20 Nov 2015

Penalty clauses: the Supreme Court redefines the test

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In a combined judgment in Cavendish Square Holding BV v El Makdessi and ParkingEye Ltd v Beavis [2015] UKSC 67, the Supreme Court has reviewed and redefined the test for determining whether a clause which pre-determines the consequences of a breach of contract is a penalty and therefore unenforceable.

The cases contained very different facts. In Makdessi the Court had to determine whether two clauses in a share purchase agreement which had the effect of depriving the seller of £44 million, amounted to unenforceable penalties. In ParkingEye Ltd, the issue was whether a parking fine of £85 for overstaying was a penalty. Although ParkingEye Ltd has attracted more attention in the press, the decision in Makdessi bears greater relevance to commercial agreements, particularly between parties of equal bargaining power and represented by experienced legal advisers.

The traditional approach for determining whether a clause is a penalty was to ask whether the clause represented a genuine pre-estimate of loss, and therefore compensatory, or a disproportionate deterrent flowing from the breach, and therefore penal. The Court thought that such terms were unhelpful and criticised the dichotomy between “genuine pre-estimates of loss” and “penalties”.

The true test, found in the leading judgment, is to ask whether the clause is a secondary obligation (e.g. an obligation to pay a specified sum following a breach of contract) which imposes a detriment that is out of all proportion to the innocent party’s legitimate interest in enforcing the contract.

The judgment confirms when the rule is engaged and in what circumstances the clause will be held unenforceable. By placing greater emphasis on the parties’ legitimate interests and punishment, the test is a better reflection of modern commercial agreements, which often contain clauses that provide for consequences following a breach of contract.

What are the implications for employers?

The penalty rule has most application to clauses seeking forfeiture, payment or repayment of sums/benefits awarded to (ex-) employees that are triggered by the (ex-) employee’s breach. The key questions for (ex-) employers seeking to enforce such clauses following Makdessi, are:

  1. Has there been a breach of contract?
     
  2. If yes, does the contract provide for specific consequences flowing from the breach, e.g. repayment of compensation monies.
     
  3. If so, what is the legitimate interest that the (ex-) employer is seeking to protect (other than punishing the (ex-) employee for the breach)?
     
  4. Are the consequences for the (ex-) employee out of all proportion to that legitimate interest?

Employers will need to draft such clauses carefully to avoid the penalty rule.

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