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That Was Never A Penalty!

That Was Never A Penalty!

As a matter of policy, the law does not allow parties to penalise each other for a breach of contract: penalty clauses are unenforceable.  Instead, clauses governing the remedies available as a result of a breach should be remedial i.e. fair compensation.  In recent years, the test frequently applied by the courts to identify penalties was whether or not the level of damages agreed was a “genuine pre-estimate of the loss” which would be suffered by the innocent party as a result of a breach by the other party.  If not, it was an unenforceable penalty.

ParkingEye and Makdessi

The Supreme Court has considered two very different cases regarding potential penalty clauses in a joint appeal in England.

In ParkingEye, a motorist parked in private car park at a retail park for about three hours – one hour more than was allowed by the car park terms and conditions.  He was charged £85 as a result.

Mr Makdessi, a Lebanese businessman, sold a stake in the advertising company which he founded for a potential total sum of about $150M, some of which was deferred.  Mr Makdessi retained non-executive positions within the organisation following the sale, and was not entitled to compete with the business for a period of time.  However, Mr Makdessi admitted having involvement in the affairs of a rival business.  In those circumstances, the share sale agreement provided that Mr Makdessi would receive up to $44M less than if he had not breached the restrictive covenant.

In both cases, it was accepted that the £85 parking fee and potential $44M share price deduction were not “genuine pre-estimates” of the losses which would have been incurred by ParkingEye and Cavendish, the company which acquired Mr Makdessi’s shares.

Decision of the Supreme Court

Seven Supreme Court Justices heard the appeal.  The judges, including one Scottish judge, Lord Hodge, commented that the Scottish and English law in this area was virtually identical, and indeed one of the leading Scottish cases, decided over 100 years ago, had been fundamental to the development of this area of law.  Crucially, the judges concluded that the development of penalty law had been haphazard.  They agreed that the “genuine pre-estimate of loss” test was not helpful and a new test was formulated:

  1. The courts will not review the fairness of the main contract terms, only the secondary terms which deal with what happens when there is a breach of the main terms;
  2. A damages clause will only be justified if it protects some legitimate interest of the innocent party; and
  3. A damages clause will be unenforceable if it is exorbitant.

In Makdessi, the purchaser had a legitimate interest in preserving the goodwill of the business by requiring Mr Makdessi to remain loyal for a certain period of time – particularly given the importance of personal relationships in Middle Eastern business culture.  In ParkingEye, the legitimate interest was parking space maximisation for the benefit of retail park stores and their customers.  It was also held that neither the £85 nor the $44M was exorbitant in the circumstances, and that neither clause was a penalty designed to punish.

Damages clauses arise in all kinds of contracts: default interest on loans; bad leaver clauses in senior employee relationships; late payment fees in trade supply contracts; liquidated damages clauses in outsourcing and IT contracts; etc.

The share price clause in Makdessi explained the legitimate interest being protected, namely the importance of goodwill in the value of the business.  Such explanations may become more common in clauses setting out the remedies for breaches of contract given the second limb of the new test.

This decision limits the scope for challenges to any liquidated damages or other breach clauses unless they are clearly exorbitant.  That is helpful for business certainty as it gives parties comfort that the contractual arrangements they put in place are likely to be upheld by the courts.  The case continues a line of authority that the courts will not come to the rescue of those who make a bad bargain.  It is, therefore, essential that all contract terms are carefully scrutinised and negotiated before agreeing any contract.

The judgment is not technically binding in Scotland but seems certain to be followed by the Scottish courts given the comments and analysis of Lord Hodge.

Stuart Murdoch
Senior Associate

LChalmers