The recent judgment of the Supreme Court of the United Kingdom in Cavendish Square Holding BV v Talal El Makdessi is a must-read for anyone involved in contract law.

In this decision of some 132 pages and 316 paragraphs, the U.K. Supreme Court provides an exhaustive analysis of the history and policy behind one of the most contentious principles of contract law: the penalty doctrine. In doing so, the court lays to rest, at least for U.K. law, many of the contentious issues relating to the rule against penalties. This decision is bound to influence the views of Canadian courts as they wrestle with the same issues.

Under the traditional penalty doctrine of contract law, a clause in a contract which imposes a “penalty” for breach of the contract is unenforceable, while a clause which imposes a reasonable pre-estimation of damages – called “liquidated damages” – is enforceable. Because the penalty doctrine interferes with the freedom of contract –by striking down penalty clauses – it is a contentious one in modern contract law. Some commentators argue that the doctrine should be eliminated. Others argue that it should be extended to apply to all types of claims and clauses in contract law, not just those involving a breach of contract.

It was into that controversy that the U.K. Supreme Court dived in the Cavendish Square decision.

There are many elements of that decision which may be important for the development of Canadian law. However, the one that may be the most important is the conclusion of the U.K. Supreme Court that a contractual clause imposing agreed damages or repercussions on the wrongdoer is valid even if those damages are not a reasonable pre-estimate of damages, as long as they are justified by an interest of the innocent party in the performance of the contract, and are not extravagant or exorbitant.

The Background

The U.K. Supreme Court’s decision arose from two cases.

In Cavendish Square, one group of shareholders bought control of the company from the other group. The agreement between the two groups provided that if the seller breached the agreement by competing with the company whose shares were being sold, then two consequences occurred; under clause 5.1 the buyer did not have to pay the balance of the purchase price; and under clause 5.6, the buyer had the right to purchase the seller’s remaining shares at a much reduced price. In fact, the seller did breach the agreement by joining a competitor, and the buyer refused to pay the balance of the purchase price and exercised the right to buy the seller’s remaining shares at the lower price. The seller argued that those two rights amounted to unenforceable penalties because the impact of the exercise of those rights was totally disproportionate to any loss suffered by the buyer. The seller’s position was upheld in the Court of Appeal. The U.K. Supreme Court reversed that decision, holding that neither of the rights exercised by the buyer violated the penalty doctrine.

In the Parking Eye case, Parking Eye leased and operated a parking lot. Drivers could park their cars on the lot for up to two hours for free, but no longer. If they parked longer than two hours, then they had to pay £85. The idea behind this parking lot and charging system was to provide short term free parking for customers of the near-by shops, so customers could shop and park for short terms and get out of the lot and other customers could then come in. Mr. Beavis parked longer than two hours and when he was charged this amount, he argued that the charge was a penalty, saying that the charge was totally disproportionate to any loss suffered by Parking Eye due to his over-staying the two hours. His position was not accepted by the Court of Appeal or the U.K. Supreme Court.

Decision of the U.K. Supreme Court

Anyone interesting in the penalty doctrine should read this decision, so I am going to take this opportunity to set out what, in my view, are the principle issues decided by the Court:

  1. Enforcement of a remedial, or secondary, obligation

The U.K. Supreme court outlined three elements of the penalty doctrine. Under the first element, a contractual clause only falls within the rule against penalties if it imposes a secondary means of enforcing a primary contractual obligation.

The reason for this element of the rule is that the courts should not be allowing parties out of a bad deal, and the penalty doctrine does not permit them to do so. If a party enters into an “unfair” bargain, that is not a problem that the penalty doctrine can address. Lord Neuberger and Lord Sumption stated it this way:

“This principle is worth restating at the outset of any analysis of the penalty rule, because it explains much about the way in which it has developed. There is a fundamental difference between a jurisdiction to review the fairness of a contractual obligation and a jurisdiction to regulate the remedy for its breach. Leaving aside challenges going to the reality of consent, such as those based on fraud, duress or undue influence, the courts do not review the fairness of men’s bargains either at law or in equity. The penalty rule regulates only the remedies available for breach of a party’s primary obligations, not the primary obligations themselves.” This [concept]…. provided the whole basis of the classic distinction made at law between a penalty and a genuine pre-estimate of loss, the former being essentially a way of punishing the contract-breaker rather than compensating the innocent party for his breach…It is not a proper function of the penalty rule to empower the courts to review the fairness of the parties’ primary obligations, such as the consideration promised for a given standard of performance. For example, the consideration due to one party may be variable according to one or more contingencies, including the contingency of his breach of the contract. There is no reason in principle why a contract should not provide for a party to earn his remuneration, or part of it, by performing his obligations. If as a result his remuneration is reduced upon his non-performance, there is no reason to regard that outcome as penal. Suppose that a contract of insurance provided that it should be cancelled ab initio if the insured failed to pay the premium within three months of inception. The effect would be to forfeit any claim upon a casualty occurring in the first three months but it would be difficult to regard the provision as penal on that account.” (emphasis added)

