Important Changes to the English law rule on penalty clauses - what does it mean for franchising?
In a recent landmark decision, the highest court in England and Wales, the Supreme Court, considered the long established principles underlying the law relating to contractual penalty clauses (the penalty rule). The Supreme Court issued a joint judgment in the cases of Cavendish Square Holding BV v Talal El Makdessi (El Makdessi) and ParkingEye Ltd v Beavis  UKSC 67 (ParkingEye), which is one of the most important decisions in English common law for the last 100 years.
The Supreme Court judgment sets out a new, progressive test for determining whether or not a contractual provision will be considered penal and therefore unenforceable. The judgment is relevant to all franchise systems which operate under English law agreements, as it re-calibrates the application of the penalty rule and potentially gives franchisors greater scope to deter certain types of behaviour and impose contractual penalties for certain types of breaches.
What was the penalty rule?
The origins of the penalty rule can be traced back as far as the 16th century, and originates in the concern of the Courts to prevent exploitation in an age when credit was scarce and borrowers were particularly vulnerable. Essentially, a penalty is a payment of money stipulated in the contract and is unenforceable against the offending party if it is an exorbitant alternative to common law damages.
At the beginning of the 20th century, the judgment in the case of Dunlop Pneumatic Tyre Co Ltd v New Garage & Motor Co. Ltd  A.C. 847 (Dunlop) sought to restate the law on the penalty rule by providing four tests which were designed to be "helpful, or even conclusive" in determining whether or not a clause was an unenforceable penalty. The Dunlop judgment distinguished between penalty clauses (which are unenforceable) and "liquidated damages" clauses, which are enforceable provided that the specified sum is "a genuine pre-estimate of loss" – wording which has since appeared in many English law commercial contracts over the last 100 years.
However, in El Makdessi and ParkingEye the Supreme Court noted that the Dunlop tests had taken on the status of a "quasi-statutory code", which was never the intention, and the Dunlop test has been applied too rigidly, particularly in cases where there is a clear commercial justification for including a penalty clause, or where there may be interests beyond the compensatory which justify the imposition on a party in breach of an additional financial burden.
What were the cases about?
The El Makdessi case related to the sale of a Middle Eastern media business and the provisions of a share purchase and shareholders' agreement. The agreements provided that if the seller was in breach of certain non-compete restrictions, then he lost his entitlement to deferred consideration that would otherwise have been payable, and he must sell his remaining shares at a price that excluded the value of the goodwill (which would have been diminished by his breach of the covenants). The Court of Appeal held that these provisions were penal, as their purpose was to deter an act rather than to compensate the loss suffered by the innocent party.
The ParkingEye case related to a parking fine of £85 imposed after a driver overstayed the two-hour limit in a privately-run car park. The driver, Mr Beavis, attempted to argue that this was a penalty (as the owner of the car park had not suffered any clear loss) and therefore unenforceable. The Court of Appeal disagreed but granted Mr Beavis permission to appeal, and it is testament to the integrity and impartiality of the English court system that the Supreme Court gave such a detailed judgment on a case involving a £85 fine.
The new test
The Supreme Court's judgment has moved the law on contractual penalties away from the narrowly applied tests in Dunlop and has re-cast the test as follows: "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 ".
Lord Hodge expanded on this, stating that the "correct test for a penalty is whether the sum or remedy stipulated as a consequence of a breach of contract is exorbitant or unconscionable when regard is had to the innocent party's interest in the performance of the contract ".
In El Makdessi, the Court concluded that the provisions in the agreements protected the buyer's legitimate interest in enforcing the non-compete restrictions so that the goodwill of the business was protected. The goodwill of the business was critical to its value to the buyer. The provisions therefore did not go beyond protecting the buyer's legitimate interests.
In ParkingEye, it was clear that whilst the £85 charge may have been perceived understandably by users of the car park as a deterrent from over-staying the two-hour limit, there were also clear legitimate commercial interests that it was seeking to protect by imposing the charge. These included preserving the traffic management system and efficient use of parking space in the surrounding outlets and their users by deterring long-stay parking. The charge was also relied upon to generate the income needed to run the scheme. As a result, the charge was held not to be "out of all proportion" to those interests and therefore not penal.
