What are penalty clauses?
After a Summer of the Euros and the Olympics, penalties are decidedly on the mind. Below, I unfortunately do not discuss penalty shoot-outs or controversial Olympic points deductions. Instead, I present a quick guide to the rule against contractual penalties.
I also look at two key controversies: (i) how, in practice, one should approach the legal test for penalties, and (ii) the scope of the rule against penalties (particularly whether it applies to price adjustment and similar clauses).
In brief: what is a penalty clause?
Parties are generally free to agree their own remedies for breach of contract. This is a natural consequence of the ‘freedom of contract’ philosophy which is the lodestar of English contract law. Expressly agreeing a remedy for breach can also have practical benefits for the parties. A liquidated damages clause can bring clarity on the sum owed in the event of a breach and can save the parties the time, cost, and strife of arguing over the quantum of unliquidated damages in litigation or arbitration.
Freedom of contract, however, has its limits. The rule against penalties is a manifestation of the court’s concern that parties will create oppressive remedies for breach that amount to punishment of a counterparty. This is seen by the court as an improper use of the law of contract, the remedies for which are meant to be compensatory and not punitive in nature.
Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd [1915] AC 79 involved the well-known appellant tyre manufacturer seeking to rely upon a liquidated damages clause which, inter alia, required the respondent garage to pay a £5/tyre sum for every tyre it sold for less than the recommended retail price. The liquidated damages clause in issue was held to be valid and enforceable. It was held that a liquidated damages clause would be penal if it ‘did not fairly pre-estimate the loss and was unconscionable’.
This manifestation of the test seemed to chime with the justification for the rule I set out above – that the court is concerned to ensure that liquidated damages clauses are used to compensate and not to punish. The boundary between valid and enforceable liquidated damages clauses and void and unenforceable penalty clauses, according to that test, quite naturally tracks the distinction between clauses which aim to fairly pre-estimate loss and those which set a liquidated sum above and beyond a fair estimation of loss.
Things changed just under a decade ago. In the jointly heard cases of Cavendish Square Holding BV v Makdessi and ParkingEye Ltd v Beavis [2015] UKSC 67 it was clarified that the correct test for a penalty clause is instead whether it 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’, and that it was not necessary for an enforceable clause to provide for a pre-estimate of loss.
Those cases involved agreed remedies which could reasonably be described as deterrent in their effect. Cavendish concerned a share purchase agreement which contained a non-compete clause, breach of which disentitled the defendant to further payments for the acquired shares and entitled the claimant to exercise an option to acquire additional shares from the defendant at a discounted price. The defendant resisted the claim on the basis that the clauses were penal. ParkingEye concerned the validity of a liquidated damages clause for use of a carpark which was free to use for two hours, and then imposed an £85 charge for stays over two hours. The defendant stayed in the carpark for some three hours and resisted a claim for the sum on the basis that it was penal. In both cases, the clauses were held to be enforceable. Essentially, both claimants had good reason for wanting the defendants to comply with their primary obligations – in Cavendish, the defendant’s non-competition was essential to the purchased business’ goodwill value, and in ParkingEye the efficacy of the free-two-hour car park depended on large fees for those who overstayed their gratuitous allowance.
How to apply the new test?
Although Cavendish v Makdessi/ParkingEye v Beavis looks like a fairly simple re-statement of the test for the rule against penalties, it raises some difficult questions about how the test is actually to be applied. What are the ‘legitimate interests’ of the party seeking to rely upon the alleged penalty clause, and how is the court to judge the legitimacy of these interests? Are these interests limited to commercial ones, or could there be other interests taken into consideration? Is the legitimacy of a commercial strategy something the court can judge on its own, or is this a matter for expert evidence?
In my opinion, the correct reading of Cavendish v Makdessi/ParkingEye v Beavis is to see it as a gloss on the old test set out in Dunlop rather than a total re-statement of the test. In effect, there are now two different limbs to the rule against penalties.
First, (which more aptly applies to liquidated damages clauses of the ordinary sort), the old rule should be used to see if the clause fairly pre-estimates loss. If it does, the clause will not be penal and there is no need to consider the second limb. See GPP Big Field LLP v Solar EPC Solutions SL [2018] EWHC 2866 (Comm) as an example of a post-Cavenidsh case which involved the application of the Dunlop formulation of the test. That claim involved a fairly typical liquidated delay damages clause in a construction contract and it was held to be enforceable on the basis that it fairly pre-estimated the loss caused by delay.
Second, for agreed remedies which go beyond mere fair pre-estimation of loss, the test in Cavendish v Makdessi/ParkingEye v Beavis should be considered and a proportionality assessment should be carried out between the primary obligation and the importance of its observance, and the detriment imposed by the agreed remedy to determine whether it is penal. It is useful to keep the facts of Cavendish v Makdessi/ParkingEye v Beavis in mind and not to see the test in isolation. Although the test is a fact-sensitive one which is difficult to apply, in the ordinary way one should look to the growing body of post-Cavendish case law for analogous factual scenarios. Houssein v London Credit Ltd [2024] EWCA Civ 721 provides a useful recent illustration of how judges ought to go about considering the Cavendish v Makdessi/ParkingEye v Beavis test – the judgment usefully illustrates that sufficient attention ought to be given the relevant primary obligations, their effect, and the importance of their observance before the agreed remedy is analysed. Legitimacy of commercial interests seems to be a matter of law and not of expert evidence, that case suggests.
