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Surely that’s a foul? Business Money talks to City barrister Professor Mark Watson-Gandy about contractual penalties
What is the legal situation with contractual penalties? Penalties are unenforceable under English law. Penalty clauses were clauses in terrorem to provide a contractual stick to discourage a party from breaching the terms; a contractual fine which was imposed to punish a nonperforming party. By contrast, where a party has agreed a predetermined sum would be payable in lieu of damages being assessed, that would be enforceable provided it was a genuine pre-estimate of likely damages. Or that is where the law stood. Have things changed? The Supreme Court restated the law on penalties in its November 2015 judgment in Cavendish Square Holding BV v Makdessi. Is it still all about genuine preestimates of loss?
the Latin equivalent, in terrorem – does not add anything. A deterrent provision in a contract is simply one species of provision designed to influence the conduct of the party potentially affected. It is no different in this respect from a contractual inducement. Neither is it inherently penal or contrary to the policy of the law.” How does one approach the test? So what is the true test now? The true test was described as follows: “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.” Cavendish Square Holding BV v Makdessi [2015]. What does that mean?
No. The court firmly rejected the rigid preestimate of loss approach. Now, instead, the real question when a contractual provision is challenged as a penalty is whether it is penal. Lord Neuberger in Cavendish Square Holding BV v Makdessi said that these are not natural opposites or mutually exclusive categories. A damages clause may be neither or both. So is it about whether the penalty is a deterrent? The court also rejected the proposition that the fact that the clause is intended to act as a deterrent makes it penal: Lord Neuberger in Cavendish Square Holding BV v Makdessi said: “Describing it as a deterrent – or, to use February 2016
The penalty rule arises where there is an interference with the freedom of contract. By contrast, the parties are now given latitude to negotiate their own terms. In a negotiated contract between properly advised parties of comparable bargaining power, the strong initial presumption must thus be that the parties themselves are the best judges of what is legitimate in a provision dealing with the consequences of breach. Commercial interests may justify the imposition on a breach of contract of a financial burden, which cannot either be related directly to loss caused by the breach or justified by reference to the impossibility of assessing such loss. www.business-money.com
What is necessary in each case is to consider (a) whether any legitimate business interest is served and protected by the clause, and (b) whether, assuming such an interest exists, the provision made for the interest is nevertheless in the circumstances extravagant, exorbitant or unconscionable: Cavendish Square Holding BV v Makdessi [2015]. Will it matter if lawyers were instructed? In judging what is extravagant, exorbitant or unconscionable, the extent to which the parties were negotiating at arm’s length on the basis of legal advice and had every opportunity to appreciate what they were agreeing must at least be a relevant factor: Lordsvale Finance [1996], Cavendish Square Holding BV v Makdessi [2015].
Questions for Counsel’s Opinion should be e-mailed to:
[email protected] Professor Mark Watson-Gandy is a barrister at The Chambers of John McDonnell QC, 13 Old Square, Lincoln’s Inn, London WC2A 3UA Tel: +44 (0) 20 7831 4445 Fax: +44 (0) 20 7841 5825 E-mail:
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