UK Supreme Court judgement on penalties
ISSUE 2, 2015:
UK Supreme Court judgement
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Earlier this month, the Supreme Court handed down its judgement, clarifying and restating the English law rule against penalties, in the consolidated cases of Cavendish and ParkingEye. The judgement replaces the previous rule regarding penalties with a more flexible test based on whether the contractual provision in question imposes a detriment to the party in breach out of proportion to any legitimate interest of the innocent party.
This judgement will be of great interest to employers, as it will have a significant impact on the assessment of whether provisions in an employment contract dealing with the consequences of a breach will be regarded as unenforceable penalties. This is particularly relevant for contracts that contain provisions relating to clawback in the form of bonus or share incentive awards, repayment of training or recruitment or breaches of restrictive covenants.
Previous rule regarding penalties
The basis for English law on penalties stems from a House of Lords case a hundred years ago. Following this case, a clause in a contract would be deemed a penalty, and so unenforceable, where such clause was primarily intended to deter breach and the amount stipulated to be paid on breach was not a genuine pre-estimate of loss at the time the contract was made.
The new, "true test" regarding penalties
The new test distinguishes between a "primary obligation" and a "secondary obligation". Although this distinction is not always straightforward, generally, a primary obligation will be the contractual obligation, for example, a non-competition clause, and the secondary obligation will be the remedy for the breach of this clause.
The new test is not intended to regulate the fairness of a primary obligation, only that of a secondary obligation. The new test provides that for a provision to be a penalty it needs to be a secondary obligation which imposes a detriment on the party in breach out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation.
The aim of the secondary obligation cannot be to simply punish the party in breach. If the secondary obligation is a genuine pre-estimate of loss, the clause containing the secondary obligation will be valid. However, even if the clause does not provide for a payment which is a genuine pre-estimate of loss, this does not necessarily mean that the clause will be a penalty. In assessing whether the clause is penal, it should be considered whether such clause can be deemed "unconscionable" or "extravagant" by reference to some norm, which could include relevant industry standards.
Importantly, it was also recognised that in a negotiated contract between properly advised parties of comparable bargaining power, the strong initial presumption must be that the parties themselves are the best judges of what is legitimate in a provision dealing with the consequences of breach.
The judgement should be of comfort to employers entering into employment contracts with senior management, which have been negotiated with a clear commercial rationale for terms that might otherwise appear harsh. If such a contract has been negotiated between parties with relatively equal bargaining power, with the benefit of legal advice, it is likely to be difficult to rebut the presumption that the innocent party has a legitimate interest in enforcing a term providing for the consequences of breach. However, clauses in standard employment contracts will be assessed with greater scrutiny, as there will often be an inequality in the bargaining power of the two parties.
As a result of this judgement, employers should give consideration as to future drafting of employment contracts. The judgement confirms that the rule against penalties will not apply to primary obligations of the parties or to provisions that arise as a result of any event other than a breach of contract. As a result, it may in some cases be possible to structure contractual provisions so that they provide for a series of primary and/ or conditional primary obligations which fall outside the scope of the penalty doctrine altogether. This possibility was acknowledged by the Supreme Court. For example, a provision could be drafted to make payment conditional upon aspects of conduct or performance based on objective measures rather than the occurrence of a breach.
Alternatively, employers could consider drafting clauses that specifically address this judgement and set out the legitimate business interests being protected, the commercial rationale, industry standards (if applicable) and the equilibrium between the consequences of the breach and the detriment caused by the party in breach. Whatever approach is adopted, the Supreme Court has noted that courts should examine the substance of the parties' agreement, rather than its form or the label attached to it.
Before redrafting any employment contract, employers should consider the effect on other potential recourses they may have against the breaching party. For example, a remedy that an employer has at its disposal against a breach of a post-termination restriction is a claim for injunctive relief. If a specific provision has been drafted in the employment contract to address such breach, with a nuanced payment, then it may be that a claim for injunctive relief in respect of such breach is undermined.
The judgement of the Supreme Court introduces some well overdue flexibility into the doctrine of penalties. There are still areas of doubt when predicating whether the rule against penalties may apply, in particular, the distinction between primary and secondary obligations. There will doubtless also be debate as to the proportionality of the detriment envisaged by a clause and the legitimate interest of the innocent party.
Provided parties can show a genuine commercial interest for agreeing the terms of remedies for breach, beyond simply punishing a contract breaker, they should now be able to have a higher degree of confidence that their agreement will be upheld. However, it remains to be seen how the Supreme Court's new test will be applied by the lower courts in practice.
 Cavendish Square Holding BV v El Makdessi and ParkingEye Ltd v Beavis  UKSC 67.
 Dunlop Pneumatic Tyre Co Ltd v New Garafe & Motor Co Ltd  A.C.79.
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