A review of the Supreme Court’s judgment of November 4th 2015 in the Makdessi and ParkingEye cases
Historically, when parties entered into a contract, they had the possibility to include clauses providing for payment of a pre-determined sum in order to compensate for a breach of contract. This type of clause is meant to compensate for the damage actually incurred, in which case it would be deemed enforceable. However, clauses designed to deter parties from breaching the contract, known as penal clauses, are unenforceable under English law. Those clauses may appear similar but must be differentiated for their consequences on the contract will not be the same.
The traditional rule to differentiate between those two types of clauses was to look at the clause’s aim. If it aimed at deterring a breach it would be penal, and unenforceable. If the aim was only to compensate for a loss, or a pre-estimate of a loss then it would not be penal, and would be enforceable. However, the Supreme Court has observed that a number of courts have misunderstood this rule of law and the underlying justification for its application. As a result, on the 4th of November 2015, in a judgment regrouping two cases, Cavendish Square Holding v. Makdessi, and ParkingEye v. Beavis, the Supreme Court introduced and explained a new test as to whether or not a clause is penal and therefore unenforceable.
Quick fact summary of the cases:
Makdessi concerned the sale of shares of Mr Makdessi’s company to Cavendish Square Holding. The agreement was subject to extensive negotiations over a period of 6 months, and the parties were represented by “highly experienced and respected commercial lawyers”.[2] The contract provided for consequences in the event Mr Makdessi breached certain non-compete restrictions, such as losing entitlement to defer consideration otherwise payable, as well as losing the option to sell his remaining shares at a price determined by reference to goodwill. In other words, if Mr Makdessi breached the non-compete provisions of the contract, a call option would be triggered, which would allow Cavendish to buy the remaining shares with no provision for goodwill, and at a price based on net asset value.
ParkingEye concerned Mr Beavis who left his car parked for 56 minutes over a permitted two-hour period in a shopping car park provided by ParkingEye. The car park was full of notices including the statements “2 hour max stay”, “Parking limited to 2 hours,” “Failure to comply will result in a Parking Charge of £85”, or “By parking within the car park, motorists agree to comply with the car park regulations”. Mr Beavis argues that the charge of £85 is an unenforceable penal clause.
Ultimately, the Supreme Court was asked to analyze the provisions in these two cases, and determine whether or not they are penalty clauses, and thus unenforceable.
First of all, the Supreme Court rejected the traditional test to determine a penalty clause, and created a new one. The new test is whether the clause 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”.[3] If those requirements are met the clause will be deemed penal, and unenforceable. The clause must impose an “out of all proportion” burden on the contract breaker, which appears to be a more flexible rule. Indeed, the Supreme Court recognized that a party might have a legitimate interest in the enforcement of a contract, which might go beyond the mere recovery of compensation for the breach (traditional enforceable clause). As a result from this new test a clause that goes beyond compensation for the breach may be upheld as long as it is not “out of all proportion.” In other words, a penalty clause might be valid if the penalty it imposes is reasonable.
For example in ParkingEye, the Supreme Court found that the charge of £85 had two purposes: (1) increase the efficiency of the car park by deterring customers to stay for a very long period of time, which would (2) provide a steady income enabling ParkingEye to meet the costs of the operation and profit from its services. The Supreme Court ruled that those objectives were reasonable. ParkingEye had a legitimate interest in the enforcement of the contrat and the means to achieve that interest could not be seen as “out of proportion”. Thus, this clause could not be penal, even though it aims at deterring the customer from breaching the contract by staying over 2 hours on the parking lot.
Secondly, the Supreme Court reaffirmed that the rule only applies where a clause sets a secondary obligation like a remedy for breach or “a contractual alternative to damages”, and should not be extended to provisions taking effect outside of a breach of contract.[4]
Applying this to Makdessi, the Supreme Court found that the provisions were primary obligations and were not a remedy for a breach or a contractual alternative to damages, even though the clauses would only operate after a breach happened. Indeed, the clause depriving Mr Makdessi of his entitlement to defer consideration is only a price adjustment clause. Furthermore, the clause requiring Mr Makdessi to sell his remaining shares at a reduced price in case of breach of contract only reflected the price Cavendish was already willing to pay in the event Cavendish could not count on Mr Makdessi’s loyalty. Thus this clause’s purpose was not to punish Mr Makdessi in case of a breach of contract, it was only to achieve a legitimate interest, such as “Cavendish’s commercial objective in acquiring the business.”
Lastly, the Supreme Court reinforced the importance of looking at the circumstances under which the contract was made, and the nature of the parties to determine whether the penal clause rule applies to the case. For example the Supreme Court states “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.”[5]
Indeed, in Makdessi, the Supreme Court found that “the parties were represented by highly experienced and respected commercial lawyers”, and furthermore, that the parties, who were “sophisticated, successful and experienced commercial people”, were “bargaining on equal terms” and thus were the best judges on how their own commercial interests should be reflected in their agreement. Here the Supreme Court emphasizes the importance of contractual freedom between parties.
In conclusion, the Supreme Court established a new test in determining whether or not a clause is penal, and thus unenforceable. In a nutshell, a penalty clause may be valid as long as the penalty it imposes on a breach is reasonable. This is a good news because the modified test is more flexible than the traditional one, and courts will probably interfere significantly less in contracts between commercial parties of similar bargaining power. Just be aware of the important “reasonableness” requirement. In the future, it will be interesting to see how, in practice, the lower courts apply this new test.
For further information please feel free to contact us (see “Contact us” section), and subscribe to our newsletter. You may also look at the original decision of the Supreme Court: Cavendish Square Holding v. Makdessi, and ParkingEye v. Beavis, 4th November 2015.
> Cavendish Square Holding v. Makdessi, and ParkingEye v. Beavis, 4th November 2015
[1] §4 of Supreme Court judgment of Novembre 4th 2015 Cavendish Square Holding v. Makdessi, and ParkingEye v. Beavis
[2] §47 idem note 1
[3] §32 idem note 1
[4] §13 and §14 idem note 1
[5] §35 idem note 1
[6] Idem note 3