Data
- Date:
- 05-11-2015
- Country:
- United Kingdom
- Number:
- Court:
- Supreme Court
- Parties:
- CavendishSquare Holding BV vTalalEl Makdessi / ParkingEye Ltd v Beavis
Keywords
SHARE PURCHASE AGREEMENT - BETWEEN LEBANESE INDIVIDUALS AND DUTCH COMPANY - GOVERNED BY ENGLISH LAW - REFERENCE TO UNIDROIT PRINCIPLES TO CONFIRM SOLUTION PROVIDED BY APPLICABLE DOMESTIC LAW
CONSUMER CONTRACT - BETWEEN ENGLISH PARTIES- GOVERNED BY ENGLISH LAW - REFERENCE TO UNIDROIT PRINCIPLES TO CONFIRM SOLUTION PROVIDED BY APPLICABLE DOMESTIC LAW
PENALTY CLAUSES VOID AND UNENFORCEABLE UNDER ENGLISH LAW - REFERENCE TO OTHER DOMESTIC LAWS ADOPTING A SIMILAR RULE AS WELL AS TO UNIDROIT PRINCIPLES (ARTICLE 7.4.13) AND OTHER INTERNATIONAL SOFT LAW INSTRUMENTS SUCH AS UNCITRAL UNIFORM RULES ON CONTRACT CLAUSES FOR AN AGREED SUM DUE UPON FAILURE OF PERFORMANCE (ARTICLE 6)
Abstract
In the judgment at hand the Supreme Court decided on two appeals dealing with two different cases both of which raised the same issue, i.e. the validity and enforceability of contractual penalty clauses under English law.
The first case concerned an agreement (“the Agreement”) between two Lebanese individuals (“the Sellers”) and a Dutch company (“the Buyer”), whereby the Sellers, who owned 100% of the shares in the holding company (“the Company”) of the largest advertising and marketing communications group in the Middle East (“the Group”), agreed to sell to the Buyer 60% of their shares in the Company. The Agreement, which had been the subject of extensive negotiations conducted by highly experienced commercial lawyers for both parties, provided for the payment of the purchase price in four instalments. The Agreement also contained a “Goodwill protection” clause whereby the Sellers undertook, for a period of two years after the completion of the Agreement, not to carry on, nor be engaged in the provision of goods or services which competed with the Group´s companies. The Agreement finally provided in a separate “Default” clause that in case of breach by the Sellers of their obligations under the “Goodwill protection” clause, they would no longer be entitled to the third and fourth instalments of the price. The Sellers subsequently breached their obligations, but when the Buyer brought an action against the Sellers seeking a declaration that they had lost their right to payment of the third and fourth instalments, the Sellers objected that the “Default” clause in reality amounted to a penalty clause and, as such, was void and unenforceable.
While the trial judge found the clause to be valid and enforceable, the Court of Appeal reversed the decision on the ground that the clause constituted a penalty which under English law was void and unenforceable.
The second case concerned a consumer contract between a motorist and a parking management company (“the Contract”) whereby the former had a contractual license to park his car in the retail park on the terms of the notice posted at the entrance, which he accepted by entering the site. According to that notice, the motorist was permitted to stay for not more than two hours and had to park only within the marked bays, and on breach of any of those terms would have to pay £85. When the motorist exceeded the two-hour free parking period and the parking management company requested payment of the £85 charge, the motorist refused payment on the ground that it constituted a penalty and was therefore void and not enforceable.
Both the trial judge and the Court of Appeal rejected the motorist´s argument.
In deciding on the two appeals, the Supreme Court first addressed the English law on penalties in general, and then discussed the merits of the two cases.
Speaking in general terms, the Court admitted that “the penalty rule in England is an ancient, haphazardly constructed edifice which has not weathered well” and that “the application of the penalty rule was often adventitious”. Nevertheless the Court implicitly confirmed (at para. 21, per Lord Neuberger and Lord Sumption, with Lord Carnwath agreeing) the four tests formulated by Lord Dunedin back in 1915 in the Dunlop case to distinguish between penalty clauses, which under English law were considered invalid and unenforceable, and liquidated damage clauses, which on the contrary were valid and enforceable: (a) that the provision would be penal if “the sum stipulated for is extravagant and unconscionable in amount in comparison with the greatest loss that could conceivably be proved to have followed from the breach”; (b) that the provision would be penal if the breach consisted only in the non-payment of money and it provided for the payment of a larger sum; (c) that there was “a presumption (but no more)” that it would be penal if it was payable in a number of events of varying gravity; and (d) that it would not be treated as penal by reason only of the impossibility of precisely pre-estimating the true loss. Or to quote the much more succinct formulation adopted in the case at hand by Lord Hodge (para. 255) and endorsed by Lord Toulson (para. 293) “the correct test for a penalty is whether the sum or remedy stipulated as a consequence of a breach of contract is exorbitant or unconscionable when regard is had to the innocent party’s interest in the performance of the contract”.
The Court then addressed the question as to whether the English penalty rule, which is increasingly criticized even within the English legal community as antiquated and anomalous, should be abrogated as was openly demanded by one of the parties in the case at hand. The Court candidly confessed that “[w]e rather doubt that the courts would have invented the rule today if their predecessors had not done so three centuries ago” but at the same time pointed out that “this is not the way in which English law develops, and we do not consider that judicial abolition would be a proper course for this court to take.”
The Court went on stating (at para. 37, per Lord Neuberger and Lord Sumption, with Lord Carnwath agreeing) that “the penalty rule is not only a long-standing principle of English law, but is common to almost all major systems of law, at any rate in the western world […]”, and in this context specifically mentioned not only the common law jurisdictions, including the United States but, rather surprisingly, also the civil codes of France, Germany (for non-commercial contracts only), Switzerland, Belgium and Italy, as well as “influential attempts to codify the law of contracts internationally, including the UNIDROIT Principles of International Commercial Contracts (2010) (article 7.4.13), and the UNCITRAL Uniform Rules on Contract Clauses for an Agreed Sum Due upon Failure of Performance (article 6) […].” Also the other Members of the Court were of the opinion that the abolition of the English penalty rule would – in the words of Lord Hodge (para. 263) – “go against the flow of legal developments both nationally and internationally”, but when referring in support of their conclusions to the European civil codes as well as to international soft law instruments such as the UNIDROIT Principles and the UNCITRAL Uniform Rules, they – more correctly – spoke of “a general convergence of approaches […] towards a recognition of the utility and desirability of judicial control of disproportionately, excessively, manifestly or grossly high or unreasonable penalties” (per Lord Mance at para. 164).
Turning to the merits of the two appeals, the Court held that none of the disputed clauses in the two cases were penalty clauses since they had nothing to do with punishment of the party in breach. Indeed, despite the fact that the occasion of their operation was a breach by one of the parties, they concerned the parties’ primary obligations which aimed at a perfectly legitimate commercial objective. As a consequence the Court decided that none of the clauses was avoided by the penalty rule, and allowed the appeal in the first case and dismissed the appeal in the second case.
Fulltext
Michaelmas Term
[2015] UKSC 67
On appeal from: [2013] EWCA Civ 1539 and [2015] EWCA Civ 402
JUDGMENT
Cavendish Square Holding BV (Appellant) v Talal
El Makdessi (Respondent)
ParkingEye Limited (Respondent) v Beavis
(Appellant)
before
Lord Neuberger, President
Lord Mance Lord Clarke Lord Sumption Lord Carnwath Lord Toulson Lord Hodge
JUDGMENT GIVEN ON
4 November 2015
Heard on 21, 22 and 23 July 2015
LORD NEUBERGER AND LORD SUMPTION: (with whom Lord
Carnwath agrees)
1. These two appeals raise an issue which has not been considered by the Supreme Court or by the House of Lords for a century, namely the principles underlying the law relating to contractual penalty clauses, or, as we will call it, the penalty rule. The first appeal, Cavendish Square Holding BV v Talal El Makdessi, raises the issue in relation to two clauses in a substantial commercial contract. The second appeal, ParkingEye Ltd v Beavis, raises the issue at a consumer level, and it also raises a separate issue under the Unfair Terms in Consumer Contracts Regulations 1999 (SI 1999/2083) (“the 1999 Regulations”).
