The doctrine of penalties survives

For the first time in a century, the principles underlying the law relating to contractual penalty clauses were considered by the Supreme Court. The review
was long overdue and most certainly needed. In their
joint judgment, the president of the Supreme Court, Lord Neuberger, and Lord Justice Sumption (with whom Lord Clarke JSC and Lord Carnwath JSC agreed) observed: 'The penalty rule in England
is an ancient, haphazardly constructed edifice which has not weathered well.'

The two appeals heard by the court lie at opposite ends of the financial spectrum. The first appeal, Cavendish Square Holding BV v Talal El Makdessi [2015] UKSC 67, raised the issue in relation to two clauses in a substantial commercial contract. The second appeal, ParkingEye Ltd v Beavis, raised the issue at
a consumer level.

The penalty rule as traditionally understood
was directed against deterrent clauses - provisions for payment in the event of breach where the amount to be paid or lost is out of all proportion to the loss attributable to the breach. According to Lord Dunedin in Dunlop Pneumatic Tyre Co Ltd
v New Garage and Motor Co Ltd [1915] AC 67: 'The essence of
a penalty is a payment of money stipulated in terrorem of the offending party; the essence of liquidated damages is a genuine pre-estimate of the damage.'

Legitimate interest test

More recently, the courts introduced 'commercial justification' as part of the test - the assumption being that
a provision cannot have a deterrent purpose if there is
a commercial justification (which the Supreme Court found 'to be questionable').

But while recognising that there is a case to be made for
the abolition of the doctrine,
and casting 'doubt that the courts would have invented the rule today if their predecessors had not done so three centuries ago', the court declined to abrogate or extend the doctrine, preferring reformulation.

The court held that the real question when a contractual provision is challenged as a penalty is whether it is penal,
not whether it is a pre-estimate of loss. The fact that the clause is not a pre-estimate of loss does not, therefore, mean that it is penal.

Lords Neuberger and Sumption found: 'The true test is whether the impugned provision is a secondary obligation which imposes a detriment on the contract-breaker out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation'. Meanwhile, Lord Mance stated: 'What is necessary in each case is to consider, first, whether any (and if so what) legitimate business interest is served and protected by the clause, and, second, whether… the provision made for the interest is nevertheless in the circumstances extravagant, exorbitant or unconscionable.'

The scope of 'legitimate interest' appears to be broader than 'commercial justification', including social as well as economic considerations. Compensation is not the only legitimate interest that the innocent party may have in the performance of the defaulter's primary obligation.

Unlawful penalty charge?

The facts of ParkingEye can be stated succinctly: the respondent operated the car park in the Riverside retail park in Chelmsford. The first two hours
of parking were free to customers of the retail park. Thereafter,
a 'parking charge' (in fact a sum payable on breach and not a genuine pre-estimate of loss) of £85 was imposed on overstayers. Mr Beavis overstayed. He contended the charge was
an unlawful penalty charge.

The Supreme Court held that the penalty rule was engaged, but, applying the reformulated test, the charge did not contravene the rule. The court found that ParkingEye had legitimate interests in charging that extended beyond the recovery of any loss, which were to manage the efficient use of parking space and to generate an income in order to operate the scheme, stating: 'Deterrence is not penal if there is a legitimate interest in influencing the conduct of the contracting party which is not satisfied by the mere right to recover damages for breach of contract.'

This seminal judgment provides welcome clarity as
to the applicable test, yet the introduction of a legitimate interest test enlarges the scope of enforceable deterrence
to include what would otherwise, and conventionally, have been an unlawful penalty clause. As each case turns on its own facts, inevitably litigation in this area will increase. SJ

David Lewis is a barrister practising from Hardwicke and was counsel for Barry Beavis in the Supreme Court