"Penalty, Ref...." The Supreme Court allows some leeway…..

When can you penalise default? A developed system of law must control the imposition of disproportionate sanctions.

 

  • “If you breathe a word, I will have to kill you…”
  •  “If you step across this line, your entire worldly goods will be forfeit…”
  •  “If you breach this contract, you will pay me a million pounds…”

Freedom of contract has a limit. Where is it?

Before the recent Supreme Court decisions in ParkingEye v. Beavis and Cavendish Square v. El Makdessi, the determination in contract cases was made on the basis of the rule against penalties: a sanction had to be a genuine pre-estimate of loss: if it could be interpreted as “penal” or intended to terrorize the defaulter into compliance, it was invalid.

The penalty rule was said by Lord Neuberger and Sumption to be: “an ancient, haphazardly constructed edifice which has not weathered well, and which in the opinion of some should simply be demolished, and in the opinion of others, should be reconstructed and extended”.

These cases were the Supreme Court’s attempt at reconstruction.

The true test (as in other fields of law, notably costs) has now been said to be one of proportionality: is the detriment imposed on a contract breaker out of all proportion to any legitimate interest of the innocent party? Is there an “extravagant disproportion” between the stipulated, and the highest level of damages that could possibly arise?

Further, to be subject to the test at all, the clause needs to be a secondary obligation arising from a breach, not a primary obligation specifically agreed as part of the expected performance.

Applying these principles to the ParkingEye case, the Supreme Court found that a penalty of £85 applied in the Riverside Retail Park in Chelmsford was legitimate and properly chargeable. It was not a genuine pre-estimate of loss but it did protect the landowners’ legitimate interest in controlling the efficient use of their space. It was not disproportionate. It was an “understandable ingredient of a scheme serving legitimate interests”.

There was one dissenter out of seven Supreme Court judges: Lord Toulson took the view that in a consumer context, the penalty did not comply with the Unfair Terms in Consumer Contracts Regulations 1999. It was not reasonable to assume that Mr Beavis would have agreed to the charge in individual negotiations.

The Cavendish Square case was a commercial contract involving a sale of a business and breach of restrictive covenants. The sanction for breach involving forfeiture of consideration and forced sale of retained shares at a low price were held to be perfectly proper.

In summary, assuming a charge can properly be described as a penalty, it will be invalid only if it is “exorbitant.” However, from there, it is very much a matter of individual judgment in a particular case and, at present, only one Supreme Court judge out of seven would invalidate a particular clause.

Each case has to be assessed on its merits: in what context would £850 be exorbitant and when might £8,500 be reasonable. Ultimately it is a value judgement.

Contracts involving death, sacrifice of first born and forfeiture of all worldly goods would ultimately be governed by public policy, even if they involved primary obligations not engaging the penalties rule (i.e. the first two examples given above).

The main conclusion to draw from these cases is that there is a presumption of validity for commercial contracts negotiated in good faith and “take it or leave it” consumer engagements. There is increased scope for uncertainty and judicial discretion.

There can be no automatic response of “Ref, penalty!”