2. We shall start by addressing the law on the penalty rule generally, and will then discuss the two appeals in turn.
The law in relation to penalties
3. The penalty rule in England is an ancient, haphazardly constructed edifice which has not weathered well, and which in the opinion of some should simply be demolished, and in the opinion of others should be reconstructed and extended. For many years, the courts have struggled to apply standard tests formulated more than a century ago for relatively simple transactions to altogether more complex situations. The application of the rule is often adventitious. The test for distinguishing penal from other principles is unclear. As early as 1801, in Astley v Weldon (1801) 2 Bos & Pul 346, 350 Lord Eldon confessed himself, not for the first time, “much embarrassed in ascertaining the principle on which [the rule was] founded”. Eighty years later, in Wallis v Smith (1882) 21 Ch D 243, 256, Sir George Jessel MR, not a judge noted for confessing ignorance, observed that “The ground of that doctrine I do not know”. In 1966 Diplock LJ, not a judge given to recognising defeat, declared that he could “make no attempt, where so many others have failed, to rationalise this common law rule”: Robophone Facilities Ltd v Blank [1966] 1
WLR 1428, 1446. The task is no easier today. But unless the rule is to be abolished or substantially extended, its application to any but the clearest cases requires some
underlying principle to be identified.
[…]
What makes a contractual provision penal?
19. As we have already observed, until relatively recently this question was answered almost entirely by reference to straightforward liquidated damages clauses. It was in that context that the House of Lords sought to restate the law in two seminal decisions at the beginning of the 20th century, Clydebank in 1904 and Dunlop in 1915.
20. Clydebank was a Scottish appeal about a shipbuilding contract with a provision (described as a “penalty”) for the payment of £500 per week for delayed delivery. The provision was held to be a valid liquidated damages clause, not a penalty. Lord Halsbury (p 10) said that the distinction between the two depended on
“whether it is, what I think gave the jurisdiction to the courts in both countries to interfere at all in an agreement between the parties, unconscionable and extravagant, and one which no court ought to allow to be enforced.”
Lord Halsbury declined to lay down any “abstract rule” for determining what was unconscionable or extravagant, saying only that it must depend on “the nature of the transaction – the thing to be done, the loss likely to accrue to the person who is endeavouring to enforce the performance of the contract, and so forth”. Lord Halsbury’s formulation has proved influential, and the two other members of the Appellate Committee both delivered concurring judgments agreeing with it. It is, however, worth drawing attention to an observation of Lord Robertson (pp 19-20) which points to the principle underlying the contrasting expressions “liquidated damages” and “penalty”:
“Now, all such agreements, whether the thing be called penalty or be called liquidate damage, are in intention and effect what Professor Bell calls ‘instruments of restraint’, and in that sense penal. But the clear presence of this does not in the least degree invalidate the stipulation. The question remains, had the respondents no interest to protect by that clause, or was that interest palpably incommensurate with the sums agreed on? It seems to me that to put this question, in the present instance, is to answer it.”
21. Dunlop arose out of a contract for the supply of tyres, covers and tubes by a manufacturer to a garage. The contract contained a number of terms designed to protect the manufacturer’s brand, including prohibitions on tampering with the marks, restrictions on the unauthorised export or exhibition of the goods, and on resales to unapproved persons. There was also a resale price maintenance clause, which would now be unlawful but was a legitimate restriction of competition according to the notions prevailing in 1914. It was this clause which the purchaser had broken. The contract provided for the payment of £5 for every tyre, cover or tube sold in breach of any provision of the agreement. Once again, the provision was held to be a valid liquidated damages clause. In his speech, Lord Dunedin formulated four tests “which, if applicable to the case under consideration, may prove helpful, or even conclusive” (p 87). They were (a) that the provision would be penal if “the sum stipulated for is extravagant and unconscionable in amount in comparison with the greatest loss that could conceivably be proved to have followed from the breach”; (b) that the provision would be penal if the breach consisted only in the non-payment of money and it provided for the payment of a larger sum; (c) that there was “a presumption (but no more)” that it would be penal if it was payable in a number of events of varying gravity; and (d) that it would not be treated as penal by reason only of the impossibility of precisely pre-estimating the true loss.
[…]
33. The penalty rule is an interference with freedom of contract. It undermines the certainty which parties are entitled to expect of the law. Diplock LJ was neither the first nor the last to observe that “The court should not be astute to descry a‘penalty clause’”: Robophone at p 1447. As Lord Woolf said, speaking for the PrivyCouncil in Philips Hong Kong Ltd v Attorney General of Hong Kong (1993) 61 BLR41, 59, “the court has to be careful not to set too stringent a standard and bear inmind that what the parties have agreed should normally be upheld”, not least because“[a]ny other approach will lead to undesirable uncertainty especially in commercial contracts”.
[…]
Should the penalty rule be abrogated?
36. The primary case of Miss Smith QC, who appeared for Cavendish in the first appeal, was that the penalty rule should now be regarded as antiquated, anomalous and unnecessary, especially in the light of the growing importance of statutory regulation in this field. It is the creation of the judges, and, she argued, the judges should now take the opportunity to abolish it. There is a case to be made for taking this course. It was expounded with considerable forensic skill by Miss Smith, and has some powerful academic support: see Sarah Worthington, Common Law Values: the Role of Party Autonomy in Private Law, in The Common Law of Obligations: Divergence and Unity (ed A Robertson and M Tilbury (2015)), pp 18-26. We rather doubt that the courts would have invented the rule today if their predecessors had not done so three centuries ago. But this is not the way in which English law develops, and we do not consider that judicial abolition would be a proper course for this court to take.
37. The first point to be made is that the penalty rule is not only a long-standing principle of English law, but is common to almost all major systems of law, at any rate in the western world. It has existed in England since the 16th century and can be traced back to the same period in Scotland: McBryde, The Law of Contract in Scotland, 3rd ed (2007), paras 22-148. The researches of counsel have shown that it has been adopted with some variants in all common law jurisdictions, including those of the United States. A corresponding rule was derived from Roman law by Pothier, Traité des Obligations, No 346, which is to be found in the Civil Codes of France (article 1152), Germany (for non-commercial contracts only) (sections 343,348), Switzerland (article 163.3), Belgium (article 1231) and Italy (article 1384). It is included in influential attempts to codify the law of contracts internationally, including the Unidroit Principles of International Commercial Contracts (2010) (article 7.4.13), and the UNCITRAL Uniform Rules on Contract Clauses for an Agreed Sum Due upon Failure of Performance (article 6). In January 1978 the Committee of Ministers of the Council of Europe recommended a number of common principles relating to penal clauses, including (article 7) that a stipulated sum payable on breach “may be reduced by the court when it is manifestly excessive”.
38. It is true that statutory regulation, which hardly existed at the time that the penalty rule was developed, is now a significant feature of the law of contract. In England, the landmark legislation was the Unfair Contract Terms Act 1977. For most purposes, the Act was superseded by the Unfair Terms in Consumer Contracts Regulations 1994 (SI 1994/3159), which was in turn replaced by the 1999 Regulations, both of which give effect to European Directives. The 1999 Regulations contain an “indicative and non-exhaustive list of the terms which may be regarded as unfair”, including terms which have the object or effect of “requiring any consumer who fails to fulfil his obligation to pay a disproportionately high sumin compensation”. Nonetheless, statutory regulation is very far from covering thewhole field. Penalty clauses are controlled by the 1999 Regulations, but the Regulations apply only to consumer contracts and the control of unfair terms under regulations 3 and 5 is limited to those which have not been individually negotiated. There are major areas, notably non-consumer contracts, which are not regulated by statute. Some of those who enter into such contracts, for example professionals and small businesses, may share many of the characteristics of consumers which are thought to make the latter worthy of legal protection. The English Law Commission considered penalty clauses in 1975 (Working Paper No 61, Penalty Clauses and Forfeiture of Monies Paid, April 1975), at a time when there was no relevant statutory regulation, and the Scottish Law Commission reported on them in May 1999 (Report No 171). Neither of these Reports recommended abolition of the rule. On the contrary, both recommended legislation which would have expanded its scope.
