Liquidated damages clauses: UK Supreme Court changes the law

Monday 9 November 2015

Authors: Sophie East, Jenny Stevens, Jane Standage and Elliott Couper

​​​​​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:

  1. 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 penalties; and

  2. 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 facts

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:

  1. the sellers would not receive the final two instalments of the agreed price (clause 5.1); and

  2. 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.

The outcome

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 provisions.

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.


1 Andrews v Australia and New Zealand Banking Group Ltd (2012) 247 CLR 205.

2 The Unfair Terms in United Kingdom – see Consumer Contracts Regulations 1999. New Zealand Unfair Contract Terms – see the Fair Trading Act 1986.

3 (2012) 247 CLR 205 (HCA).

4 The Court in Andrews held that a clause can be a penalty if either: (a) the detriment is applied on breach of a contractual term (a penalty under the common law); or (b) the clause was a collateral stipulation designed to force a party to comply with another primary obligation thereby imposing an additional detriment (a penalty in equity). Under Australian law, the detriment under the penalty at common law or equity also needs to be extravagant in relation to the maximum conceivable loss flowing from the breach.

5 Torchlight Fund No 1 LP (in rec) v Johnstone [2015] NZHC 2559. This case considered whether a late payment fee of $500,000 per week in a loan contract between two commercial parties was an unenforceable penalty. The Judge held that the late payment fee was an unenforceable penalty as it was payable on breach of contract and was extravagant in comparison to the maximum conceivable loss flowing from the failure to repay.


Disclaimer

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.

For more information
  • Sophie East

    Partner Auckland
  • Jenny Stevens

    Partner Wellington
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  • Litigation and dispute resolution