Penalties in English law are contractual terms which are not enforceable in the courts because of their penal character.[1] Since at least 1720[2] it has been accepted as a matter of English contract law that if a provision in a contract constitutes a penalty, then that provision is unenforceable by the parties. However, the test for what constitutes a penalty has evolved over time. The Supreme Court most recently restated the law in relation to contractual penalties in the co-joined appeals of Cavendish Square Holding BV v Talal El Makdessi, and ParkingEye Ltd v Beavis.[3]
The law relating to contractual penalties in England has been entirely developed by judges at common law without general statutory intervention. The Supreme Court has noted that "[t]he penalty rule in England is an ancient, haphazardly constructed edifice which has not weathered well".[3]
The origin of the common law rules relating to penalties is often taken to be the decision of the House of Lords in the Dunlop Pneumatic Tyre Co Ltd v New Garage & Motor Co Ltd decision in 1914.[4] But the jurisdiction is actually much older. The oldest reported case relating to penalties appears to date from 1720,[2] but even that case is decided on the basis that penalties were already generally considered unenforceable.
In their decision in Makdessi the Supreme Court reviewed the historical origins of the rule against penalty clauses in contracts.[5] The law originated in the fifteenth century in relation to "defeasible bonds" (sometimes called penal bonds) which were a contractual promise to pay money, which might be discharged if certain obligations were performed (and if the obligations were not performed, then the payment terms under the bond could be enforced).[6] However the courts of equity regarded these as what they really were - security for performance of the underlying obligation - and were prepared to restrain enforcement of such bonds where the defaulting party paid any damages due at common law.[7] In time the courts of common law began to mirror this approach and stay any proceedings on such bonds where the defendant gave an undertaking to pay damages together with interest and costs. The position of the common law courts was adopted and codified in the Administration of Justice Act 1696 and later the Administration of Justice Act 1705. Accordingly, procedurally relief in relation to such bonds was thereafter administered entirely by the common law courts without intervention by the courts of equity. However, the courts of equity began to develop concurrent remedies for relief from forfeiture. With the decline of the use of defeasible bonds the procedural mechanics became increasingly applied to liquidated damages clauses.
However, the decision in Dunlop in 1914 was taken to authoritatively restate the law. That case concerned what was expressed to be a liquidated damages clause. The courts had to determine whether the clause was in fact a penalty. The leading judgment was given by Lord Dunedin, who opined as follows:
Though the parties to a contract who use the words "penalty" or "liquidated damages" may prima facie be supposed to mean what they say, yet the expression used is not conclusive. The Court must find out whether the payment stipulated is in truth a penalty or liquidated damages.
...
The essence of a penalty is a payment of money stipulated as in terrorem of the offending party; the essence of liquidated damages is a genuine covenanted pre-estimate of damage.
...
It will be held to be penalty 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.
...
It is no obstacle to the sum stipulated being a genuine pre-estimate of damage, that the consequences of the breach are such as to make precise pre-estimation almost an impossibility. On the contrary, that is just the situation when it is probable that pre-estimated damage was the true bargain between the parties.[8]
Difficulties with the rule
The rule is one which judges over the years have confessed difficulty with. In Astley v Weldon[9]Lord Eldon admitted ("not for the first time" according to the Supreme Court in Makdessi[10]) to being "much embarrassed in ascertaining the principle on which [the rule was] founded". In Wallis v Smith,[11]Sir George Jessel MR similarly confessed: "The ground of that doctrine I do not know". In Robophone Facilities Ltd v Blank[12]Diplock LJ famously said that he would make "no attempt where so many others have failed to rationalise this common law rule".
Although the decision of Lord Dunedin sought to bring greater clarity to the law in 1914, in practice it often proved difficult to apply. Cases continued to come before the courts challenging provisions as a penalty, and the courts continued to wrestle with the issue. In Workers Trust & Merchant Bank Ltd v Dojap Investments Ltd[13]Lord Browne Wilkinson tried to describe the scope of the law of penalties, and noted the slightly anomalous rules in relation to forfeiture of deposits in relation to sales of land: "In general a contractual provision which requires one party in the event of his breach of contract to pay or forfeit a sum of money to the other party is unlawful as being a penalty, unless such provision can be justified as being a payment of liquidated damages being a genuine pre-estimate of the loss which the innocent party will incur by reason of the breach. One exception to this general rule is the provision for the payment of a deposit (customarily 10% of the contract price) on the sale of land..."