[…]
The first appeal: Cavendish v El Makdessi
The factual and procedural history
44. Mr Makdessi founded a group of companies (“the Group”) which by 2008 had become the largest advertising and marketing communications group in the Middle East, and operated through a network of around 20 companies with more than 30 offices in over 15 countries. At that time, Mr Makdessi was one of the most influential Lebanese business leaders, his name was closely identified with the business of the Group, and he had very strong relationships with its clients and senior employees.
45. In 2008, the holding company of the Group was Team Y & R Holdings Hong Kong Ltd (“the Company”). The Company had 1,000 issued shares, which were owned by Mr Makdessi and Mr Joseph Ghossoub, with the exception of 126 shares which were held by Young & Rubicam International Group BV (“Y & RIG”), a company in the WPP group of companies (“WPP”), the world’s largest market communications services group.
46. By an agreement of 28 February 2008 (“the Agreement”) Mr Makdessi and Mr Ghossoub (described as “the Sellers”) agreed to sell to Y & RIG (described as “the Purchaser”) 474 shares (described as “the Sale Shares”) in the Company. Y & RIG then transferred those shares to Cavendish Square Holdings BV (“Cavendish”), another WPP company, and by a novation agreement of 29 February 2008, Cavendish was substituted for Y & RIG as a party to the Agreement. Thus Cavendish came to hold 60% of the Company while the Sellers retained 40%. For present purposes, Y & RIG can be ignored and the Purchaser can be treated as Cavendish.
47. The Agreement had been the subject of extensive negotiations over six months, and both sides were represented by highly experienced and respected commercial lawyers: Allen & Overy acting for Cavendish, and Lewis Silkin for the Sellers, Mr Makdessi and Mr Ghossoub.
48. By clause 3.1, the price payable by Cavendish “[i]n consideration of the sale of the Sale Shares and the obligations of the Sellers herein” (and which was to be apportioned 53.88% to Mr Makdessi and 46.12% to Mr Ghossoub) was to be paid by Cavendish in the following way:
i) A “Completion Payment” of US$34m to be paid on completion of the
Agreement;
ii) A “Second Payment” of US$31.5m to be paid into escrow on completion, and to be released in four instalments, as restructuring of the Group companies took effect;
iii) An “Interim Payment”, to be paid 30 days after agreement of the group operating profits (“OPAT”) for 2007-2009, and to be the amount by which the product of eight, 0.474 and the average annual OPAT 2007-2009 exceeded US$63m (being the sum of the earlier payments less US$ 2.5m representing interest);
iv) A “Final Payment”, to be paid 30 days after agreement of the OPAT for 2007-2011, and to be the amount by which the product of a figure between seven and ten (depending on the level of profit), 0.474 and the annual average annual OPAT for 2009-2011 exceeded the aggregate of US$63m and the Interim Payment.
Clause 6 contained provisions relating to the “calculation of OPAT and payment of the consideration”.
49. Clause 3.2 of the Agreement provided that, if the Interim Payment and/or the Final Payment turned out to be a negative figure, it or they should be treated as zero, but there was to be no claw back of the earlier payments. Clause 3.3 of the Agreement provided that the maximum of all payments would be US$147.5m. By clause 9.1 of, and paragraph 2.15(c) of Schedule 7 to, the Agreement, the Sellers warranted that the Net Asset Value (“NAV”) of the Company at 31 December 2007was just over US$69.74m.
50. Clause 15 contained a put option which entitled each of the Sellers to require Cavendish, by a Notice served at any time between 1 January and 31 March in 2011 or any subsequent year (in the case of Mr Makdessi) and any time between 1 January and 31 March in 2017 or in any subsequent year (in the case of Mr Ghossoub), to buy all their remaining shares in the Company. The price payable on the exercise of this option was (subject to a cap of US$75m in the case of each Seller) to be therelevant seller’s proportion of a sum eight times the average OPAT for a reference period of seven years (the year in which the notice was served, the previous year and the two subsequent years). It was to be payable by instalments.
51. Clause 11 was concerned with the “protection of goodwill”. Clause 11.1
provided as follows:
“11.1. Each Seller recognises the importance of the goodwill of the Group to [Cavendish] and the WPP Group which is reflected in the price to be paid by the Purchaser for the Sale Shares. Accordingly, each Seller commits as set out in this clause 11 to ensure that the interest of each of [Cavendish] and the WPP Group in that goodwill is properly protected.”
52. Clause 11.2 provided that, in Mr Makdessi’s case, until two years after he ceased to hold any shares in the Company or the date of the final instalment of any payment under clause 15, and in Mr Ghossoub’s case, until two years after he ceased employment with the Company, the Sellers would not (a) carry on, or be engaged or interested in “Restricted Activities” (ie the provision of goods or services which competed with the Group companies) in “Prohibited Areas” (ie in countries in which any of the Group companies carried on business); (b) solicit or accept orders, enquiries or business in respect of Restricted Activities in the Prohibited Areas; (c) divert orders, enquiries or business from any Group company; or (d) employ or solicit any senior employee or consultant of any Group company.
53. Clause 11.7 started by recording that Cavendish “recognises the importance of the goodwill of the Group to the Sellers and to the value of the Interim Payment and the Final Payment”. It then contained a covenant by Cavendish that neither it nor any other WPP company would “without the Sellers’ prior written consent other than within the Group companies, trade in any of the [23 identified] countries … using [specified] names [including ‘Adrenalin’]”.
54. Under clause 7.5, Messrs El Makdessi and Ghossoub agreed that, within four months of completion, they would dispose of any shares in Carat Middle East Sarl
(“Carat”), and procure the termination of a joint venture agreement which another
Carat company had entered into with a member of the Aegis group of companies.
Carat describes itself on its website as “the world’s leading independent media planning and buying specialist … [o]wned by global media group Aegis Group plc
… [with] more than 5,000 people in 70 countries worldwide”. It is a competitor of
WPP, including Cavendish and the Company.
55. The two provisions of central relevance for present purposes were included
in clause 5, which was headed “Default”. Clauses 5.1 and 5.6 provided:
“5.1 If a Seller becomes a Defaulting Shareholder [which is defined as including ‘a Seller who is in breach of clause 11.2’] he shall not be entitled to receive the Interim Payment and/or the Final Payment which would other than for his having become a Defaulting Shareholder have been paid to him and[Cavendish]’s obligations to make such payment shall cease.
…
5.6. Each Seller hereby grants an option to [Cavendish] pursuant to which, in the event that such Seller becomes a Defaulting Shareholder, [Cavendish] may require such Seller to sell to [Cavendish] all … of the Shares held by that Seller (the Defaulting Shareholder Shares). [Cavendish] shall buy and such Seller shall sell … the Defaulting Shareholder Shares… within 30 days of receipt by such Seller of a notice from [Cavendish] exercising such option in consideration for the payment by [Cavendish] to such Seller of the Defaulting Shareholder Option Price [defined as ‘an amount equal to the [NAV] on the date that the relevant Seller becomes a Defaulting Shareholder multiplied by [the percentage which represents the proportion of the total shares the relevant Seller holds].”
56. Mr Ghossoub signed an agreement by which he agreed to remain an employee and director of the Company. During the negotiations, Mr Makdessi had made it clear that he did not wish to remain an employee. However, he signed an agreement, by which he became a non-executive director of the Company (as well as other companies in the Group) and non-executive chairman, for an initial term of
18 months which was renewable. Under this he agreed to certain specific obligations by way of ongoing support of the Company.
57. Mr Makdessi resigned as non-executive chairman of the Company in April
2009. On 1 July 2009, at the Company’s request, he resigned as non-executive director of all companies in the Group, save the Company itself. He was removed from the board of the Company on 27 April 2011, after the commencement of these proceedings.
58. Mr Makdessi has been paid his share of the first two payments stipulated by clause 3.1, namely the Completion Payment and the Second Payment, together with some additional interest. However, he has not yet been paid the remaining payments under clause 3.1, namely the Interim Payment or the Final Payment, or any part thereof. His remaining shares represent just over 21.5% of the whole issued share capital of the Company.
