Contractual penalties: a new legal test in England for determining whether a provision is a penalty

The United Kingdom’s highest court recently handed down an important judgment concerning the doctrine of penalties: Cavendish Square Holding BV v Talal El Makdessi; ParkingEye Limited v Beavis [2015] UKSC 67 (Cavendish/ParkingEye).

The UK Supreme Court judgment, which decided two separate appeals with markedly different fact scenarios, has altered and simplified the law of penalties in England. Whether this landmark decision will have an impact in Australia remains to be seen.

The facts

In Cavendish Square Holding BV v Talal El Makdessi (Cavendish), Mr Makdessi and Cavendish Square were parties to a share sale and purchase agreement, which imposed restrictive covenants on Mr Makdessi as one of the vendors. The agreement provided that if Mr Makdessi breached his non-compete obligations, certain consequences would follow, including that Mr Makdessi would lose his entitlement to be paid deferred consideration, and a call option would be triggered valuing Mr Makdessi’s remaining shares on a basis that excluded any goodwill component, the effect of which would be a dramatic decrease in the effective purchase price for the shares (up to US$44 million less). Cavendish Square alleged that Mr Makdessi breached his non-compete obligations and sought declarations that Mr Makdessi was not entitled to the further payments, and specific performance in respect of its exercise of the call option.

In ParkingEye Limited v Beavis (ParkingEye), ParkingEye operated a car park at a shopping centre. The terms and conditions of use of the car park (notified to customers via signs) included an entitlement for ParkingEye to levy an £85 charge on users of the car park for certain breaches of the terms and conditions, including for overstaying the two hour free parking period. Mr Beavis left his car at the car park for just under three hours, thereby exceeding the two hour limit, and was charged the £85 fee accordingly.

The doctrine of penalties – the position in Australia

It has long been the case that a contractual stipulation that imposes a penalty on a party is illegal and void, or otherwise unenforceable. However, the rationale for the penalties doctrine has proved elusive and it can in practice be notoriously difficult to apply the rule.

In Andrews v ANZ Banking Group Ltd (2012) 247 CLR 205 the High Court of Australia undertook a detailed review of the historical authorities on the penalties rule, deciding that:

• the penalties rule operates in Australia both at law and in equity;
• the doctrine may be enlivened at law in respect of a clause that imposes a detriment on a party as a consequence of that party’s breach of contract;
• the doctrine may be enlivened in equity in the absence of a breach of contract, where a clause is in substance collateral or accessory to another (primary) obligation and imposes an additional detriment in terrorem (i.e. as a threat) to secure compliance with that primary obligation;
• where the doctrine applies:
  • if the sum payable is extravagant and unconscionable in amount in comparison with the greatest loss that could conceivably be proved, it will be a penalty;
  • conversely, if the sum stipulated to be paid is a genuine pre-estimate of loss or damage it will not be a penalty;
• a fee charged in accordance with pre-existing arrangements, according to which the enforcing party chose whether or not to grant a further benefit to the other party, falls outside the scope of the penalties doctrine; and
• a clause that is a penalty will not be void and will instead be enforceable only up to the amount of the loss that can be proved to have been actually sustained.

The English approach: Cavendish/ParkingEye

In contrast, the UK Supreme Court in Cavendish/ParkingEye rejected the High Court’s decision in Andrews, which it described as a ‘radical departure from the previous understanding of the law’. The Supreme Court determined that there is no residual equitable doctrine of penalties in England, and articulated a new test at law to determine when a contractual provision is a penalty, which focuses on the ‘legitimate interests’ of the parties to the contract. The binary distinction between a penalty and a genuine pre-estimate of loss, adopted in some previous cases, was singled out as unsatisfactory.

The ‘true test’ under English law now requires two conditions to be satisfied for a contractual provision to be a penalty:

1. the provision is a secondary obligation that imposes a detriment on the party breaching a primary obligation under the contract; and
2. the detriment is ‘out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation’.

The Supreme Court expressly acknowledged that limiting the rule to stipulations which operate upon breach may allow parties to avoid its operation by ‘ingenious drafting’, but justified this on the basis that the rule is already an incursion into parties’ freedom to contract which should not be extended otherwise than by legislation.

The Court also noted in relation to the identification of the critical ‘legitimate interest’ of the innocent party:

• the interest must be in performance of the primary obligation (or some appropriate alternative to performance) and punishment of the defaulting party will not be a legitimate interest;
• there is a ‘strong’ presumption that, in the case of negotiated (as opposed to standard form) contracts between properly advised parties of comparable bargaining power, the parties’ agreement as to the consequences of breach will reflect the innocent party’s legitimate interest; and
• where the innocent party’s interest is simply monetary (i.e. pure damages clauses) a legitimate interest will ‘rarely extend beyond compensation for the breach’; in such cases the genuine pre-estimate of loss test (amongst others) will still be applicable.

In Cavendish, the Supreme Court held that the clause that provided for Mr Makdessi’s disentitlement to receive further payment instalments was not a secondary provision, but a primary provision in the nature of a price adjustment clause (albeit one enlivened by breach), and Cavendish had a legitimate interest in Mr Makdessi observing the restrictive covenants, which interest extended beyond mere recovery of loss and went to the heart of the value of the business. The Court also held that the provision entitling Cavendish to exercise a call option (which attributed a goodwill value of nil to Mr Makdessi’s shares) was proportionate to Cavendish’s legitimate interest in matching the price of Mr Makdessi’s retained shares to the value of Mr Makdessi’s continuing contribution to the business. Therefore, applying the ‘true test’, neither provision was a penalty.

In ParkingEye the Court considered that the term under which the £85 fee was charged to Mr Beavis was a secondary obligation operating upon breach, not a ‘parking charge’, and was also not a genuine pre-estimate of loss. However, it was held not to be a penalty because the charge was not out of proportion to ParkingEye’s legitimate interest, which was to ensure regular turnover of customers –consistent with its arrangements with the landowner of the site – even though the charge was primarily intended to deter customers from overstaying. In considering proportionality, the Court was persuaded by evidence that customers chose to park in the car park notwithstanding the possibility of an £85 fine and the availability of alternative parking options, that parking fines imposed by local authorities (with legislative sanction) were not substantially different in amount, and that charges for overstaying in private car parks were common in the UK.

Implications of Cavendish/ParkingEye in Australia

Despite its attractive apparent simplicity, the UK Supreme Court’s approach may not lead to a substantial change to the law of penalties in Australia, which has diverged in significant respects from the position under English law. The penalties doctrine in Australia, as stated in Andrews, is both wider in scope (potentially applying to stipulations not involving a breach of contract) and different in emphasis, focusing on extravagance or unconscionablity of the stipulation in comparison to the innocent party’s potential provable loss, rather than proportionality to the innocent party’s legitimate interests. It is unlikely that the High Court would depart from its reasoning in Andrews in favour of the Cavendish/ParkingEye approach, particularly given how recently Andrews was handed down.

The High Court is due to hear substantive argument in another penalties case, Paciocco v ANZ, early next year. That case relevantly concerns whether or not late payment fees are penalties. The High Court has not been invited to revisit Andrews, but it will be interesting to see what, if anything, the Court has to say about the English approach to penalties adopted in Cavendish/ParkingEye, particularly in light of the criticism of Andrews in that judgment.