In addition to the principles of primary versus secondary obligations, proportionality and the legitimacy of a deterrent, the Supreme Court judgment in respect of El Makdessi also referred to the importance of considering the circumstances in which the parties entered into the contract – "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 ". This is relevant to franchise agreements, which can appear across this spectrum depending on whether it is an international deal, a domestic multi-unit or high value deal or a domestic business format unit franchise deal.
What's changed? Some practical implications
The Supreme Court has set a new test which recognises that a contractual party will often have a legitimate interest which can be protected by a contractual penalty which does not have to be a genuine pre-estimate of loss.
Provided that a contracting party can demonstrate that it is using a penalty clause to protect a legitimate interest and the penalty is not exorbitant or unconscionable, the following principles now apply:
- It is no longer necessary for the penalty to be a genuine pre-estimate of loss.
- A party relying on the penalty clause does not have to suffer a loss.
- The predominant purpose of a clause can be to act as a deterrent against a certain breach of contract.
- The penalty does not just have to be a specified financial amount. A party can, for example, withhold deferred consideration or require the transfer of certain property as the consequence for breach.
- Generally, parties have a greater freedom to contract for the consequences for breach.
It is also worth noting that the penalty rule only operates on and regulates against breaches of "primary obligations". For example, if the contract provides that Party A shall perform an act (the primary obligation) and goes on to state that if Party A does not perform that act, Party A is obliged to pay Party B a specified sum of money, the obligation to pay is a "secondary obligation" and is capable of being a penalty. If an obligation to pay a penalty can be expressed as a primary obligation, this would circumvent the application of the penalty rule. However, the Supreme Court judges had differing views on what constituted a primary and a secondary obligation, so clever drafting will not always guarantee that the penalty rule can be avoided by framing a penalty as a primary obligation.
What does this mean for English law franchise agreements?
Franchise agreements typically fall into two categories:
- those which are issued on a "take it or leave it" basis, which is common in domestic business format franchising, when the parties are not of comparable bargaining position and the franchisee may not even take proper legal advice; or
- those which are negotiated freely between well-advised parties of comparable bargaining positions, which is common in larger scale, often multi-unit domestic franchising and international franchising.
It therefore seems like a fair assumption that the greater freedoms conferred by the Supreme Court will have most impact on English law large scale domestic and international franchise agreements, as opposed to smaller scale domestic agreements.
Nevertheless, all franchisors have a number of legitimate interests to protect and contractual penalties can therefore play an important role in focussing the mind of the franchisee on the franchisor's key interests and the types of behaviours and breaches which cannot be tolerated. For example:
- Franchisors must protect the goodwill and reputation of the brand and the system, both for themselves and their other franchisees. The goodwill and reputation is essential to maintaining and attracting franchisees and customers to the business.
- Franchisors are vulnerable when a franchisee decides to leave the network, as each franchisee has the potential to become a direct competitor of the franchisor, having benefitted from training, support and access to know-how.
- Franchisors have a legitimate interest in maintaining a high degree of contractual power and discretion so that they can effectively monitor and police their franchise networks and introduce innovations into the system.
This judgment is welcome news for franchisors, who may have previously hesitated from including deterrents and specified financial consequences for certain breaches. There may be more scope now to charge penalties for repeated operational breaches, breaches of audit protocols and breaches of in-term and post-term covenants. The approach to franchise sales could also be revised in light of El Makadessi.
However, the new test does raise a number of queries which will no doubt be tested in the Courts in the years to come. At what point does a specified sum become exorbitant? In Parkingeye, £85 was proportional, but would the court take the same view to a fine of £250? There is a degree of uncertainty over what constitutes a primary and secondary obligation and the extent to which it is therefore possible to "draft around" the whole issue of contractual penalties.
In terms of practical steps, franchisors should consider taking legal advice and reviewing carefully the terms of their template agreements with a view to:
- weaving in the thread of "legitimate interests" and linking it to certain standards of performance
- including more financial consequences for certain breaches
- reviewing restrictive covenants and franchise sale provisions in light of El Makadessi
- replacing references to "genuine pre-estimates of loss"
- framing certain clauses as primary obligations
If you would like more information on this topic, please contact Gordon Drakes.