59. By December 2010, Cavendish and the Company concluded that Mr Makdessi had acted in breach of his duties to the Company as a director and in breach of his obligations to Cavendish under clause 11.2 of the Agreement. On 13December 2010 Cavendish gave notice of the exercise of its Call Option under clause 5.6.
60. In December 2010, these proceedings were commenced against Mr Makdessi, with Cavendish suing for breach of the Agreement, and the Company suing for breach of fiduciary duty. Their re-amended particulars allege that in breach of his fiduciary duties and the restrictive covenants Mr Makdessi had throughout2008 and 2009 in Lebanon and Saudi Arabia (both of which were within the Prohibited Area), in breach of clause 11.2, engaged in Restricted Activities, solicited clients and employees away from Group companies and accepted orders in respect of Restricted Activities.
61. The essence of the complaints was that Mr Makdessi had (i) continued to provide services to Carat, including assisting it to generate business, diverting business to it and soliciting clients and diverting their business to it; and (ii) set up rival advertising agencies in Lebanon and Saudi Arabia with “Adrenalin” in their name and that those agencies had poached or tried to poach a number of the Company’s customers and employees.
62. Mr Makdessi subsequently admitted that from February 2008 he had had an ongoing, unpaid involvement in the affairs of Carat pending the appointment of a replacement CEO and that such involvement placed him in breach of fiduciary duty to the Company with effect from 1 July 2008, and that, if the covenants in clause
11.2 were valid and enforceable (as they have been held to be) his involvement in the affairs of Carat rendered him a Defaulting Shareholder within the meaning of the Agreement. The Company’s claim for breach of fiduciary duty was settled by its
acceptance of a payment into court made by Mr Makdessi in the sum of
US$500,000. Cavendish claimed to have suffered loss and damage in the form of a loss of value of its shareholding in the Company, but it subsequently accepted that such loss was irrecoverable as it was merely “reflective” of the loss which could be claimed, indeed had been claimed, by the Company.
63. More importantly for present purposes, Cavendish claimed that Mr Makdessi’s admissions of breach of fiduciary duty demonstrated that he was in breach of clause 11.2 in relation to (at least) his continued involvement in Carat. Cavendish accordingly sought a declaration that he was a Defaulting Shareholder, was not entitled to the Interim Payment or the Final Payment as a result of clause
5.1, and was obliged, as of the date 30 days after the service of its notice exercising the Call Option, namely 14 January 2011, to sell to Cavendish all his shares in the Company at the Defaulting Shareholder Option Price, and it sought specific performance of the latter obligation.
64. The case was tried by Burton J and the appeal was heard in the Court of Appeal by Patten, Tomlinson and Christopher Clarke LJJ. The issue at both stages was the same, namely whether clauses 5.1 and 5.6 were valid and enforceable as Cavendish contended, or whether as Mr Makdessi argued they both were void and unenforceable because they constituted penalties. The courts below were naturally constrained by the perceived need to fit any analysis into the framework set by Lord Dunedin’s four principles. Burton J felt able to escape those constraints, and concluded that the two provisions were valid and enforceable. However, Christopher Clarke LJ, giving the leading judgment in the Court of Appeal, held that the two provisions were unenforceable penalties under the penalty rule as traditionally understood. No short summary can do justice to Christopher Clarke LJ’s thoughtful and careful analysis, but essentially he felt unable to uphold Burton J’s decision because he felt bound by the traditional explanation of the rule as being directed against deterrent clauses as such: see [2012] EWHC 3582 (Comm) and [2013] EWCA Civ 1539 respectively. Cavendish now appeals to this court.
The implications of the Agreement
65. Clause 5 deals with the obligations of a “Defaulting Shareholder”. So far as Mr Makdessi was concerned, that meant a Seller in breach of the restrictive covenants at clause 11.2. In the case of Mr Ghossoub, who remained an employee of the Company, it meant a Seller who was either in breach of the restrictive covenants or else had been summarily dismissed on any of a number of specified grounds, all of them serious and potentially discreditable to the Company.
66. The background to clause 5 is of some importance. Burton J found that the Agreement was negotiated in detail over a considerable period by parties dealing on equal terms with professional assistance of a high order. Cavendish was acquiring
47.4% of the Company so as to bring its holding up to 60%. It is common ground that a large proportion of the purchase price represented goodwill. The NAV
(without goodwill) of the Company was warranted by the Sellers at over US$69.7m
as at 31 December 2007, whereas the maximum consideration for 47.4% of the Company, including the profit-related element, was US$147.5m, implying a maximum value of more than US$300m for the whole Group. Clause 11.1 recorded the Sellers’ recognition that the restrictive covenants reflected the importance of the goodwill, and Burton J found that its value was heavily dependent on the continuing loyalty of Mr Makdessi and Mr Ghossoub. Subject to various options, they retained a 40% shareholding between them and were expected to maintain their connection with the business for a minimum period, Mr Ghossoub as an employee and director, and Mr Makdessi as a non-executive director and chairman. The following summary in the agreed Statement of Facts and Issues is based on the unchallenged evidence given at the trial:
“The structure of the Agreement was typical of acquisition agreements in the marketing sector. As in this case, the vendor is typically the founder or operator of the business, and has important relationships with clients and key staff. If they decide to turn against the business, its success can be significantly affected, and provisions are therefore included to protect the value of the investment, and in particular the value of the goodwill represented by the vendor’s existing personal relationships. The respondent fell into that category; the importance of personal relationships with clients is even stronger in the Middle East than the UK, and he had very strong relationships with clients and senior employees, and he was such a well known figure that if he acted against the Group, itwould inevitably cause it to lose value.”
67. Clause 3.1 provided that the first two instalments of the purchase price amounted to US$65.5m, which would be received by the Sellers in any event. The effect of clause 5.1 was that in the event that a Seller acted in breach of the restrictive covenants, he would not be entitled to receive the last two instalments of the purchase price, the Interim Payment and the Final Payment, both of which were calculated by reference to the audited consolidated profit of the Company for years after completion of the Agreement (2007-2009 for the Interim Payment, and 2007-2011 for the Final Payment). The result of Cavendish’s exercise of its rights under clause 5.1 according to its terms was to reduce the consideration for the Defaulting Shareholder’s shares from his proportion of the maximum of US$147.5m to his proportion of US$65.5m. In Mr Makdessi’s case, he would receive up to US$44,181,600 less.
68. Under clause 15, the Sellers had a put option to require Cavendish to buy their remaining shareholdings, which in Mr Makdessi’s case was first exercisable during the first three months of 2011. The provisions determining the option price have been summarised in para 50 above. It was a multiple of average audited consolidated profit over a reference period, a formula which would reflect the value of goodwill. The effect of clause 5.6 was that if before the exercise of the clause 15 put option a Seller was in breach of the restrictive covenants, Cavendish acquired an option to acquire his retained shareholding at a lower price, namely the relevant proportion of the net asset value at the time of the default. The result of Cavendish’s implementation of clause 5.6, according to its terms, was that insofar as, at the date of default, Mr Makdessi’s shareholding had a value attributable to goodwill, he would not receive it and would not be able to exercise the clause 15 put option in 2011.
Was clause 5.1 contrary to the penalty rule?
[…]
74. Where, against this background, does clause 5.1 stand? It is plainly not a liquidated damages clause. It is not concerned with regulating the measure of compensation for breach of the restrictive covenants. It is not a contractual alternative to damages at law. Indeed in principle a claim for common law damages remains open in addition, if any could be proved. The clause is in reality a price adjustment clause. Although the occasion for its operation is a breach of contract, it is in no sense a secondary provision. The consideration fixed by clause 3.1 is said to be payable “[i]n consideration of the sale of the Sale Shares and the obligations of the Sellers herein”. Those obligations of the Sellers herein include the restrictive covenants. Clause 5.1 belongs with clauses 3 and 6, among the provisions which determine Cavendish’s primary obligations, ie those which fix the price, the manner in which the price is calculated and the conditions on which different parts of the price are payable. Its effect is that the Sellers earn the consideration for their shares not only by transferring them to Cavendish, but by observing the restrictive covenants. As Burton J said at para 59 of his judgment, “[t]he juxtaposition on the one hand of substantial delayed payment for goodwill and on the other hand a series of covenants which is intended to safeguard and protect that goodwill is of particular significance”.
