A penalty is now to be regarded as: “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 UK Supreme

A penalty is now to be regarded as:

“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 UK Supreme Court has reviewed the English law of penalties and re-formulated the test in a landmark judgment on two unrelated appeals heard together:

• Cavendish Square Holding BV – v – Talal El Makdessi (“Cavendish”); and
• ParkingEye Ltd – v – Beavis (“Beavis”).[1]

The two appeals did not involve construction matters. The judgment will nevertheless be of great interest to construction industry practitioners, including lawyers, when considering whether a liquidated damages clause is valid and so fixes the sum payable in the event of a breach of contract, or alternatively, is an unenforceable penalty. If it is a penalty, the innocent party will need to prove his damages at common law.

Practitioners should note that the distinction has just become rather more clouded. The test provided 100 years ago has been replaced by more subjective considerations on which more guidance will inevitably be required from the courts. It may transpire that those certain types of construction employer, in seeking to protect a wide interest, may now seek greater sums in liquidated damages than previously.

Penalties are Secondary Obligations

The law regarding penalties is a rule of contract law based on public policy. A contract may not “punish” a contract-breaker. Penal provisions will therefore not be enforced by the courts. They have for a long time acknowledged that the law regarding penalties does not apply to primary contractual obligations. Save for circumstances involving illegality, duress, or questions of consent and the like, primary obligations are matters for the parties alone. The courts will generally not interfere; to do so would run counter to the parties’ freedom of contract.

Only secondary obligations that respond to a breach of contract may be subject to the law on penalties. The most obvious example of a secondary obligation is one whereby the contract-breaker must pay money in the form of liquidated damages to the innocent party. But, as we shall see, other secondary obligations may be equally amenable to the test for a penalty. For example, the requirement to transfer property or shares may also qualify as a penalty in the appropriate context.

Former Distinction Between Liquidated Damages and Penalty

In 1915, the House of Lords decision in Dunlop[2] famously underlined the dichotomy between a penalty and a liquidated damages provision in a contract. It was said to be ultimately a question of construction.

Dunlop held that the essence of a penalty was the payment of money stipulated as in terrorem of the offending party i.e. intended to deter a breach. In contrast, Dunlop also held that the essence of a valid liquidated damages provision was “a genuine, covenanted, pre-estimate of damage”. Anything that was not a genuine pre-estimate was at risk of being found penal after Dunlop. If the sum stipulated was “extravagant and unconscionable in amount in comparison with the greatest loss that could conceivably be proved to have followed from the breach”, it was definitely penal according to Dunlop.

Now, whilst the dichotomy between a penalty and a valid liquidated damages clause still exists as a matter of law, the boundary between the two has moved.

Cavendish v Makdessi

The Supreme Court case of Cavendish concerned an agreement for the sale of a majority shareholding by Mr Makdessi to Cavendish at a price per share that reflected very valuable goodwill. The agreement provided for stage payments; an initial payment to Makdessi followed by further payments calculated to reflect company profits when they were known. There was an anti-competition covenant that was later broken by Makdessi. In such circumstances, the agreement provided that Makdessi forfeited entitlement to the further payments and that he could also be required to transfer his remaining shareholding to Cavendish at a price per share stripped of the value of goodwill. Makdessi contended that the provisions, including that for the transfer of his remaining shareholding, were penalties and unenforceable.

The Supreme Court resisted a submission for the penalty rule’s complete abolition. However, it recognised many problems inherent in Dunlop. For example, secondary obligations following the breach of a primary obligation, particularly in modern commercial contexts, were said not always to be confined to the payment of money, contrary to the test set out in Dunlop. They might involve the forfeiture of a deposit in money or even the transfer of property e.g. in shares. It was said to depend on the nature of the right which the contract-breaker was being deprived of and the basis on which he was being deprived of it. The courts should be free to examine such secondary obligations to determine whether they are penal and therefore unenforceable, the Supreme Court said.

The Court was not unanimous in its categorisation of the provisions for the treatment of goodwill under Makdessi’s agreement. A minority decided that the provisions regarding loss of entitlement to further payments were not secondary obligations by Makdessi but were in fact part of a conditional primary obligation to pay by Cavendish. They were no more than a price adjustment mechanism whereby Makdessi, as the seller, effectively earned his future goodwill payments by not competing with the company he was selling. Goodwill was part of his consideration for the sale.  If it was not provided, Cavendish was not required to pay for it. Non-payment under the agreement did not amount to damages for breach of the anti-competition covenant. The law regarding penalties could not therefore apply, according to the minority. A majority of the Court however considered the forfeited payments were indeed secondary obligations on the part of Makdessi but were not penal for other reasons.

