This article was written by Edmund Wan and Zi Wei Wong.
The UK Supreme Court’s (“UKSC”) decision in Cavendish Square Holding BV v Talal El Makdessi and ParkingEye Limited v Beavis  UKSC 67 clarified – and, to an extent, liberalised – the legal position on penalty clauses.
This decision involved an appeal from two cases, Cavendish Square Holding BV v Talal El Makdessi and ParkingEye Limited v Beavis:
Cavendish Square Holding BV v Talal El Makdessi
One of the defendants, Mr Makdessi, was a co-founder and owner of an advertising and marketing communications group (the “Group”) in the Middle East. He entered into an agreement to sell 47.7% of the Group to Cavendish Square Holding (“Cavendish”) under which he was subject to several restrictive covenants, including obligations to refrain from competing activities.
Under the agreement, if Mr Makdessi was in breach of the covenants:
- he would not be entitled to the payment instalments due to be paid (“Clause 5.1”); and
- he would be required to sell his remaining holdings in the Group to Cavendish for a price that ignores any value for goodwill by way of a put option offered to Cavendish (“Clause 5.6”).
Mr. Makdessi breached the restrictive covenants (this was not disputed at trial), and alleged that the above obligations were penalties and were unenforceable.
The UKSC held that neither Clause 5.1 nor 5.6 were penalties because they were primary obligations. In drawing a distinction between primary and secondary obligations, the court held that it does not review the fairness of the parties’ primary obligations, such as the consideration promised for a given standard of performance. On the other hand, a secondary obligation provides a contractual alternative to damages at law and is capable of being a penalty.
The UKSC reasoned that Clause 5.1 was a “price adjustment clause”. Its effect was that Mr Makdessi would earn the consideration for his shares not only by transferring them to Cavendish, but also by observing the restrictive covenants. Further, Cavendish had a legitimate interest in Mr Makdessi observing the restrictive covenants because his loyalty was critical to the value of the business. This was because personal relationships were essential to the business and if the founder acted against the Group, it would cause the Group to lose value.
Clause 5.6 was also held to not be a penalty because conferring an option to acquire shares for distinct commercial reasons was a primary obligation, even though the occasion for its operation is a breach of contract. The UKSC found that Clause 5.6 served a legitimate commercial purpose which was to sever any connection between a shareholder in default and the Group.
Consequently, both clauses were found to be enforceable against the Mr Makdessi.
ParkingEye Limited v Beavis
ParkingEye managed a car park at a retail park. Parking was free, but customers were required to comply with a two-hour parking time limit. A failure to comply resulted in a parking charge of £85.
Mr Beavis overstayed the two hour limit by almost an hour and refused to pay the £85 charge arguing that it was a penalty.
The UKSC held that while the penalty rule could apply, the £85 charge was not a penalty. This is because ParkingEye had a legitimate interest in charging the £85 fee, namely that ParkingEye:
- had to manage the efficient use of parking space in the interests of the retail outlets and the users of those outlets. This was achieved by deterring commuters from occupying parking spaces for long periods.
- required an income stream to meet the costs of operating the parking scheme, without which those services would not be available.
Key to the decision was that ParkingEye had a legitimate interest in charging the £85 charge, without which the deterrence imposed by the charge would have led to the £85 charge being a penalty.
These cases provide clarification to the law on penalties and will have an impact on how liquidated damages provisions are interpreted going forward. The UKSC has substantially reshaped the test for identifying penalty clauses in the following ways:
- the fact that a clause is not a pre-estimate of loss does not necessarily mean the clause is penal;
- courts look at whether the clause “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”; and
- a clause may only amount to a penalty if it is a secondary obligation. A clause imposing a primary obligation cannot be a penalty.
While the “legitimate interest” test has replaced the traditional “pre-estimate of loss” test, the pre-estimate of loss would still be a useful indicator of whether an impugned provision imposes a disproportionate detriment in most circumstances.
This recast of the penalty rule has several implications:
- Share purchase agreements – parties to share purchase or joint operating agreements governed by English law should have greater confidence that buy-out clauses (even at a discount to fair market value) will have a greater likelihood of being enforced in court or by a tribunal. On this basis, parties may be willing to negotiate larger discounts on a buyout.
- Construction contracts – It appears that the previous test of a “genuine pre-estimate of loss” would become less relevant under English law. Although this case does not involve a construction dispute, employers and developers may welcome this decision because assessing actual losses on delayed projects can be extremely difficult. Instead, courts would focus on whether or how the liquidated damages clause is proportionate to the legitimate interests of the employer.
This decision does not mean that all liquidated damages or buy-out clauses would be enforced in all circumstances. Arguably, these tests of legitimate commercial interest and proportionality give judges and arbitrators a wider discretion than before. In some circumstances, particular clauses might still be regarded as penal by tribunals.
The UKSC clarified that English law does not subject primary obligations to the penalty regime because an obligation could not be a penalty unless it provided an exorbitant alternative to common law damages.
But on balance, parties should have increased confidence that discounted buy-out clauses will be enforceable and liquidated damages clauses are more likely to be enforceable under English law. It remains to be seen whether the Hong Kong courts would adopt these principles. Until they do so, the traditional test of “genuine pre-estimate of loss” remains good law in Hong Kong.