75. Although clause 5.1 has no relationship, even approximate, with the measure of loss attributable to the breach, Cavendish had a legitimate interest in the observance of the restrictive covenants which extended beyond the recovery of that loss. It had an interest in measuring the price of the business to its value. The goodwill of this business was critical to its value to Cavendish, and the loyalty of Mr Makdessi and Mr Ghossoub was critical to the goodwill. The fact that some breaches of the restrictive covenants would cause very little in the way of recoverable loss to Cavendish is therefore beside the point. As Burton J graphically observed in para 43 of his judgment, once Cavendish could no longer trust the Sellers to observe the restrictive covenants, “the wolf was in the fold”. Loyalty is indivisible. Its absence in a business like this introduces a very significant business risk whose impact cannot be measured simply by reference to the known and provable consequences of particular breaches. It is clear that this business was worth considerably less to Cavendish if that risk existed than if it did not. How much less? There are no juridical standards by which to answer that question satisfactorily. We cannot know what Cavendish would have paid without the assurance of the Sellers’ loyalty, even assuming that they would have bought the business at all. We cannot know whether the basic price or the maximum price fixed by clause 3.1 would have been the same if they were not adjustable in the event of breach of the restrictive covenants. We cannot know what other provisions of the agreement would have been different, or what additional provisions would have been included on that hypothesis. These are matters for negotiation, not forensic assessment (save in the rare cases where the contract or the law requires it). They were matters for the parties, who were, on both sides, sophisticated, successful and experienced commercial people bargaining on equal terms over a long period with expert legal advice and were the best judges of the degree to which each of them should recognise the proper commercial interests of the other.
76. We have already drawn attention to the fact that damages are in principle recoverable in addition to the price reduction achieved by clause 5.1. In this case, the Company recovered US$500,000 from Mr Makdessi. Cavendish has abandoned any claim of their own for damages, because any loss of theirs would simply reflect the Company’s loss. But it would not always be so. There are hypotheses, for example that the restrictive covenants had been broken after he ceased to be a director, in which Cavendish’s loss by his breach of the restrictive covenants would not have been reflective and might in principle have been recovered in addition to the reduction of the price under clause 5.1. Does any of this matter? We do not think so. Clause 5.1 is not concerned with the measure of compensation for the breach. It cannot be regarded as penal simply because damages are recoverable in addition. The real question is whether any damages have been suffered on account of the breach in circumstances where the price has been adjusted downwards on account of the same breach. As between Mr Makdessi and the Company, the right of Cavendish to a price reduction cannot affect the measure or recoverability of the Company’s loss. It is res inter alios acta. It is an open question whether the right to a price reduction would go to abate any loss recoverable by Cavendish themselves if they had suffered any. We do not propose to resolve it on this appeal: the issue does not arise and was not argued. It is enough to note that if Cavendish’s loss is not abated, that would be because the law regards Cavendish as having suffered it notwithstanding its right to the reduction. That can hardly make clause 5.1 a penalty.
77. We do not doubt that price adjustment clauses are open to abuse, and if clause 5.1 were a disguised punishment for the Sellers’ breach, it would make no difference that it was expressed as part of the formula for determining the consideration. But before a court can reach that conclusion, it must have some reason to do so. In this case, there is none. On the contrary, all the considerations summarised above point the other way.
78. We conclude, in agreement with Burton J, that clause 5.1 was not a penalty.
Was clause 5.6 contrary to the penalty rule?
79. Clause 5.6 gives rise to more difficult questions, but the analysis is essentially the same.
[…]
82. In our view, the same legitimate interest which justifies clause 5.1 justifies clause 5.6 also. ..It was an interest in matching the price of the retained shares to the value that the Sellers were contributing to the business. There is a perfectly respectable commercial case for saying that Cavendish should not be required to pay the value of goodwill in circumstances where the Defaulting Shareholder’s efforts and connections are no longer available to the Company, and indeed are being deployed to the benefit of the Company’s competitors, and where goodwill going forward would be attributable to the efforts and connections of others. It seems likely that clause 5.6 was expected to influence the conduct of the Sellers after Cavendish’sacquisition of control in a way that would benefit the Company’s business and its proprietors during the period when they were yoked together. To that extent it may be described as a deterrent. But that is only objectionable if it is penal, ie if the object was to punish. But the price formula in clause 5.6 had a legitimate function which had nothing to do with punishment and everything to do with achieving Cavendish’s commercial objective in acquiring the business. And, like clause 5.1, it was part of a carefully constructed contract which had been the subject of detailed negotiations over many months between two sophisticated commercial parties, dealing with each other on an equal basis with specialist, experienced and expert legal advice.
83. More fundamentally, a contractual provision conferring an option to acquire shares, not by way of compensation for a breach of contract but for distinct commercial reasons, belongs as it seems to us among the parties’ primary obligations, even if the occasion for its operation is a breach of contract. This may be tested by asking how the penalty rule could be applied to it without making a new contract for the parties. The Court of Appeal simply treated clause 5.6 as unenforceable, and declared that Mr Makdessi was not obliged to sell his shares whether at the specified price or at all. That cannot be right, since the severance of the shareholding connection was in itself entirely legitimate, and indeed commercially sensible. If the option to acquire the retained shares is to stand, the price formula cannot be excised without substituting something else. Yet there is no juridical basis on which a different pricing formula can be imposed. There is no fall- back position at common law, as there is in the case of a damages clause.
[…]
88. The Court of Appeal in this case thought clauses 5.1 and 5.6 should both be treated in the same way when it came to applying the penalty rule, and we take the same view, but, in agreement with Burton J at first instance, we consider that neither clause is avoided by the penalty rule.
The second appeal: ParkingEye v Beavis
[…]
Introductory
94. It was common ground before the Court of Appeal, and is common ground in this court, that on the facts which we have just summarised there was a contract between Mr Beavis and ParkingEye. Mr Beavis had a contractual licence to park his car in the retail park on the terms of the notice posted at the entrance, which he accepted by entering the site. Those terms were that he would stay for not more than two hours, that he would park only within the marked bays, that he would not park in bays reserved for blue badge holders, and that on breach of any of those terms he would pay £85. Moore-Bick LJ in the Court of Appeal was inclined to doubt this analysis, and at one stage so were we. But, on reflection, we think that it is correct. The £85 is described in the notice as a “parking charge”, but no one suggests that that label is conclusive. In our view it was not, as a matter of contractual analysis, a charge for the right to park, nor was it a charge for the right to overstay the two-hour limit. Not only is the £85 payable upon certain breaches which may occur within the two-hour free parking period, but there is no fixed period of time for which the motorist is permitted to stay after the two hours have expired, for which the £85 could be regarded as consideration. The licence having been terminated under its terms after two hours, the presence of the car would have constituted a trespass from that point on. In the circumstances, the £85 can only be regarded as a charge for contravening the terms of the contractual licence.
95. Schemes of this kind (including a significant discount on prompt payment after the first demand) are common in the United Kingdom. Some are operated by private landowners, some by parking management companies like ParkingEye, and some by local authorities. They are subject to a measure of indirect regulation. Under section 54 of the Protection of Freedoms Act 2012, parked cars may not be immobilised or towed away by a private operator, but section 56 and Schedule 4 provide for the recovery of parking charges. Where a motorist becomes liable by contract for a “sum in the nature of a fee or charge” or in tort for a “sum in the nature of damages”, there is a right under certain conditions to recover it: Schedule 4, paragraph 4. One of those conditions is that the keeper’s details must have been supplied by the Secretary of State in response to an application for the information: ibid, para 11. The Secretary of State’s functions in relation to the provision of this information are performed by the DVLA. Under article 27(1)(e) of the Road Vehicles (Registration and Licensing) Regulations 2002 (SI 2002/2742), the Secretary of State is empowered to make available particulars in the vehicle register to anyone who “has reasonable cause for wanting the particulars to be made available to him”. Since 2007, the policy of the Secretary of State has been to disclose the information for parking enforcement purposes only to members of an accredited trade association. The criteria for accreditation were stated in Parliamentto include the existence of “a clear and enforced code of conduct (for example relating to conduct, parking charge signage, charge levels, appeals procedure, approval of ticket wording and appropriate pursuit of penalties” (Hansard (HC Debates), 24 July 2006, col 95WS).
