In an eagerly anticipated judgment, the United Kingdom Supreme Court has
reconsidered the test for whether a liquidated damages clause is an
unenforceable penalty – Cavendish Square Holding BV v Makdessi. The Supreme
Court applied a new broader test, asking whether the liquidated damages clause
protects the legitimate interest of the innocent party. If so, it is not a
penalty (unless it is out of proportion to that interest). This contrasts with
the traditional test which is to examine whether a clause imposes a fee or
obligation which is a genuine pre-estimate of possible loss to the innocent
party upon breach (a permissible liquidated damages clause) or is “extravagant”
or “unconscionable” in relation to that possible loss (a penalty).
The Supreme Court also expressly rejected the recent approach taken to these
clauses by the High Court of Australia.1 As a
result, New Zealand courts will eventually be faced with a decision on whether
to follow UK or Australian law, the key difference being:
under the English approach a court may consider a broad range of matters in
relation to the clause and it is expected that a greater range of clauses are
likely to be found to be genuine liquidated damages clauses as opposed to
under the Australian approach, the courts will apply a more restrictive and
formulaic test focusing on whether the liquidated damages sum is extravagant in
comparison with the maximum conceivable loss. Under the Australian approach
there may be a higher likelihood that a liquidated damages clause with a
deterrent purpose would be held to be an unenforceable penalty.
The Court combined two appeals in the Makdessi judgment: the
Makdessi and the ParkingEye Ltd v Beavis appeals.
ParkingEye concerned the validity of a £85 fee charged to drivers who
stayed in a retail car park longer than the two hour limit. Mr Beavis
argued the £85 fee was an unenforceable penalty and that the fee was unfair
under the United Kingdom Unfair Contract Terms legislation (the equivalent of
the New Zealand Unfair Contract Terms provisions).2
By contrast Makdessi was a commercial case involving the sale of
shares in an advertising company. The sale contract required the sellers not to
compete with the company after the share sale and stated that if they breached
that term then two consequences followed:
the sellers would not receive the final two instalments of the agreed price
(clause 5.1); and
the sellers must sell their remaining shares to the buyer at a price which
excluded the value of the company’s goodwill (clause 5.6). Makdessi (one of the
sellers) breached the non-compete clause and argued that the price reduction
clauses were unenforceable penalties.
The existing law
A liquidated damages clause is a clause which requires a party to pay a sum
if it breaches a term of the contract. Traditionally, a liquidated damages
clause was an unenforceable penalty if the amount payable was extravagant in
comparison to a genuine pre-estimate of the loss flowing from the breach. If the
clause was intended to deter breach, this also suggested that the clause was a
penalty. In the Makdessi/ParkingEye appeals the Supreme Court was asked
to consider abolishing the law on penalties on the basis it had become too
formulaic and an unwarranted intrusion into parties’ freedom to contract on
whatever terms they saw fit. Although the Supreme Court seriously considered
abolishing the rule, instead it ended up adjusting the test in a way which may
see fewer clauses held to be unenforceable penalties.
So what is the new test?
The Supreme Court focused on
protecting the legitimate business interests of the innocent party. The Court
held that a clause is an unenforceable penalty if it imposes a detriment on the
contract-breaker which is out of all proportion to any legitimate interest of
the innocent party in the enforcement of the clause which is breached. So the
test is no longer whether or not the purpose of the clause is to deter breach
and whether or not the amount payable on breach is a genuine pre-estimate of
loss. The Court stated that the strong initial presumption is that parties with
comparable bargaining power are the best judges of what is a legitimate
consequence of the breach.
The Court also considered whether it should follow the approach of the High
Court of Australia in the recent case of Andrews v Australia and New Zealand
Banking Group Ltd3 and extend the penalty
doctrine to equity as well as common law breach of contract.4 However, the UK Supreme Court declined to do this, stating
that the Australian Court had got it wrong and that a clause was only capable of
being a penalty if it applied on breach of a contractual term.
In ParkingEye, the majority held that the fee was not a penalty.
Although ParkingEye did not suffer loss as a result of overstaying motorists
(and therefore £85 could not be a genuine pre-estimate of ParkingEye’s loss),
ParkingEye had a legitimate interest in charging motorists for overstaying – to
ensure the availability of parking spaces. The fact that the fee was designed to
deter overstaying motorists did not convert the charge into a penalty as
ParkingEye was entitled to try and influence the conduct of motorists to protect
its legitimate interest. The Court considered that £85 was not out of proportion
in terms of protecting that interest.
The majority in ParkingEye also held that the fee was not unfair
under the UK Unfair Contract Terms legislation. The Court stated there was no
significant imbalance in the parties’ rights and obligations and the fee was
imposed in good faith as ParkingEye had a legitimate interest in ensuring
turnover of parks. Moreover, motorists were under no pressure to accept the
terms and a reasonable motorist would have agreed to the terms which were
prominently and clearly displayed.
In Makdessi, the Court also held that the clauses were not
penalties. The price formula in clauses 5.1 and 5.6 reflected the reduced
price the buyer was prepared to pay for the shares where it could not count on
the loyalty of the sellers. The buyer had a legitimate commercial interest in
ensuring that the sellers complied with the non-compete provisions as
non-compliance would damage the goodwill of the company. The Court held that the
parties were the best judges of the value of compliance with the non-compete
Comment – what does this mean for New Zealand law?
There are now two different approaches to the law of penalties: the
Australian approach and the UK approach. It is unclear what approach the New
Zealand courts will take when the next penalty case comes to be considered.
Despite this uncertainty, contractual parties can take comfort that liquidated
damages clauses which reflect a genuine pre-estimate of loss are likely to be
enforceable. If Makdessi is followed in New Zealand, it will permit the
courts to consider broader legitimate commercial interests, and it may be harder
for parties to escape from agreements they have entered into.
Interestingly, a New Zealand Court has recently followed the Australian
approach in Andrews, although it had no real choice as the contract in
question required it to apply the law of New South Wales.5 The High Court of Australia will also consider the law on
penalties again early next year in the Australia and New Zealand Banking
Group v Paciocco appeal which relates to bank fees. It is possible that the
High Court of Australia might take the opportunity to follow the wider
Makdessi test based on “legitimate interest” (rather than focusing
solely on loss) while still maintaining the Australian position that a clause
may be an unenforceable penalty in equity.
Finally, the decision in the ParkingEye appeal on unfair contract
terms is now the leading case on unfair contract terms in the United Kingdom. As
the New Zealand unfair contract terms provisions are similar to the UK
legislation, this is likely to be influential in New Zealand.
This publication is necessarily brief and general in nature. You should seek professional advice before taking any action in relation to the matters dealt with in this publication.