Penalty Rule Versus Modern Law of Contract: Argumentative Essay

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Since the penalty rule was for the first time formed in the Englsih contract law it has caused controversy. Some have argued against it and believed it should be abolished as it is believed it provides no suffiecient justification. However, its supporters believe the rule shoud be kept because it politically and economically will benefit them.

The aim of this essay is to discuss why the opponents of the penalty rule believe the penalty rule is a controversial issue to the modern law of contract. Which in summary, they believe that parties do not have the freedom to agree to contractual solutions that have a punitive, than just entirely compensatory. This means that contracting parties are banned by the penalty

Whilst contracting parties are in principle free to agree in advance what their obligations will be following a breach of contract (and even to prescribe a measure of damages that will fall due in such circumstances; a so-called ‘liquidated damages clause’), the penalty rule prohibits them from doing so where the consequences that are to be imposed on the prospective defaulter are disproportionate to any legitimate interest that the innocent party has in protecting itself against that particular breach. [6]

The modern version of the rule has been in existence for more than 100 years, [7] but it has been heavily criticised by judicial [8] and academic commentators. [9] In attempts to justify the rule’s existence, commentators have not only constructed arguments using legal theory, but have also drawn upon a variety of other disciplines, including ethics, politics, psychology and economics

as recently noted by the UK Supreme Court, the penalty rule ‘is common to almost all major systems of law, at any rate in the western world’ and ‘…is included in influential attempts to codify the law of contracts internationally’. [12]

Main argument:

As noted above, most of the literature that opposes the penalty rule starts from the premise that contracting parties should be free to decide for themselves what the terms of their agreement will be, and it is fair to say that this principle has a long history in English law. [15]

the starting point is that contractual rules should give legal effect to the obligations that the parties themselves create. It has also been argued that too much intervention by the courts risks uncertainty for contracting parties, which in itself has potential implications for justice [18] and for the economy. [19]

One way in which supporters of the rule have sought to justify its existence from the perspective of legal theory, is its compatibility with the compensatory principle. [20] This is the well-established idea that contractual damages should have the effect of putting the innocent party in the position that they would have been in if the contract had been properly performed (awarding the ‘expectation interest’) [21] or alternatively, and less commonly, of restoring that party to the position they were in prior to formation of the contract (awarding the ‘reliance interest’), [22] provided that this would not facilitate recovery of losses that would have been incurred even if the contract had been properly performed. [23] In other words, in the vast majority of cases damages should be calculated with reference to the claimant’s ‘loss’ (however defined) and perform a restorative function, rather than with reference to the defendant’s wrongdoing; in English law punitive/exemplary damages will not typically be awarded for a breach of contract. [24]

Nevertheless, however well-established or well-justified the compensatory principle might be, it does not of itself provide a complete justification for the penalty rule. In fact, many of Fuller and Purdue’s own arguments that justify the compensatory principle could be used as ammunition against the penalty rule. Similarly, the compensatory principle is not the only restriction that the law imposes on the recoverability of loss. For example, losses which do not strictly arise as a direct result of the breach, [26] which are too remote [27] or which are properly attributable to the innocent party’s failure to mitigate, [28] will not be recoverable at all. However, in the interests of party autonomy parties are permitted to contract out of each of these rules and/or, less controversially, to limit the damages that are recoverable following a breach. [29] Given the extensive freedom that parties have to contractually adjust the extent of their liability in other respects, the compensatory principle alone cannot explain why intervention is justified when it comes to clauses which prescribe the measure of damages payable.

Since a watertight justification could not be found within legal theory alone, supporters have also turned elsewhere in search of compelling arguments for retaining the penalty rule. Arguably the most obvious place to turn to next was ethics. Fried argued that the (intrinsically moral) concept of ‘promise’ is ‘the moral basis of contract law’. [30] Building on the classical ‘will theory’, Fried contended that, when a contractual promise is made, there is a self-imposed moral obligation to honour that promise, and principles of contract law should, so far as possible, fit with this idea. [31] Indeed, contract lawyers will be well familiar with the maxim ex turpi causa non oritur actio, which in a range of circumstances can prevent a party from receiving a contractual remedy where there has been illegal or otherwise immoral conduct. [32] Ethics is therefore embedded within contract law. Query then: could there be a moral reason for retaining the penalty rule? For many, if left unregulated, penalty clauses typically produce a result that ‘conflict[s] with our intuitive understanding of justice’, [33] and thus intervention is needed to prevent this result.