96. As at April 2013, there was only one relevant accredited trade association, the BPA, to which reference was made on the Notice, and to which ParkingEye still belongs. The BPA Code of Practice is a detailed code of regulation governing signs, charges and enforcement procedures. Clause 13 deals with grace periods. Clause
13.4 provides:
“13.4 You should allow the driver a reasonable period to leave the private car park after the parking contract has ended, before you take enforcement action.”
Clause 19 provides:
“19.5 If the parking charge that the driver is being asked to pay is for a breach of contract or act of trespass, this charge must be based on the genuine pre-estimate of loss that you suffer. We would not expect this amount to be more than £100. If the charge is more than this, operators must be able to justify the amount in advance.
19.6 If your parking charge is based on a contractually agreed sum, that charge cannot be punitive or unreasonable. If it is more than the recommended amount in 19.5 and is not justified in advance, it could lead to an investigation by the Office of Fair Trading.”
The maximum of £100 recommended by the BPA may be compared with the penalties charged by local authorities, which are regulated by statute. The Civil Enforcement of Parking Contraventions (Guidelines on Levels of Charges) (England) Order 2007 (SI 2007/3487) lays down guidelines for the level of penalties outside Greater London. For “higher level contraventions” (essentially unauthorised on-street parking), the recommended penalty is capped at £70 and for other contraventions at £50. The corresponding figures for Greater London are £130 and £80.
Parking charges and the penalty rule
97. ParkingEye concedes that the £85 is payable upon a breach of contract, and that it is not a pre-estimate of damages. As it was not the owner of the car park, ParkingEye could not recover damages, unless it was in possession, in which case it may be able to recover a small amount of damages for trespass. This is because it lost nothing by the unauthorised use resulting from Mr Beavis overstaying. On the contrary, at least if the £85 is payable, it gains by the unauthorised use, since its revenues are wholly derived from the charges for breach of the terms. The notice at the entrance describes ParkingEye as being engaged to provide a “traffic space maximisation scheme”, which is an exact description of its function. In the agreed Statement of Facts and Issues, the parties state that “the predominant purpose of the parking charge was to deter motorists from overstaying”, and that the landowner’s objectives include the following:
“a. The need to provide parking spaces for their commercial
tenants’ prospective customers;
b. The desirability of that parking being free so as to attract customers;
c. The need to ensure a reasonable turnover of that parking so as to increase the potential number of such customers;
d. The related need to prevent ‘misuse’ of the parking for purposes unconnected with the tenants’ business, for example by commuters going to work or shoppers going to off-park premises; and
e. The desirability of running that parking scheme at no
cost, or ideally some profit, to themselves.”
98. Against this background, it can be seen that the £85 charge had two main objects. One was to manage the efficient use of parking space in the interests of the retail outlets, and of the users of those outlets who wish to find spaces in which to park their cars. This was to be achieved by deterring commuters or other long-stay motorists from occupying parking spaces for long periods or engaging in other inconsiderate parking practices, thereby reducing the space available to other members of the public, in particular the customers of the retail outlets. The other purpose was to provide an income stream to enable ParkingEye to meet the costs of operating the scheme and make a profit from its services, without which those services would not be available. These two objectives appear to us to be perfectly reasonable in themselves. Subject to the penalty rule and the Regulations, the imposition of a charge to deter overstayers is a reasonable mode of achieving them. Indeed, once it is resolved to allow up to two hours free parking, it is difficult to see how else those objectives could be achieved.
99. In our opinion, while the penalty rule is plainly engaged, the £85 charge is not a penalty. The reason is that although ParkingEye was not liable to suffer loss as a result of overstaying motorists, it had a legitimate interest in charging them which extended beyond the recovery of any loss. The scheme in operation here (and in many similar car parks) is that the landowner authorises ParkingEye to control access to the car park and to impose the agreed charges, with a view to managing the car park in the interests of the retail outlets, their customers and the public at large. That is an interest of the landowners because (i) they receive a fee from ParkingEye for the right to operate the scheme, and (ii) they lease sites on the retail park to various retailers, for whom the availability of customer parking was a valuable facility. It is an interest of ParkingEye, because it sells its services as the managers of such schemes and meets the costs of doing so from charges for breach of the terms (and if the scheme was run directly by the landowners, the analysis would be no different). As we have pointed out, deterrence is not penal if there is a legitimate interest in influencing the conduct of the contracting party which is not satisfied by the mere right to recover damages for breach of contract. Mr Butcher QC, who appeared for the Consumers’ Association (interveners), submitted that because ParkingEye was the contracting party its interest was the only one which could count. For the reason which we have given, ParkingEye had a sufficient interest even if that submission be correct. But in our opinion it is not correct. The penal character of this scheme cannot depend on whether the landowner operates it himself or employs a contractor like ParkingEye to operate it. The motorist would not know or care what if any interest the operator has in the land, or what relationship it has with the landowner if it has no interest. This conclusion is reinforced when one bears in mind that the question whether a contractual provision is a penalty turns on the construction of the contract, which cannot normally turn on facts not recorded in the contract unless they are known, or could reasonably be known, to both parties.
100. None of this means that ParkingEye could charge overstayers whatever it liked. It could not charge a sum which would be out of all proportion to its interest or that of the landowner for whom it is providing the service. But there is no reason to suppose that £85 is out of all proportion to its interests. The trial judge, Judge Moloney QC, found that the £85 charge was neither extravagant nor unconscionable having regard to the level of charges imposed by local authorities for overstaying in car parks on public land. The Court of Appeal agreed and so do we. It is higher than the penalty that a motorist would have had to pay for overstaying in an on-street parking space or a local authority car park. But a local authority would not necessarily allow two hours of free parking, and in any event the difference is not substantial. The charge is less than the maximum above which members of the BPA must justify their charges under their code of practice. The charge is prominently displayed in large letters at the entrance to the car park and at frequent intervals within it. The mere fact that many motorists regularly use the car park knowing of the charge is some evidence of its reasonableness. They are not constrained to use this car park as opposed to other parking facilities provided by local authorities, Network Rail, commercial car park contractors or other private landowners. They must regard the risk of having to pay £85 for overstaying as an acceptable price for the convenience of parking there. The observations of Lord Browne-Wilkinson in Workers Bank at p 580 referred to in para 35 above are in point. While not necessarily conclusive, the fact that ParkingEye’s payment structure in its car parks (free for two hours and then a relatively substantial sum for overstaying) and the actual level of charge for overstaying (£85) are common in the UK provides support for the proposition that the charge in question is not a penalty. No other evidence was furnished by Mr Beavis to show that the charge was excessive.
101. We conclude, in agreement with the courts below, that the charge imposed on Mr Beavis was not a penalty.
[…]
Conclusion on the two appeals
115. For these reasons, we would allow the appeal in Cavendish v El Makdessi and dismiss the appeal in ParkingEye v Beavis, and we would declare that none of the terms impugned on the two appeals contravenes the penalty rule, and that the charge in issue in ParkingEye v Beavis does not infringe the 1999 Regulations.
LORD MANCE:
[…]
The concept of a penalty
131. The doctrine of penalties is commonly expressed as involving a dichotomy between compensatory and deterrent clauses. In Robophone Facilities Ltd v Blank [1966] 1 WLR 1428, 1446H-1447A, Diplock LJ even expressed the doctrine in terms of a rule of public policy that did not “permit a party to a contract to recover in an action a sum greater than the measure of damages to which he would be entitled at common law”. All three of the early 20th century decisions of highest jurisdictions which together constitute the origin of the modern doctrine contain dicta suggestive of a mutually exclusive dichotomy. But all three show that there is no requirement that the measure of damages at common law should be ascertainable - indeed that an inability to ascertain this can justify an agreement to pay a fixed sum on breach. In this connection, they point to a broad understanding of the interests which can justify such an agreement. All three decisions must also be read in context, which involved interests different from those relevant on the present appeals.
