Posted by James Worrall, Partner
Do you have to pay your £85 parking charge, or is it a penalty clause?
If you breach a contract (like overstaying the permitted time in a car park), the test for whether you are bound to pay any charge imposed as a consequence of your breach has historically been whether the charge is a genuine pre-estimate of the loss the other party suffers (a liquidated damages clause) as a result of your breach, or a penalty. Liquidated damages clauses are generally enforceable whereas penalty clauses are not. The Supreme Court has recently shed more light on the issue in two recent cases and introduced a new, “legitimate interest test” for courts to consider when deciding whether a clause is an unenforceable penalty.
A motorist recently made press headlines when he appealed against an £85 parking charge imposed for overstaying the permitted time in a car park. The motorist argued that the £85 was a “penalty clause” and so not enforceable. The case progressed to the Supreme Court by way of a combined appeal with another case on penalty clauses (Cavendish Square Holding BV v El Makdessi and ParkingEye Ltd v Beavis  UKSC 67). In deciding on these appeals, the Supreme Court clarified the law regarding when certain contractual terms are deemed unenforceable penalties.
The principles regarding when a clause is deemed an unenforceable penalty were laid down by the House of Lords a century ago: “The essence of a penalty is a payment of money stipulated as in terrorem of the offending party; the essence of liquidated damages is a genuine covenanted pre-estimate of damage.” In short, the law was that to be enforceable a clause saying that a party has to pay a sum to another party for breach of contract must be a genuine pre-assessment of the loss that the innocent party would suffer in the event of such breach. The sum should not be extravagant or unconscionable in comparison with the greatest loss that could conceivably be proved to have followed from the breach.
In Cavendish, Mr Makdessi and his co-owner had sold off a proportion of their shareholdings in a group of companies (Group) to Cavendish Square Holding BV (Cavendish), making Cavendish the majority shareholder of the Group. Pursuant to the share purchase agreement (SPA), a proportion of the purchase price was payable on an “earn-out” basis, i.e. an interim and final payment were linked to the operating profits of the Group post-completion. The SPA also contained provisions preventing Mr Makdessi from competing with the interests of the Group and stated that if Mr Makdessi breached these non-compete provisions, he would not be entitled to any earn-out payments and he would have to sell to Cavendish the balance of his shares in the Group at a reduced price (based on asset value without reference to goodwill). Mr Makdessi admitted that he had breached the non-compete provisions, but argued that the forfeiture of the earn-out payments and obligation to sell his shares at a reduced price constituted unenforceable penalty clauses.
In ParkingEye, a motorist overstayed a 2 hour maximum stay in a car park by 56 minutes and was issued with a parking charge of £85. The motorist did not pay, claiming (among other things) that the charge was an unenforceable penalty.
The Supreme Court upheld the validity of the clauses in both Cavendish and ParkingEye, stating that: “The true test is whether the impugned provision 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. 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 other words, the important issue is whether a clause is penal, not whether it is a pre-estimate of loss.
In Cavendish, the Court found that the clause under which Mr Makdessi forfeited his earn-out payments when he breached the non-compete restrictions was a price adjustment clause, not a penalty clause. The SPA was negotiated in detail and a significant proportion of the price paid for the shares represented value for the goodwill of the business. The Court held that Mr Makdessi’s compliance with the non-compete was critical to the goodwill of the business and so Cavendish had a genuine interest in Mr Makdessi not breaching the non-compete. The Court further held that the option to acquire Mr Makdessi’s remaining shares triggered by the breach was for genuine commercial reasons rather than by way of compensation for a breach. The test to determine whether a clause is penal is whether the provision is a secondary obligation which imposes a detriment on the offending party out of all proportion with any legitimate interest the innocent party has in the enforcement of the primary obligation.
In ParkingEye, the Court found that the £85 charge was not an unenforceable penalty either. ParkingEye had a legitimate interest in charging a sum which extended beyond the loss suffered, the legitimate interest being that the proper management of the car park was in the interests of the retail outlets, customers and public.
What does this mean for UK businesses?
The introduction of a “legitimate interest” marks a significant clarification of the law surrounding penalty clauses. It is important that the Supreme Court endorsed the presumption that courts should try to respect a negotiated contract between properly advised parties of comparable bargaining power, with a strong initial presumption that the parties themselves are the best judges of what is legitimate in a provision dealing with the consequences of a breach. The assessment to be made is whether a clause is extravagant, out of proportion or unconscionable rather than whether it is a genuine pre-estimate of loss. The concern however, is that working out what is a “legitimate interest” may be challenging as little guidance has been offered. This may be the new area where allegations that clauses amount to penalties are fought. Whatever the circumstances, these cases emphasise the importance of proper legal advice when negotiating contracts to make sure that provisions which apply in the event of a breach have the best chance of being enforceable.
For more information about any of the above, or any other contract matter, please contact James Worrall or another member of our Corporate & Commercial team
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