Supreme Court Judgment: Cavendish Square Holding BV v Talal El Makdessi and ParkingEye Ltd v Beavis [2015]

In Cavendish Square Holding BV v Talal El Makdessi and ParkingEye Ltd v Beavis [2015], the Supreme Court considered a combined appeal as to whether certain contractual clauses which imposed a sanction, were unenforceable due to them being penalty clauses.

Background

The 1914 case of Dunlop Pneumatic Tyre Co set the rule that penalty clauses in contracts in England and Wales would unenforceable. The court found that if a requirement to pay a sum of money on breach of contract was extravagant and unconscionable, in comparison to the amount of loss that could conceivably be suffered by the innocent party, the clause would be an unenforceable penalty. The court did however make clear that if the requirement to pay a sum of money was a ‘genuine pre-estimate of loss’ it would be enforceable as a liquidated damages.

Whilst the case of Dunlop did provide a definition as to what would constitute a penalty clause, over the years confusion has developed as to how one can identify a penalty clause in a contract.

The joint Supreme Court judgment in Cavendish and ParkingEye has provided some clarity on the law on penalty clauses and provided an updated rule on how parties can identify if a clause is an unenforceable penalty clause. This article will focus on the facts and outcome of Cavendish.

In Cavendish, Mr Makdessi agreed to sell to Mr Cavendish a controlling stake in what was to become the largest advertising group in the Middle East. The SPA contained two clauses which stated that if Mr Makdessi was to breach the restrictive covenants set out, he would forfeit the final two instalments of the deferred consideration payable by Mr Cavendish (Clause 5.1) and he would be required to transfer all his remaining shares to Mr Cavendish, at a price which did not take into consideration the value of goodwill attached to them (Clause 5.6). Mr Makdessi argued that these two clauses were penalty clauses and thus unenforceable, and the Court of Appeal, overturning the trial judge’s conclusion, agreed.

In coming to their decision, the Supreme Court considered the following:

  1. Whether the rule against penalties applies to commercial contracts negotiated between sophisticated parties;
  2. If the rule does apply to such contracts, whether the clauses are within the scope of the rule on penalty clauses; and
  3. If the clauses are within the scope of the rule against penalties, whether the Court of Appeal was wrong to conclude they were penal and therefore unenforceable.

Supreme Court decision

Whilst the law of penalties was described as ‘an ancient, haphazardly constructed edifice,’ Lords Neuberger, Sumption, Clarke and Carnwath declined to extend the law or abolish it, but instead reset and clarified the test required to establish if a clause was an unenforceable penalty.

The updated and clarified test is intended to suit more modern commercial contracts and states that a sanction will be considered a penalty clause if it imposes a secondary obligation on the party in breach, which in turn imposes a detriment on the party in breach, which is out of all proportion to any legitimate interest of the innocent party, in seeking to enforce the primary obligation of the contract.

Additionally, Lords Neuberger and Sumption stated that in negotiated contracts between sophisticated parties of equal bargaining power, the strong initial presumption of the courts should be that the parties themselves are the best judges as to what is a legitimate provision for dealing with the consequences of a breach.

In Cavendish, it was found that the two clauses in question were not penalty clauses. Clause 5.1 was a price adjustment clause which formed part of Mr Makdessi’s primary obligation under the contract – namely if he breached the restrictive covenants, the price would be adjusted. Additionally, Mr Cavendish had a legitimate interest in the observance of the restrictive covenants by Mr Makdessi, as his loyalty was essential for preserving the goodwill of the company. Clause 5.6 was construed in a similar way and was thus not an unenforceable penalty clause.

Analysis

Whilst the judgment is a welcome clarification on the law of penalties, it has not removed all the confusion which surrounds penalty clauses. There is no clear definition as to what a ‘legitimate interest’ is or what is ‘out of all proportion’ to that legitimate interest and it is therefore likely that confusion will arise around this. It is important for businesses (and their legal advisers) to look carefully at the commercial context of the contract and ensure that if there is to be a sanction for breach, that the sanction is clearly constructed so that it forms part of the primary obligation of the contract.

Whilst there have been changes to the rule on penalty clauses, the courts will still look at whether the sanction is beyond the norm and therefore potentially extravagant, however consideration will now also be given as to what is the current industry norm for similar contracts.

This article was written by Jessica Nugent, Partner, Corporate department with assistance from Caroline Mathews, trainee solicitor.

This guide is for general information and interest only and should not be relied upon as providing specific legal advice.  If you require any further information about the issues raised in this article please contact the author or call 0207 404 0606 and ask to speak to your usual Goodman Derrick contact.