Certain phrases in contracts are reassuringly familiar to English commercial lawyers, however weird they may appear to clients. One of these concerns what are known as ‘liquidated damages clauses’. Typically, the clause will say something along the following lines:
If the Supplier is late in delivering the Goods, it will pay the Buyer liquidated damages of 1% of the Price for each week of delay. The Parties acknowledge this is a genuine pre-estimate of the loss that the Buyer will suffer from late delivery, and is not a penalty.
By explicitly agreeing that the payment obligation is a ‘genuine pre-estimate of loss’, drafters have hoped to persuade the court (in a future dispute) that it is a liquidated damages clause and not a penalty. It has long been thought that the former are enforceable under English law, but the latter are not.
IP Draughts considers this form of words to be largely pointless and self-serving, but that it does no harm. What should matter to the court is the substance, and not the label. An interesting, if irritating, variant appeared in a publishing agreement that a publisher recently asked IP Draughts to sign:
In the event that the Publisher wishes to cancel or terminate this Agreement prior to the delivery of an acceptable manuscript or the publication of the Work without due cause, then the Publisher’s total liability to the Author shall be capped at £100 (one hundred pounds), such payment being made by the Publisher by way of liquidated damages. The parties confirm that these sums represent a genuine pre-estimate of the loss that the Author would suffer in the event that the Publisher terminated or cancelled this Agreement.
This clause is fundamentally misconceived, in that it is an attempt to limit liability masquerading as a liquidated damages clause. Thankfully, the editor at IP Draughts’ publisher has agreed to go back to the wording of the agreement used for the previous edition of the same work, which didn’t include this kind of lawyers’ nonsense.
The general assumption, that under English law penalties are unenforceable but liquidated damages clauses are enforceable, goes back at least 100 years. One of the leading cases on this subject was a House of Lords decision, Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd  AC 79. In that case, Lord Dunedin proposed 4 tests for whether a payment obligation was a penalty. One of those tests used the phrase ‘genuine pre-estimate of damage’, and this phrase seems to have been picked up by the courts in subsequent cases.
Last week the UK Supreme Court issued its decisions in two combined cases on the subject of penalties. The judgments and an abbreviated ‘press release’ can be found here. In effect, this is the first time that the Supreme Court (formerly the House of Lords) has looked in detail at this subject
in a century. The second of the two cases (Parking Eye Limited v Beavis) concerned the owner of a fish-and-chip shop, who refused to pay an £85 penalty charge for staying in a free, short-term car park connected to a shopping mall for more than the permitted 2 hours. Their lordships’ decision in this case, that the charge was enforceable, was reported in most of the national newspapers earlier this week.
The first of the two joined cases (Cavendish Square Holdings BV v Talal el Makdessi) was a large commercial dispute in respect of a contract to sell a majority shareholding in a major advertising agency in the Middle East. The contract included stage payments, and non-compete obligations on the sellers. If the sellers breached the non-compete obligations, there would be two consequences: (1) later stage payments would not become due, and (2) the sellers would have to sell their remaining shares to the buyers at a pre-determined price. The seller argued that both of these provisions were unenforceable penalty clauses. The Supreme Court disagreed.
Usually, a panel of 5 justices decides Supreme Court cases. Occasionally, as in this case, where major issues are at stake, 7 are empanelled. Readers who think they could handle the pressure of having difficult legal questions fired at them continuously and for a long period by 7 extremely bright justices may wish to see the recordings of the proceedings, which can be viewed here.
In essence, the Supreme Court has introduced some new tests for whether a contractual penalty is enforceable. Exactly what those tests are needs to be unpicked from the various judgments, which in total run to a staggering 123 pages.
Probably, we should focus on the joint judgment of Lords Neuberger and Sumption, not least because (a) they are brainier than the others, (b) their judgment is clearer than the others (even if it does take up a whopping 49 pages), and (c) Lords Carnwath and Clarke agreed with their judgment, which means that a majority of the justices have agreed that the legal points made in this judgment form the basis of the decision.
Lords Neuberger and Sumption (hereinafter collectively referred to as Lord Numpter) considered the previous focus on pre-estimates of loss to have been unsatisfactory, and to have resulted in the law on penalties becoming ‘the prisoner of artificial categorisation’.
Nor is it helpful to consider whether a provision is a ‘deterrent’, as this is just the flip-side of an ‘inducement’ and not inherently bad. Instead, the test of whether something is a penalty should be whether it is ‘penal’. [Duh!]
Unconscionable or extravagent
To determine whether a provision is penal and therefore unenforceable, it is necessary to consider whether it seeks to influence a party’s conduct in an ‘unconscionable’ or ‘extravagent’ way (these words also appear in Lord Dunedin’s 1915 judgment).
