Some further thoughts on the penalty clause rule in the Supreme Court

The Edinburgh Law School’s Private Law Centre held a very enjoyable lunchtime seminar last week, at which the subject for discussion was the penalty clause rule. There was a good round table discussion, including some interesting observations on how the Cavendish Square/ParkingEye cases were pled before the Supreme Court (Bobby Lindsay, a Glasgow PhD student, had been present during the appeals, and gave us his insights on pleading and on questions from the bench). The attendees were also reminded by Professor George Gretton of a case in the Sheriff Court in which Edinburgh University had sought to recover unpaid parking charges from a repeat non-payer: the case is University Of Edinburgh v Onifade, reported at 2005 SLT (Sh Ct) 63. I was able to add some news of a very recent incident similar to the ParkingEye v Beavis litigation, concerning an individual who repeatedly overstayed at a car park in Glasgow which provided 2 hour free parking for customers using a McDonalds restaurant (the story is reported here).

In leading the discussion at the seminar, I made the following points about the Cavendish Square Holding v Makdessi and ParkingEye v Beavis conjoined appeals before the UK Supreme Court:

• The decision is another example of ever longer judgments, this one running to 316 paragraphs. A lot of this is a recitation of earlier case law – do we really need this? Even allowing for the fact this was a conjoined appeal, the courts need to get a hold of these overly long judgments. If the Bundesgerichthof can deliver judgments on contract cases in 30 paragraphs, our highest court should be able to do the same.
How has the decision changed the law? The shift in the law is that, before this case, the view had taken hold that clauses for the payment of an agreed sum on breach (or forfeiture of an agreed sum) had to equate to the reasonably foreseeable losses arising on breach (with an exception allowed for cases where likely losses were too uncertain to predict). This is now no longer to be taken as being so. As Lords Neuberger and Sumption put it in para 28, the correct approach is that “A damages clause may properly be justified by some other consideration than the desire to recover compensation for a breach. This must depend on whether the innocent party has a legitimate interest in performance extending beyond the prospect of pecuniary compensation owing directly from the breach in question.” In taking this decision, it is interesting to note that the Supreme Court is adopting the same view as the Scottish Law Commission did in its draft Penalty Clauses (S) Bill published in 2010, clause 1(2) of which said: “Any rule of law under which such a clause [i.e. a penalty clause] is unenforceable if it is not founded in a pre-estimate of damages ceases to have effect”. (This Bill has not thus far become law, but the SLC is going to return to considering the penalty clauses rule as soon as its third party rights Report has been completed.)
What has not changed? The penalty clause rule is still tied to a sum payable on breach of a primary contractual obligation, which sum is extravagant or unconscionable: Lords Neuberger and Sumption said that a clause is an unenforceable penalty if it 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” (para 32). Similarly, Lord Hodge expressed the matter as being: “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” (para 255). Lords Sumption and Neuberger add (see para 30) that describing penalty clauses as a deterrent, or as in terrorem, is not helpful, as any deterrent effect it may is not what gives it the character of an unenforceable penalty.
• Note also that: (1) the penalty rule was not abolished (as some had thought it might be); and (2) the rule was not extended: the concept of a penalty clause remains restricted to one of a secondary obligation triggered on the breach of a primary obligation, and (unlike developments in Australian law) the SC did not recognise “an equitable jurisdiction to relieve against any sufficiently onerous provision which was conditional on a failure to observe some other provision, whether or not that failure was a breach of contract” (para 41). Lord Hodge notes, in relation to possible extension of the doctrine, that “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” (para 241). This may well be one of the issues which the SLC will consider in due course.
• At the seminar, I offered a few words on the penalty rule’s basis in the distinction between primary and secondary obligations. From what I could tell from a reasonably quick Lexis search conducted in the week before the seminar, there is no UK case law analysing the meaning in general of the language of “primary” and “secondary” obligations. There are a number of different meanings that can be given to such terms in obligations law. A secondary obligation might be an obligation which is triggered if another obligation (the primary obligation) is breached. Or it might be one which is triggered if another obligation is fulfilled. One can add further permutations by bringing in more than two parties: a secondary obligation might be an obligation of C’s which is triggered if an obligation to be performed by B in favour of A is not so performed (in this sense, cautionary obligations are secondary obligations). (As my colleague Lorna Richardson noted at the seminar, a distinction has also been drawn in the case law on retention between primary and secondary obligations, which provides a further sense in which the words have been used) The penalty rule does not embrace all of these meanings: it applies only to secondary obligations in the sense of an obligation of B’s triggered by a failure of B to perform a different (the primary) obligation. But the Supreme Court in these appeals do not explore these different permutations in the meanings of “primary” and “secondary”. Speaking of clause 5.1. Lords Neuberger and Sumption simply state it is “in no sense a secondary provision”, without saying what “senses” they might have in mind. If in reality clause 5.1 is a penalty clause, then it has clearly been well disguised.
• And indeed parties can attempt to disguise penalty clauses, sometimes successfully, sometimes not. So, one can come across clauses referring to one party not doing something which is framed in conditional and not mandatory terms: e.g. without saying that B is obliged not to do something, a clause might just say: “if B doesn’t do x, B will have to pay £1,000”. Lords Neuberger and Sumption say (in para 15) that such a clause can still be a penalty: if the substance of the term is a penalty, it doesn’t matter what its form is. One can see how courts can dig a bit to thwart a clause of the sort “if B doesn’t do x, B will have to pay £1,000”, as there is still a negative act which attracts payment of a sum.
• But what if one disguises potential penalties even further, by seeming to present two positive acts simply as alternative options? e.g. a provision which says: if A pays before 1st January, the price will be £1,000; if A pays after 1st January, the price will be £5,000. Could payment of the higher price be attacked as being in substance a penalty? It’s hard to see how. Such a provision could without too much difficulty be justified as an increased price on account of allowing the buyer more extended payment terms. In the same way, the clauses at issue in CSH were in fact characterised by Lords Sumption and Neuberger simply as providing an alternative basis for payment: £X if Mr Makdessi doesn’t compete against the company; lesser sum £Y if he does. If Lords Neuberger and Sumption are right, then it seems to me that one can without too much difficult simply avoid the penalty rule altogether in many cases. The CSH case doesn’t address this problem of evasion of the rule, but it is perhaps irresoluble: attempts to enable a scrutiny of more subtly disguised penalties might open up all manner of contractual clauses to investigation of whether they are fair or not. Not only would that cause huge certainty, but it is arguably unnecessary given that we already have unfair terms legislation addressing the wider issue of unfairness in contracts. It’s true, however, that such legislation does not allow scrutiny of the fairness of the primary obligations of the parties, including price. So, e.g., the Consumer Rights Act 2015, s 64(1) excludes from scrutiny as to its fairness a term of a contract to the extent that “(a) it specifies the main subject matter of the contract, or (b) the assessment is of the appropriateness of the price payable under the contract …” So, one can still disguise penalties by providing for fluctuating prices which depend on the circumstances of payment. It’s hard to see how one can avoid this happening, and indeed the policy of the Consumer Rights Act is that one ought not to investigate such things.
