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Focus: UK Supreme Court counters High Court on penalties

19 November 2015

In brief: The highest appellate court in the UK has affirmed and restated the penalty rule as it applies in the UK in a recent decision that directly addresses, and counters, the High Court of Australia's approach to the rule in Andrews. Partner Nick Rudge (view CV) and Lawyer Patrick Easton report. 

 
 

How does it affect you?

  • The penalty rule is an exception to freedom of contract and courts remain reluctant to intervene in the context of properly advised parties with comparable bargaining power.
  • The United Kingdom Supreme Court decision will not substantially shift the decision of the High Court in Andrews which expanded the application of the penalty rule in Australia.
  • The decision may influence the High Court in its determination of the Paciocco appeal to give greater emphasis to the concept of 'legitimate interest' of the enforcing party under the penalty rule.
  • When drafting liquidated damages clauses and stipulating a sum for recovery, in order to discharge the evidential onus of the penalty rule, records of pre-estimates of loss should be kept.

Facts

The UK Supreme Court decision in Cavendish Square Holding BV v Talal El Makdessi; ParkingEye Limited v Beavis [2015] UKSC 671 addresses two appeals with distinct contextual backgrounds. Cavendish2 concerned a commercial contract for the sale of a controlling stake in a marketing company. The contract provided that if restrictive covenants were breached by the vendor, the vendor would lose an entitlement to payment instalments and would be required to sell the remaining stake at a price adjusted down by US$44 million. ParkingEye3 concerned a consumer contract with an £85 charge for exceeding the maximum stay in a car park. The entitlement and price adjustment provisions in Cavendish and the extended parking charge provisions in ParkingEye were challenged on the basis of the penalty rule.

The penalty rule

The penalty rule is a limitation on the freedom of contract that Australia inherited from the UK. Contracting parties may seek to provide certainty of consequences upon non-compliance with contractual provisions by specifying the remedies available, such as liquidated damages. However, if those remedies are penal in nature, the courts will not enforce those provisions.

In the UK, the penalty rule precludes enforcement by courts of agreed remedies to be recovered by an innocent party upon breach of contract. In Australia, the High Court decision of Andrews4 extended the application of the rule beyond circumstances of contractual breach.

The UK Supreme Court decision

In this recent decision, the UK Supreme Court was directly asked to abolish or restrict the application of the penalty rule. The UK Supreme Court did neither and instead acknowledged the ongoing role of the penalty rule before restating the law as it applies in the UK.

The concepts of, and distinctions between, 'genuine pre-estimate of loss' and 'deterrent' were labelled by the UK Supreme Court as 'unhelpful'. The common treatment of these tests as a 'code' was eschewed in favour of a new test emphasising the 'legitimate interests' of a contracting party.

Simply, the UK's new test for whether a contractual provision is penal 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.

 

In application to Cavendish, the UK Supreme Court has demonstrated that the penalty rule only applies to secondary obligations upon breach of contract, and not primary obligations. While noting that loss of an entitlement may amount to a penalty, the provisions for the vendor's disentitlement from the payment instalments were a primary obligation and therefore not subject to the penalty rule. The disentitlement on breach of the restrictive covenants was held to amount to a price adjustment regime reflecting the consideration that would be paid in the absence of the loyalty and goodwill of the vendor.

For ParkingEye, the charge was found not to be a penalty. The UK Supreme Court held that, although the penalty rule was engaged, the charge was not out of all proportion to the parking operator's legitimate interests to ensure turnover of consumers in the landowner's associated retail outlets and to profit from its services.

The UK court rejected the extension by the High Court in Andrews of the rule beyond breach of contract as a 'radical departure' from law.5 Additionally, the continued existence of the equitable doctrine of penalties, a significant finding in Andrews, was all but rejected by the UK Supreme Court which applied the common law doctrine.