A liquidated damages/penalty clause is typically, by its nature, very clear: it prescribes specifically the consequences that a party will suffer if it fails to comply with its contractual obligations. Putting aside (for obvious reasons) the question of enforceability, such a clause is potentially able to provide contracting parties with a level of clarity and certainty that far exceeds any understanding that they might have about common law damages. As such, whenever such a clause has been included in a written contract then, absent any vitiating factors (e.g. duress, misrepresentation, undue influence or unconscionability) one might assume that the parties understood and voluntarily accepted the effect of the clause (or were at least careless in that regard), particularly in the case of individually negotiated contracts. Yet, as the law stands, where the rule against penalties is invoked a promisor is potentially able to escape paying the very sum that they promised to pay in the very circumstances they promised to pay it.

There already exists legislation to provide consumers with protection against unfair contractual terms [40] which ensures that a vulnerable and inexperienced consumer is not unwittingly caught out by an excessive or disproportionate liquidated damages clause, and neither the European nor domestic legislature has so far considered it necessary to extend the same level of protection to small businesses or those contracting on another’s standard terms. [41]

The Supreme Court of England and Wales was recently asked to consider the legitimacy and utility of the penalty rule in the conjoined appeals of Cavendish v Makdessi and ParkingEye v Beavis. [62] The currency and complexity of the debate surrounding the rule is evident from the judgment, and it serves to highlight the pressing need for further research in this area.

In the absence of a clear justification for its departure from party autonomy, one might have expected – and indeed the appellants had hoped – that the Supreme Court might abolish the rule altogether. Yet, citing the rule’s long history, [63] the court declined to do so and instead decided to adopt a legislative role and rewrite the penalty rule, albeit in a form that was rather more limited in scope. Lord Neuberger PSC and Lord Sumption JSC (with whom Lord Carnwath JSC agreed) decreed that the penalty rule would henceforth only be infringed only where:

‘…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. The innocent party can have no proper interest in simply punishing the defaulter.’ [64]

In the particular appeals before the court, none of the clauses under scrutiny were deemed to infringe this new version of the penalty rule; Mr Makdessi, a wealthy businessman who had sold a large proportion of his shares in a group of companies, lost out on up to $44m due to having breached certain restrictive covenants in the sale agreement, and Mr Beavis was required to pay an £85 parking ticket issued by ParkingEye, for overstaying in a privately owned and managed car park.

Although these cases represent two ends of the spectrum, they do have something important in common. In both cases the court was strongly of the view that the contractual provisions were sensible, legitimate and not overly punitive, and that there were key pragmatic reasons for permitting such clauses to stand. In that sense, the fact that the clauses in question were able to withstand the new version of the penalty rule may be seen as positive – the court arrived at the ‘right’ outcome in both of these cases. Yet the basis for and implications of the decision are less satisfactory. A severely restricted version of the penalty rule may be more palatable to its opponents, but cannot dispose of the argument that the rule itself is without any underpinning justification.

Conclusion:

The penalty rule is arguably one of the most contentious doctrines in contract law today. Whether or not the departure from party autonomy that it entails can be justified remains a hotly contested issue and law and policy makers across the western world are faced with decisions about whether to extend or restrict the rule. It is clear from the decision in ParkingEye, that law ‘makers’ are torn between the fact that the doctrine appears to be unjustified, and an inherent conviction about its legitimacy.

In summary, it appears that some would support a penalty rule which ensured contractual provisions did not subvert the compensatory principle.

However, others would not support the existing penalty rule; what matters is not so much whether the obligation in question is primary or secondary, but whether it is necessary and/or whether there is any oppression either at the point of contract formation or in its application.

The present formulation of the penalty rule appears to prioritise certainty and commercial pragmatism. Whilst these are laudable aims, it seems likely that it will be recommended that… of the penalty rule would be willing to sacrifice these aims to some extent, in favour of an approach that ensures: (1) a restorative approach; (2) that freedom from oppression in each individual case is not compromised; and (3) that parties have regard to the likely impact on each other and on society more generally, when agreeing damages clauses, or indeed any other clauses.

It isn’t suggested that it would be appropriate for law and policy reform to blindly follow a… However, when determining the future of the penalty rule and of the law more generally, it is submitted that there is still significant merit in having regard to what has happened previously and how it has impacted the law now and then. Law and policy makers can then decide whether or not those principles represent the views and the rights of people, and thereby ensure that law and policy is developed in a way that is informed, democratic and socially useful.

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Penalty Rule Versus Modern Law of Contract: Argumentative Essay

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