The distinction between what is a primary and a secondary contractual obligation and the prospect of “disguising” the true position in complex arrangements is therefore a potential problem for the future. Equally problematic may be the potential overlap between the common law right of an innocent party to withhold something otherwise due under an agreement, and the equitable remedy of relief against forfeiture available to a contract breaker.

The Law Lords in Cavendish also found the Dunlop concept of in terrorem, or deterrence, to be unhelpful. They said that an innocent party might have a legitimate interest in the performance of the contract by the other party which went well beyond the simple right to recover damages (i.e. financial compensation for breach) even if the damages could readily be calculated. There might be a wider purpose to the bargain; deterrence might be reasonable and appropriate to protect it.

Particularly in cases where the parties have access to legal advice and can negotiate on equal terms (as was the case with Cavendish and Makdessi), the Court considered that they should have the freedom to agree terms that were a deterrent to breach. Here the Court found that Cavendish and Makdessi placed a very high value on Makdessi’s accumulated goodwill. It was central to the bargain and Cavendish wanted to acquire it. Cavendish had a legitimate interest in protecting it. Once Makdessi had breached the anti-competition covenant, “the wolf was in the fold” as the lower court judge expressed it. The goodwill was effectively lost. Makdessi accordingly lost the entitlement to payment.

Furthermore, once this had happened, Cavendish had a legitimate interest in severing the relationship between the parties as quickly as possible. It could not proceed with a disaffected minority shareholder in Mr Makdessi. It was entitled to acquire the balance of Makdessi’s shareholding immediately and without the goodwill component, as provided for in the agreement. The requirement for the share transfer did not amount to a penalty.

For similar reasons the Supreme Court in Cavendish also thought unhelpful Dunlop’s requirement for a valid liquidated damages provision to be a genuine pre-estimate of loss that might flow from the breach.

Circumstances might mean that the amount to be paid following breach or other secondary obligation could not satisfy that strict test. As stated above, Dunlop had referred to a penalty in terms of the sum paid being “extravagant and unconscionable.” Similar phraseology is to be found in the review of more than 100 years of case law helpfully set out in Cavendish. One sees phrases such as “exorbitant”, “wholly disproportionate”, “gross excessiveness”, “unreasonable”, “manifest excess”, “extravagant disproportion” (and combinations of most of them) all used to describe a penalty provision over the years.

From this raft of egregious terms, the Supreme Court has distilled down the essence of a penalty. It has now approved the following succinct re-statement of the test. The test for a penalty now 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.”.

ParkingEye v Beavis

ParkingEye managed the car park of a retail centre containing many individual stores. Signs throughout the car park stated that the first two hours’ parking by customers was free but those who parked for anything longer would incur an £85 single charge. The signs also stated that, by parking in the facility, motorists were agreeing to the above terms. Mr Beavis overstayed by almost one hour and was charged £85. In court proceedings brought by ParkingEye to recover the charge, Beavis alleged that it was unenforceable at common law because it was a penalty. He also alleged that it was unfair and unenforceable by virtue of the Unfair Terms in Consumer Contracts Regulations 1999 (“Regulations”).

The Supreme Court heard the scheme described as a “traffic space maximisation scheme”. The £85 charge clearly had nothing to do with compensating ParkingEye for Beavis’s breach. Its predominant purpose was in terrorem – to deter over-stayers – prohibited by Dunlop. The entire scheme benefitted the retailers who relied on the offer of two hours’ free parking to attract potential customers to the retail centre and on the £85 charge then to repel them, so ensuring that there was a regular turnover of visitors. The subsidiary purpose of the charge was to fund the scheme.

That benefited ParkingEye by allowing it to make a reasonable profit. Even the car park’s users benefitted from the scheme through having access to parking space that might otherwise be clogged up with vehicles not belonging to customers of the retail centre.

ParkingEye therefore was found to have a legitimate interest in the enforcement of the charge which was not out of line with those of other such schemes elsewhere in the UK. The charge was therefore not wholly disproportionate to that legitimate interest and not a penalty. Neither was it unfair under the Regulations.

