Recent decisions by the UK Supreme Court on penalty clauses are of some interest from the point of view of European private law.
The decisions were in the conjoined cases ofCavendish Square Holding BV v Talal El Makdessi and ParkingEye Limited v Beavis UKSC 67. They have been admirably discussed by Martin Hogg in his Obligations blog on this website. It suffices here to say that the court disapproved of using the distinction between penalty clauses and liquidated damages clauses, incorporating a genuine pre-estimate of loss, as a determinative test, although it may still be a factor to be taken into account in applying the new tests outlined below. The court also disapproved of any test based on whether a clause was intended to operate in terrorem. Under the law as now explained, after a re-assessment of the old cases, a clause providing for the payment of an agreed sum for non-performance of a contractual obligation will be enforceable if the person seeking to enforce it has a legitimate interest in doing so and if the agreed sum is not, in the words of Lord Neuberger at paragraph 32, “out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation.” So the two new tests could be said to be (1) legitimate interest and (2) proportionality. Other judges described the second test slightly differently. Lord Mance said the question was whether the charge was “extravagant, exorbitant or unconscionable” (para.152). Lord Hodge referred to the test of “exorbitance or manifest excess compared with the innocent party’s commercial interests” (para. 248). But all were expressing the same idea of a charge which is grossly excessive in the circumstances.
I will now concentrate on the ParkingEye case because it illustrates in a simpler way than the Cavendish case how the new tests apply and because it raises more points of interest for European private law. This is because it discussed not only the penalty clause doctrine but also the rules derived from Council Directive 93/13/EEC on unfair terms in consumer contracts.
ParkingEye Ltd managed car park schemes for supermarkets and retail parks. The contract with the user in this case provided for two hours of free parking. If the user was in breach of the obligation not to overstay a penalty of £85 was payable. Here Mr Beavis had overstayed by almost an hour and had been charged £85. It was held that ParkingEye had a legitimate interest in imposing this charge (because otherwise the whole parking management scheme would not have worked) and that the sum was not out of proportion to its interests or grossly excessive having regard to comparable sums charged elsewhere. So the charge survived the penalty clause rule as now reformulated. It would not have survived the rule as it used to be formulated because it was not based on a genuine pre-estimate of loss: ParkingEye suffered no actual loss from the overstay.
The first point of interest from the point of view of this blog is the use made by the judges of European and international soft law instruments. It had been argued by counsel that the penalty clause doctrine ought to be abolished entirely, so that penalty clauses would be enforceable just like any other contractual terms. The judges disagreed and in support of their view referred not only to the views of the Law Commissions and to a number of foreign laws but also to the fact that rules on agreed payments for damages were retained in various European and international soft-law instruments, including the Principles of European Contract Law (PECL), the Principles of International Commercial Contracts (PICC) and the Draft Common Frame of Reference (DCFR). See lord Neuberger at paragraph 37, Lord Mance at paragraph 164 and Lord Hodge at paragraph 265.
One difference between the approach taken in these instruments and the reformulated UK law is that the instruments allow a court to modify an excessive penalty. For example, under article III. – 3:712 of the DCFR a stipulated payment for non-performance of an obligation “may be reduced to a reasonable amount where it is grossly excessive in relation to the loss resulting from the non-performance and the other circumstances.” The need for the reference to “other circumstances” is demonstrated by the ParkingEye case. In UK law there is no power to modify: an excessive penalty will be wholly unenforceable. It would take legislation to introduce a power to modify.On the other hand, the instruments and UK law are alike in that they distinguish between an agreed charge for non-performance of an obligation and a variable pricing structure, with options for the performing party and different payments being due depending on which option is exercised. The distinction can be criticised as artificial. Clearly it leaves room for drafting round the penalty clause rule. However, as Lord Mance pointed out (at paragraph 130), “in most cases parties know and reflect in their contracts a real distinction, legal and psychological, between what, on the one hand, a party can permissibly do and what, on the other hand, constitutes a breach and may attract a liability to damages for – or even to an injunction to restrain – the breach”.
A second noteworthy point in the ParkingEye case is the way in which the court approached the question of whether the £85 charge was unenforceable because of the rules in the Unfair Terms in Consumer Contracts Regulations 1999, which transposed the 1993 Directive into UK law. Under regulation 5(1), a contractual term which has not been individually negotiated “shall be regarded as unfair if, contrary to the requirement of good faith, it causes a significant imbalance in the parties’ rights and obligations arising under the contract, to the detriment of the consumer.” One type of term which may be regarded as unfair is a term which has “the object or effect of requiring any consumer who fails to fulfil his obligation to pay a disproportionately high sum in compensation”. The court mentioned the UK Regulations and the fact that there was a House of Lords case on them but then went straight to the European Court of Justice’s decision in Aziz v Caixa d’Estalvis de Catalunya, Tarragona i Manresa (Case C-415/11)  3 CMLR 89, which was concerned with an allegedly high rate of interest charged on the debtor’s default. The court found the observations of the Advocate General in that case particularly helpful and concluded that the term imposing the charge of £85 was not unfair. In the words of Lord Neuberger (at paragraph 107)
… there was an imbalance in the parties’ rights. But it did not arise “contrary to the requirement of good faith”, because ParkingEye and the landlord to whom ParkingEye was providing the service had a legitimate interest in imposing a liability on Mr Beavis in excess of the damages that would have been recoverable at common law. ParkingEye had an interest in inducing him to observe the two-hour limit in order to enable customers of the retail outlets and other members of the public to use the available parking space. To echo the observations of the Advocate General at para AG94 of her opinion, charging overstayers £85 underpinned a business model which enabled members of the public to park free of charge for two hours. This was fundamental to the contractual relationship created by Mr Beavis’s acceptance of the terms of the notice, whose whole object was the efficient management of the car park. It was an interest of exactly the kind envisaged by the Advocate General at para AG87 of her opinion and by the Court of Justice at para 74 of the judgment. There is no reason to regard the amount of the charge as any higher than was necessary to achieve that objective.
The court also considered that the term was one which a reasonable motorist would have agreed to, given the availability of convenient free parking for two hours and the fact that the risk of overstaying was within his or her control.
What is interesting about the overall result of these cases is that the new approach adopted in relation to the penalty clause rule is rather similar to the approach of European private law under the Unfair Contract Terms Directive.
The puzzle which remains is what is meant by “legitimate interest”. It can hardly be confined to “commercial interest” because a public body or a charity might well have legitimate non-commercial interests in imposing a penalty for non-performance. What, it might be asked, would be a non-legitimate interest? Would, for example, a religious interest be a legitimate interest? Suppose that a religious body is contracting for construction work on one of its religious buildings. It says to the contractor “This is a holy site and we do not want it to be defiled. So would you agree to an obligation to ensure that there is no blasphemy or use of foul language by any of your employees on the site during the work? And would you agree to pay a penalty of £50 for each infringement?” If the contractor, keen to get the work, agreed to this and if the obligation was sufficiently defined (e.g. by a schedule of offending words or phrases) could the penalties be enforced? And how would proportionality be assessed? The religious interest and the financial penalty are not of a comparable nature. The religious body might feel that death was the appropriate penalty for blasphemy on a holy site and therefore that no merely financial penalty could be regarded as disproportionately high. There seems to be no reason why such a clause, freely agreed to, should not be enforceable. And perhaps, in the light of such examples, a test of grossly excessive in the circumstances might be more flexible than any test based on proportionality.