Penalties on car rental agreements

Many sale and hire-purchase contracts contain a clause entitling the seller to terminate the contract, forfeit the instalments already paid and retake possession of the subject-matter of the contract if the purchaser defaults in any of the instalments of the purchase price. Such a forfeiture clause is to be contrasted with a penalty, which represents a stipulated sum payable on breach of the contract and which, unlike liquidated damages, is inserted not as a genuine attempt to pre-estimate the likely loss to the innocent party but in terrorem of the party in breach as a strong incentive for the performance of the contract.

Unlike forfeiture, the process involves the imposition of an additional and extravagant liability on the defaulting party in the event of his non-performance of the contract.

The question whether a clause is penal or a genuine pre-estimate of damages depends on its construction, the intention of the parties and the surrounding circumstances. Unfortunately, there are few cases which give any practical guidance on this important distinction, so the recent decision of HH Judge Sennitt in Volkswagen Financial Services (UK) Ltd v Ramage, [2007], CC Cambridge (unreported elsewhere), involving a clause in a care hire agreement, merits close analysis.

Mr Ramage hired a new Audi two-door coupe car from a finance company for a term of 36 months at £567.40 per month. The agreement contained a clause that, upon repudiation, the hirer was to pay the total amount of rentals payable during the hiring period, less the amount of rentals already paid and a small rebate (4 per cent) on rentals that had not become due.

About a year after entering into the agreement, Mr Ramage fell into arrears. The company wrote to him stating that, because of his non-payment, he had shown an intention not to proceed with the agreement and had, therefore, repudiated it. The company accepted the repudiation and the car was later recovered. The company then brought proceedings claiming the arrears of rentals to the date of termination (£2,837), a recovery fee (£100) and a sum representing future rental payments amounting to £10,428. Mr Ramage, acting in person, responded by arguing that the clause providing for payment of future rentals was not a genuine pre-estimate of loss and, accordingly, it was a penalty and unenforceable.

Arguing liability

The thrust of his argument was that the clause made him liable for the whole of the rental payments due over the entire hire period (less the four per cent rebate) even if his repudiation of the agreement had occurred very early on during the hire (even before delivery of the car). This would permit the company to recover the car in new (or nearly new) condition (allowing it to sell or hire the car to someone else) and also receive the windfall of an accelerated payment on the whole of the rental instalments. Although in his case, the car had been recovered after 14 months use with some depreciation, it would still have been significantly more valuable than if it had been reclaimed at the end of the three-year hire period. In support of his contention, Mr Ramage relied heavily on the well-known House of Lords' ruling in Bridge v Campbell Discount Co Ltd [1962] AC 600. Here, the appellant entered into a hire-purchase contract with the respondents for a second-hand car. The hire-purchase price was £482, of which £105 was payable immediately and the balance by 36 monthly instalments. The appellant returned the car after only paying the initial payment and one instalment. A clause in the agreement provided that, in the event of early termination, the hirer would have to pay to the owners 'by way of agreed compensation for depreciation' of the vehicle such further sum as may be necessary to make the rentals paid and payable equal to two-thirds of the hire purchase price.

The respondents, relying on this clause, sought payment of £206. However, the House of Lords held that the money was irrecoverable as the clause constituted a penalty as opposed to a genuine pre-estimate of damages. Being a second-hand car, the depreciation in its value would naturally become greater the longer it remained with the appellant. By contrast, the sum to be paid under the agreement would be largest when (as in that case) the car was returned after only a short time in the hirer's possession. On this analysis, therefore, the 'sliding scale of compensation' was clearly the wrong way round.

Anglo-Finance Co Ltd v James

Similarly, in Anglo-Finance Co Ltd v James [1963] 3 All ER 566, another hire-purchase case involving a car, the relevant clause permitted the finance company to recover 100 per cent of the total hire-purchase price (after giving credit for the amount realised by the vehicle). Here, unlike in Bridge, the clause made no reference to compensation for depreciation but this did not deter the Court of Appeal from holding that the provision was not a genuine pre-estimate of loss.

Here again, the point was made that the clause entitled the finance company to recover all of the hire-purchase price regardless whether the termination of the contract took place at the beginning or end of the agreement. In other words, the clause provided just a single formula for measuring the damage notwithstanding that the actual loss could fluctuate considerably depending on when termination of the contract actually took place.