Conclusion on the Implications of Cavendish and Beavis

The concept of penalty remains, but the point at which it is reached has become more elastic. It would seem that with the disappearance of the emphasis on requiring a genuine pre-estimate of loss, there is now scope for liquidated damages to exceed previous levels. Some deterrence is in principle now acceptable.  So long as there is a legitimate interest in enforcement of the original obligation and the sums stipulated are not “out of all proportion” and unconscionably so, the courts are likely to tolerate the level of damages agreed. Much uncertainty, however, remains:

• The distinction between primary and secondary obligations was unclear even to the seven-member bench assembled in Cavendish. For complex commercial matters, further guidance will be required on this question and on how one may identify a penalty masquerading as a primary obligation. In the commercial arena, one can now expect to see obligations framed as primary obligations so far as possible to render them immune from
• In the field of construction, a simple obligation to pay liquidated damages for completion after an agreed date is unlikely to be regarded as primary in nature. However, where differences in performance of the final product attract liquidated damages, depending upon how the provisions are drafted when looked at overall, there might be greater scope for such a finding.
• A further problem lies in the identification of what a legitimate interest is, and on its distinction from an “illegitimate” one. May an employer, say, a high-profile authority with responsibilities towards the general public, now argue that its interests entitle it to enforce a contractor’s obligation to pay liquidated damages for delay or under-performance far exceeding the “genuine pre-estimate of loss” which formerly it would have demanded?
• If so, the importance of an Employer’s “legitimate interests” in performance and the potential effects of a breach on those interests are best declared at the outset and set out clearly within the contract
• Given the considerations of the Supreme Court in Cavendish, in those circumstances it would also be sensible to include a declaration that the parties are of comparable bargaining power and have had access to legal

A still further problem resides in determining what constitutes a detriment “out of all proportion” to a legitimate interest. Which, if any, of the superlatives may still be relied upon now for further guidance? Lord Mance considered them to be “extravagant, exorbitant or unconscionable”, at least in cases where the parties were not of equal bargaining power and properly advised.

Please get in touch at victoria.tyson@howardkennedy.com with your thoughts or to discuss any concerns.

[1] [2015] UKSC 67.

[2] Dunlop Pneumatic Tyre Company Ltd v New Garage & Motor Company Ltd [1915] AC 79 (“Dunlop”).

The English Supreme Court has ruled that losers in adjudications have six years to challenge an adjudicator’s decision from the payment date, while winners' rights to seek improvement end with the original claim's limitation period. This article considers the implications.

How long do you have to challenge an adjudicator’s decision?

Controversially, the English Supreme Court has now ruled as follows:

• If you were the loser and required to pay monies, you will have the full limitation period, typically six years, to bring your claim to recover those monies starting from when you were required to make payment to the winner; whereas

• If you were the winner, your right to seek an improvement of the result will come to an end at the same time as the limitation period for the original claim.

In our last issue we discussed the background to the then forthcoming Supreme Court’s decision in the Aspect v Higgins case (“the Decision”).

If I had been forced to lay my cards on the table then about which way the Decision might go, I would have predicted that Aspect would succeed and the Court of Appeal’s decision would be upheld. That would have been a fairly unpopular opinion since many considered this would be not just an unfair result but one that would seriously undermine the adjudication process.

We are now going to see how prophetic those views turn out to be because the five members of the Supreme Court, with Lord Mance delivering the single judgment, have unanimously found in favour of Aspect. [1]

The Key Facts

The rather complicated factual background of this case can be summarised as follows:

• In April 2004 Higgins engaged Aspect to provide asbestos advice on a project;
• In July 2009 Higgins obtained an adjudicator’s decision condemning Aspect’s advice and awarding damages of approximately £658,000 which Aspect duly paid in August 2009;
• By August 2010 the six-year limitation period had expired for any claim that Higgins might have brought against Aspect;
• Subsequently, Aspect issued proceedings at first instance in the Technology and Construction Court to recover the full £658,000 which it had paid to Higgins in complying with the adjudicator’s decision, claiming it had been an over-payment;
• Higgins defended the proceedings by arguing that Aspect’s claim was time-barred;
• At first instance, before Akenhead J, Aspect’s claim was indeed held to be time-barred [2];
• That decision was overturned by the Court of Appeal. [3]

The nature of Aspect’s Case for Recovery of the Monies

Readers will recall that, both at first instance and in the Court of Appeal, Aspect had pursued a two-pronged case against Higgins.