In the course of their exhaustive review of earlier authorities in Makdessi, the Supreme Court sorted through a large variety of obiter dicta relating to penalties, many of which they considered doubtful, misinterpretations of earlier decisions, or simply capable of being misconstrued.[14]
Change in approach
The law relating to contractual penalties has been almost entirely developed by judges in England.
In more recent cases the courts have taken a considerably more relaxed approach in relation to penalties. In Philips Hong Kong Ltd v AG of Hong Kong[15] the Privy Council expressly endorsed the comments of Dickson J in the Supreme Court of Canada in Elsey v J.G. Collins Insurance Agencies Ltd[16] that:
... the power to strike down a penalty clause is a blatant interference with freedom of contract and is designed for the sole purpose of providing relief against oppression for the party having to pay the stipulated sum. It has no place where there is no oppression.
However, the approbation by the Privy Council did not move the editors of Chitty on Contracts in relation to the point of law.[17] Subsequent to the publication of that edition of Chitty the Court of Appeal expressly replicated that statement.[3]:para 44 But even the editors of Chitty have acknowledged that their own preferred test of the requirement of genuine pre-estimate of loss has become very flexible.[18]
In 2005 Jackson LJ in Alfred McAlpine Projects v Tilebox[19] noted that he had only seen four reported cases where a clause has been struck down as a penalty. In the same year Arden LJ, giving the judgment of the Court of Appeal in Murray v Leisureplay plc[20] set out a series of five questions which the court should consider in relation to penalties:[21]
To what breaches of contract does the contractual damages provision apply?
What amount is payable on breach under that clause in the parties' agreement?
What amount would be payable if a claim for damages for breach of contract was brought under common law?
What were the parties' reasons for agreeing for the relevant clause?
Has the party who seeks to establish that the clause is a penalty shown that the amount payable under the clause was imposed in terrorem, or that it does not constitute a genuine pre-estimate of loss for the purposes of the Dunlop case, and, if he has shown the latter, is there some other reason which justifies the discrepancy between i) and ii) above?
In Azimut-Benetti SpA v Healey[22] the court has to consider a provision whereby a boat builder was entitled to terminate for non-payment of instalments and to claim 20% of the contracted price as liquidated damages. Upholding the clause, Clarke J said that commercially justifiable clauses should be enforceable provided the dominant purpose is not to deter the other party from breach. On the facts, it was clear that the purpose of the clause was to set out a pre-determined commercial solution in the event that the buyer defaulted.
The current position – Cavendish Square Holdings BV v Makdessi
In November 2015 the Supreme Court held joint appeals in the matter of Cavendish Square Holding BV v Talal El Makdessi and ParkingEye Ltd v Beavis,[3] and took the opportunity to restate the law in a lengthy judgment. The leading judgment was a joint judgment of Lord Neuberger and Lord Sumption, but the court was unanimous save that Lord Toulson dissented in part on the ParkingEye decision. Their Lordships recounted the relevant legal history, noting that the law originated in cases relating to "penal bonds", and noting the parallel developments between the rule against penalties (in the common law courts) and relief from forfeiture (in the equitable courts). After noting the rule had "not weathered well", their Lordships recorded that in relation to consumer contracts the matter was now effectively regulated by the Unfair Terms in Consumer Contracts Regulations. However the rule on penalties still had a purpose to serve in relation to non-consumer contracts and it should not, therefore, be abolished. But equally the court felt that it should not be extended.[23]
The Supreme Court then reformulated the common law test for what constitutes an unenforceable penalty clause. They held that the validity of such a clause turned on whether the party seeking to enforce the clause could claim a legitimate interest in the enforcement of the clause:[23]
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. The innocent party can have no proper interest in simply punishing the defaulter. His interest is in performance or in some appropriate alternative to performance. ... 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 Privy Council in Philips Hong Kong Ltd v Attorney General of Hong Kong (1993) 61 BLR 41, 59, “the court has to be careful not to set too stringent a standard and bear in mind 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”.[3]:paras 32-33
Accordingly, the reformulated test has essentially two elements:[23]
is any legitimate business-interest protected by the clause; and
if so, is the provision made in the clause extravagant, exorbitant or unconscionable?
