Penalty Clauses: Has the Supreme Court finally clarified when a clause may amount to a penalty and is therefore unenforceable?

The El Makdessi case arose out of the sale of a media business in the Middle East. Following the sale, El Makdessi acted in breach of various covenants in the sale agreement. This then triggered two clauses in the sale agreement, with the consequence that El Makdessi lost his right to the balance of the purchase price for the shares, and was obliged to sell his remaining shares in the business at a discounted value. El Makdessi challenged these clauses as unenforceable penalties.

The Supreme Court held that the clauses were not penalties, and were therefore enforceable.  The decision of the Supreme Court is complex, not least because four detailed judgments were given (one of which was a "joint" judgment). However, despite the differences that exist between the various judgments, some high-level principles can be drawn from the decisions issued by the Supreme Court as follows:

1. Primary versus secondary obligation: The question of whether a clause is a penalty clause will only arise where the clause in question provides a remedy for a breach of another, primary obligation in the contract. The most obvious example of such a clause is a liquidated damages clause, which sets out payment of a sum of money in the event of a breach of an obligation. However, whether a clause is a primary or secondary obligation will not always be clear. In El Makdessi the Supreme Court had differing views on whether the clauses at issue were primary or secondary obligations.
2. Proportionality of the remedy: Where a clause is providing a remedy for a breach of a primary obligation, the question that arises is whether that remedy is "exorbitant"; "unconscionable" or "out of all proportion" to the legitimate interest being protected. While in some cases the only legitimate interest of the party may simply be compensation for the breach, the Supreme Court noted that "compensation is not necessarily the only legitimate interest that the innocent party may have in the performance of the defaulter's primary obligations".
   
3. Relevance of circumstances surrounding entry into the contract: Where a contract is negotiated between "properly advised parties" of "comparable bargaining power" there is a strong presumption that they are the best judges of what is a legitimate provision dealing with the consequences of breach. In other words, the courts should be reluctant to get involved.
4. Rejection of the test of "genuine pre-estimate of loss": The Supreme Court considered that just because a remedy is not a genuine pre-estimate of loss does not mean, at least without more, that it is penal. It also rejected the concept that if a clause was designed to deter, it must be a penalty.

The application of the principles arising out of the Supreme Court decision is unlikely to be straightforward, and considerable further debate and case law in this area is likely. Even on the facts of the El Makdessi case itself, the court was divided on whether the clauses at issue were primary or secondary obligations, and therefore whether the question of whether they amounted to penalty clauses even arose.

What this means for you?

We will be discussing the implications of the El Makdessi decision for businesses in our breakfast seminar on 11 February 2015. If you would like to attend, please click here to request an invitation.  If you would like to read more about this decision, you can access our more detailed article, published in November 2015, here.

Previous Dispute Resolution Essentials briefings:

Penalty Clauses: Has the Supreme Court finally clarified when a clause may amount to a penalty and is therefore unenforceable?

Reminder of the Limitations of Without Prejudice Privilege

Update on the Recast Brussels Regulation

CPR Part 36 - significant changes from 6 April 2015