tests’ – or points to consider – in assessing whether a provision would be penal:
- Extravagant/unconscionable: whether the specified sum was ‘extravagant and unconscionable’ in comparison with the greatest loss that could conceivably follow from the breach at issue.
- Non-payment: whether the breach consisted only in the non-payment of money and the contact provided for payment of a larger sum.
- One-size-fits-all: there was a presumption that a provision would be penal if the same amount was payable in response to a number of events of varying gravity.
- Pre-estimate impossible: a provision would not be treated as penal simply because it was impossible to precisely pre-estimate the true loss.
The Supreme Court’s judgment in El Makdessi and ParkingEye confirmed that the straightforward application of any of these short-hand tests is not (of itself) the correct approach, and went on to set out a more nuanced set of questions/considerations.
The Supreme Court judgment
Focussing on the ‘rule’ against penalties, the recent Supreme Court judgment suggests the following ‘true test’ should apply when assessing the enforceability of a ‘penalty’ clause:
- Does the clause impose a burden on the defaulting party which is out of all proportion to any legitimate interest of the innocent party in the enforcement of the relevant contractual obligation?
In that regard, previous judgments had shown that the innocent party’s ‘legitimate interest’ is not confined to financial compensation.
For example, the contractually-determined amount may legitimately be calculated to reflect some form of deterrent element. Indeed, this was the case in the ParkingEye appeal, where the Supreme Court upheld an £85 charge levied on customers for parking violations – on the basis that the charge was designed, amongst other things, to deter motorists from parking badly or overstaying. On the other hand, the Supreme Court noted that an innocent party would have no legitimate interest in simply seeking to punish the defaulting party (as an end in itself).
The Supreme Court judgment significantly restates the ‘rule against penalties’ as it had been traditionally understood, confirming that the real question to consider is whether a particular provision imposes a penalty which is disproportionate when viewed against the legitimate interests of the innocent party, i.e. not only whether the ‘penalty’ represents a genuine pre-estimate of loss.
Whilst this new test is (in our view) more likely to result in a ‘fairer’ answer should a dispute arise as to the enforceability of a contractually agreed remedy, it will be some time before a sufficient body of case law is generated to allow the test – relying, as it does, on fluid concepts such as proportionality and legitimate expectations – to be applied with certainty in practice.
If you have any questions or would like to discuss how the above might apply to your business’s standard terms and conditions, or if you think your business might be subject to an unenforceable penalty clause, please contact Andrew Kirke, Raymond Duddy or your usual Tughans’ contact.
While great care has been taken in the preparation of the content of this article, it does not purport to be a comprehensive statement of the relevant law and full professional advice should be taken before any action is taken in reliance on any item covered.