Firstly, Aspect had based its claim upon a term which should be implied into the Scheme for Construction Contracts (which itself takes effect as a series of implied terms), giving a party who is required to pay monies under an adjudication decision the right to recover any over-payment (“the Contract Argument”).

Secondly, Aspect pursued an alternative claim based upon restitutionary principles and more specifically unjust enrichment (“the Restitution Argument”).

The Nature of Higgins’ Case Against Aspect

Before examining how the Supreme Court approached these two arguments, it is worth reminding ourselves of the thrust of Higgins’ case against Aspect at first instance and before the Court of Appeal because it was here that the battle-lines for the Supreme Court were really drawn.

It was central to Higgins’ case that Aspect’s position was inherently unfair and, if supported by the courts, would seriously undermine adjudication as we have come to know it. Higgins contended that the facts of this case showed precisely why that was so.

Instead of seeking a final determination of the underlying dispute, as it had been entitled to, Aspect had just sat back and done nothing until the limitation period had expired for any claim that Higgins might have wished to advance. This meant that, in any subsequent action for recovery of monies which Aspect might pursue, Higgins would be unable to pursue any set-offs or counterclaims in relation to these matters.

Such a result, Higgins contended, was clearly unfair and, by potentially doubling the limitation period for such claims, would undermine the intended finality and therefore the efficacy of the adjudication process itself. Those propositions have received much support from commentators ahead of the Supreme Court’s judgment in this matter.

In the Decision, Lord Mance described Higgins’ complaint about the Court of Appeal’s approach to limitation as being that it “gives Aspect a one-way throw and undermines finality”.  However, he had a simple but, in his view, complete answer to that complaint:-

“That consequence follows, however, from Higgins’s own decision not to commence legal proceedings within six years from April 2004 or early 2005 and so itself to take the risk of not confirming (and to forego the possibility of improving upon) the adjudication award it had received. Adjudication was conceived, as I have stated, as a provisional mechanism, pending a final determination of the dispute. Understandable though it is that Higgins should wish matters to lie as they are following the adjudication decision, Higgins could not ensure that matters would so lie, or therefore that there would be finality, without either pursuing legal or arbitral proceedings to a conclusion or obtaining Aspect’s agreement.”

One gets the feeling that if ever there was a case where the merits, whichever way they are perceived, seem to be dictating both popular opinion and judicial outcome, then this is surely that case.

In any event, having reached that view on the “merits” of this case, the precise route that the Supreme Court adopted to arrive at the appropriate conclusion almost seems superfluous. Nevertheless, in summary, we explore below how the Supreme Court arrived at its conclusions.

The Contract Argument

Their Lordships had no real hesitation in deciding the following, which was central to Aspect’s arguments:

“[I]t is a necessary legal consequence of the Scheme implied by the 1996 Act into the parties’ contractual relationship that Aspect must have a directly enforceable right to recover any overpayment to which the adjudicator’s decision can be shown to have led, once there has been a final determination of the dispute.”

In reaching that conclusion, the Supreme Court agreed with the Court of Appeal’s analysis that the legal basis for that right is an implied term arising from the Scheme which provided a positive “right to recover an alleged over-payment”.

Furthermore, since the right was in essence a right to recover an over-payment that had been made, their Lordships considered that it was obvious that the right would accrue as and when the payment in question had taken place.  It followed that, for limitation purposes, a claim based upon that right could be brought at any time within six years from that date.

It also followed from that relatively straightforward analysis of the situation that Aspect had been perfectly within its rights to bring the claim when it had done.

Readers will recall that the contractual analysis advanced by Higgins, with which Akenhead J at first instance had agreed, was very different. There was no room or necessity, Higgins had argued, to imply a term of the sort accepted by the Court of Appeal and now also the Supreme Court.

Instead, Higgins argued, Aspect did have an appropriate right, which it should have exercised within six years from when the contract had been performed, and that was to obtain a negative declaration confirming that it was not liable for the monies which Aspect claimed.

The Supreme Court had little hesitation in rejecting this “negative declaration” approach, Lord Mance commenting:-

“It ignores a core ingredient of and the immediate trigger to Aspect’s current claim, which is that it has been ordered to make and has made a large payment in 2009. It is artificial to treat a claim to recover that sum as based on an alleged cause of action accruing in 2004 or early 2005. To treat Aspect’s remedy as being to seek a declaration, and then to invite the court to use its alleged consequential powers in order to grant relief which is the true object of the proceedings, is equally artificial.”