The Supreme Court also affirmed that the rule against penalties will only apply to secondary obligations, i.e. obligations which arise upon breach of a primary obligation.[23] A clause which stipulates onerous provisions in a contract may be onerous, but unless it is triggered by breach it is not a penalty in the eyes of the law. Their Lordships also observed that a penalty clause may often be simple payment of money, but it could also encompass other things, such as the withholding of payments, requirements to transfer assets, or (on the facts before them) a requirement to repay a non-refundable deposit.
A case addressed in the Court of Appeal in parallel with Cavendish and ParkingEye and recognising the relevance of this legal development, Edgeworth Capital (Luxembourg) SARL v Ramblas Investments BV, found that a provision for payment of a financing fee should not be treated as an unenforceable penalty clause, but was to be treated as a fee payable in specific circumstances which "had nothing to do with damages for breach of contract".[24]
Requirement for breach
A clause which provides for a large payment in pursuant of the performance of obligations is not a penalty at law.[25] In Berg v Blackburn Rovers FC[26] it was held that where a football club exercised its right to terminate employment of a manager upon payment out of the remaining salary due under the contract, this was the performance of a term and not a provision designed to constrain breach. Accordingly, it could not be a penalty. For English law this position was reaffirmed by the Supreme Court in the Makdessi decision.[23]
The Supreme Court's ruling in respect of the ambit of the penalty rule represents the clear contrast between Australian and UK contract law. In 2012, the High Court of Australia concluded that a provision can be a penalty even if it is not triggered by a breach of contract.[27] The court held that in general terms,' a stipulation prima facie imposes a penalty on a party (“the first party”) if, as a matter of substance, it is collateral (or accessory) to aprimary stipulation in favour of a second party and this collateral stipulation, upon the failure of the primary stipulation, imposes upon the first party an additional detriment, the penalty, to the benefit of the second party'.[27]:para 10 In 2014, the Federal Court of Australia clarified and constrained the limits of the "Andrew's Test", noting that the loss must be "extravagant or unconscionable" compared with the greatest calculation of the proved loss in order to trigger the doctrine.[28]
Effect
Cases referring to penalty clauses use the words "void" and "unenforceable" interchangeably. In the High Court of Australia in the decision of AMEV-UDC Finance Ltd v Austin,[29]Mason and WilsonJJ stated: "At least since the advent of the Judicature system a penalty provision has been regarded as unenforceable or, perhaps void, ab initio". (emphasis added)
Because an allegation that a clause constitutes a penalty is usually raised as a defence to a contractual claim, there is no practical difference. However, if a party were to pay out under such a clause and then seek the return of the money paid, then clearly it would be material to establish whether the clause was merely unenforceable (in which case the money could not be claimed back) or void (in which case it could).[30]
In Makdessi the Supreme Court stuck scrupulously to the word "unenforceable"[31][32] but they also noted that Mr Makdessi had claimed that the clause was "void and unenforceable",[33] but did not expressly comment upon whether it might be void (and did not need to do so, as they held it was not a penalty).
↑ Chitty on Contracts. Vol.1 (31sted.). Sweet & Maxwell. 2012. 26–172. However, the correct question is not whether one party secured the clause by the use of unequal bargaining power or oppression, but whether or not the clause is a genuine pre-estimate of loss.
↑ Chitty, at 26–174, citing Murray v Leisureplay plc [2005] EWCA Civ 963 at [43]: "The parties are allowed a generous margin."
↑ Alfred McAlpine Projects v Tilebox[2005] EWHC 281, at paragraph 48.
↑ The word "unenforceable" appears 28 times in the judgment. The word "void" appears only three time - twice in quotes from other judgments, and once in relation to the summary of Mr Makdessi's claim.
At common law, damages are a remedy in the form of a monetary award to be paid to a claimant as compensation for loss or injury. To warrant the award, the claimant must show that a breach of duty has caused foreseeable loss. To be recognised at law, the loss must involve damage to property, or mental or physical injury; pure economic loss is rarely recognised for the award of damages.