Lords Neuberger and Sumption held that Cavendish Square’s claims for the non-payment of the balance of the purchase price of the shares already bought was:

“in reality a price adjustment clause…... Clause 5.1 belongs with clauses 3 and 6, among the provisions which determine Cavendish’s primary obligations, ie those which fix the price, the manner in which the price is calculated and the conditions on which different parts of the price are payable. Its effect is that the Sellers earn the consideration for their shares not only by transferring them to Cavendish, but by observing the restrictive covenants.” (emphasis added)

  1. Not a legitimate interest of the innocent party    

Second, for the clause to contravene the penalty doctrine, the impact of the clause must be one which does not fall within the innocent party’s legitimate interest under the contract. In this respect, the court has narrowed the financial consequence of a contractual provision before it will offend the penalty doctrine. As long as the financial consequence has a legitimate relationship to the contract (and is not egregious), then it will not be a penalty.

The inquiry about the legitimacy interest of the innocent party is not confined to the actual damages arising from the breach, and the amount need not be justifiable as a reasonable pre-estimation of the likely damages that will be suffered by the innocent party. Rather, the overall consequences of the breach, and other similar breaches, may justify the imposition of the amount forfeited by the clause. As Lord Neuberger and Lord Sumption said:

“ 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. In the case of a straightforward damages clause, that interest will rarely extend beyond compensation for the breach……. But compensation is not necessarily the only legitimate interest that the innocent party may have in the performance of the defaulter’s primary obligations.” (emphasis added)

Lord Hodge and Lord Mance agreed with this approach. In Lord Hodge’s view, this “broader approach escapes the straightjacket into which the law risked being placed by an over-rigorous emphasis on a dichotomy between a genuine pre-estimate of damages on the one hand and a penalty on the other.”

In the present cases, the court held that the amounts involved had a legitimate relationship to the contracts. Cavendish Square’s right not to pay the balance of the purchase price of the already purchased shares, and to pay a lower price for the to-be purchased shares, were direct consequences of the larger harm inflicted on the company, and thus the lesser value of the company to the shareholders, due to the seller’s breach of his fiduciary duty to the company. Lords Neuberger and Sumption said:

“Although clause 5.1 has no relationship, even approximate, with the measure of loss attributable to the breach, Cavendish had a legitimate interest in the observance of the restrictive covenants which extended beyond the recovery of that loss. It had an interest in measuring the price of the business to its value. The goodwill of this business was critical to its value to Cavendish, and the loyalty of Mr Makdessi and Mr Ghossoub was critical to the goodwill. The fact that some breaches of the restrictive covenants would cause very little in the way of recoverable loss to Cavendish is therefore beside the point. As Burton J graphically observed in para 43 of his judgment, once Cavendish could no longer trust the Sellers to observe the restrictive covenants, “the wolf was in the fold”. Loyalty is indivisible. Its absence in a business like this introduces a very significant business risk whose impact cannot be measured simply by reference to the known and provable consequences of particular breaches. It is clear that this business was worth considerably less to Cavendish if that risk existed than if it did not. How much less? There are no juridical standards by which to answer that question satisfactorily.”

The court arrived at a similar conclusion with respect to clause 5.6. As Lords Neuberger and Sumption said:

“[Cavendish had] an interest in matching the price of the retained shares to the value that the Sellers were contributing to the business. There is a perfectly respectable commercial case for saying that Cavendish should not be required to pay the value of goodwill in circumstances where the Defaulting Shareholder’s efforts and connections are no longer available to the Company, and indeed are being deployed to the benefit of the Company’s competitors, and where goodwill going forward would be attributable to the efforts and connections of others. It seems likely that clause 5.6 was expected to influence the conduct of the Sellers after Cavendish’s acquisition of control in a way that would benefit the Company’s business and its proprietors during the period when they were yoked together. To that extent it may be described as a deterrent. But that is only objectionable if it is penal, ie if the object was to punish. But the price formula in clause 5.6 had a legitimate function which had nothing to do with punishment and everything to do with achieving Cavendish’s commercial objective in acquiring the business.” (emphasis added)

Parking Eye’s claim to £85, while apparently egregious in relation to what might be a very minor breach of the parking limit, was reasonably related to its interest in ensuring that parkers did not overstay the parking time limit, and funding Parking Eye’s operation of the parking lot for other patrons at no cost. The very fact that it was an amount that was in terrorem was part of its legitimacy in making the whole “free-parking for a short period” system operable. Lords Neuberger and Sumption explained the situation as follows:

