When is a clause deemed to be a penalty clause?

In the two recent cases of Cavendish Square Holding BV v El Makdessi and ParkingEye v Beavis, the Supreme Court clarified the position as to when clauses are deemed to be penalty clauses and therefore invalid.

It is not uncommon for parties to a commercial contract to agree that specified sums shall be paid upon breach of a contractual provision. The general rule is that, if a clause is a liquidated damages clause (i.e. the sum to be paid upon breach of the clause is a genuine pre-estimate of loss) then it is enforceable and the sum is recoverable. However, if it is a penalty (i.e. the sum is excessive and disproportionate to the estimated loss) then it will be unenforceable and the sum will not be recoverable.

An exception to the general rule is when a party can show that the charge is necessary in order to legitimately protect the interests of the innocent party (even if that charge is excessive and disproportionate to the estimated loss).

Cavendish

In Cavendish, Makdessi was subject to some restrictive covenants, including restrictions against competing with the business. If Makdessi breached the restrictive covenants then he would:

(a) lose his entitlement to receive the deferred payments that would otherwise be payable to him for the sale of his shares; and
(b) have to sell his remaining shares in the company to the buyer for a reduced price.

Makdessi breached his restrictive covenants (which he acknowledged), but claimed that the results of such breach were penalties and therefore unenforceable.

It was held by the Supreme Court that Cavendish had a legitimate interest in protecting the business and that the clauses were proportionate in order to protect those interests.

It is worth noting that the judge took into consideration the fact that the agreement was negotiated in detail, over a period of time and with the benefit of professional advice.

ParkingEye

In ParkingEye, Mr Beavis parked in a car park for longer than the permitted 2 hours maximum stay. He was issued with a parking notice of £85 (£50 if he paid within 14 days). Mr Beavis did not pay the charge, nor did he appeal the notice.

ParkingEye commenced proceedings to recover the charge.

Mr Beavis claimed that the charge was excessive and disproportionate and was therefore unenforceable.

The Supreme Court sided with ParkingEye saying that it had a legitimate interest in charging a sum which exceeded any genuine loss. That interest included providing a service to the landowner to manage the car park in the interests of retail outlets, their customers and the wider public.

The Court highlighted that this did not mean that ParkingEye could charge what it liked, but that £85 was not out of all proportions to its interests and was therefore not unenforceable.

Comment

These cases serve as a useful reminder of the importance of making sure that restrictive covenants and any clauses dealing with breach of those restrictive covenants are carefully drafted, taking into account the particular circumstances at hand. Failure to do so may result in them being unenforceable in their entirety.

In particular, it is important to note that the Courts may be willing to allow charges that are disproportionate, if the party can show that this is in its “legitimate interests”. Defining “legitimate interest” will be considered on a case-by-case basis but it is important to take particular care on this point.

Instructing a solicitor at the outset to any transaction is important to ensure that any clauses are drafted correctly and to protect your interests in the transaction. Here at Farleys we have extensive experience in drafting, negotiating and advising you on a wide range of commercial contracts; making sure that your interests are fully protected. If you would like to speak to one of our solicitors then please don’t hesitate to contact us today.