It’s a penalty ref!

A bad tackle, a deliberate handball, or even a sly tug of the shirt; everybody knows a penalty when they see one. Don’t they?

For over 100 years the law on contractual penalties has been built upon a central principle. Dunlop Pneumatic Tyre Company Ltd v New Garage & Motor Company Limited established that where a contract has been breached, a clause providing for the payment of money is a penalty, and unenforceable, if it does not represent a genuine attempt to pre-estimate the loss incurred. Traditionally, this meant a Judge’s decision on whether a clause was a penalty hinged on whether the function of the clause was compensatory (and enforceable), or to serve as a deterrent (an unenforceable penalty).

However, the goalposts have been moved. Cavendish v Makdessi looks to have superseded Dunlop as the leading authority on penalties. This will have ramifications for those parties and their advisors involved in negotiating commercial contracts, including those in the construction industry.

Cavendish v Makdessi

This case saw a clash of marketing giants. Cavendish is a holding group within the WPP group, the world’s leading marketing communications services group, headed by British business mogul Sir Martin Sorrell. Mr Makdessi founded a group of companies that became the largest advertising, marketing and PR group in the Middle East.

In 2008, Mr Makdessi and his co-owner, who were majority shareholders of their group of companies, decided to sell Cavendish a significant proportion of their shares. The price for the shares was to be paid to the sellers by way of stage payments over an agreed period of time. However, Mr Makdessi would not be entitled to the further payments due to him if he carried out activities which had the potential to compete with the interests of the Cavendish Group. If he did this then, under another clause, Mr Makdessi could be required to sell to Cavendish the remainder of his shares in the Group at default price.

Before the first trial, Mr Makdessi admitted that he had breached the agreement. However, Mr Makdessi argued that both the provision allowing the innocent party to withhold money that would otherwise be due to him, and the provision requiring him to sell his shares at default price, were unenforceable penalty clauses.

Cavendish was successful at first instance, however this decision was overturned by the Court of Appeal in favour of Mr Makdessi. Lord Justice Clark concluded that although both clauses had been designed with a legitimate commercial purpose in mind, the first of adjusting payment, and the second of allowing the parties to separate cleanly in the event of a breach, each clause was extravagant and unconscionable.

ParkingEye Ltd v Barry Beavis

Shortly before the hearing, the Supreme Court attached another case to Cavendish, one which had captured the national media’s attention.

Mr Beavis, the owner of the Happy Haddock fish-and-chip shop in Billericay, challenged a parking ticket received in a car park managed by ParkingEye, the largest supplier of Automatic Number Plate Recognition systems in the UK. Here the potential penalty consisted of charge imposed on those overstaying the “2 hour max stay”, which was displayed on signs around the car park. After staying for 2 hours and 56 minutes, Mr Beavis exited the carpark with an £85 charge. Mr Beavis’ case received widespread popular support, and his court costs were met by donations on a crowd-funding website.

Both the court at first instance and the Court of Appeal agreed that this was not a penalty. They felt that while the £85 charge was intended to serve as a deterrent, it was a legitimate charge for ParkingEye to make because they needed to discourage overstaying, in order to maintain a high turnover of parking within their carpark.

While the sum at stake in this case may have been modest, this and the Cavendish case had one important thing in common; the purpose of the relevant clauses was not to compensate for the breach.

Impact

The law on penalties has changed dramatically. The decision in the Dunlop case has long been interpreted on the basis that a clause is either a genuine pre-estimate of damages or it is serving as a deterrent. While their Lordships stopped short of abolishing the penalty rule, they acknowledged that it was an “ancient, haphazardly constructed edifice which has not weathered well”.

Their Lordships ruled that in anything but the simplest contracts, the current penalty rule, and the concepts of ‘deterrence’ versus ‘genuine pre-estimate of loss’ are unhelpful. They accepted that a clause operating on breach that was not pre-estimating loss, and appeared to serve as a deterrent, could be justified.

The true test is now as follows:

  • Firstly, it is necessary to establish whether the particular clause gives rise to a primary or secondary obligation. (A primary obligation being one which is related to achieving the commercial objectives of the parties; a secondary obligation being one that seeks to punish for breach of a primary obligation);
  • Secondly, if the clause is a secondary obligation, is the detriment which it seeks to impose on the contract breaker out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation? This has been termed the ‘commercial justification test’.

The Supreme Court held by a majority that the provisions in Cavendish were primary obligations and so the penalty rule had not been engaged. The clauses had the legitimate function of protecting the goodwill of Cavendish when acquiring the other businesses, rather than to punish Mr Makdessi. In deciding this the Courts were able to consider the wider commercial context of the transaction, specifically that it had been negotiated between properly advised parties of comparable bargaining power.

On that basis, the parties themselves were felt to be the best judges of what constituted a legitimate provision.

Conversely in Parkingeye, the Court held that whilst the penalty rule had been engaged, the charge was not a penalty. Whilst the £85 charge was undoubtedly a deterrent, it was held to be within the legitimate commercial interests of the car park operators. Here the effect of the clause was held to be proportionate.

The effect of these decisions is that judges have greater freedom to depart from the more prescriptive approach in Dunlop if the circumstances require.

So where does this leave us?

This decision still leaves some key areas of uncertainty. Firstly we’re left with the potentially artificial distinction between primary and secondary obligations, and secondly, it may be difficult to distinguish between a legitimate commercial justification and a deterrent that is “out of all proportion” to that legitimate interest.

What is clear, is that provisions in a contract seeking to impose payments/deductions on a contract breaker must be drafted with caution if courts are to enforce them.

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Cannings ConnollyCannings Connolly
10 October 2016

Disclaimer:
This Legal Update is published as a general guide only and it is not intended to contain definitive legal or professional advice, which should be obtained as appropriate in relation to any particular matter. This publication relates to matters prevailing at the date of its original publication and may not have been updated to reflect subsequent developments.

For further information or advice on the matters addressed in this Legal Update or any other related matters please contact: Tim Barwick on 020 7003 8104 or email tbarwick@cclaw.co.uk