Impact on Australian authority

To the extent that the UK Supreme Court decision contrasts with the unanimous decision of the Australian High Court in Andrews, the authority of the UK Supreme Court decision in Australia is very limited. On the requirement for a breach of contract to engage the penalty rule and the continued existence of the equitable jurisdiction, the UK Supreme Court decision stands in contrast with the High Court's decision in Andrews. It is highly unlikely that the High Court be readily moved from these positions.

The requirement for breach is unlikely to be revisited by the High Court in its forthcoming decision in Paciocco. Paciocco is an appeal from the Full Federal Court which considered the application of the penalty rule following Andrews (See our earlier Client Update on Paciocco  v Australia and New Zealand Banking Group Limited [2015] FCAFC 50). In Paciocco, neither party has submitted to the High Court that the decision in Andrews should be disturbed and therefore it is improbable that it will be.

However, the UK Supreme Court's approach to the concept of 'legitimate interest' may indicate where the High Court might go in Paciocco or beyond. 'Legitimate interest' is broader than 'genuine pre-estimate of loss' and would provide greater commercial certainty than afforded by current Australian authority.

Commercial implications

Liquidated damages

Liquidated damages clauses are highly susceptible to arguments that they fall foul of the penalty rule. In drafting liquidated damages clauses, drafters must turn their mind to whether or not a genuine pre-estimate of cost is reflected in the stipulated sum. Where possible, an enforcing party should take steps to create and retain documentation to discharge the evidential onus of the penalty rule. While the concept of 'legitimate interest' may save a clause in the UK that falls foul of a purely mathematical pre-estimate of loss, it is not current law in Australia.

Interest rates

The Andrews decision largely considered flat fees payable upon the occurrence of particular events. The Queensland Supreme Court in PT Thiess applied Andrews in considering the case of higher interest rates payable upon default and determined the higher rates were not penalties. Authority relied upon by the UK Supreme Court decision was distinguished by the Queensland Supreme Court.6 This Queensland Supreme Court decision demonstrates that Australian authority accepts that higher interest rates are not necessarily penal.

Withholding payments

Withholding of payments and entitlements as a collateral stipulation has remained an unresolved issue since Andrews. These are frequently used in commercial contracting. The UK Supreme Court is likely to stoke this discussion in Australia by leaving open, and even accepting the possibility, that in some circumstances withholding clauses may amount to penalties.7 Withholding clauses will not be considered in Paciocco so imminent clarification from the High Court is unlikely.

Bargaining power and consumer contracts

Similarly to the High Court, the UK Supreme Court emphasised the relevance of the relative bargaining power of contracting parties and of consumer protection regulation. As a justification for the continued importance of the penalty rule, the UK Supreme Court noted that statutory regulation in the UK is not 'covering the whole field' of the rule. For example, the UK court noted, it does not apply to non-consumer contracts entered into by parties similar in character to consumers, such as professionals and small businesses.8

Additionally, the UK Supreme Court affirmed the restraint that will be shown by courts to intervene in commercial contracts, particularly in 'the context of a carefully negotiated agreement between informed and legally advised parties at arm’s length' that are 'of comparable bargaining power'. Similar restraint should also be expected under Australian authority.

Footnotes
  1. Cavendish Square Holding BV v El Makdessi; ParkingEye Ltd v Beavis [2015] UKSC 67.
  2. Talal El Makdessi v Cavendish Square Holdings BV [2013] EWCA Civ 1539.
  3. ParkingEye Ltd v Beavis [2015] EWCA Civ 402.
  4. Andrews v Australia and New Zealand Banking Group Ltd (2012) 247 CLR 205.
  5. Cavendish Square Holding BV v El Makdessi; ParkingEye Ltd v Beavis [41].
  6. PT Thiess Contractors Indonesia v PT Arutmin Indonesia [2015] QSC 123 [180].
  7. Cavendish Square Holding BV v El Makdessi; ParkingEye Ltd v Beavis [73].
  8. Cavendish Square Holding BV v El Makdessi; ParkingEye Ltd v Beavis [38].

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