• The arguably disguised penalty in CSH caused disagreement among the Justices as to whether the penalty rule was engaged: three of the Justices (Neuberger, Sumption, & Carnwath) didn’t think the clauses in question amounted to a penalty they were merely “price adjustment clauses”, thus the penalty clause rule wasn’t engaged. Lords Sumption and Neuberger note that “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”. Lord Mance thinks that the penalty rule is engaged, but that the clauses are not extravagant or exorbitant and so are enforceable. Lord Hodge doesn’t seem to reach a concluded decision on one of the clauses: he notes the view of Neuberger and Sumption on cl 5.1, saying “But even if it were correct to analyse clause 5.1 as a secondary provision operating on breach of the seller’s primary obligation, I am satisfied that it is not an unenforceable penalty clause for the following six reasons. …” (para 270); he does see cl 5.6 as a secondary obligation however (see para 280)(Lord Clarke takes the same view: he has an “open mind” on the nature of clause 5.1, and thinks cl 5.6 is a secondary obligation: see para 290). One might argue that there is something wrong with a doctrine whose application depends on a distinction between primary/secondary obligation that seems to be difficult to draw in relation to specific clauses, and something wrong with judgments in which, on a crucial issue, Supreme Court justices feels they can have an “open mind”.
• What about the other appeal? There was agreement among the Justices that the relevant clause in ParkingEye did conceivably engage the penalty rule. But they thought that ParkingEye had a legitimate interest in enforcing the clause: the clause had two purposes (1) to manage the efficient use of parking space in the interests of the retail outlets, and of the users of those outlets who wished to find spaces in which to park their cars, and (2) to provide an income stream to enable ParkingEye to meet the costs of operating the scheme and make a profit from its services, without which those services would not be available. “These two objectives appear to us to be perfectly reasonable in themselves” say Lords Neuberger and Sumption. I agree.
• As to whether the charges were excessive, I think those in the press stirring up ideas of hard done by members of the public forget that ParkingEye was not running a parking business like NCP, so to compare ParkingEye’s charge with usual car park charges misses the point. The amount charged had to be high enough to dissuade people from over-parking. But I agree with Lords Sumption and Neuberger that: “None of this means that ParkingEye 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.” (para 100)
• Three further interesting issues struck me about these appeals: (1) could penalty clauses now be used to disgorge profits from a wrongdoer, if such a measure of recovery could be justified by reference to a ‘legitimate interest’ of the party seeking to enforce the clause? If so, a penalty clause could achieve what was not permitted in common law damages under Teacher v Calder. It is interesting that in a famous case allowing an account of profit for breach of contract, AG v Blake, the House of Lords also used the phraseology of the government having a “legitimate interest” in preventing the defendant’s breach of contract and thus in disgorging profits from a contract breaker.
• (2) Roman law: one use of stipulationes poenae was to ensure protection of the interests of a third party which was unable to protect its own interests directly. There is some similarity here with allowing ParkingEye to enforce the charge in order to protect the interests of the landowner. I think this is worth pointing out because we see in the Roman law an earlier recognition that there are other legitimate interests that one might have in enforcing a penalty other than recovering one’s own losses, so the Roman approach offers an extra justification for severing the link between penalties and reasonably foreseeable losses: penalties can be a useful means to encourage performance rather than to insulate oneself against loss. This point about Roman law was not advanced in the appeals, it is simply my own observation.
• (3) There is a further subsidiary issue of interest for English law: one might question whether Mr Beavis really did have a contract with ParkingEye. It’s had to see what consideration he gave. Lord Toulson appears to regard his using the car park as itself consideration: “the use of the car park by Mr Beavis was sufficient consideration for a contract governing the terms of its usage” – para 295 – but this seems to me an entirely fanciful notion of consideration. (Perhaps, it is just about arguable that by parking there Mr Beavis had impliedly promised not to park for more than 2 hours, and that this implied promise was consideration). But I think there is a good argument for saying that this looks very much like a case of a gratuitous licence to park, an arrangement which is not necessarily contractual under English law. And if it’s not contractual, then the penalty rule wouldn’t be engaged. This possibility did not seem to trouble the Supreme Court, however, Lords Neuberger and Sumption briefly noting only that: “Mr Beavis had a contractual licence to park his car in the retail park on the terms of the notice posted at the entrance, which he accepted by entering the site … Moore-Bick LJ in the Court of Appeal was inclined to doubt this analysis, and at one stage so were we. But, on reflection, we think that it is correct.” It’s a pity that this point was not explored properly in the Sup Ct, however. Of course, this issue wouldn’t have troubled Scots law: a gratuitous contract is entirely valid in Scotland. (I should add that Bobby Lindsay offered the useful observation, gleaned from his hearing of the pleadings, that had the ParkingEye arrangements not been considered contractual, less favourable tax consequences would have resulted from this, so that it suited ParkingEye to argue the contractual approach.)
• My conclusion on these appeals was (1) that the realignment of the penalty clause rule away from requiring that stipulated sums represent a reasonable pre-estimate of loss is a sensible one. As the Roman law showed, there are other legitimate interests that one might have in enforcing a penalty other than recovering one’s own losses. The danger of over-charging can be regulated by the courts; (2) that the continuing characterisation of the rule against penalties in terms of the enforcement of a secondary obligation triggered by breach of a primary obligation will inevitably allow some penalties to be disguised and to escape the rule. It is debatable whether the CSH clauses were an example of such a disguised penalty or whether, as Lords Sumption and Neuberger argue, they were simply part of a flexible mechanism for adjusting the final price payable. It is difficult to see how such disguised clauses can be got at, unless one is conceivably to open up all manner of contract provisions to scrutiny, a course of action I think would be undesirable.

