In their recent judgment in Cavendish Square Holding BV v Talal El Makdessi1 the UK Supreme Court has revisited the rule against penalties.
What is understood by the rule against penalties?
The courts have long held that contract clauses intended to penalise a party in breach are penalties and are unenforceable2. The purpose of the law of contract is not to punish wrongdoing but to satisfy the expectations of the party entitled to performance3. Damages for breach of contract are thus intended to compensate the innocent party rather than penalise the party in breach.
Contract clauses making a party in breach liable to pay a sum that is not a genuine pre-estimate of the damages that might be incurred by the innocent party have typically been regarded as penalties.
The facts in Cavendish Square Holding BV v Talal El Makdessi
The case concerned the sale of shares in a company by Mr Makdessi and another (the Sellers) to Cavendish Square Holdings, a company in the WPP group of companies, the world’s largest market communications services group. In addition to the initial price the contract provided for further payments to be made to the Sellers calculated by reference to the operating profit achieved by the company in the years following sale.
Following the sale, Mr Makdessi was found to be in breach of a restrictive covenant prohibiting him from competing with the company. The Buyers accordingly argued the Mr Makdessi was a defaulting Seller and that this triggered provisions in the contract that:
- released the Buyers from any obligation to make the further payments to the Sellers; and
- gave the Buyers an option to purchase all the remaining shares in the company at a specified price.
The issue was whether these provisions were penalties and thus unenforceable.
On the facts of this case the Supreme Court held that these provisions were not penalties. In giving judgment the court extensively reviewed the law regarding penalties and provided useful guidance on the current law regarding penalties.
- The Supreme Court have confirmed that the rule against penalties remains effective.
- The court emphasised that there is a fundamental difference between a jurisdiction to review the fairness of a contractual obligation and a jurisdiction to regulate the remedy for its breach. The penalty rule regulates only the remedies available for breach of a party’s primary obligations, not the primary obligations themselves. The penalty rule does not operate to relieve a party from the consequences of an onerous or an imprudent bargain.
- The rule against penalties applies only in the context of a breach of contract4. It would thus not apply to sums of money due under a contract other than for breach. For example it would not apply to an agreed sum payable to exercise a right to terminate a contract other than for breach.
- A contractual clause is a penalty if it 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”.
It was also stated that, “… the correct test for a penalty is whether the sum or remedy stipulated as a consequence of a breach of contract is exorbitant or unconscionable when regard is had to the innocent party’s interest in the performance of the contract. Where the test is to be applied to a clause fixing the level of damages to be paid on breach, an extravagant disproportion between the stipulated sum and the highest level of damages that could possibly arise from the breach would amount to a penalty and thus be unenforceable. In other circumstances the contractual provision that applies on breach is measured against the interest of the innocent party which is protected by the contract and the court asks whether the remedy is exorbitant or unconscionable.
- Where a clause imposes a payment obligation it is no longer necessary for this to be a genuine pre-estimate of damages. It is sufficient if the obligation is proportionate to legitimate interest of the innocent party.
- The penalty rule applies not only to clauses which seek to set the damages to be paid on breach of contract but also to clauses which set out other consequences of a breach of contract. The rule could apply to clauses that upon breach of contract allow the innocent party to withhold moneys which are otherwise due.
- The penalty rule can apply to clauses that require the contract-breaker to transfer property to the innocent party on breach.
- The penalty rule can also apply to clauses requiring a purchaser to pay a non-refundable deposit that is excessive
1 Cavendish Square Holding BV v Talal El Makdessi and ParkingEye Limited v Beavis  UKSC 67
2 Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd  AC 79,
3 Co-operative Insurance Society Ltd v Argyll Stores (Holdings) Ltd  AC 1, 15.
4 Upholding the earlier House of Lords decision in Export Credits Guarantee Department v Universal Oil Products Co  1 WLR 399, 403