Article by Colin Riegels From Harneys

Last Updated: 29 November 2015

On 4 November 2015 the UK Supreme Court handed down its decision in the case of Cavendish Square Holdings BV v Makdessi [2015] UKSC 67.1 As had been widely anticipated, the Supreme Court took the opportunity to fundamentally review, and largely restate, the common law rules relating to the enforceability of contractual penalties.

The court noted that existing case law on the subject was tortuous, and in many respects had been superseded in England by subsequent statutory provisions. However, the court declined the temptation to abrogate the rule entirely. They also declined to try and create one single rule to supersede the common law rules in relation to penalties and the equitable doctrine of relief from forfeiture. Instead their Lordships settled for simply reformulating the rules on penalty clauses.

Instead of the old test, which was widely interpreted as requiring the courts to determine whether a clause was a “genuine pre-estimate of loss”, the courts should now simply ask whether the relevant clause imposes a sanction which is “out of all proportion” with the legitimate interests of the protected party.

Further the court noted that a party’s legitimate interest could extend beyond simply the damages that they were entitled to upon breach. Accordingly, a determination of whether the remedy was out of all proportion to their interest was not simply a matter of comparing it to the damages which might be payable.

The Supreme Court also reaffirmed that the law relating to contractual penalties only applies to clauses which impose a sanction for breach of the contract itself. They have no application where the terms of the contract simply provide for onerous stipulations upon the happening of certain events. In this regard they applied existing English case law2 in preference to the more radical approach adopted by the Australian High Court in 2012 abolishing the requirement for breach of contract in order to invoke the strictures on penalty clauses.3

Lords Sumption and Neuberger, giving the leading judgment, acknowledged that “[t]he penalty rule is an interference with freedom of contract”, and helpfully added that “[i]n a negotiated contract between properly advised parties of comparable bargaining power, the strong initial presumption must be that the parties themselves are the best judges of what is legitimate in a provision dealing with the consequences of breach.”

Overall the judgment is likely to be welcomed by commercial lawyers as reducing the potential impact of the rule against penalties, and strengthening the freedom of parties to make their own bargains. The one regret from the judgment is that the Supreme Court did not take the opportunity to definitively state the consequence of a clause being held to be penal – whether it is merely unenforceable, or void ab initio4 (Mr Makdessi’s lawyers had pleaded both as alternatives, but as the clause was held not to be penal no ruling on that point was called for). However, the fact that the Supreme Court used the word “unenforceable” to the almost total exclusion of the word “void” may indicate their thinking on that point.

The decision of the Supreme Court is likely to be followed and applied in other common law countries, like the BVI, Cayman Islands and Bermuda.

Footnotes

1 The case was heard as a joint appeal with Parking Eye v Beavis.

2 Berg v Blackburn Rovers FC [2013] EWHC 1070

3 Andrews v ANZ Banking Group Ltd [2012] HCA 30

4 The question is not purely esoteric. If a party made a payment under a clause which was subsequently held to be a penalty, whether they could recover any sums paid would depend on whether the clause was void or merely unenforceable.

SOURCE: http://www.harneys.com/files/penalty-clauses—-the-new-rules.pdf