There was some good discussion following my presentation, for which I thank the colleagues and students who attended. My further observation during those discussions that the decision could be viewed as a more performance-oriented approach to contract law – i.e. that contractual obligations are not just things to be valued in terms of damages for non-performance, but to be valued as undertakings to be enforced wherever possible – led my Edinburgh colleague Dr Descheemaeker to ponder whether the decision might cause ripples for other aspects of English contract law: might it lead to developments in other areas more receptive of the enforcement of contracts, rather than just compensating for their breach, for instance in changes to the approach taken with specific performance? That would be quite a leap for English law to take, given that specific performance is a remedy of equitable origin in English law, but it will be interesting to see whether any such ripples can indeed be detected in due course.

A further observation offered during the discussion was the thought that the penalty clause doctrine might now effectively be dead in the water, given that so long as some legitimate interest of the enforcing party can be adduced to justify the sum sought, it should (assuming it is not too outrageous in amount) be enforceable. The point is that there are many interests that might conceivably be advanced by a contracting party for enforcement. Whether the courts will take a liberal approach to this matter will be one of the aspects of this decision worthy of tracking as it is received and applied by lower courts.

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3 Responses to Some further thoughts on the penalty clause rule in the Supreme Court

  1. Pingback: ‘Some further thoughts on the penalty clause rule in the Supreme Court’ | Private Law Theory - Obligations, property, legal theory

  2. haward says:

    Thanks for this – it’s a good analysis. What struck me in reading Parking Eye was how the Courts approached legitimate interest. Parking Eye pays the BA Pension Fund to use the land and allows two hours free parking on it. The £85 fee charged to overstayers is where it makes the money. Nobody questioned this business model which seems to be to be predatory. If the £85 is based on the costs of running the car park, divided by the potential or estimated number of overstayers, plus a decent profit which it should be then no evidence of this was provided or sought. Parking Eye’s legitimate interest seemed to be described as some form of deterrence whereas their actual legitimate interest is in making a return.

    Equally the measurement of the £85 was odd. It was compared with the charges levied by local authorities in their discharge of statutory functions. The comparison appears strange. Additionally there was some discussion of the code of practice of the private association to which Parking Eye belonged without any investigation of the bona fides of the club.

  3. Eric Clive says:

    That sounds like a superb presentation and discussion. Sorry to have missed it. Were there any views on the merits, or otherwise, of a statutory power to modify excessive penalties?

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