On 4 November the Supreme Court of the United Kingdom handed down long-awaited decisions in Cavendish Square Holding BV v Talal El Makdessi and ParkingEye Ltd v Beavis [2015] UKSC 67.
These decisions represent the first significant changes to the rule against penalties at the highest level in over 100 years.
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A new test
The Supreme Court has held that the previously accepted test – whether a provision requiring payment or other action on a breach of contract was a "genuine pre-estimate of loss" – was unhelpful in more complex cases. The Court has instead set out a new test – whether the 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."
The Court expanded on this test to make it clear that two separate limbs would need to be considered: whether legitimate business interest is served by the provision and, if it is, whether the provision made is "extravagant, exorbitant or unconscionable."
Legitimate interest of the innocent party
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By GlobalDataThe shift from a test based solely on the loss likely to be suffered by the innocent party to a commercial justification should be significant for commercial parties. The Court made it clear that this extends beyond the right to recover losses and could also include the consideration of the interests of third parties. In ParkingEye the claim related to a parking fine of £85 imposed on a customer for overstaying a 2-hour time limit. The Court considered that, although ParkingEye would not suffer any direct loss as a result of the customer overstaying, the business purposes of ParkingEye, including the provision of an income stream to meet the costs of operating the scheme and make a profit, as well as the interests of the land-owner, were all reasonable considerations in determining the fine payable.
While it may be bad news for users of private car parks, these decisions have established a test which appears to be much more in tune with the way businesses operate today and the multiple factors which are taken into account when negotiating contracts and remedies for breach of primary contractual obligations or setting business terms.
What relevance does this have for leasing?
In retaining the rule against penalties the Courts made it clear that parties do still need to ensure that the contractual remedies for breach which they negotiate are not unconscionable or exorbitant as these will still be at risk of breaching the rule. Lessors may in the past have been advised that any termination sum payable for breach by the lessee should represent foreseeable losses in order to avoid constituting a penalty. Often the termination sum is calculated using discounted future rents and the market has generally regarded this test as constituting a genuine pre-estimate, particularly if rents received from a new lessee for the same period are rebated to the defaulting lessee. This new decision may mean that lessors can move away from this formula and consider other commercial factors. New discussions may arise on the factors parties should be allowed to take into account in support of their legitimate interests.
Mette Rolle is an associate at Stephenson Harwood
