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Liquidated Damages and Penalty Clauses: A change in the Law

01 Sep 2017

Jan Rzedzian, Associate Solicitor in the Construction Team at Hay & Kilner, considers the decision in the case of Cavendish Square Holding BV v Talal El Makdessi and ParkingEye Limited v Beavis, in which the Supreme Court has very much supported the approach of taking into consideration the “commercial interests” of the parties when deciding whether the liquidated damages figure is acceptable.

In Cavendish Square Holding BV v Talal El Makdessi, Mr Makdessi agreed to sell a controlling stake to Cavendish under the terms of a Share Sale Agreement. The Agreement contained restrictive covenants requiring Mr Makdessi not to become involved in a competing business in default of which (i) he would forfeit the final two instalments of deferred consideration that were to be payable to him by Cavendish for his shares, and (ii) he would be required to transfer all his remaining shares to Cavendish at a price which excluded any goodwill value. Mr Makdessi accepted he breached the restrictive covenants but he denied that the clauses were enforceable on the basis that they were penalties.

The second case considered by the Court was ParkingEye Limited v Beavis. In this case, Mr Beavis drove into the Riverside Retail Park car park in Chelmsford which was managed by private car park operator, ParkingEye. The car park displayed prominent signs at its entrance and on notice boards within the car park advising there was a maximum stay of two hours, after which time a parking charge of £85.00 would apply, which would reduce to £50.00 if paid within 14 days. Mr Beavis overstayed the maximum stay by one hour, and consequently, he was charged £85.00. He refused to pay on the basis that the clause was a penalty and was therefore unenforceable.

As both cases concerned the enforceability of the liquidated damages figures, the appeals to the Supreme Court were conjoined (2015 UKSC 67).

The Supreme Court’s Findings

The Supreme Court was unanimous that the doctrine of penalties should not be abolished, but their Lordships rejected the traditional test set down in the Dunlop case that a clause will be a penalty if it is not a genuine pre-estimate of loss. The Court held that the wider commercial interests of the innocent party should also be taken into account and the validity of the clause also depended on whether the innocent party had a “legitimate interest” in its enforcement. If the clause had an adverse impact on the party in breach that significantly exceeded that interest, it would be unenforceable as a penalty.  However, the fact that a liquidated damages figure did not amount to a genuine pre-estimate of loss did not, of itself, mean that it was penal. The innocent party may have a legitimate interest above and beyond recovering compensation.

Applying this reformulated test to the facts, the Supreme Court unanimously held in the “Cavendish” appeal that the clauses in question were not penal. They were found to be primary obligations under the contract as they provided for an adjustment to the purchase price that was equivalent to the other primary price calculation clauses in the contract, and the clauses were justified commercially by Cavendish’s legitimate interest in protecting the goodwill of the business. The parties were considered to be the best judges of how that interest should be reflected in the contract.

Similarly, in the “ParkingEye” appeal, the Court held that whilst the £85 charge was, in fact, a secondary obligation which was intended to deter motorists from a breach of contract i.e. overstaying, it was not a penalty because not only ParkingEye but also the car park owner, had a legitimate commercial interest in charging motorists who overstayed, which extended beyond the recovery of any financial loss. The interest of the car park owner was the provision of efficient management control of customer parking for the retail outlets. The interest of ParkingEye was income from the £85 charge which met the running costs of what was considered by the Court to be a legitimate commercial scheme, plus a profit margin. The reasoning behind the imposition of the charge was therefore entirely reasonable, and because it was in proportion to both ParkingEye and the car park owners’ commercial interests, it was not found to be penal.

Where are we now?

In the past, there was some comparative certainty regarding the enforceability of liquidated damages figures included in commercial contracts, with the starting point being that those figures had to represent a genuine pre-estimate of the anticipated loss that the innocent party would suffer.  Now, however, as long as the legitimate commercial interests of the parties are made clear, such as an express statement in the contract setting out the specific reasons why the liquidated damages figure needs to be set at a higher level, it is likely that the courts will not strike out the figure as being penal. Where a party’s legitimate commercial interests are purely financial and quantifiable, the Court’s task should be relatively straightforward. However, where they are not easily quantifiable, the task will be far more difficult.

Whether the uncertainty created by the Supreme Court will encourage more litigation on liquidated damages clauses or dissuade litigants from fighting remains to be seen.

For further information, please contact Jan Rzedzian, Associate Solicitor in the Construction Team at Hay & Kilner

Call: 0191 232 8345

Email: Jan.Rzedzian@hay-kilner.co.uk