Genuine pre-estimate and legitimate interests: Penalty clauses and financial institutions

On a foggy London morning in November 2015, the UK Supreme Court handed down its highly anticipated judgment on a no less foggy area of the law: penalty clauses.  Heard in tandem, the appeals of Cavendish Square Holdings B.V. v El Makdessi and ParkingEye Ltd v Beavis [2015] UKSC 67, gave the UK’s highest court its first opportunity to consider the penalty doctrine in over a century.

Despite concluding that “the penalty rule in England is an ancient, haphazardly constructed edifice which has not weathered well”, the Court unanimously refused invitations to abolish or extend the doctrine, instead choosing to re-cast the test for whether a contractual provision would be considered penal.

This article analyses the key changes to the penalty doctrine flowing from the Supreme Court’s judgment, and assesses the potential implications for banks and financial institutions.

The Supreme Court has abolished the dichotomy between a genuine pre-estimate of loss and a penalty or deterrent, and re-cast the test:

“The true test is whether the impugned provision 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.”

There are two important outcomes: first, it will now be more difficult to successfully argue that a clause is an unenforceable penalty; second, the commercial interests of the parties, rather than merely the financial implications of a breach, will become a focus of any enquiry as to whether a clause is a penalty.

From a share purchase agreement to a parking fine, the facts of the two appeals before the Supreme Court could not have been more different.

Cavendish Square Holdings B.V. v El Makdessi

Mr Makdessi sold part of his shareholding in a company to Cavendish.  Terms of the share purchase agreement provided that further consideration would be paid to Mr Makdessi at various stages after completion, provided that he did not breach certain restrictive covenants.  Mr Makdessi breached the restrictive covenants and, when Cavendish withheld the further consideration, Mr Makdessi argued that the relevant terms were unenforceable penalties.

ParkingEye Ltd v Beavis

In ParkingEye, Mr Beavis parked in a private car park which allowed two hours of free parking but charged a £85 fine if motorists overstayed this period.  Mr Beavis overstayed by almost an hour and the managers of the car park, ParkingEye, issued the £85 fine.  Mr Beavis did not pay and, when sued by ParkingEye, argued that the £85 fine was an unenforceable penalty or, in the alternative, not binding by virtue of the Unfair Terms in Consumer Contracts Regulations 1999.

Prior to the Supreme Court’s judgment, the case law had generally led to the position that if a clause was not a genuine pre-estimate of loss, it must be a penalty.

This dichotomy arose, in the opinion of the Court, as a result of an “over-literal reading of Lord Dunedin’s four tests” (paragraph 32) in the (previously) leading case of Dunlop Pneumatic Tyre Co Ltd v New Garage & Motor Co Ltd [1914] A.C. 79. In an attempt to reformulate the case law before him, Lord Dunedin had suggested the following often quoted factors:

1. A provision is penal if the sum stipulated for is extravagant and unconscionable in amount in comparison with the greatest loss that could conceivably be proved to have followed from the breach.
2. A provision is penal if the breach consisted only in the non-payment of money and the provision provided for the payment of a larger sum.
3. There is a presumption (but no more) that a provision is penal if the same sum is payable in a number of events of varying gravity.
4. A provision is not penal by reason only of the impossibility of precisely pre-estimating the true loss.

English Courts (including the Court of Appeal in both El Makdessi and ParkingEye) had more recently taken steps to mitigate the harshness of the dichotomy by taking into account other considerations such as whether a clause, if not a genuine pre-estimate of loss, is nevertheless ‘commercially justified’. The Supreme Court, however, decided to completely abolish the dichotomy, emphasising that a damages clause may be neither a genuine pre-estimate nor a penalty, or it could be both.

The Supreme Court also disagreed with the related idea that a clause which has some deterrent effect is inherently penal; deciding that there is, in effect, no difference between clauses which deter and clauses which induce. Both are designed to influence the conduct of the counterparty.

The Supreme Court’s re-cast test considers whether the impugned provision;

1. is a secondary obligation;
2. which imposes a detriment on the contract-breaker;
3. which is out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation.

Applying the new test to the cases before them, the Supreme Court held (Lord Toulson dissenting in respect of ParkingEye) that the provisions in question in both El Makdessi and ParkingEye were not penal (thereby overturning the Court of Appeal’s judgment in El Makdessi). This was because Cavendish and ParkingEye both had ‘legitimate interests’ in enforcing the primary obligations, with which the detriment imposed by the clauses was proportionate. In ParkingEye the Court accepted that there was a legitimate interest in keeping the car park available for shoppers and, separately, in ParkingEye’s ability to make a profit from the fines. In El Makdessi, the legitimate interest was the party’s commercial interests, which in this case were difficult to value.

Two issues come out of this decision which may impact the way commercial parties approach drafting contracts.

Firstly, a determination of what constitutes a “legitimate commercial interest”, and whether a contractual provision is proportionate to that interest, can only be determined on a case by case basis.  This concept of proportionality tied to the innocent party’s legitimate interest is the real paradigm shift in the law.  Courts must now consider what, if any, legitimate business interest is served and protected by a given clause, and then consider whether the clause is proportionate to such interest.

Secondly, the Supreme Court confirmed the principle that only secondary obligations (i.e. obligations that are triggered on breach of primary obligations) are capable of being penalties.  However, the Supreme Court did not deal in detail with the categorisation of certain clauses as primary or secondary obligations, which is a source of potential uncertainty as evidenced by the Court’s split in El Makdessi on whether the obligation to sell shares was a primary or secondary obligation.  Whilst careful drafting could be used with the intention of transforming a secondary into a primary obligation, there will always be a risk that a Court will construe such a clause as a secondary obligation, and therefore a potential penalty.

