The penalty rule: outdated and in need of reform?

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Introduction

Before the rule as espoused in Makdessi[1], a penalty clause was classically defined as a secondary obligation that arises (upon breach of a primary obligation) on the part of the party in breach to pay to the other party a sum of money which does not represent a genuine pre-estimate of any loss likely to be sustained to him… but is substantially in excess of that sum.[2] Although there has been major development of the penalty rule since Clydebank[3] and Dunlop[4], it is apparent that the penalty rule is not without faults and reform may be a favourable option. This report will discuss two key issues with the current law; difficulties identifying penal contractual provisions with regards to the new legitimate interest requirements and the circumstances to be considered when deciding whether to label a clause a penalty, including distinctions between commercial and consumer contracts. This will be followed by a consideration of reforms to the penalty rule, including retention, extension, contraction and abolition; concluding with an assessment of how to move forward.

Part I: Review of current law

What makes a contractual provision penal is an important issue facing English contract law. This was, until recently, determined by a penalty being ‘unconscionable and extravagant’, contrasting a liquidated damages clause.[5] This reference to Clydebank was expanded in Lord Dunedin’s quasi-statutory four tests.[6] These tests remain valid for straightforward cases, however, the court in Makdessi[7]noted that they  were not  useful in more complex cases.[8]

To solve this issue, the Supreme Court rewrote the law on penalties so that a clause is a penalty if it ‘creates a secondary obligation,…not seek(ing) to protect a legitimate interest…in the performance of the contract and imposes a detriment on the contract breaker out of all proportion to…(that)…interest.’[9] This was crucial as it moved away from the concepts of genuine pre-estimation of losses and deterrences that were previously present.

Rowan discussed the issue of legitimate interest and concluded that this requirement was ‘somewhat elusive’[10], likely due to the Supreme Court choosing not to define the matter.

The court did, however, provide some guidance on the issue as it initially noted that punishment of the party at fault is not a legitimate interest[11]. This is consistent with the purpose of contract law; to satisfy the expectations of the party entitled to performance.[12] Makdessi noted that on occasions the innocent party may have interests that go beyond compensation[13]. On this issue, Rowan believes that it: ‘reflects a more liberal approach…Its effect is to give the courts greater flexibility and increase the prospects of damages clauses being enforced.’[14] While Rowan is correct in asserting that parties can now tailor the level of protection to reflect their circumstances, allowing parties to take advantage of the court’s position through clever drafting, she fails to note that the increased flexibility that originated in Lordsvale[15], is not without criticism.

The main cost of increased flexibility is certainty, a staple of English contract law and a key reason why many companies choose to contract there. Thus, Makdessi may result in English contract law being less competitive globally, meaning English law firms may lose out on business. The court in Holyoake[16], consistent with Makdessi, considered that none of the provisions of the loan agreement amounted to penalties as its terms were not exorbitant or unconscionable.[17] Holyoake reinforces Makdessi and cements the more modern, flexible approach by the judiciary to the penalty rule. Makdessi also drew attention to another question surrounding the penalty rule – what circumstances are considered when deciding whether a sum is exorbitant or extravagant? The court in Makdessi distinguished between commercial and consumer contracts, citing Philips Hong Kong[18], which specifically mentioned the possibility of considering disparities in contracting powers when deciding whether a damages clause was a penalty.[19]

With regards to larger commercial contracts, ‘in a negotiated contract between properly advised parties of comparable bargaining power,…parties themselves are the best judges of what is legitimate.’[20] This portrays a clear commitment to the idea of freedom of contract, by giving more effect to the agreed provisions. This would have the result of improving certainty, thereby counteracting the legitimate interest requirement.

With regards to consumer contracts, there is now significant legislative protection of weaker contracting parties.[21] However, smaller commercial contractors, such as professionals and small businesses, appear to fall between the common law protection for larger commercial contracts and statutory protections for consumers. Given the fact that some of those small businesses who enter such contracts may share many of the characteristics of consumers, there is a strong argument that they are worthy of legal protection, possibly achieved through the extension of the penalty rule.[22]

Thus, the modern penalty rule is being utilised much less than before[23], indicating increased judicial restraint and a commitment to a more laissez-faire approach towards penalties.

Part II: Recommendations

The current law on penalty clauses is filled with uncertainty and many exceptions to the rule, thus leaving the rule unchanged is not a viable option.

