Reports of the decision of the Supreme Court in the joined appeals in Cavendish Square and ParkingEye left me confused because some reckoned the decision represented a narrowing of the application of the penalty doctrine whilst others considered it had expanded the doctrine’s scope. So on a wet weekend afternoon I took hold of a copy of the Judgment –  UKSC 67- and tasked myself to find out. Here is what I found.
First, the Supreme Court tells us that it declined invitations by Counsel either to abolish the penalty doctrine or to extend it.
Second, Lords Neuberger and Sumption (in the leading judgment with which Lord Carnwath agreed) suggest that they have given the doctrine a reappraisal.
I hope they will forgive me if I say that it seems to me to be more of a facelift than a remodelling.
They tell us now that:
“ 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” (my enumeration, added for convenience)
As to  – the identifier that the provision must be a secondary obligation – this might appear to be restrictive but traditionally, a penalty has always been identified as a disadvantage triggered upon breach and yet there have been cases dealing with “disguised penalties” where the court has looked beyond the draftsman’s ability to circumvent the need for the trigger of a breach. Those cases treated the doctrine as one of substance not form. From what I can see, the Supreme Court neither elevated nor diminished those cases. Lords N and S (at  to ) recognised that the secondary obligation requirement meant that in some cases the application of the penalty rule may depend on how the relevant obligation is framed in the contract. If the draftsman had framed a conditional primary obligation rather than a secondary obligation providing a contractual alternative to damages, that would usually avoid the application of the doctrine. However, Lords N and S said, the capricious consequences of this state of affairs were mitigated by the fact that the classification of terms for the purpose of the penalty rule depends on the substance of the term and not on its form or on the label which the parties have chosen to attach to it. They nevertheless declined to expand the doctrine to ensure its application did not turn on mere questions of drafting even where a realistic approach was taken to the substance of the transaction and not just its form. They felt that the fact that the application of the doctrine could turn upon questions of drafting was justified by the fact that the rule “being an inroad upon freedom of contract which is inflexible … ought not to be extended” at least by judicial, as opposed to legislative, decision-making.
Essentially, therefore, the Supreme Court does not seem to have taken the whole of the rug away from under the feet of those arguing in future of the doctrine’s application to disguised clauses. What is not clarified is whether and when a clause dressed as a conditional primary obligation will be treated as a disguised penalty. Let us take, for example, the clause in the famous Interfoto Library case beloved of all students of contract law:
“All transparencies must be returned to us within 14 days from the date of posting/delivery/collection. A holding fee of £5 plus VAT per day will be charged for each transparency which is retained by you longer than the said period of 14 days…”
which the then Lord Justice Bingham, no less, felt challengeable as a disguised penalty clause. That clause imposed a primary obligation on the hirer of the transparencies to perform an act, namely their return within 14 days but it did not purport to impose a secondary obligation providing for payment on breach of a specified sum of money in lieu of damages. Instead, it provided that, if the hirer did not perform the 14 day obligation, a holding fee would be payable.
Assuming the Supreme Court would defer to Bingham L.J.’s analysis, what factor makes that clause a disguised penalty? Presumably, it is the fact that the contract imposed the obligation to perform within 14 days. If the contract had merely stated:
“A holding fee of £5 plus VAT per day will be paid for each transparency which is retained by you longer than …14 days…”
the obligation to pay the specified sum would have amounted to a conditional primary obligation and ought not, on the reappraised test, have fallen within the doctrine. Seems a tad artificial doesn’t it?
As to  the Supreme Court did not restrict the nature of the detriment imposed to payments of money. It was more expansive in its view. Lords N and S saw no reason why an obligation to transfer assets (either for nothing or at an undervalue) should not be capable of constituting a penalty. Similarly, the fact that a sum is paid over by one party to the other party as a deposit, in the sense of some sort of surety for the first party’s contractual performance, would not prevent the sum being a penalty, if the second party in due course forfeited the deposit in accordance with the contractual terms, following the first party’s breach of contract. Lord Mance accepted that the doctrine extended to where the detriment imposed was a transfer of money’s worth rather than just of money.
What of  the new test of the measure of the detriment?
The clause must impose a disproportionate disadvantage on the party in breach if it is to be classified as penal. That is nothing new. That there is an element of deterrence in the detriment imposed is no longer enough. Moreover, the measure of the detriment will no longer always be tied to a pure damages comparison. The judgments recognise that the party imposing the disadvantage may have a legitimate commercial interest in the performance of the primary obligation extending beyond a financial substitute for performance. Lord Mance put it this way:
“What is necessary in each case is to consider, first, whether any (and if so what) legitimate business interest is served and protected by the clause, and, second, whether, assuming such an interest to exist, the provision made for the interest is nevertheless in the circumstances extravagant, exorbitant or unconscionable.”
So, in Cavendish Square, the court could look beyond the particular loss arising from the breach of the restrictive covenant to the innocent party’s legitimate commercial interest in the protection of it goodwill. In ParkingEye, the court could look at the overall cost of providing and maintaining a car parking enforcement scheme rather than the particular loss caused by the individual parker’s extended stay.
This approach undoubtedly provides a greater ambit of justification to the innocent party and restricts the circumstances in which a clause is determined to be penal in its effects.
11KBW’s Richard Leiper appeared for Cavendish Square