[…]
143. It is clear from these three decisions that a concern can protect a system which it operates across its whole business by imposing an undertaking on all its counterparties to respect the system, coupled with a provision requiring payment of an agreed sum in the event of any breach of such undertaking. The impossibility of measuring loss from any particular breach is a reason for upholding, not for striking down, such a provision. The qualification and safeguard is that the agreed sum must not have been extravagant, unconscionable or incommensurate with any possible interest in the maintenance of the system, this being for the party in breach to show.
[…]
Should the penalty doctrine be abolished or restricted?
162. This being the current state of authority, I come to Cavendish’s primary and secondary cases, that the penalty doctrine should be abolished, or, that failing, that it should be restricted to non-commercial cases or to cases involving payment of money. I am unable to accept either proposition. As to abolition, there would have to be shown the strongest reasons for so radical a reversal of jurisprudence which goes back over a century in its current definition and much longer in its antecedents. It has long been recognised that the situations in which the doctrine may and may not apply can involve making distinctions which can appear narrow and which follow lines which can be difficult to define. But that has never hitherto been regarded as a reason for abandoning the whole doctrine, which in its core exists to restrain exorbitant or unconscionable consequences following from breach. In 1966 Diplock LJ, after referring in Robophone to the public policy behind the rule in the passage which I have already quoted (para 131 above), said that “in these days when so often one party cannot satisfy his contractual hunger à la carte but only at the table d’hôte of a standard printed contract, it has certainly not outlived its usefulness”.
163. In 1975 the Law Commission in its Working Paper No 61, Penalty Clauses and Forfeiture of Monies Paid, far from suggesting abolition proposed that the doctrine should be expanded, along lines now accepted in Australia by Andrews, to cover any situation where the object of the disputed contractual obligation is to secure the act or result which is the true result of the contract (pp 18-19). In 1999, the Scottish Law Commission in its Report on Penalty Clauses (Scot Law Com No171) recommended that there should continue to be judicial control over contractual penalties, whatever form they take – whether payment of money or forfeiture of money or transfer or forfeiture of property. It suggested as the criterion for such control whether the penalty was “manifestly excessive” in all the circumstances when the contract was entered into. It further recommended a test of substance for determining whether a clause was a penalty and an extension along the same lines as the English Law Commission recommended in 1975. Cavendish’s submission that this court should abolish or rewrite radically the penalty doctrine is made without the benefit of the sort of research into the consequences and merits of such a step, which the Law Commission or Parliament would undertake before venturing upon it.
164. There is therefore an unpromising background to Cavendish’s submission that the doctrine should be either abolished or restricted. Further, the Scottish Law Commission pointed out (para 1.8) that there has been a general convergence of approaches in European civil codes and soft law proposals towards a recognition of the utility and desirability of judicial control of disproportionately, excessively, manifestly or grossly high or unreasonable penalties. The Council of Europe’s Resolution 78(3) of 20 January 1978 on Penal Clauses in Civil Law (article 7), the Principles of European Contract Law (article 9:509), the Uncitral Texts on Liquidated Damages and Penalty Clauses (article 8) and the Unidroit Principles of International Commercial Contracts (article 7.4.13) all contain provisions for such control along such lines.
165. I note in parenthesis that many national European legal systems already appear to contain similar provisions, even if only introduced legislatively as appears to be the case in France by laws of 9 July 1975 and 11 October 1985 amending article 1152 of the Code civil (and reversing the effect of the Cour de cassation decision in Paris frères c Dame Juillard Civ 14 February 1866). Germany in contrast takes a broad view of the interests which may be protected by a clause imposing a financial liability on breach (Vertragsstrafe), including among them not merely compensation, but also deterrence. But in non-business cases, the court has the power to reduce any penalty to an appropriate level under BGB (the Civil Code), section 343. However, HGB (the Commercial Code) para 248 exempts contracts between businessmen from the scope of BGB section 343, although such contracts appear still to be susceptible to control if they are standard form contracts (not the case with that between Cavendish and Mr El Makdessi) or in terms so abusive as to infringe other principles applicable generally, although only in extreme cases, such as those governing Guten Sitten, Wucher or Treu und Glauben (BGB sections 138 and 242).
166. At the court’s request, Cavendish also included as an appendix to its case a valuable examination of the law of, and relevant academic commentary from, other common law countries: Australia, Canada, New York and other United States’ states and sources, Scotland, New Zealand, Singapore and Hong Kong. It is sufficient to say that all these countries retain a doctrine broadly on the same lines as the current English doctrine. In both Australia and Canada, emphasis has been placed on the root principles of extravagance, exorbitance or unconscionability, to be found in the Clydebank Engineering and Dunlop cases: AMEV-UDC Finance Ltd v Austin [1986] HCA 63, 162 CLR 170 and Elsley v J G Collins Insurance Agencies Ltd [1978] 2 SCR 916 and Waddams, The Law of Damages (Nov 2014), para 8-340. In Australia, the doctrine has been extended, as I have noted, to cover situations falling short of breach: Andrews. In both Singapore and Hong Kong, the approach in Philips Hong Kong has been followed. In Australia, it is established that the penalty doctrine applies to clauses calling for the transfer of property (para 158 above) as well as to the withholding of sums due, and there is also Hong Kong authority for the latter (para 154 above). Waddams, The Law of Contracts, 6th ed (2010), para 461 cites Jobson v Johnson for the proposition that it applies to clauses requiring transfer of property at an undervalue in Canada, and there is no suggestion of disagreement on either of these points in any other common law country. It would be odd, to say the least, if the United Kingdom separated itself from so general a consensus.
167. It is true that, in a European Union context measures now exist which carry some of the burden which might previously have been borne by the penalty doctrine: the Unfair Terms in Consumer Contracts Regulations 1999, giving effect to Directive 93/13/EEC, and the Consumer Protection from Unfair Trading Regulations 2008, giving effect to Directive 2005/29/EC. These are confined to consumer situations, and in the case of the former at present to contract terms which are not individually negotiated. That limitation has disappeared, with the coming into force of the Consumer Rights Act 2015 on 1 October 2015 to replace the Unfair Terms in Consumer Contracts Regulations 1999, the Unfair Contract Terms Act 1977 (in relation to consumer contracts), most of the Sale of Goods Act 1979, and the Supply of Goods and Services Act 1982 (in relation to consumer contracts). It would be unsafe to assume that any of these measures makes or will make the penalty doctrine redundant. The fact that Parliament has not sought to abolish or amend the doctrine, despite their existence, is just as capable of being invoked in its favour. In any event, the doctrine protects businesses, including small businesses, which may well have a need for it.
Conclusion
214. It follows that in the Cavendish case, I would allow Cavendish’s appeal in
relation to both clause 5.1 and clause 5.6; and that I would also dismiss Mr Beavis’s
appeal in the second case brought by ParkingEye.
LORD HODGE:
215. I adopt with gratitude the summary of the facts and the procedural history of the two appeals in the joint judgment of Lord Neuberger and Lord Sumption (at paras 44-68 in relation to the Cavendish appeal and paras 89-96 in relation to Mr Beavis’s appeal). Like them, I would allow the Cavendish appeal and dismiss the appeal by Mr Beavis.
[…]
(ii) Whether the rule against penalties should be abrogated or altered?
256. I am not persuaded that there is any proper basis for abrogating the rule against penalties or restricting its application to commercial transactions where the parties are unequal in their bargaining power and there is a risk of oppression.