Recommendation 1: The rule should be retained and extended

Retention of the penalty rule is a position supported by Makdessi where it confirmed that the rule is still good law.[24] Leung found the courts’ arguments in favour of retention generally unconvincing[25]; but his overall view, however, is that ‘the rule has not entirely lost its bite,’[26] noting Lord Halsbury’s exaggerated example.[27] Acknowledging the justifications for retention of the rule, such as international prevalence and protection against gaps in statutory regulation, the most compelling argument is that of legal consistency. The English legal system is one of common law, evolved over centuries through relatively conservative judgments. Lord Mance stated: ‘there would have to be shown the strongest reasons for so radical a reversal of jurisprudence which goes back to over a century.’[28] Leung supports the legal consistency justification but deems the prevalence and protectionist justifications currently unconvincing.[29]

This report agrees with Leung’s views and thus considers an extension of the penalty rule through new statute, a position supported by the English Law Commission[30] and Australian courts.[31] Utilising historical reasoning, the Australian High Court extended the rule so that through equity they may grant relief against penalties even where there is no breach of the contract.[32] This would have a clear advantage that the rule would be engaged more often, and would apply more generally, giving the rule greater value. It would also allow the judiciary to become more active and expand its supervisory jurisdiction, better-protecting professionals and small businesses, arguably the most vulnerable group, thereby bolstering the protectionist justification. Conversely, it must be noted that this approach to penalty rules was rejected in Makdessi due to its lack of legal consistency[33], further shown by its decision to reduce the scope of the rule. More importantly, however, increased judicial interference would harm certainty.

Recommendation 2: The rule should be retained but contracted

For years academics and courts[34] alike have been struggling with knowing when to apply the rule. The arguments in favour of retention were discussed in Recommendation 1, however, this option was theorised by Obeidat in his ‘New Approach’ to penalty clauses[35], which had a more laissez-faire approach to contracts and reinforced the legal consistency justification. He suggested that damages should be awarded exactly per the agreement, irrespective of the actual loss suffered, but that where the sum is ‘manifestly disproportionate’ to the actual loss the court may reduce/or even increase the sum to the actual loss.[36] His proposals are fairly convincing and give more effect to the terms agreed upon in the contract, reducing the need for litigation and providing certainty to an area of contract law that currently experiences a deficit. Furthermore, Obeidat’s proposals satisfy the prevalence justification through unification, bringing English contract law closer to European civil law jurisdictions. He also believes that judicial intervention should be an ‘exceptional measure’[37]. This further appreciates the doctrine of freedom of contract seen recently in contract law[38] and would extend it in line with ECGD[39]. Moreover, the idea of modifying unconscionable or extravagant sums to match the actual loss appears a more pragmatic solution to the issue, rather than striking down the provision entirely. However, this may come at the cost of protection of weaker commercial parties, as Obeidat is more theoretical and assumes that the contracting parties are of equal negotiating power, meaning that ‘The New Approach’ would likely leave small businesses unprotected.

Recommendation 3: The rule should be abolished

This approach would remove the penalty rule from English contract law entirely. It is recognised that the rule has not been used very much to the point where some may argue that it is obsolete. Makdessi’s legitimate interest requirement now makes it much easier for businesses to justify their penalty clauses, meaning that courts are less likely to strike them down. Recommendation 3 has the strongest positive effect on certainty of those discussed as there would be almost no scope for judicial intervention.

Furthermore, as discussed in Recommendation 2, the penalty rule interferes with freedom of contract but also the doctrine of good faith. To remove the penalty rule would mean that England, like many European civil law jurisdictions, would have a much greater appreciation of the provisions agreed upon by the parties, strengthening the prevalence justification. It would mean that the shrewd drafting from informed businesses would not be as problematic, as even small businesses and professionals would be aware that whatever they agreed to in the contract would very likely be enforced. Galeza noted that in Makdessi the Justices’ reasons for retention of the penalty rule were limited, as they were based on tradition that the court itself acknowledged as dubious.[40]Thus, the need for legal consistency is less of a concern with this recommendation as the rule’s foundations are far from sturdy. Galeza’s most interesting commentary regarded the counsel for Cavendish who suggested making a distinction between commercial and consumer contracts. Galeza rejected making these distinctions as they are difficult to draw, especially with small businesses, evidenced by the CRA[41]not incorporating the UCPD.[42] Galeza concluded by stating: ‘instead of creating new distinctions within the already battered penal doctrine, it would be easier to let the doctrine go away completely.’[43] This report finds merit in Galeza and suggests that instead of trying to reconstruct a rule that would not be created today, the correct path would be to abolish it and allow Parliament to legislate. This would incorporate the UCPD to better distinguish between consumer and commercial contracts in future, as well as improving common law damages to better reflect the true loss so that ontractors feel less of a need to create liquidated damages clauses.

Conclusions

Ultimately, the penalty rule is an outdated aspect of English contract law. The new legitimate interest requirements mean that it is easier for parties to circumnavigate the rule, reducing its value. Furthermore, the relative bargaining power of the contracting parties is a fairly important factor in deciding whether a provision is penal, however, considering this, the gap between commerce and consumers has not been fully addressed by the rule or appropriate statute.

Extending the scope of the penalty rule is undesirable as it would create more legal uncertainty through increased judicial supervision. This would be reversed by abolition; a rather extreme stance that would diverge from legal conservatism. Thus, this report submits that Recommendation 2 would be most appropriate. This option retains the rule, satisfying the legal consistency justification in Makdessi. Contraction of the rule would also mean that it would be more in line with European jurisdictions.

