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Clarification of the law on contractual penalties

4 November 2015
The Supreme Court’s long-awaited decision in the consolidated appeals of Cavendish Square Holding BV (Appellant) v Talal El Makdessi (Respondent); ParkingEye Limited (Respondent) v Beavis (Appellant) [2015] UKSC 67 provides some useful guidance on the legality of contractual penalties.

In Cavendish, the Court of Appeal had held that clauses requiring Makdessi to (i) forego receipt of deferred payments for shares he had sold and (ii) potentially sell his remaining shares to Cavendish in the event of Makdessi breaching certain restrictive covenants were unenforceable penalties.

In Parking Eye, the Court of Appeal had ruled that a parking charge of £85 for exceeding a two hour time limit was enforceable because of a ‘social’ justification in ensuring a regular turnover of parking spaces.

The Supreme Court, reviewing both decisions, noted that the basic test for an unenforceable penalty in Dunlop Pneumatic has too often been treated as code, and that 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”. Therefore, the first step is to consider what (if any) legitimate business interest is served and protected by the clause and then consider whether the provision is extravagant, exorbitant or unconscionable.

Applying that test to Cavendish, the Supreme Court decided neither clauses were penalties as both were primary obligations and Cavendish had a legitimate interest in the observance of the covenants. In contrast, the Supreme Court were satisfied that in Parking Eye the penalty rule was engaged but that the charge was not a penalty due to a legitimate interest in charging overstaying motorists which extended beyond the recovery of any loss. Further, the charge was not extravagant in light of practice around the UK.

This decision marks a significant departure from the previous authorities and demonstrates that whilst the ‘modern’ approach still recognises the law on penalties, it should not be extended unjustifiably.

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