The new test sets a higher threshold, which will make it harder for commercial parties successfully to raise penalty arguments, particularly in circumstances where the terms of a contract were negotiated between sophisticated commercial parties of roughly equal bargaining power, who have been legally advised.

When dealing with simple default interest clauses, the bank’s legitimate interest will rarely extend far beyond compensation for the breach – in the form of additional interest compensating for any increase in the bank’s costs of funding the shortfall - and therefore (as recognised by the Supreme Court) the Dunlop principles (as outlined above) are still ‘good law’ as to whether a clause is penal. That said, the Supreme Court’s recognition that “compensation is not necessarily the only legitimate interest that the innocent party may have in the performance of the defaulter’s primary obligations” may provide a means by which a slightly higher rate of default interest may be found to be permissible – if it can be said, for example, that the rate protects the legitimate interest of the bank in ensuring payments are made on time in order to manage its own internal funding arrangements.

Of course, there is a wide spectrum of Clauses other than default interest provisions that potentially fall within the penalty rule. In recent years, the English Courts have considered the application of the penalty rule to clauses ranging from alternative default interest structures (such as a “facility fee” which resulted in enhanced interest being payable if the borrower was in arrears or otherwise in breach of the loan or security terms – see Aodhcon LLP v Bridgeco Ltd [2014] EWHC 535 (Ch)), to a provision in an “Upside Fee Agreement” entitling a bank to receive a large fee upon default of a loan in a sale and lease back property financing (see Edgeworth Capital (Luxembourg) SARL v Ramblas Investments BV [2015] EWHC 150 (Comm)) and, in the recent decision of Hayfin Opal Luxco 3 SARL v Windermere VII CMBS Plc [2016] EWHC 782 (Ch) (“Hayfin”), provisions relating to application of a “Class X Interest Rate” to alleged historical underpayments of interest under a commercial mortgage-backed securitisation structure.

In Hayfin, Snowden J – although he did not decide the point – tended to the view that the relevant interest provision did constitute a penalty. As the holder of Class X notes in a commercial mortage-backed securitisation, Hayfin was essentially entitled to the excess monies in the hands of the issuer generated by the structure. The Class X interest rate was then calculated as the relationship between this amount and the principal value of the Class X notes on the relevant interest payment date. In other words, the interest rate bore no connection to contractual interest on monies invested in what the Court termed as the “conventional sense”. It was not consideration payable for use of the monies borrowed at a stated rate by reference to the principal amount borrowed and the period of the loan but a sum that was entirely independent of the principal value of the notes. Between 2006 and 2009, the Class X rate varied between 2,700% and 6,001%.

At the time of contracting, the parties could have foreseen that the Class X rate would have no relationship to the level of damage that would be suffered by the Class X holder in the event of underpayment of interest. Further, the parties also could have foreseen that the application of the Class X rate to any shortfall would be a very large multiple of the unpaid amount every quarter, consequently amounting to a sum that was “many times the amount that would adequately compensate the innocent party for being kept out of its money”. The Court consequently found that the Class X rate was potentially so exorbitant that it could have been out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation.

On the facts of the case, the Court ruled as a matter of construction that Class X interest had not been payable. Also, the Court did not decide whether the accrual and payment of the Class X rate was properly categorised as a conditional primary or secondary obligation so as to bring the penalty doctrine into play. However, if it had been applicable, the Court’s findings strongly suggest that the interest provision would have been deemed to be a penalty.
At this more complex end of the spectrum, Courts (and therefore parties) may take into greater account ancillary commercial factors (such as reputational damage and loss of goodwill, back-to-back contractual obligations, and possibly even incentive payments) in determining the scope of the innocent party’s legitimate interest in performance of the primary obligation.

However, whilst the El Makdessi and ParkingEye judgments are significant, in practical terms the decision is likely to have a limited impact on how secondary obligation clauses in financing contracts governed by English law will be drafted.

Whether a party has a legitimate commercial interest (which the clause in question protects) will be measured at the time the contract is entered into (or subsequently amended). It is therefore necessary to consider that point in time when reviewing the provisions of any agreements already in place.

However, it is open to commercial parties negotiating contracts to take a number of steps in light of this decision.  If relevant, it may be important to ensure that:

1. If a clause is to be effective as a primary obligation, that this is drafted carefully.  However, it is worth bearing in mind that drafting alone will not prevent a Court from determining that a clause is a penalty – such a clause must be a primary obligation as a matter of substance, and whether the clause is proportionate to an actual legitimate interest will be a question of fact.
2. The commercial justification for the inclusion of such secondary obligations should be recorded and communicated to contractual counterparts. This could be achieved in the contract itself, if not as an operative provision then as a part of the pre-amble or recital, or in a separate side letter. The record should include a description of the legitimate interests and the commercial considerations that led to the negotiated penalty amount. The aim is to fix as much of this background as possible as part of the factual matrix reasonably available to both parties and therefore relevant to contractual construction.  
3. Again, whilst not determinative, it may be useful to record the parties’ agreement as to the innocent party’s legitimate interests and that a given clause is proportionate to such interests. This could also be achieved in the contract itself as part of the pre-amble or recital, or in a side letter confirming the other party’s acceptance of the legitimate and proportionate nature of the interest.