“The reason is that although Parking Eye was not liable to suffer loss as a result of overstaying motorists, it had a legitimate interest in charging them which extended beyond the recovery of any loss. The scheme in operation here (and in many similar car parks) is that the landowner authorises Parking Eye to control access to the car park and to impose the agreed charges, with a view to managing the car park in the interests of the retail outlets, their customers and the public at large. That is an interest of the landowners because (i) they receive a fee from Parking Eye for the right to operate the scheme, and (ii) they lease sites on the retail park to various retailers, for whom the availability of customer parking was a valuable facility. It is an interest of Parking Eye, because it sells its services as the managers of such schemes and meets the costs of doing so from charges for breach of the terms (and if the scheme was run directly by the landowners, the analysis would be no different). As we have pointed out, deterrence is not penal if there is a legitimate interest in influencing the conduct of the contracting party which is not satisfied by the mere right to recover damages for breach of contract. Mr. Butcher QC, who appeared for the Consumers’ Association (interveners), submitted that because Parking Eye was the contracting party its interest was the only one which could count. For the reason which we have given, Parking Eye had a sufficient interest even if that submission be correct. But in our opinion it is not correct. The penal character of this scheme cannot depend on whether the landowner operates it himself or employs a contractor like Parking Eye to operate it. The motorist would not know or care what if any interest the operator has in the land, or what relationship it has with the landowner if it has no interest.….

  1. Extravagant or Exorbitant Impact of the clause

Third, in order to offend the penalty doctrine the clause must impose a consequence which is out of all proportion to the second element of the test, namely any interest that the innocent party can legitimately seek to protect. Lord Mance expressed how this third element works in relation to the second element:

“There may be interests beyond the compensatory which justify the imposition on a party in breach of an additional financial burden…… What is necessary in each case is to consider, first, whether any (and if so what) legitimate business interest is served and protected by the clause, and, second, whether, assuming such an interest to exist, the provision made for the interest is nevertheless in the circumstances extravagant, exorbitant or unconscionable……the focus should be not on any particular possible breach or its timing or consequences, but on the general interest being protected, and the question whether the protection which the parties agreed can be condemned as unconscionable or manifestly excessive.” (emphasis added)

Lord Hodge explained the same elements as follows:

“ I therefore conclude that the correct test for a penalty is whether the sum or remedy stipulated as a consequence of a breach of contract is exorbitant or unconscionable when regard is had to the innocent party’s interest in the performance of the contract. Where the test is to be applied to a clause fixing the level of damages to be paid on breach, an extravagant disproportion between the stipulated sum and the highest level of damages that could possibly arise from the breach would amount to a penalty and thus be unenforceable. In other circumstances the contractual provision that applies on breach is measured against the interest of the innocent party which is protected by the contract and the court asks whether the remedy is exorbitant or unconscionable.”

Lords Neuberger and Sumption explained why Parking Eye’s charge did not infringe this element of the rule:

“None of this means that Parking Eye could charge overstayers whatever it liked. It could not charge a sum which would be out of all proportion to its interest or that of the landowner for whom it is providing the service. But there is no reason to suppose that £85 is out of all proportion to its interests.….. While not necessarily conclusive, the fact that Parking Eye’s payment structure in its car parks (free for two hours and then a relatively substantial sum for overstaying) and the actual level of charge for overstaying (£85) are common in the UK provides support for the proposition that the charge in question is not a penalty.”

  1.  Other remedies or secondary obligations may fall within the rule against penalties

The members of the court who gave reasons stated that other clauses, aside from those requiring payment of damages as a result of a breach of contract, might be subject to the penalty doctrine. They appeared to agree that withholding payments on breach, or requiring the transfer of money or property on breach, also ran afoul of the doctrine. But the members of the court do not appear to have entirely agreed as to whether, or in what circumstances, the forfeiture of instalments or deposits could be classified as penalties. Those issues did no arise in the present appeals.

  1.  Penalty doctrine should not be abolished or limited

By one side of the debate, the U.K. Supreme Court was asked to abolish the penalty doctrine as an arcane piece of old contract law that interfered with freedom of contract and made no sense in today’s world, or to limit the doctrine to commercial contracts, procedural misconduct or payment of money. The court declined to do so, and gave lengthy reasons for its decision. It basically held that the penalty doctrine: continued to fulfill a public policy purpose in eliminating unconscionable financial remedies for breach of contract; was in line with contract law in other comparable jurisdictions; and should only be eliminated by legislators after a proper inquiry which courts are not able to undertake.

