The Supreme Court has handed down judgment in the cases of Cavendish Square Holding BV v Talal El Makdessi and ParkingEye Ltd v Beavis. It was not just the construction sector that waited patiently and speculated cautiously as to what the court would do with the rule against penalties. Would it confirm the current rule, abolish it, extend it, restrict its scope, or change the formulation? The prospects of obtaining a simple clear answer from the court were not promising: two cases with very different factual circumstances were heard together, there were seven judges on the bench, and the case was complicated by recent changes to the law in Australia and the Consumers’ Association “intervening” in the court proceedings.
In the event, while the judgment is a challenging 123 pages long, the result is straightforward, with all seven judges broadly agreeing as to the principles of the rule against penalties (albeit some diverging views on the relevant test to be applied) and their application to the two cases at hand. Lord Toulson’s part dissenting judgment considered that the relevant provision in ParkingEye infringed the Unfair Terms in Consumer Contracts Regulations 1999.
The “test” and some key principles
According to the majority view, the true test is whether the clause is a secondary obligation which imposes a detriment on the contract breaker that is out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation. If so, it may be struck down as involving an element of punishment that it is not the policy of the law to support.
Some broad principles emerge from the judgments:
- The penalty rule applies to commercial and consumer cases.
- It applies to clauses which require payments to be withheld, deposits to be forfeited and assets to be transferred as well as those providing for the payment of money.
- The penalty rule regulates only the remedies available for breach of a party’s primary obligations, not the primary obligations themselves. Although the courts will look at the substance of the term and not simply its form, this means that in some cases the application of the penalty rule may depend on how the relevant obligation is framed in the contract.
- The penal character of a clause depends on its purpose, which is a question of construction, to which evidence of the commercial background is relevant in the ordinary way.
- The traditional four tests in Lord Dunedin’s judgment in Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd  are useful for cases concerning standard damages clauses but are of little use in more complex cases. The “four tests” are not immutable rules of general application and were never intended to be this.
- In more complex cases, the concepts of “genuine pre-estimate of loss” and “deterrence” are not determinative or particularly helpful in deciding whether a clause is a penalty. A broader approach, which focuses on the nature and extent of the innocent party’s interest in the performance of the relevant obligation, is more suitable.
- The “commercial justification” approach adopted in recent cases provides a valuable insight into the real basis of the penalty rule, namely that a damages clause may properly be justified by some other consideration than the desire to recover compensation for a breach.
- The penalty rule is an interference with freedom of contract. In a negotiated contract between properly advised parties of comparable bargaining power, the strong initial presumption must be that the parties themselves are the best judges of what is legitimate in a provision dealing with the consequences of breach.
Application to El Makdessi and ParkingEye
Applying these principles to the cases at hand:
- In El Makdessi, the court held that the price adjustment clause and the forced share sale clause were primary obligations and therefore the penalty rule was not engaged. Even if it was, the provisions existed to further a legitimate interest of Cavendish. The fact that there was no relationship between these clauses and the measure of loss attributable to their breach was of no relevance.
- In ParkingEye, the court held that the £85 charge imposed on Mr Beavis for leaving his car in the car park more than the agreed two hours did engage the penalty rule but did not constitute a penalty. Although ParkingEye was not liable to suffer any loss as a result of overstaying motorists, the charge furthered legitimate interests of both ParkingEye and the landowner, and the level at which it was set was not extravagant or unconscionable when compared with relevant benchmarks.
What is the impact of this decision?
The Supreme Court’s decision to maintain the penalty rule broadly in its existing form is the conservative outcome of fairly radical submissions from the opposing sides. Cavendish invited the court to abolish the rule altogether. El Makdessi invited it to extend the application of the rule to cover not just secondary obligations but also primary obligations, such that it would not just operate in cases of breach of contract. The court had some sympathy for these submissions. Lord Neuberger and Lord Sumption described the rule as “an ancient, haphazardly constructed edifice which has not weathered well” and admitted that limiting it to secondary obligations had “capricious consequences”. It considered with interest the High Court of Australia’s decision in Andrews v Australia and New Zealand Banking Group Ltd  in which that Court had concluded that there was an equitable jurisdiction to relieve against any sufficiently onerous provision conditional on a failure to observe some other provision, whether or not that failure was a breach of contract.
Ultimately, however, the court decided to leave the penalty rule in place unchanged. The rule merited retention for three reasons:
- Tradition and universality: “the penalty rule is not only a long-standing principle of English law, but is common to almost all major systems of law, at any rate in the western world.”
- Protection of weaker parties who may not fall within the scope of the unfair terms regulations: “some of those who enter into contracts, for example professionals and small businesses, may share many of the characteristics of consumers which are thought to make the latter worthy of legal protection.”
- Consistency with other principles involving the court declining to give full force to contractual provisions, such as relief from forfeiture, the equity of redemption, and refusing to grant specific performance.
The court declined to follow the Australian extension to the penalty rule, finding it inconsistent with established English authority, uncertain in the breadth of its application and contrary to the principle that an inroad upon freedom of contract ought not to be extended.
The result is a victory for established practice, both in the legal world and the real world. As several of the judges recognised, sophisticated contract drafters are already adept at drafting provisions so as to avoid application of the penalty rule. That practice can continue with minor refinements to take account of the court’s expression of the rule. In parallel, litigators involved in making or defending a claim that a contract provision operates as a penalty may continue to use statutory or contractual benchmarks. The court’s assessment of whether Mr Beavis’ parking charge was extravagant or unconscionable by comparison with maximum charges in a relevant code of practice and the practice of local authorities in relation to on-street parking, confirms the validity of that approach.
The result is also a victory for a broader approach to enforcing contractual provisions in the absence of identifiable or proven loss to the innocent party. Neither Cavendish nor ParkingEye could prove that it had suffered any identifiable head of loss which might have satisfied the test in Hadley v Baxendale. Indeed, ParkingEye stood only to gain from Mr Beavis’ breach. Yet the court was satisfied that the legitimate interest in enforcing restrictive covenants relating to the value of good will (in Cavendish’s case) and the legitimate interest in enforcing a rational parking management scheme (in ParkingEye’s case) extended beyond the recovery of any loss. It is striking that the legitimate interests considered sufficient to enforce the charge in ParkingEye included interests of third parties, notably the landowner.
Overall, the Supreme Court has preserved the penalty rule for future generations, resolving uncertainty about its scope and application which had crept in over recent years. In doing so, the court has slightly refashioned the rule, clarified the relevant considerations and has left no obvious legal traps for the future. A long judgment, but worth the read, and perhaps the only one of its kind for another century.
This article was first published by Practical Law Construction as part of our regular construction blog series in which we share our practical experiences of working in construction and engineering and give our opinion on the current and future legal developments that shape and will shape the industry. To read more from the series, visit the Practical Law blog.