Penalty Clauses: What is left? Jonathan Owen

Penalty Clauses: What is left? Jonathan Owen

The history of the issue 1. Every undergraduate law student has had to grapple with the common law rule against penalty clauses in contracts, in the sense of contractual clauses whereby one party would be entitled to recover a sum of money in respect of a breach of contract committed by a defendant which bears little or no relationship to the loss actually suffered by the plaintiff as a result of the breach by the defendant (Export Credits Guarantee Department -v- Universal Oil Products Co [1983]1 WLR 399, per Lord Roskill at p. 403). 2. The rule against penalty clauses represents a tension in the law. 3. On the one hand the common law of England and Wales has through its rules rarely sought to judge or police the fairness or prudence of bargains and has generally taken the view (as explained by Lord Roskill further on in the passage referred to above) that it is not and never has been for the courts to relieve a party from the consequences of what may in the event prove to be an onerous or possibly even a commercially imprudent bargain. This is essentially a reflection of respect for the parties freedom to contract as they wish, with the enforcement of bargains, freely entered into, offering certainty, which is one of the attractions of the law of England and Wales which has led to it being chosen as the law for many international contract, as well as simply contracts entered into, or relating to, that jurisdiction. 4. On the other hand, however, simple freedom to contract as parties wish can lead to abuse of one party by the other, with such parties not always being in an equal bargaining position. Rarely do people enter into contracts thinking that they will break them, and yet events sometimes make breach inevitable. Should the Court lend itself, in the name of certainty and freedom of contract, to the enforcement of bargains which provide for sums to be paid by a party breaching a contract which are extravagant and unconscionable in amount in comparison with the greatest loss that could conceivably be proved to have followed from the breach (per Lord Dunedin in Dunlop Pneumatic Tyre Co Limited -v- New Garage & Motor Co Limited [1915] AC 79 Dunlop - at p. 87)? 5. How and if a legal system deals with penalty clauses inevitably represents a policy choice or balance between competing interests, all of which are on their own are rationally defensible. 6. The common law of England and Wales began to control penalties in the 17 th Century as Lord Neuberger of Abbotsbury PSC and Lord Sumption SCJ explained in their opinion in Cavendish Square Holding BV -v- Makdessi [2015] 3 WLR 1373 ( Makdessi ). That control originated in the concern of the courts to prevent exploitation in an age when credit was scarce and borrowers were particularly vulnerable (paragraph 34 of Makdessi per Lord Neuberger of Abbotsbury PSC and Lord Sumption SCJ). 7. Freedom to contract is now restricted by extensive consumer protection regulations, none of which existed when the common law originally sought to control penalty clauses. The common law rule against penalty 2/5

clauses, however, continues to be of interest not merely to law students but to legal representatives involved in breach of contract cases. The previous classic formulation of the penalty clauses rule 8. As explained by Lord Neuberger of Abbotsbury PSC and Lord Sumption SCJ at paragraphs 21 and 22 of Makdessi Lord Dunedin formulated in his speech in Dunlop four tests which achieved the status of a quasi-statutory code in the subsequent case law. Those tests were as follows:- (a) that the provision would be penal if the sum stipulated for is extravagant and unconscionable in amount in comparison with the greatest loss that could conceivably be proved to have followed from the breach ; (b) that the provision would be penal if the breach consisted only in the non-payment of money and it provided for the payment of a larger sum; (c) that there was a presumption (but no more) that it would be penal if it was payable in a number of events of varying gravity; and (d) that it would not be treated as penal by reason only of the impossibility of precisely pre-estimating the true loss. The modern formulation of the penalty clauses rule - Makdessi 9. In Makdessi the Supreme Court had to consider directly whether the common law rule against penalties should be abolished and, if not, whether it should be extended and how it should be restated. 10. The Supreme Court determined that the rule should not be abolished by judicial decision. It was longstanding in the law of England and Wales and a comparable rule exists in many other legal jurisdictions. Further, although many contracts are regulated by statutory schemes, not all contracts are. There was a legitimate place for it. 11. Similarly, the Supreme Court did not consider that judges, rather than the legislature, should extend the rule against penalty clause. The extension of the penalty clauses rule would represent the expansion of the courts' supervisory jurisdiction into a new territory of uncertain boundaries, which has hitherto been treated as wholly governed by mutual agreement (paragraph 42 per Lord Neuberger of Abbotsbury PSC and Lord Sumption SCJ). 12. Although the Court considered that there anomalies and difficulties with the rule, the Court considered that best solution was to restate and clarify the rule, focussing on the purpose of the rule:- many, though not all of these [problems with the rule] are better addressed (i) by a realistic appraisal of the substance of contractual provisions operating on breach, and (ii) by taking a more principled approach to the interests that may properly be protected by the terms of the parties' agreement (paragraph 39, per Lord Neuberger of Abbotsbury PSC and Lord Sumption SCJ). 3/5

