Construction Law Update - Penalty clauses

Penalty clauses

Two appeals have recently been heard together by the Supreme Court (namely Cavendish Square Holding BV v Talal El Makdessi ("Makdessi") and ParkingEye Limited v Beavis ("ParkingEye")),  both dealing with whether the contractual principles in dispute were penalties. A penalty is a contractual provision which states that a specified sum is payable in the event of a breach; such sum being excessive when compared with the loss or compensation that would fall due to the innocent party in respect of the breach and is thereby unenforceable. Whilst the Makdessi appeal was allowed and the ParkingEye appeal was dismissed, the findings in both cases were that the contractual clauses in question were not penalties and were enforceable.

This decision is important both within the context of the subject matter of the two cases (being business acquisition and commercial charges) but also in a much wider context including construction contracts when it is often argued that clauses within such contracts are penalties and, as a result, unenforceable. Prior to this decision, the test established almost 100 years ago in Dunlop Pneumatic Tyre Co Limited v New Garage and Motor Co Ltd ("Dunlop"), has largely been relied upon to determine whether or not a clause is considered to be a penalty. Those tests were (i) whether the sum to be paid on breach was "extravagant or unconscionable" when compared with the greatest loss that could be incurred, (ii) if the provision provided for a sum of money greater than that required to be paid under the contract, (iii) there would be a presumption that a provision was a penalty if the sum in question was payable in relation to a number of events of varying gravity and (iv) a provision would not be deemed a penalty if it was impossible to pre-estimate the true loss.

This recent decision has clarified that the tests established in Dunlop remains helpful when considering damages clauses in standard contracts but are not easily applied to more complex cases. It therefore sets out the considerations to be taken into account when determining whether a clause is in fact a penalty in more complex contracts.

Makdessi

This case concerned the acquisition of a business as part of which some payments were made on execution of the contract with further payments (totalling some $44 million) to be paid at set points after the contract was entered into. The case did not concern a liquidated damages provision (i.e. an agreed amount in lieu of common law damages) and a claim for damages arising from the breach of contract remained open.

The contract included restrictive covenants on the seller (Makdessi), breach of which would disentitle him to receive those future payments (clause 5.1) and would further require him to sell the remainder of his shares to the buyer at a rate which did not take account of the goodwill transferring with the sale of the business (clause 5.6). Makdessi argued that these clauses were penalties and therefore unenforceable despite acknowledging that he was in breach of the restrictive covenants in the contract.

The purpose of the restrictive covenants was to protect the goodwill of the company being sold and thereby the purchaser's interests in the same. They were effectively non-compete clauses pursuant to which Makdessi agreed not to undertake certain activities in specified locations.

The courts assessed the historic case law on this point at length before reaching the conclusion that these clauses could be enforced by the purchaser. Whilst, of course, every case will turn on its own facts, the court was particularly swayed in this case because:

1. the impact of the breach of the restrictive covenants was linked to the goodwill of the company. Whilst there may be no "loss" caused to the purchaser as a result of Mr Makdessi's breach, the judges agreed that protection of that goodwill was a legitimate business interest in the circumstances and was unconcerned with compensation for the breach;
2. the effect of the restrictive covenants was to protect the legitimate business interests of the purchaser as opposed to seeking to punish Mr Makdessi;
3. the contract in question had been negotiated for six months with both parties having legal representation; and
4. the sum that would not be paid to Mr Makdessi as a result of his breach of contract was not considered to be "extravagant, exorbitant or unconscionable".

ParkingEye

This case involved payment of a fine/parking charge when the motorist in question parked for longer than the two hours free parking. In terms of value, this case was therefore at the opposite end of the scale to Makdessi and concerned the payment of £85.

All three courts (first instance, Court of Appeal and the Supreme Court), had no difficulty finding that (i) there was a contract between Mr Beavis and ParkingEye, (ii) Mr Beavis was entitled to park his car in the car park for two hours free of charge, (iii) if Mr Beavis overstayed in the car park he would be liable to pay £85 (reduced to £50 if paid within 14 days) and (iv) payment of the £85 was not a penalty.

This was notwithstanding the fact that ParkingEye were not the owners of the land and would not incur a loss if motorists stayed in the car park for longer than the stipulated two hours free parking.

As with Makdessi, the court found that ParkingEye had legitimate business interests that went beyond recoverable loss/damages. This was effectively a breach of contract claim. The signs at the car park were clear as to the conditions for using the car park, including that a motorist could park for two hours for free and that parking in excess of that time would incur a charge of £85. By choosing to park there, Mr Beavis had agreed to abide by those contractual terms.

In determining that the charge was not a penalty, the court considered that ParkingEye had legitimate business interests for making that charge including the fact that it was used to manage use of car parking spaces for the retail outlets, would deter commuters from parking there all day and would provide an income stream which allowed ParkingEye to operate the scheme and generate a profit. As a result, whilst the law relating to penalties was engaged, the charge of £85 for overstaying in the car park regardless of how long a motorist overstayed by, was not a penalty.

What is the effect of this decision?

The application of the penalty rule can apply in respect of clauses relating to payments to be withheld, assets to be transferred and payment of money, all arising from a breach of contract. It will therefore be necessary to consider the business interests to be protected by such clauses in the contract in question and assess the purpose of the same; the intention of deterring a party from breaching the contract will not of itself be conclusive on this point.

This judgment has helpfully clarified the law as to the circumstances in which a contractual clause could be deemed a penalty; it is far wider than considering the traditional liquidated damages clauses which have recently tended to focus on whether the stipulated sum is a genuine pre-estimate of the loss likely to be incurred as a result of a breach of contract. Liquidated damages represent a contractually agreed figure that will apply in respect of a specified breach of contract in lieu of common law damages.  However, if the contractual term is question is not a liquidated damages clause, the ability for an innocent party to claim common law damages in addition to contractually agreed sums is not precluded.

In construction contracts, it will remain important for liquidated damages clauses to be carefully considered and for the sums stated to be payable in such clauses to be calculated by reference to the loss likely to be incurred by the Employer in respect of the relevant breach, typically late completion of the Works. However, if for example the contract in question provides for sums to be withheld in the event that a contractor fails to comply with some other term of the contract, the enforceability of such a term will be governed by this decision and will involve a review of the business interests sought to be protected by the operation of the clause in question and whether the effect of such a clause is disproportionate to the protection of those interests. Determination of whether such a clause is to be considered a penalty cannot be established by considering whether the sum to be paid or withheld is a genuine pre-estimate of the loss alone.

In PFI contracts it is often argued that deductions levied under the payment mechanism are penalties and therefore unenforceable. In the PFI context the NHS Trust, School or other public body has far wider interests to protect than simply the financial loss it may incur as a result of not being able to use a room or other area of the public building. It is now clear that the protection of those legitimate interests can form part of an assessment of the deductions to be levied in the event that they are challenged as a penalty by the private sector company.