  1.  Penalty doctrine should not be extended beyond breach of contract

By the other side of the debate, the U.K. Supreme Court was asked to extend the penalty doctrine so that it applied to any term of a contract that imposed an egregious or unconscionable result, whether or not the claim arose from a breach of contract. In particular, the court was asked to follow the decision in Andrews v Australia and New Zealand Banking Group Ltd (2012) 247 CLR 205. In that decision, the Australian High Court held that the penalty doctrine applied to any clause in a contract, and not just a breach of contract, if the nature of the clause (in that case, the payment of a bank fee to process an NSF cheque) and the circumstances rendered the clause egregious or unconscionable. (See my article dated October 20, 2012 on the Andrew case)

The U.K. Supreme Court refused to follow the Andrews decision, and declined to extend the penalty doctrine beyond the field to which it has usually applied, namely as a consequence of a breach of contract. Lord Hodge said: “There is no freestanding equitable jurisdiction to render unenforceable as penalties stipulations operative as a result of events which do not entail a breach of contract. Such an innovation would, if desirable, require legislation.”

  1.  Relief from forfeiture may apply even if the penalty doctrine does not

The U.K. Supreme Court drew attention to the fact that relief from forfeiture may be available even if the clause is valid and does not infringe the penalty doctrine. Lord Mance and Lord Hodge were explicit in holding that relief from forfeiture could be granted in this situation. Lord Neuberger and Lord Sumption said that it was not necessary to decide that issue in the present appeals, but they could see the “force of the argument” to that effect.

The impact of the two rules occurs at different times. A clause is invalid under the penalty doctrine at the time the contract is written, and the actual circumstances in which it is imposed are irrelevant. Lord Neuberger and Lord Sumption stated this point as follows:

“The question whether a damages clause is a penalty falls to be decided as a matter of construction, therefore as at the time that it is agreed…. This is because it depends on the character of the provision, not on the circumstances in which it falls to be enforced. It is a species of agreement which the common law considers to be by its nature contrary to the policy of the law. One consequence of this is that relief from the effects of a penalty is….“mechanical in effect and involves no exercise of discretion at all.” Another is that the penalty clause is wholly unenforceable…”

But relief from forfeiture only occurs if, at the time a remedy is sought, the court decides that relief from forfeiture should be granted and the remedy declined. Accordingly, the penalty doctrine is “forward looking” and relief from forfeiture is “20-20 hindsight”. Again, Lord Neuberger and Lord Sumption stated the matter this way:

“What equity (and, where it applies, statute) typically considers to be contrary to the policy of the law is the enforcement of such rights in circumstances where their purpose, namely the performance of the obligations in the lease or the mortgage, can be achieved in other ways – normally by late substantive compliance and payment of appropriate compensation. The forfeiture or foreclosure/power of sale is therefore enforceable, equity intervening only to impose terms.” (emphasis added)

So a defendant may well wish to seek relief from forfeiture even if the claim against him or her arises under a valid clause which survives the rule against penalties.

Discussion

The Cavendish Square will undoubtedly fuel the debate in Canada as to whether the penalty doctrine should be abolished, extended or varied. Apart from that public policy debate, this decision is a “good news – bad news” story for those enforcing (usually owners) or defending against (usually contractors) clauses which impose consequences for breach of contract.

By stating the elements of the penalty doctrine in the way it did, the U.K. Supreme Court has greatly widened the basis upon which these clauses may be justified by the party seeking to enforce them. The traditional Canadian approach is simply to look at whether the agreed-upon damages or amounts referred to in the clause represent a reasonable pre-estimation of the damages that the innocent party would suffer from the breach of contract sued upon. According to this decision, there is a much broader basis upon which the clause may be upheld. If the clause can be justified as a reasonable basis to secure the total performance of the contract, and if the amounts or damages called for in the clause are not ridiculous in relation to that interest, then the clause is valid. In some circumstances, the innocent party may have an time demonstrating those facts than showing that the amounts or damages are a reasonable pre-estimation of damages.

On the other hand, a party defending itself against such a clause may rely on this decision to seek relief from forfeiture even though the clause is valid under the penalty doctrine. That possibility is not one that has been widely recognized in Canada.  

This decision is going into our toolbox to be used the next time we have to deal with penalty clauses.

See Heintzman and Goldsmith on Canadian Building Contracts (5th ed.), chapter 4, part 3(h) and chapter 9, part 6(j).

Cavendish Square Holding BV v Talal El Makdessi [2015] UKSC 67

Construction contract – penalty clause – liquidated damages clause – relief from forfeiture

Thomas G. Heintzman O.C., Q.C., FCIArb                                    November 29, 2015

www.heintzmanadr.com

www.constructionlawcanada.com