Penalty or pre-estimate of loss?

The landmark case of Talal El Makdessi v Cavendish Square Holding BV [2013] EWCA Civ 1539 will be heard by the Supreme Court in July and will grapple with the tricky issue of how to justify penalty clauses. While this can seem a somewhat technical and obscure point, its relevance is demonstrated by another case being heard at the same time – Beavis v ParkingEye Ltd [2015] EWCA Civ 402 – which has definitely caught the public’s imagination since it deals with the ever-contentious issue of parking fines.

The basic legal principle is that any clause which requires a party who breaches the terms of the contract to either pay or forfeit a sum of money to the other party (a ‘penalty clause’) is deemed unlawful, unless such payment or forfeiture can be justified as a genuine pre-estimate of the loss which the innocent party will suffer as a consequence of the breach.

Although the courts will generally not interfere with the contractual terms which the parties have negotiated and agreed between them, they are willing to render penalty clauses unenforceable. The law of penalties is therefore a blatant interference with freedom of contract.

The classic test applied by
the courts was set out in Dunlop Pneumatic Tyre Co Ltd [1915] AC 79. Dunlop stated: ‘The essence of a penalty is a payment of money stipulated as in terrorem
of the offending party; the essence of liquidated damages
is a genuine covenanted pre-estimate of damage.’ Later decisions treated ‘in terrorem’ as somewhat archaic, with ‘intended to deter’ becoming the modern equivalent.

Makdessi referred to a more modern approach, developed in response to arguments that the distinction between a genuine pre-estimate of loss and a penalty was too rigid. A line of thinking had developed through recent cases that while a payment upon breach of contract may not really be a genuine pre-estimate of loss, it should not mean that the clause should be immediately struck out as being a penalty clause.

Modern approach

The modern approach set out in Makdessi appears to be more flexible and considers whether there is some commercial justification for the provision, which may provide sufficient grounds to deduce that the deterrence of breach was not the dominant purpose of the term and it should therefore be enforceable.

The case arose from an agreement whereby Mr Makdessi sold his controlling interest in a company but retained a significant number of shares. Under the terms of the sale agreement, Makdessi agreed to forfeit a significant proportion of his consideration for the shares in the event that he became a defaulting shareholder by breaching various restrictive covenants contained in the agreement. Furthermore, in
the event that he became a defaulting shareholder, he would also exercise a put option and sell his remaining shares to Cavendish at what would likely constitute an undervalue.

Makdessi subsequently breached the restrictive covenants within the agreement, causing Cavendish to seek a declaration that he was a defaulting shareholder.
Makdessi submitted that these clauses were unenforceable
as penalty clauses.

In reaching its decision, the court adopted the modern approach and found that the provisions were not in themselves penalty clauses. There had been a commercial justification, the provisions were not extravagant or oppressive, the predominant purpose had not been to deter breach, and they had been negotiated on a level playing field.

Commercial justification

Makdessi will therefore be
of interest to lawyers and contracting parties, as it shows the court explicitly deciding a penalty clause issue by reference to the commercial justification test, under which a clause may be upheld on commercial grounds, provided that its principal purpose is not to deter breach of contract and it is not oppressive.

The modern approach has already been applied by the Court of Appeal in Parkingeye Ltd, in which it was held that a parking fine was not a penalty clause, even though the principal purpose of the parking fine was deterrence, as there was a commercial justification and the fine was not extravagant
and unconscionable.
The justification was that motorists had to be deterred from staying beyond the period of free parking so as to ensure the regular availability of free parking for the benefit of consumers and local retailers.
As a result, it was not a penalty under common law.

Both cases are due to be heard in the Supreme Court between 21 and 23 July 2015. The court will consider whether the modern approach is appropriate, and will ultimately determine the future of penalty clauses in contracts. SJ

Carole Spiller, pictured, is a partner and James Whittaker is a solicitor at Weightmans