Breach of contract is a legal cause of action and a type of civil wrong, in which a binding agreement or bargained-for exchange is not honored by one or more of the parties to the contract by non-performance or interference with the other party's performance. Breach occurs when a party to a contract fails to fulfill its obligation(s), whether partially or wholly, as described in the contract, or communicates an intent to fail the obligation or otherwise appears not to be able to perform its obligation under the contract. Where there is breach of contract, the resulting damages have to be paid to the aggrieved party by the party breaching the contract.
Liquidated damages, also referred to as liquidated and ascertained damages (LADs), are damages whose amount the parties designate during the formation of a contract for the injured party to collect as compensation upon a specific breach. This is most applicable where the damages are intangible, such as a failure by the contractor on a public project to fulfill minority business subcontracting quotas.
Penal damages are liquidated damages which exceed reasonable compensatory damages, making them invalid under common law. While liquidated damage clauses set a pre-agreed value on the expected loss to one party if the other party were to breach the contract, penal damages go further and seek to penalise the breaching party beyond the reasonable losses from the breach. Many clauses which are found to be penal are expressed as liquidated damages clauses but have been seen by courts as excessive and thus invalid.
The law of contract in Australia is similar to other Anglo-American common law jurisdictions.
In legal theory, particularly in law and economics, efficient breach is a voluntary breach of contract and payment of damages by a party who concludes that they would incur greater economic loss by performing under the contract.
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"Time is of the essence" is a term used in contract law in England and Wales, Canada, Australia, New Zealand, other Commonwealth countries and the United States, expressing "the need for timely completion", i.e. indicating that one or more parties to the agreement must perform by the time to which the parties have agreed if a delay will cause material harm. However, in the case of Foundation Development Corp. v. Loehmann's Inc. 788 P.2d 1189, in which the lease included a Time is of the essence clause, the court ruled that a minor delay did not cause material harm and thus no breach of contract occurred.
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Attorney General v Blake[2000] UKHL 45, [2001] 1 AC 268 is a leading English contract law case on damages for breach of contract. It established that in some circumstances, where ordinary remedies are inadequate, restitutionary damages may be awarded.
A take-or-pay contract is a rule structuring negotiations between companies and their suppliers. With this kind of contract, the company either takes the product from the supplier or pays the supplier a penalty. For any product the company takes, they agree to pay the supplier a certain price, say $50 per ton. Furthermore, up to an agreed-upon ceiling, the company is required to pay the supplier even for products they do not take. This "penalty" price is lower, say $40 a ton.
Dunlop Pneumatic Tyre Co Ltd v New Garage & Motor Co Ltd[1914] UKHL 1 is an English contract law case, concerning the extent to which damages may be sought for failure to perform of a contract when a sum is fixed in a contract. It held that only if a sum is of an unconscionable amount will it be considered penal and unenforceable. The legal standing of this case has been superseded by the Supreme Court's 2015 ruling in the combined cases of Cavendish Square Holding BV v Talal El Makdessi and ParkingEye Ltd v Beavis.
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Afrox Healthcare Ltd v Strydom, an important case in South African contract law, was heard in the Supreme Court of Appeal (SCA) on May 13, 2002, with judgment handed down on May 31.
A penal bond is a written instrument executed between an obligor and an obligee designed to secure the performance of a legal obligation through the in terrorem effect of the threat of a penalty for nonperformance.
Cavendish Square Holding BV v Talal El Makdessi[2015] UKSC 67, together with its companion case ParkingEye Ltd v Beavis, are English contract law cases concerning the validity of penalty clauses and the application of the Unfair Terms in Consumer Contracts Directive. The UK Supreme Court ruled on both cases together on 4 November 2015, updating the established legal rule on penalty clauses and replacing the test of whether or not a disputed clause is "a genuine pre-estimate of loss" with a test asking whether it imposed a proportionate detriment in relation to any "legitimate interest" of the innocent party.
Rock Advertising Ltd v MWB Business Exchange Centres Ltd[2018] UKSC 24 is a judicial decision of the Supreme Court of the United Kingdom relating to contract law, concerning consideration and estoppel. Specifically it concerned the effectiveness of "no oral variation" clauses, which provide that any amendments or waiver in relation to the contract must be in writing.
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