Fair is foul and foul is fair?

On 4 November the Supreme Court handed down its judgments in the conjoined cases of Cavendish Square v Makdessi and ParkingEye Limited v Beavis [2015] UKSC 67. A seven-strong Supreme Court panel had heard the conjoined appeals in July.

The case has received significant press attention since its inception. This is because the appellant in ParkingEye, Barry Beavis, a 47-year-old chip shop owner who disputed an £85 parking fine, had relentlessly driven his principled stand all the way to the Supreme Court. His battle with a private parking company had been played out in the High Court, the Court of Appeal, and across the pages of the national newspapers. Beavis attracted the strong support of Which?, the consumer rights pressure group that ultimately joined the case as an intervener.

Beavis' fight was not the only matter of principle at stake in the Supreme Court, however. The legal argument before their lordships was wholly concerned with the penalty doctrine. This is a long-standing and much debated common law principle that, in summary, can be applied to render a clause in a contract unenforceable if it imposes an unfair penalty on a party that has breached that contract. It was argued on behalf of Beavis that his parking fine was such a penalty.

In Cavendish, the defendant had agreed to sell to Cavendish a controlling stake of a Middle Eastern communications company. The contract provided that if the defendant breached certain restrictive covenants, he would not be entitled to receive the final two instalments of the purchase price, and could be required to sell the remainder of his stake to Cavendish at a reduced price. The defendant argued that those provisions of the contract were unenforceable penalty clauses.

The Supreme Court took the chance to consider the entire basis of the penalty doctrine, considering in turn whether it should be maintained, extended or abolished. Their lordships' judgments have far-reaching implications for businesses and their legal advisers as the status of liquidated damages clauses, which are commonplace in commercial contracts, will be affected by reforms to the doctrine.

Controversial doctrine

The doctrine has been controversial since its emergence at the beginning of the 19th century. This is because it allows parties to escape from bargains they freely entered into, and accordingly presents a challenge to the all-embracing principle of freedom of contract. Lords Neuberger and Sumption, at paragraph 3 of their joint judgment, described the rule as '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 or extended'.

Rejecting the former option, the court unanimously decided that the penalty doctrine should be neither abolished nor restricted. They noted the continued existence of the doctrine was justified by:

a) Its status as a tried and well established rule in the law of England and Wales;

b) Its broad adoption and endorsement by other common law jurisdictions, such as Australia and Scotland;

c) Its consistency with other established principles of the law of England and Wales that protect contracting parties; and

d) The fact that the Law Commission had considered the doctrine but not recommended its removal.

Defining 'penalty'

The Supreme Court, did, however, squarely address the previously contentious and confused issue of the definition of a 'penalty'. The modern case law has been heavily influenced by Lord Dunedin's speech in Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd [1915] AC 79. Lords Neuberger and Sumption noted at [22] that this case had 'achieved the status of a quasi-statutory code'.

In his judgment, Lord Dunedin set out four tests that, he argued, 'may prove helpful, or even conclusive' in deciding whether a particular clause amounted to an unenforceable penalty. They were:

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 loss.

In the present case, Lords Neuberger and Sumption (with whom all the other Lords agreed on this point) emphatically stated, at paragraph 31, that 'in our opinion the law relating to penalties has become the prisoner of artificial categorisation, itself the result of unsatisfactory distinctions: between a penalty and a genuine pre-estimate of loss, and between a genuine pre-estimate of loss and 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'.

Lord Neuberger and Lord Sumption then sought to sweep away a century of confusion by laying down a new test for determining in each case whether a particular clause was an unenforceable penalty. The test is set out at paragraph 32 and is as follows: A clause will be an unenforceable 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'.

Lord Mance specifically approved the new test, while Lord Carnwarth simply endorsed their judgment in its entirety.

Lord Hodge, however, offered a slightly different test. He stated, at [225] that 'the correct test for a penalty is whether the sum or remedy stipulated as a consequence of the breach of contract is exorbitant or unconscionable when regard is had to the innocent party's interest in the performance of the contract'. Lord Toulson endorsed Lord Hodge's test.

It is not yet clear how great the practical distinction - if any - is between the two tests, although it could be argued that Lord Hodge's test leans further in favour of finding clauses to be an unenforceable penalty than Lord Neuberger and Lord Sumption's, in which the bar appears to be set higher. Nevertheless there is a clear majority in favour of Lord Neuberger and Lord Sumption's test, and it can be said with relative certainty that it will be the formulation that is applied going forward.

Applying the test

That will only take matters so far, however. Lord Neuberger and Lord Sumption's judgement is not as clear on how their test should be applied by lower court judges on a day-to-day basis. Helpfully, Lord Mance did offer some practical guidance on how the courts should approach the test, noting, at paragraph 152 that 'the first step is to consider whether any (and if so what) legitimate business interest is served and protected by the clause, and if so and secondly, whether the provision made for that interest is extravagant, exorbitant or unconscionable'. Clearly, as before, much will depend on the specific facts of each case.

It should be noted that in both cases, on the substantive appeals, the clauses that had been challenged were upheld by the majority of the Supreme Court, with only Lord Toulson dissenting in ParkingEye. In Cavendish, the court unanimously decided that the penalty doctrine was not engaged as the disputed clauses imposed primary, not secondary, obligations.

In Parking Eye, the majority decided that the £85 charge was not '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' or, following Lord Hodge's test, 'extravagant, exorbitant or unconscionable'. As a result, Beavis has to pay his £85 fine.

In short, the seven-strong Supreme Court has emphatically endorsed the penalty doctrine. They have also taken the opportunity to clarify the law and to give directions on how the doctrine is to be applied in future. It is to be regretted that their lordships did not settle on a single test, and did not offer substantial guidance to judges in the courts below on its practical, day-to-day application.

For now, therefore, much uncertainty remains for businesses and their legal advisers. It will take decisions at a lower level to address that uncertainty. Whatever the result of those decisions, businesses now need to revisit the liquidated damages clauses in the contracts following this Supreme Court's decision.

Theo Barclay is a barrister practising from Hailsham Chambers @Hailsham_Chamb