The scope of the rule against penalties
Cavendish v Makdessi/ParkingEye v Beavis clarified that the rule against penalties applies not just to liquidated damages but also to agreed remedies which involve the surrender of property or which disentitle a party from receiving a sum to which it would have otherwise been entitled. The court in that case made clear that the essential point governing the scope of the rule against penalties was that it applied to secondary and not primary obligations. This is a difficult concept which is best illustrated by an example.
X agrees to pay Y for professional services.
Consider the three following situations:
- The contract price is £1m. The completion date is 1 September 2024. If Y fails to complete the services by 1 September 2024, Y shall pay X a £250,000 sum by way of liquidated damages;
- The contract price is £1m. The completion date is 1 September 2024. If Y fails to complete the services by 1 September 2024, the contract price is reduced to £750,000;
- The contract price is £1m if the services are completed by 1 September 2024, with a price reduction of £10,000 per day for each full day thereafter that the work is not completed;
- The contract price is £750,000, with a bonus payment of £250,000 if the work is completed by 1 September 2024.
Y completes the work on the 27 September 2024. All four of these clauses have the same financial effect on X and Y in that the net sum due to Y is £750,000, when Y could have earned a net sum of £1m for the work if it was performed on time.
The differences in the above three scenarios lies in the classification of the obligations. In (1), the clause involves a secondary obligation. This means that the obligation to pay the £250,000 liquidated damages arises on breach of a primary obligation, i.e. failing to complete by the stipulated date. Primary obligations are independent from and antecedent to secondary obligations. Secondary obligations are dependent on the breach of primary obligations for their efficacy.
In (3) and (4), on the other hand, although they are potentially identical in their effect to (1), the clauses are drafted in such a way that they involve primary obligations. There is no antecedent clause, the breach of which triggers these clauses. They are not in that sense remedial. Rather, they simply set out the price (subject to conditions), which is a primary obligation.
(2) raises a rather more difficult question. Do price adjustment clauses of this nature involve primary or secondary obligations, and are they within the scope of the rule against penalties? As a matter of construction, it looks like there is a secondary obligation in that the price adjustment is triggered upon a ‘failure’ to meet a completion date (a typical primary obligation). However, the clause is drafted in such a way as to be framed as a price adjustment, price being the typical primary obligation.
In Cavendish v Makdessi, Lords Neuberger, Sumption, and Carnwath (a minority of the bench of seven) were of the view that the clause disentitling the defendant to further payment on breach of the non-compete clause were instances of a price adjustment, which was a matter of primary obligation and not within the scope of the rule against penalties. Helpfully, the rest of the bench does not address the point in their judgments and seems to proceed on the assumption that the clause was within the scope of the rule and that it was not penal in any event.
Subsequent to Cavendish that there has been some suggestion that price adjustments contingent on breaches of primary obligations are within the scope of the rule: see Vivienne Westwood Ltd v Conduit Street Development Ltd [2017] EWHC 350 (Ch); but this approach is arguably at odds with the minority opinion of the Supreme Court in Cavendish. The authorities do not give us a clear answer as to how situations such as (2) are to be treated. Whether price adjustment clauses are within the scope of the penalties rule remains an open, fact-sensitive question.
To complicate matters further, there was suggestion from the court in Cavendish v Makdessi/ParkingEye v Beavis including from Lord Neuberger at [77] that the scope of the rule against penalties is a matter of substance and not form, and that it will apply notwithstanding attempts to ‘disguise’ a penalty using the language of primary obligations. That line of thinking may mean (2) and (3) are within the scope of the penalties rule, the price reductions there seeming to be a formal attempt to circumvent the rule against penalties when as a matter of substance the price adjustment operates in the same way that a liquidated damages clause would.
However, if attempts to ‘disguise’ penalties using the drafting language of primary obligations can be within the scope of the rule against penalties, where does that leave (4) above, which is almost identical to (2) save for some clever drafting which frames it in terms of primary and not secondary obligations? If one takes the idea of ‘disguised’ penalties too seriously, the entire division between primary and secondary obligations breaks down.
Conclusion
Although it is fairly simple to re-state Cavendish v Makdessi/ParkingEye v Beavis nearly a decade on, the penalties doctrine still raises some difficult and fundamental questions about primary and secondary obligations, form and substance, the ability of clever drafting to circumvent the rule against penalties, the continuing relevance of Dunlop, and how the court is meant to assess legitimate interests and their proportionality to agreed remedies.
In summary: penalties are as difficult a subject for lawyers as they are for England’s football team.
This article is not intended as a substitute for legal advice. Advice about a given set of facts should always be taken.