However, the most compelling reason for contracting the rule would be a practical one. Many have noted that there are difficulties when applying the penalty rule and thus its simplification would make its application much easier, saving businesses money.

Furthermore, this reform flows with the evolution of the rule, promoting freedom of contract and increasing certainty, serving to make UK legal exports more valuable.


[1] Cavendish Square Holdings BV v Talal El Makdessi; Parking Eye Ltd v Beavis [2015] UKSC 67.

[2] Scandinavian Trading Tanker Co AB v Flota Petrolera Ecuatoriana (The Scaptrade) [1983] 2 AC 694 [702].

[3] Clydebank Engineering & Shipbuilding Co v Yzquierdo y Castaneda [1905] AC 6.

[4]  Dunlop Pneumatic Tyre Co. Ltd v New Garage & Motor Co. Ltd [1915] AC 79.

[5] Clydebank (n 3).

[6] Dunlop (n 4).

[7] Makdessi (n 1).

[8]  ibid [22].

[9]  ibid [32], [152], [255].

[10] Solene Rowan, ‘The “legitimate interest in performance” in the law on penalties’ (2019) 78(1) CLJ 148, 174 <https://doi.org/10.1017/S0008197318000958> accessed 20 April 2020.

[11] Makdessi (n 1) [32], [243].

[12] Co-operative Insurance Society Ltd v Argyll Stores (Holdings) Ltd [1998] AC 1 [15].

[13] Makdessi (n 1) [28]-[32], [99], [152], [255].

[14]  Solene Rowan, (n 10) 148, 152 <https://doi.org/10.1017/S0008197318000958> accessed 20 April 2020.

[15]  Lordsvale Finance v Bank of Zambia [1996] QB 752.

[16]  Holyoake v Candy [2017] EWHC 3397 (Ch).

[17]  ibid [471].

[18] Philips Hong Kong Ltd v Attorney General of Hong Kong [1993] 2 WLUK 128.

[19] ibid 57-59.

[20] Makdessi (n 1) [35].

[21]  Unfair Contract Terms Act 1977; Unfair Terms in Consumer Contracts Regulations 1994, SI 1994/3159; Unfair Terms in Consumer Contracts Regulations 1999, SI 1999/2083, Consumer Rights Act 2015.

[22]  Makdessi (n 1) [38].

[23] Alfred McAlpine Capital Projects v Tilebox [2005] EWHC 281 (TCC) [48].

[24] Makdessi (n 1) [36].

[25]  Kal K C Leung, ‘The Penalty Rule: A Modern Interpretation’ (2017) 29 Denning LJ 41, 51 <https://heinonline.org/HOL/P?h=hein.journals/denlj29&i=41> accessed 21 April 2020.

[26] ibid 41, 62.

[27] Clydebank (n 3), 10.

[28] Makdessi (n 1) [162].

[29] Kal K C Leung (n 25) 41, 51  <https://heinonline.org/HOL/P?h=hein.journals/denlj29&i=41> accessed 21 April 2020.

[30] Law Commission, Penalty Clauses and Forfeiture of Moneys Paid (Working Paper No 61, 1975) at 65, accessed 25 April 2020.

[31] Andrews v Australia and New Zealand Baking Group Ltd (2012) 247 CLR 205.

[32] ibid [10].

[33]  Makdessi (n 1) [42].

[34] Wallis v Smith (1882) 21 Ch D 243 256 (Jessel MR); Robophone Facilities Ltd v Blank [1966] 1 WLR 1428 1446.

[35] Yusuf Mohammed Gassim Obeidat, ‘The ‘Penalty’ Clause in English Law: A Critical Analysis and Comparison with Jordanian Law’ (DPhil thesis, University of Leeds 2004) <http://etheses.whiterose.ac.uk/id/eprint/11265 > accessed 22 April 2020.

[36] ibid 26.

[37]  ibid 27.

[38] Makdessi (n 1) [35].

[39] Export Credits Guarantee Department v Universal Oil Products Co [1983] 1 WLR 399 (‘ECGD’) 403.

[40]  Dorota Galeza, ‘Getting rid of the penal doctrine – the implications of the joint cases Cavendish Square v El Makdessi and ParkingEye v Beavis’ (2016) 27(6) ICCLR 175. <https://uk.westlaw.com/Document/I6DCC01F0189C11E69D63A840B6A801B6/View/FullText.html> accessed 26 April 2020.

[41] Consumer Rights Act 2015.

[42] Council Directive 2005/29 of 11 May 2005 concerning unfair business-to-consumer commercial practices in the internal market and amending Council Directive 84/450/EEC, Directives 97/7/EC, 98/27/EC and 2002/65/EC of the European Parliament and of the Council and Regulation (EC) No 2006/2004 of the European Parliament and of the Council (‘Unfair Commercial Practices Directive’) [2005] OJ L 149/22.

[43] Dorota Galeza (n 40). <https://uk.westlaw.com/Document/I6DCC01F0189C11E69D63A840B6A801B6/View/FullText.html> accessed 26 April 2020.

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