257. The rule against penalties is an exception to the general approach of the common law that parties are free to contract as they please and that the courts will enforce their agreements – pacta sunt servanda. The rule against penalties may have been motivated in part by a desire to prevent oppression of the weaker party by the more powerful party to a contractual negotiation. As I have said, Viscount Stair spoke of this danger when he spoke of necessitous debtors having to yield to exorbitant penalties (IV.3.2). Diplock LJ in Robophone (p 1447A) recognised the reality that many contracting parties could not contract à la carte but had to accept the table d’hôte of the standard term contract. In AMEV–UDC Finance Ltd v Austin (1986) 162 CLR 170, Mason and Wilson JJ (at pp 193-194) suggested that the rule was aimed at preventing oppression and that the nature of the relationship between the contracting parties was a factor relevant to unconscionableness. In Philips v Hong Kong (pp 58-59) Lord Woolf suggested that in some cases the fact that one of the contracting parties was able to dominate the other as to the choice of the contract terms was relevant to the application of the rule. But the application of the rule does not depend on any disparity of power of the contracting parties: Imperial Tobacco Co (of Great Britain and Ireland) Ltd v Parslay [1936] 2 All ER 515 (CA), Lord Wright MR at p 523. Because the rule is not so limited, Ms Joanna Smith QC arguedthat the rule interferes with freedom of contract in circumstances in which it is not needed.
258. The rule may also be criticised because it can be circumvented by careful drafting. Indeed one of Cavendish’s arguments was that clause 5.1 could have been removed from the scope of the rule if it had been worded so as to make the payment of the instalments conditional upon performance of the clause 11 obligations. This is a consequence of the rule applying only in the context of breach of contract. But where it is clear that the parties have so circumvented the rule and that the substance of the contractual arrangement is the imposition of punishment for breach of contract, the concept of a disguised penalty may enable a court to intervene: see Interfoto Picture Library Ltd v Stiletto Visual Programmes Ltd [1989] QB 433, Bingham LJ at pp 445-446 and, more directly, the American Law Institute’s “Restatement of the Law, Second, Contracts” section 356 on liquidated damages and penalties, in which the commentary suggests that the court’s focus on the substance of the contractual term would enable it in an appropriate case to identify disguised penalties.
259. It may also be said against the rule that it promotes uncertainty in commercial dealings as the contracting parties may not be able to foresee the judges’ value judgment on whether a particular provision is exorbitant or unconscionable. There is beyond doubt real benefit in parties being able to agree the consequences of a breach of contract, particularly where there would be difficulty in ascertaining the sum in damages which was appropriate to compensate the innocent party for loss caused by the breach. Parties save on transaction costs where they can avoid expensive litigation on the consequences of breach of contract. It has also been said that judges should be modest in their assumptions that they know about business: Wallis v Smith (1882) 21 Ch D 243, Jessel MR at p 266.
260. Legislative measures have been introduced to control unfair terms in contracts. In recent years, the Unfair Terms in Consumer Contracts Regulations1999 and the Consumer Protection from Unfair Trading Regulations 2008 have given effect to European Directives and more recently the Consumer Rights Act2015 has been brought into force. But while this legislation may have reduced the need for the rule against penalties in consumer contracts, it has no bearing on commercial contracts.
261. There are therefore arguments that can be made against the rule against penalties, or at least against its scope. But I am persuaded that the rule against penalties should remain part of our law, principally for three reasons.
262. First, there remain significant imbalances in negotiating power in the commercial world. Small businesses often contract with large commercial entities and have little say as to the terms of their contracts. Examples such as the relationship between a main contractor and a sub-contractor in the construction industry and that between a large retail chain and a small supplier spring to mind.
263. Secondly, abolition of the rule against penalties would go against the flow of legal developments both nationally and internationally. Both the Law Commission of England and Wales and the Scottish Law Commission have looked at the rule against penalties and neither has recommended its abolition. The Law Commission’s Working Paper No 61 on “Penalty Clauses and Forfeiture of Monies Paid” in 1975 proposed the extension of judicial control to embrace penalty clauses that come into operation without any breach of contract. More recently, the Scottish Law Commission’s “Report on Penalty Clauses” in 1999 recommended the retention of judicial control over penalties whether they took the form of a payment of money, a forfeiture of money, a transfer of property or a forfeiture of property. It recommended a criterion of “manifestly excessive” and the abolition of any requirement that the clause be founded in a pre-estimate of damages. It also recommended that judicial control should not be confined to cases where the promisor is in breach of contract.
264. As counsel’s very helpful researches showed, other common law countries such as Australia, Canada, New Zealand, Singapore and Hong Kong have rules against penalties, as has the commercially important law of New York, the Uniform Commercial Code and, as I have mentioned, the American Law Institute’s “Restatement of the Law, Second, Contracts”.
265. In the civil law tradition, which has had a profound influence on Scots law and which under Lord Mansfield influenced the development of English commercial law, the modern civil codes of Belgium (article 1231), France (article 1152), Germany (section 343), and Italy (article 1384) and the Swiss Code of Obligations (article 163) all provide for the modification of contractual penalties using tests such as “manifestly excessive”, “disproportionately high”, or “excessive”. Further, in what Mr Bloch described as “soft law”, recent international instruments prepared by expert lawyers, such as the Council of Europe’s Resolution (78) 3 on Penal Clauses in Civil Law (1978) (article 7), the Principles of European Contract Law (1995) (article 9.509), the Unidroit Principles of International Commercial Contracts (1994) (article 7.4.13) and Uncitral texts on liquidated damages and penalty clauses (1983) (article 8) also provide for the restriction of “grossly excessive” or “manifestly excessive” or “substantially disproportionate” penalty clauses. The Draft Common Frame of Reference (III – 3:712) also provides for the reduction of stipulated payments for non-performance if they are “grossly excessive”.
266. Thirdly, I am not persuaded that the rule against penalties prevents parties from reaching sensible arrangements to fix the consequences of a breach of contract and thus avoid expensive disputes. The criterion of exorbitance or unconscionableness should prevent the enforcement of only egregious contractual provisions.
267. Ms Smith’s alternative proposal, that the rule should not extend to commercial transactions in which the parties are of equal bargaining power and each acts on skilled legal advice, does not appeal to me. Creating such a gateway to the application of the rule would risk adding to the expense of commercial disputes by requiring the court to rule on issues of fact about the bargaining power of the parties and the calibre of their respective legal advisers.
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Conclusion
290. I would therefore allow the appeal in Cavendish v El Makdessi and dismiss the appeal in ParkingEye v Beavis and make the declarations that Lord Neuberger and Lord Sumption propose in para 115 of their joint judgment.
LORD CLARKE:
291. I agree that the appeal in Cavendish should be allowed, that that in Beavis should be dismissed and that we should make the declarations proposed by Lord Neuberger and Lord Sumption. In reaching those conclusions I agree with the reasoning of Lord Neuberger and Lord Sumption, Lord Mance and Lord Hodge, save that on the question whether clauses 5.1 and 5.6 are capable of constituting penalties, I agree with Lord Hodge in having an open mind about clause 5.1, and in concluding that clause 5.6 is a secondary obligation – see paras 270 and 280 respectively. As to the relationship between penalties and forfeiture, my present inclination is to agree with Lord Hodge (in para 227) and with Lord Mance (in paras 160 and 161) that in an appropriate case the court should ask first whether, as a matter of construction, the clause is a penalty and, if it answers that question in the negative, it should ask (where relevant) whether relief against forfeiture should be granted in equity having regard to the position of each of the parties after the breach.
LORD TOULSON: (dissenting in part on ParkingEye Limited)
292. I agree with paras 116 to 187 of the judgment of Lord Mance and paras 216 to 283 of the judgment of Lord Hodge. In short, I agree with them on all points of general principle about the doctrine of penalties, its interrelationship with forfeiture and the application of the principles in the Cavendish case.
293. On the essential nature of a penalty clause, I would highlight and endorse Lord Hodge’s succinct statement at para 255 that “the correct test for a penalty is whether the sum or remedy stipulated as a consequence of a breach of contract is exorbitant or unconscionable when regard is had to the innocent party’s interest in the performance of the contract”. Parties and courts should focus on that test, bearing in mind a) that it is impossible to lay down abstract rules about what may or may not be “extravagant or unconscionable”, because it depends on the particular facts and circumstances established in the individual case (as Lord Halsbury said in the Clydebank case, [1905] AC 6, 10, and Lord Parmoor said in the Dunlop case, [1915] AC 79, 101), and b) that “exorbitant or unconscionable” are strong words. I agree with Lord Mance (para 152) that the word “unconscionable” in this context means much the same as “extravagant”.
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295. I disagree with the other members of the court in the parking case.
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