Lord Mance helpfully clarified that, in providing for the final determination of matters decided in adjudication, “what the Scheme contemplates is the final determination of the dispute referred to the adjudicator, because it is that which determines whether or not the adjudicator was justified in his or her assessment of what was due under the contract”.

This process will involve the court or tribunal in reviewing the “substantive merits of the original dispute”, in his Lordship’s words, although limitation will be irrelevant. The Decision is not entirely clear regarding the extent to which matters occurring after the adjudicator’s decision can be relied upon in the final determination process and this will need clarification in future court decisions.

Lastly, in the context of final determination, Lord Mance confirmed that, in defending its position, Higgins would be entitled to advance all matters upon which it relied in the adjudication, including any set-offs which the adjudicator may have rejected, given that the adjudicator’s reasoning would have “no standing” in the process. This softens the blow somewhat for successful parties facing final determination in these circumstances.

The Restitution Argument

The Restitution Argument had been raised, without really going anywhere, at first instance. The Court of Appeal disposed of the appeal from Akenhead J’s decision on the basis of the Contract Argument without feeling it necessary to look into restitutionary issues.

However, in giving Higgins permission to appeal, the Supreme Court went to the lengths of stating that it might require the parties to address it on “the legal position regarding restitution”.

As it happens, the Supreme Court, like the Court of Appeal before it, felt it unnecessary to look into the Restitution Argument in any great detail in the Decision.  What Lord Mance did say, in considering the limitation position, was the following:

“Since Aspect’s cause of action arises from payment and is only for repayment, it is, whether analysed in implied contractual or restitutionary terms, a cause of action which could be brought at any time within six years after the date of payment to Higgins, i.e. after 6 August 2009. For this purpose an independent restitutionary claim falls to be regarded as “founded on simple contract” within section 5 of the Limitation Act…”

The fate of the Restitution Argument therefore remains slightly unclear. However, the reality is that it would only really have come into play had Aspect failed on the Contract Argument or if there had been limitation issues about it in circumstances where the position in restitution would have been more favourable for Aspect.

The Consequences of the Decision

Much has already been made about the damaging effect that the Decision will have on the adjudication process. My own view is that these concerns are exaggerated and that the Decision’s future impact on a user can be summarised as follows:

• The law is now settled regarding the steps that a party must take if he believes that the adjudicator has required him to make an over-payment; he should commence proceedings to seek final determination of the matters in issue; he will have six years to do so from when the payment was actually made;

• In the final determination proceedings, although the successful party will be able to defend itself by relying on all matters that it raised in the adjudication, what it will not be able to do is to counterclaim in respect of any of its own claims if they have become time-barred on the basis of the application of the normal rules;

• It may be that a losing party in adjudication who has been required to pay out monies to the successful party will seek to “do an Aspect” by deliberately holding off from taking any steps to recover an over-payment; however, this would only make any sense where the successful party has its own claims which might become time-barred by the time the final determination proceedings have to be commenced; such cases are going to be relatively rare;

• We may well see a number of cases where successful parties in adjudication do take pre-emptive action to prevent themselves from falling into the same position in which Higgins has ultimately found itself but I think those cases are also going to be rare; I suspect it is more likely that in such cases a deal will be done to achieve finality, but successful parties would be well-advised to consider the limitation position in any cases where they have been paid monies on the back of an adjudicator’s decision;

• It would be prudent for professional advisers who have assisted parties in such cases also to address the potential implications of the Decision in the context of the matters with which they were involved.

[1] Aspect Contracts (Asbestos) Ltd v Higgins Construction Plc [2015] UKSC 38 (17 June 2015) http://www.bailii.org/uk/cases/UKSC/2015/38.html

[2] Aspect Contracts (Asbestos) Ltd v Higgins Construction Plc [2013] EWHC 1322 (TCC) (23 May 2013) http://www.bailii.org/ew/cases/EWHC/TCC/2013/1322.html

[3] Aspect Contracts (Asbestos) Ltd v Higgins Construction Plc [2013] EWCA Civ 1541 (29 November 2013)  http://www.bailii.org/ew/cases/EWCA/Civ/2013/1541.html