Option to purchase

In the Volkswagen case, the company sought to distinguish Bridge and Anglo-Finance on the basis that these were both hire-purchase cases and not cases involving a contract of hire. In a hire-purchase contract, the intention is that the option to purchase will be exercised at some point during the agreement so that the chattel is not usually returned at the end of the contract. By contrast, in hire contracts, the intention is usually that the chattel will be returned at the end of the period of hire with still some value.

Only exceptionally will the whole of the capital cost be written off over the period of hire (see, Robophone Facilities Ltd v Blank [1966] 3 All ER 128) involving the hire of office equipment. Despite these potential differences, HH Judge Sennitt concluded that the same principles applied generally to both types of agreement, albeit that in hire cases, there would usually be the added factor of a chattel (having still some value) being returned at the end of the hire period.

It was also argued on behalf of the company that Bridge should be distinguished because the clause in that case referred specifically to 'compensation for depreciation' whereas in the instant case the relevant provision was expressed in quite different terms entitling payment for all future rentals 'as compensation or agreed damages'. On this analysis, the loss that the clause was seeking to compensate was not depreciation (because it was always envisaged that the car would be returned in a depreciated state) but loss of future rentals and these would inevitably be higher at the start of the period of hire (when only a few payments had been made) becoming progressively lower the further the contract continued into the hire period. Viewed in this way, therefore, the clause, it was argued, could not be characterised as penal and should be upheld. Despite the attraction of this argument, it was rejected by HH Judge Sennitt. In his view, the ruling in Bridge was of universal application and could not be confined to a clause dealing specifically with compensation for depreciation. Like in Bridge, the purpose of the clause before him was not to provide compensation at all but to afford the company a substantial guarantee against the loss of their hiring contract.

In Bridge, the finance company could demand two-thirds of the total hire-purchase price regardless of any realistic measurement of its loss because the car would come back into the company's possession with a value that could well exceed the one-third balance of the price which the company could not claim back. Similarly, in the instant case, the whole of the future rental payments were payable to the company (less the rebate) and no account was to be taken of the considerably greater value of the car occasioned by its early return rather than at the end of the period of hire.

Essentially, the fatal flaw in the clause was that it did not refer at all to the value of the car in assessing the company's loss. Looked at in this way, the clause could only be seen as a penalty aimed at deterring Mr Ramage from breaking his contract. In the result, therefore, the company was limited to recovering only its actual loss (if any) occasioned by Mr Ramage's breach.

Strength of the parties

It was suggested at first instance (by the district judge) that a court should be slow to strike out as a penalty terms which had been freely agreed between the parties. Although, in the present case, the agreement had been written on a standard printed form, it was apparent that Mr Ramage was 'an articulate, intelligent man who work(ed) as a tax consultant'. According to the district judge, the car rental business operated within a free market and it was always open to Mr Ramage to have hired a car from elsewhere. In particular, there was no oppression on the part of the company compelling him to enter into the agreement. Interestingly, this approach was firmly rejected by HH Judge Sennitt, who acknowledged that, in practice, it would not be easy even for an articulate and intelligent person to persuade a finance company to change its standard printed conditions against its financial interests. More fundamentally, the question whether a term in a contract is a penalty or a genuine pre-estimate of loss is not determined by reference to the vulnerability or otherwise of the contacting party. In other words, Mr Ramage was just as entitled to rely on the fact that the clause was a penalty as anyone else so long as it was not a genuine pre-estimate of loss.

Pre-estimate the loss

The district judge at first instance had also intimated that where it was difficult to pre-estimate the loss, this may be some indication of the appropriateness of a liquidated damages clause. While not necessarily disagreeing with this view, HH Judge Sennitt considered it important that an owner, before inserting such a clause in a contract, should carry out some form of calculation to see what loss there might be if it were calculated on common law principles: 'Otherwise how can one say that it is a genuine pre-estimate of loss in the relevant clause if one has no idea of what the actual loss might be. One needs something to compare it with.' (ibid, at para. 20).

Interestingly, the judge made reference to the Robophone case, above, in which Diplock LJ carried out a number of his own calculations demonstrating that the formula used in that case (50 per cent of future rentals) was sufficiently close to the actual loss to represent a genuine pre-estimate of damages.

The message seems clear. It will now be incumbent on owners to adduce evidence of their actual loss if they are to successfully persuade the courts to uphold recovery of future rental payments under their hire agreements. Moreover, it is apparent that minimum payment clauses entitling owners to claim future rentals on breach will now need to take specific account of the fact that, upon repudiation by the hirer, the owner receives back the vehicle earlier and, therefore, in better condition (and more valuable) than if the vehicle had been returned at the end of the hire period.