The Supreme Court recently handed down two important judgments concerning penalty clauses (Cavendish Square Holding BV v Talal El Makdessi and ParkingEye Limited v Beavis). Although these cases related to commercial contracts, the principles are equally applicable to any contractual arrangements including settlement agreements.
A penalty clause in a contract provides a fixed or pre-determined amount payable to the innocent party on breach. In Settlement Agreements, clauses requiring the repayment of the settlement money in the event the employee breaches any of its terms are common. Whether or not these clauses are enforceable depends on whether they are liquidated damages clauses (which are generally enforceable) or penalty clauses (which are not enforceable beyond the actual loss suffered by the innocent party).
The Supreme Court has now clarified the law in this area, thereby providing useful guidance.
In the first case considered by the Supreme Court, Mr Talal El Makdessi entered into an agreement to sell a controlling stake of his company to Cavendish Square, a British multinational advertising and public relations company
The contract provided that if Mr Makdessi was in breach of certain restrictive covenants against competing activities there would be two consequences:-
- he would not be entitled to $44 million in payments which would otherwise be due, and
- Cavendish would have the option to purchase Mr Markdessi’s remaining shares at a reduced value.
When Mr Makdessi breached the terms of the contract, Cavendish attempted to enforce these terms.
In the second case considered by the Supreme Court, Mr Beavis overstayed the two-hour free parking time limit imposed by the car park operator, ParkingEye. The signs exhibited at the entrance and throughout the car park were large, prominent and legible:
“2 hour max stay….Failure to comply with the following will result in a Parking Charge of £85”
ParkingEye sent Mr Beavis a standard “First Parking Charge Notice” which demanded that he pay the £85 charge within 28 days. If he paid within 14 days, the charge would be reduced to £50.
Mr Beavis ignored this demand, as well as a subsequent standard form reminder notice and warning letter. ParkingEye then began proceedings in the County Court to recover the £85 alleged to be due.
Supreme Court Assessment
In the first case, the Lords confirmed that the contract between Talal El Makdessi and Cavendish Square was “not concerned with regulating the measure of compensation for breach of the restrictive covenants.” Neither was it “a contractual alternative to damages at law.” They described the clause as a “price adjustment clause.” Although this was not regarded as a penalty clause, the Supreme Court treated the clause as if it were. The price adjustment clause belonged to a class of clauses in the contract that fixed the price. It determined the manner in which the price was calculated and the conditions on which different parts of the price were payable. The clause formed part of Mr Makdessi’s primary obligations not to breach the restrictive covenants i.e. Mr Makdessi would earn consideration for the shares by observing the restrictive covenants.
The true test in establishing whether a clause amounts to a penalty clause is whether the clause is a secondary obligation which imposes a detriment and is out of all proportion to any legitimate interest of the innocent party. In other words, if a primary obligation is breached, is there a secondary obligation which is engaged which is also penal? If so, then the clause is unlikely to be enforceable. The Supreme Court gave an example of a secondary obligation, e.g. a clause that authorised a contractor to withhold all remuneration due to the other party until the contractors claim had been resolved.
The Supreme Court were persuaded that “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.” Accordingly, the Court upheld the validity of the clauses.
In the second case, the presence of the car beyond the two hour time limit constituted a trespass under the terms of the contractual licence which resulted in a charge of £85.00. Although ParkingEye did not suffer any loss if motorists stayed longer than the permitted 2 hours, the Lords were persuaded that ParkingEye had a “legitimate interest to protect” in providing a service to the owners of the retail park: managing the efficient use of parking space by encouraging two hour turnaround, in the interests of the retail outlets. Furthermore, the Lords found that the fine was not out of proportion to any legitimate interest Parkingeye was seeking to protect; the sum was “not extravagant nor unconscionable”. The fine was similar to fines issued by a local authority and was less than the maximum suggested by the British Parking Association.
The Lords acknowledged that the Penalty rule was “plainly engaged” but the charge in question was not a penalty and Mr Beavis had not shown that the charge was excessive.
One of the key messages from the judgments is that, when considering whether a clause constitutes a penalty, it is necessary to determine the nature and extent of the innocent party’s legitimate interest in the performance of the relevant obligation and whether the sanction imposed is proportionate to protect that legitimate interest.
If the clause is a genuine pre-estimate of loss, it is perfectly possible for it to be commercially justified. It can be a deterrent for breach without being a penalty and regarded as a liquidated damages clause.
On the other hand, if the clause is “unconscionable or extravagant”, it is a penalty and unlikely to be enforceable.
As Lord Neuberger and Lord Sumption put it, if it “imposes a detriment on the contract breaker that is out of all proportion to the legitimate interest of the innocent party,” it will not succeed.
What does this mean for Settlement Agreements?
If an employer and employee have negotiated a Settlement Agreement on a level playing field and with the assistance of professional advisors, it may be more challenging for the employee in breach to argue that a compensation clause is unenforceable on the basis that it is a penalty.
If the innocent party has a legitimate interest and the amount indicated is a genuine pre-estimate of loss and not extravagant, exorbitant or unconscionable, then it is likely to be enforceable. When negotiating settlement agreements, ensuring there is a genuine pre-estimate of loss rather than a simple repayment clause is key: exorbitant penalties in contracts will continue to be unenforceable.
Furthermore, employers will have to consider what legitimate interest they are seeking to protect in order to justify a particular charge or sanction in the settlement agreement.
Simple clawback provisions may continue to be of practical benefit in deterring breaches, but employers need to be mindful of the challenges they may face with enforcement further down the line.
For advice on negotiating and drafting settlement agreements, please speak to a member of the Devonshires Employment Team.