13. The rule was re-stated as follows in paragraph 32, per Lord Neuberger of Abbotsbury PSC and Lord Sumption SCJ:- 32 The true test is whether the impugned provision 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. The innocent party can have no proper interest in simply punishing the defaulter. His interest is in performance or in some appropriate alternative to performance. In the case of a straightforward damages clause, that interest will rarely extend beyond compensation for the breach, and we therefore expect that Lord Dunedin's four tests would usually be perfectly adequate to determine its validity. But compensation is not necessarily the only legitimate interest that the innocent party may have in the performance of the defaulter's primary obligations 14. No longer will it be enough to focus on whether a clause represents a genuine pre-estimate of loss [or] a deterrent. These distinctions originate in an over-literal reading of Lord Dunedin's four tests and a tendency to treat them as almost immutable rules of general application which exhaust the field. The effect of the reformulation of the rule 15. The reformulation of the rule against penalties in Makdessi will redefine understanding of this area of law and will require a much more nuanced and fact-sensitive approach to judging whether a contractual clause is penal in nature. 16. It will require the Court to assess what, if any, legitimate interest the clause seeks to protect and whether the means employed to protect that interest in the clause are out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation. 17. On the one hand these are more open-textured and less certain concepts than the quasi-statutory scheme embodied by Lord Dunedin s tests in Dunlop. That superficially leads to greater uncertainty. On the other hand, however, this reformulation is likely to lead to the enforcement and upholding of what might once have been categorised as penalty clauses in greater numbers in future cases. That is because clauses will not now be unenforceable simply for offending against formal rules. Instead, the Court will focus on the substance of the contractual provision, what it seeks to achieve and whether it goes too far. Provided that a clause is not exploitative, opportunistic and can be defended as being legitimate and proportionate the Court will enforce the parties bargain. 18. This is illustrated by the application of the re-stated legal principles to the cases in issue in Makdessi itself. The first concerned a commercial contract and a clause which disentitled a defaulting shareholder from receiving money which would otherwise have been due to him as his proportion of the price of the 4/5

transferred shares. The Supreme Court looked at the substance of the provision. The negative effect for the defaulting shareholder bore no relationship, even approximate, with the measure of loss attributable to the breach, but, in substance it was a price adjustment clause and there was a legitimate interest in the observance of the restrictive covenants which extended beyond the recovery of that loss. The clause was upheld. It would have been otherwise had the clause been a disguised punishment for the sellers' breach. 19. The second case concerned a penalty charge incurred by a consumer parking in a private car park who over-stayed the allotted time. The 85 charge was not a genuine pre-estimate of the loss caused by a person over-staying. The rule against penalties was engaged, but it was not a penalty. The Court found that that there was a legitimate interest in the contractual scheme regulating use of the car park and that there was no reason to suppose that 85 was out of all proportion to the legitimate interest. This was so even though the charge applied no differently if someone over-stayed by 1 minute or 4 hours. The future 20. The future of penalty clauses will be less simplistic, both for those drafting such clauses and those considering such clauses after the event. The law will no longer be concerned with the mechanistic application of formalistic rules in judging whether a penalty clause is enforceable. Instead what will be required is consideration of whether there is a legitimate interest being protected by the clause, and, if so, whether or not proportionate means are being employed. Whilst the Court will still not lend its aid to enforcing disguised punishments out of all proportion to the losses incurred, this broader approach, looking more at the substance of the matter, does open up the door to the drafting and enforcement of clauses which would once have been considered to be penal in nature, as long as they are legitimate in the aims that they protect and proportionate in the means that they deploy. Jonathan Owen September 2016 Disclaimer: The information and any commentary on the law contained in this article is provided free of charge for information purposes only. The opinions expressed are those of the writer(s) and do not necessarily represent the view of Ropewalk Chambers as a whole. Every reasonable effort is made to make the information and commentary accurate and up to date, but no responsibility for its accuracy and correctness, or for any consequences of relying on it, is assumed by the writer(s) or by Ropewalk Chambers. The information and commentary does not, and is not intended to, amount to legal advice to any person on a specific case or matter. You are expressly advised to obtain specific, personal advice from a lawyer about your case or matter and not to rely on the information or comment contained within this article. 5/5