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Commercial Contracts: Supreme Court rules on Penalty Clauses

Commercial Contracts: Supreme Court rules on Penalty Clauses
Tuesday 1st December 2015

The Supreme Court recently considered the combined appeal of Cavendish Holding BV v. Talal El Makdessi and ParkingEye Ltd v. Beavis [2015] UKSC 67. The combined appeal examined whether specific contractual clauses were “penalties” and therefore unenforceable.

Traditionally, contracting parties have been free to agree that a specific sum of money will be paid by one party to the other in the event of a breach of contract. Generally, the courts held that if the amount payable under such a clause was a genuine “pre-estimate” of the damage suffered as a result of the breach, the clause would be valid and enforceable. However, if the amount payable was considered to be punitive in nature then the clause would be unenforceable, for example, if the amount to be paid was excessive.

In simplistic terms, the enforceability of a clause was decided by assessing whether the amount payable under the clause exceeded the loss resulting from the breach. If it did, the clause would more than likely be considered to be “punitive” and therefore unenforceable.

The Supreme Court has now rejected this traditional approach, describing it as “ancient” and “haphazard” in the recent combined appeal. The traditional approach has not been abolished however; it has simply been reconstructed and clarified.

Now, the key consideration is whether the clause relating to payment following a breach imposes “a detriment on the contract-breaker out of all proportion to any legitimate interest of the innocent party”. The rationale for this is that the innocent party can have “no proper interest in simply punishing the defaulter”. Therefore, it is likely that the amount payable under a clause taking effect on breach can exceed the amount lost if the innocent party has a legitimate interest in charging that amount and such a figure is proportionate to that interest.

The facts of ParkingEye Ltd v. Beavis (one of the two cases forming the combined appeal) perhaps demonstrate the new approach most clearly. In that case, fining an individual £85 for overstaying a free 2 hour car parking limit was enforceable and was not considered to be a penalty clause.

The decision in ParkingEye was arrived at even though ParkingEye (the manager of the car park) suffered no direct loss as a result of any motorist who overstayed the 2 hour car parking limit. This was because the court considered that ParkingEye had a legitimate interest in ensuring that it managed the car park in the interests of the local retail outlets and the public, and did so by preventing motorists from occupying parking spaces for prolonged periods. The court also recognised that ParkingEye could not meet the costs of operating the car park in the manner it did without receiving income from parking fines. As such, imposing a fine of £85 to those individuals who overstayed the 2 hour free parking period was reasonable in the context of its legitimate aims of managing the car park effectively and covering its costs.

The decision of the combined appeals is likely to be well-received. It provides a clearer and more modern approach in considering the enforceability of clauses operating on breach and potentially caters for an element of deterrence beyond mere compensation. However, as there is no exact definition of what is a “legitimate interest” and whether such an interest will be considered as “proportionate”, there is arguably more scope for contracting parties to challenge the enforceability of such clauses.