Landmark Supreme Court decision confirms role for penalties doctrine

Late in 2015, the year that marked the 800th anniversary of Magna Carta, the UK Supreme Court handed down a landmark decision on contractual penalty clauses. The decision in Cavendish Square Holding BV v Talal El Makdessi [2015] preserves the place of the centuries-old penalties doctrine at the legal high table.  However, the approach to the doctrine has been changed, with the result that parties contracting in the modern commercial world now face the challenge of looking at their contracts through a new lens with the inevitable blurring that flows from this.

The case is the first time the Supreme Court has considered the penalties doctrine in more than 100 years. No doubt as a consequence, the court comprehensively traversed the scope and application of the law both as regards complex commercial contracts between sophisticated parties and consumers.  In doing so, it had regard to the law on penalty clauses in all common law (and some civil law) jurisdictions. Indeed, the Supreme Court impliedly reprimanded the highest Australian court for having misunderstood certain aspects of the doctrine.

Far reaching implications

The penalties doctrine is a fundamental part of contract law in common law jurisdictions, which can render contractual clauses unenforceable.  It applies to all species of contract, irrespective of industry sector. As a result, anyone who enters into contracts needs to understand both how the decision will affect existing contracts and what approach they can or should take to new contracts.

Further, given the close ties between the UK and other common law jurisdictions, the decision in this case is resonating globally and may give rise to a change in the law in other common law jurisdictions in future. For example, the High Court of Australia is scheduled to look again at the doctrine early next year, when it will have an opportunity to respond to the UK Supreme Court’s judgment.

Acratopulo Julian Clifford Chance
Julian Acratopulo

What’s changed?

In essence, the scope of the penalties doctrine has been narrowed in two ways. First, the Court has confirmed the exclusion of a range of clauses from the scope of the doctrine. The doctrine only applies to clauses characterised as secondary obligations, i.e. clauses that replace the damages that might otherwise be awarded for breach of contract.  Indeed, this category may have been reduced. A price adjustment clause, even if triggered by breach of contract, can remain a primary obligation and therefore beyond the reach of the doctrine, rather than being seen as a secondary obligation. This may add a new colour to the contractual pencil case for parties wanting to draft around the boundaries of the penalties doctrine.   There may, as a result, be a shift towards shaping provisions as primary obligations, rather than secondary obligations, but this will not be practicable in all cases.

Secondly, if a clause is subject to the penalties doctrine, parties are no longer necessarily constrained to somewhat artificial assessments of the losses likely to be suffered in the event of breach or required to refrain from drafting clauses that deter parties from breaching their obligations (although clauses designed to punish offending parties for contractual breaches will still not be enforceable).  Instead, the test is whether the clause offers a proportionate protection of legitimate interests (whether or not financial). Parties with a sufficient risk appetite can probably afford to be more aggressive in their negotiations and drafting than they could previously.

Angela Morris Clifford Chance
Angela Morris

Overall, the message from the senior judiciary is clear: courts should be very reluctant to interfere in freely negotiated commercial contracts by striking down clauses, particularly where both parties have had the benefit of legal advice during the negotiations.

However, enthusiasm for these new freedoms may well be tempered by the uncertainty that will exist while the new test beds down.  There is certainly scope for disputes regarding the enforceability of clauses, particularly as parties seek further guidance from the courts on the classification of contractual terms as “primary” and “secondary” obligations and the meaning of the key concepts of “legitimate interest” and “proportionality”.

What next?

Parties need to give their contracts a health check and consider if they are still fit for purpose in achieving their intended commercial objectives.

For those with global businesses, now more than ever, they should wear different hats according to the jurisdictions within which they operate (particularly, those operating in both the UK and Australia), but be prepared for other common law jurisdictions to follow the UK’s lead in the freedom of contract crusade in the coming months and years.

By Julian Acratopulo, partner, Clifford Chance. Senior associate Angela Morris assisted with this article.