At this point in Lord Numpter’s judgment, and in the equivalent parts of the judgments of the other justices, a selection of words and phrases is used to elaborate on the threshold of unconscionableness. IP Draughts noted the following:
- out of all proportion to a legitimate interest of the innocent party
- in terrorem
And in the different context of a claim in the Parking Eye case based on the Unfair Terms in Consumer Contract Regulations:
- significant imbalance in the parties’ rights
- disportionately high sum in compensation
Several of their lordships referred to the fact that penalty rules also existed in certain civil-code countries, where provisions might be unenforceable if they were:
- manifestly excessive
- disproportionately high
Lord Hodge also referred to certain ‘soft law’ principles established by international bodies such as UNCITRAL, which would limit the right to damages that are:
- grossly excessive
- substantially disproportionate
He also referred to the tests of exorbitance and unconsionableness as preventing the enforcement of ‘egregious’ contractual provisions.
So much for the adjectives. Lord Numpter’s judgment also focussed on the following points:
Primary or secondary?
Is the financial obligation a primary obligation or merely the (secondary) consequence of failing to comply with a primary obligation? In the words of Lord Numpter:
The penalty rule regulates only the remedies available for breach of a party’s primary obligations, not the primary obligations themselves…
This means that in some cases the application of the penalty rule may depend on how the relevant obligation is framed in the instrument, ie whether as a conditional primary obligation or a secondary obligation providing a contractual alternative to damages at law…
This topic is discussed at greater length in the judgment. In other words, the question of whether a provision is unconscionable and extravagent, and therefore unenforceable, is only relevant if the obligation is a secondary one. If the obligation is a primary one, the penalty rule doesn’t apply.
IP Draughts’ reaction is that this distinction is ‘too clever by half’ and that manoeuvring around the penalty rule on the basis of primary and secondary obligations will be fraught with difficulty for us mere mortals who actually draft contracts.
Later in the judgment Lord Numpter concluded that both of the financial provisions at issue in the commercial case – the loss of future stage payments and the obligation to sell the remaining shares at a pre-determined price – were primary obligations and therefore not subject to the penalty rule. In the consumer case, Lord Numpter concluded that the £85 charge was a secondary obligation and therefore the penalty rule was engaged, but on the facts it was justified and not an unlawful penalty.
In their judgments, Lords Mance and Hodge seemed unconvinced that the obligations in the commercial case were primary obligations. But this ultimately didn’t matter, as they found them not to be unconscionable or extravagent in the circumstances of the case. Lord Toulson seemed to agree with this analysis.
If we take the Mance/Hodge/Toulson line, it may be risky to make any assumption about a clause being a primary obligation. If we take the Neuberger/Sumption line, it should be possible to draft many penalty-like clauses so that they fall outside the penalty rule altogether. Which line represents the current state of English law?
Your guess is as good as mine. In his short judgment, Lord Clarke “agree[d] with the reasoning of Lord Neuberger and Lord Sumption, Lord Mance and Lord Hodge.” With respect, you can’t agree with all of them on this point, as they had different views. Rather oddly, Lord Carnwath says nothing in the official judgment; there is simply a laconic statement, in parenthesis and as part of the heading, before Lord Numpter’s judgment, that Lord Clarke and Lord Carnwath ‘agree’ with that judgment.
Relief against forfeiture
Lord Numpter spends some time discussing the differences between (a) the law on relief against penalties and (b) the law on relief from forfeiture, but declines to reach any conclusions on whether relief from forfeiture might be available in a contract case, even if the penalty rule doesn’t apply. Lords Mance and Hodge expressed the view that relief from forfeiture could be available in these circumstances, and Lord Clarke’s single paragraph of judgment is mainly devoted to saying that his “present inclination” is to agree with them. In other words, an obligation might not be so bad as to amount to an unlawful penalty, but might be avoided under the rule on relief against forfeiture. However, this was not the basis of the decisions in the present, joined cases.
Their lordships declined counsels’ invitations to abolish or significantly expand the rule on penalties. Instead they sought to ‘explain’ the rule, which had been misunderstood by an undue emphasis, over the previous century, on Lord Dunedin’s 4 tests, including the phrase ‘genuine pre-estimate of damage’.
Where the penalty rule is engaged (and it may well not be engaged if the obligation is a ‘primary’ one), the test for whether an obligation should be struck down as a penalty is, in the words of the press release that accompanied the judgment, the following:
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
Following this judgment it will be easier, in IP Draughts’ view, to enforce what the world knows as penalty clauses . In English law agreements, there will be less emphasis on formulaic drafting of clauses that refer to genuine pre-estimates of loss.
Finally, congratulations to the lawyers at Allen & Overy who advised Cavendish Square Holdings in 2008 and presumably drafted the clauses that the Supreme Court upheld in the commercial case. Job well done. Does anyone know who the individuals were who drafted these clauses?