The rule against penalty clauses has long been contentious with some arguing for its abolition and some for its wider application. It had been thought that any clause in a contract introducing a penalty for failure to perform going beyond compensation for loss was void. However, in a judgement handed down on 4 November 2015, the Supreme Court has radically altered how this rule is to be applied. 

A seven strong bench in the Supreme Court ruled that instead of being focused on loss the test should be whether the clause is in proportion to the innocent party’s legitimate interest in enforcing the counterparty’s obligations under the contract. The decision also confirmed that the rule against penalties only applies in breach of contract cases. 

The Background
In Cavendish Square Holding BV v Talal El Makdessi and ParkingEye Limited v Beavis two appeals relating to alleged penalty clauses were heard together by the Supreme Court. 

Cavendish Square Holding BV v Talal El Makdessi related to the consideration to be paid to Mr Makdessi for the sale of some of his shares in a group of companies. One of the clauses of the sale agreement provided that Mr Makdessi would not, for a period of two years, carry out certain activities which might compete with the group companies within a certain area nor employ or solicit any senior employee or consultant of any group company. If he breached this clause Mr Makdessi would become a “Defaulting Shareholder” and would not be entitled to part of the consideration for the shares. Mr Makdessi subsequently admitted breaching the clause but argued that the clause withholding part of the consideration was unenforceable as a penalty clause. At first instance it was held that the clause was enforceable but the Court of Appeal ruled that it was a penalty clause and therefore unenforceable. Mr Makdessi then appealed to the Supreme Court.

In ParkingEye Limited v Beavis Mr Beavis sought to challenge a £85 charge from the operators of a car park, ParkingEye, on the basis that it was unenforceable as a penalty clause and/or unenforceable by virtue of the Unfair Terms in Consumer Contracts Regulations 1999 (the “1999 Regulations”). Both of his arguments were rejected at first instance and in the Court of Appeal and so Mr Beavis appealed to the Supreme Court.

The Decisions
The Supreme Court decided that neither of the clauses at issue were penalty clauses. It therefore allowed the appeal in Cavendish v El Makdessi and dismissed it in ParkingEye v Beavis (although Lord Toulson dissented in the ParkingEye case on the basis that the clause was unfair in terms of the 1999 Regulations).

In coming to this decision the Supreme Court took the opportunity to look at the principle behind the rule and set out how it should be applied. In their joint judgement Lord Neuberger and Lord Sumption considered two key questions: in what circumstances is the penalty rule engaged and, what makes a contractual provision penal? These will be the key questions that contracting parties need to consider in the future.

In what circumstances is the penalty rule engaged?
Lords Neuberger and Sumption confirmed that a clause can only be considered penal if it applies on failure to perform in accordance with an obligation of the contract. There is still some uncertainty over what the “penalty” can be but it was common ground that possible “penalties” include the payment of a sum of money, the transfer of property or the withholding of either of these. This is contrasted with a clause which, while not obliging a party to perform an act, provides that if they do not perform they are to pay a specified sum. This second situation was characterised as simply a conditional obligation and therefore not capable of being a penalty. However, the judgement makes clear that attempts to avoid the penalty clause rule through use of this distinction will not be straightforward as the characterisation of a particular clause depends on its substance not its form.

What makes a contractual provision penal?
This is the question that took up the majority of each of the judgements. There is wide discussion of the development of the rule up to this point and the unsatisfactory and confused nature of its current application. They then go on to set out how the test should be applied. 

Lords Neuberger and Sumption state that “The innocent party can have no proper interest in simply punishing the defaulter. His interest is in performance or in some appropriate alternative to performance”. In contrast to the position that has been applied to date, they go on to say that “compensation is not necessarily the only legitimate interest that the innocent party may have in the performance of the defaulter’s primary obligation”. 

The test as applied to the two cases being heard here is neatly set out by Lord Hodge: “The correct test for a penalty is whether the sum or remedy stipulated as a consequence of a breach of contract is exorbitant or unconscionable when regard is had to the innocent party’s interest in the performance of the contract”.

This interpretation falls on the side of freedom of contract but parties negotiating contracts should take care as the judgements also emphasise that the circumstances surrounding the creation of the contract may be taken into account in some situations and the court may still consider what a reasonable party would have agreed to.

Impact Going Forward
This decision is an important development of the law on penalty clauses. The distinction between the test based on compensation and the test based on the legitimate interests of the innocent party in the performance of the obligation may seem subtle but could have important affects. In coming down in favour of the latter test the Supreme Court has given commercial parties increased leeway to enter into contracts that reflect their real interests in a bargain with less fear of having clauses ruled penal and therefore unenforceable. However, care should still be taken particularly when drafting contracts, especially if the two parties to the contract are not in an equally strong bargaining position.

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