Commercial Property

Cavendish – how big is your legitimate interest?

Counting the number of the Supreme Court Justices who hear an appeal is a sure way of determining how important the Supreme Court thinks the decision will be. Out of the 12 Lords Justices currently on that bench, seven heard the joint appeals in Cavendish Square Holding BV v El Makdessi and ParkingEye Ltd v Beavis. The Press has understandably concentrated on ParkingEye which held that an £85 penalty charge for parking in a shopper’s car park for longer than the permitted two hours was neither an unenforceable penalty nor a breach of the Unfair Terms in Consumer Contracts Regulations 1999.

However the bigger point from a property perspective is the wide-ranging review of the law of penalty clauses to which the two conjoined cases gave rise. Until now, the law has not, as a general rule, allowed an innocent party to enforce a penalty clause in a contract if that would force the contract-breaker to pay a sum manifestly more than a genuine pre-estimate of the innocent party’s losses. A deposit paid under a property purchase contract is capable of being a penalty, although deposits of 10% have always been treated an exception to the rule, albeit an anomalous one.

In legal terms, a deposit is said to be “earnest money”. In the words of Fry LJ in Howe v Smith in 1884:

“It is not merely a part payment, but is then also an earnest to bind the bargain so entered into, and creates, by the fear of its forfeiture, a motive in the payer to perform the rest of the contract.”

If the buyer fails to complete, the seller forfeits (i.e. gets to keep) the deposit money even though it still owns the property and even if the losses caused by the buyer’s default total less than the amount of the deposit. Conversely the Courts have almost invariably held that a deposit of more than 10% is an unenforceable penalty and awarded a deposit larger than that back to the buyer in full.

Cavendish does not appear to change this basic rule. Hodge LJ put it very succinctly:

“I conclude therefore that in both English law and Scots law (a) a deposit which is not reasonable as earnest money may be challenged as a penalty and (b) where the stipulated deposit exceeds the percentage set by long established practice the seller must show special circumstances to justify that deposit if it is not to be treated as an unenforceable penalty.”

Hodge LJ’s reference to a “special circumstances” exception is supported in the other judgements in Cavendish. It is not new. A “special circumstances” exception was also found to exist in Workers Trust and Merchant Bank v Dojap Investments, a 1993 Privy Council decision involving a Jamaican auction sale. The selling mortgagee was ordered to pay the 25% deposit back to the buyer; even though the buyer had defaulted and failed to pay the balance of the price. No specific examples of “special circumstances” are given in Cavendish, but we can infer some from the decision.

Cavendish concerned a non-competition restriction placed on Mr Makdessi in a share sale agreement over shares in an advertising/media company of which he was a founder and shareholder. His name was closely identified with the business of the company. He had very strong relationships with its customers and senior employees. 60% of the shares were sold to Cavendish by Mr. Makdessi and a Mr. Ghossoub, who between them retained the remaining 40%. The share sale agreement sought to ensure their continued loyalty to the company’s on-going business by providing that if either of them contravened the non-competition restriction (for example by introducing business to a competitor) two consequences would follow. One was that the contract-breaker would forfeit the right to be paid the last two instalments of the purchase price. The other was that Cavendish would be entitled to exercise an option to buy the contract-breaker’s remaining shares in the company at a price that discounted the value of goodwill.

Mr. Makdessi admitted infringing the restriction but claimed that the two sanctions were penalties which English law would not enforce. Losing the last two price instalments would cost him some $44m. No figure was given for his potential loss in suffering the forced sale his remaining shares at the (arguably) discounted price fixed under the share sale agreement.

The Supreme Court’s press summary of the decision says this:

“The true test 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.”

In this case the Supreme Court decided that Cavendish had a legitimate interest in seeing that Mr. Makdessi complied with the restriction; because, if he did not, the business Cavendish had bought was worth much less. The sanctions imposed were found to be proportionate to Cavendish’s legitimate interest in seeing that the business was worth what it had paid for it.

This decision has obvious relevance to property transactions under which the purchase price is paid by instalments after legal completion or by instalments whose amount varies depending of the extent to which the seller carries out obligations owed to the buyer. Where the contract deprives a defaulting seller of all or part of such payments, consideration must now be given to the extent of the buyer’s legitimate interest. But how might this translate into property transactions generally?

For example, a chain of house purchases involves Angela selling her house for £2m to Bruce, who is in turn selling his house for £1m to Charlotte. She in turn is selling her current home to David for £250,000. Charlotte knows that if David defaults, she will be unable to complete her contract with Bruce and that this will trigger an involuntary breach of the Angela/Bruce contract by Bruce. Bruce’s damages claim against Charlotte will include not only his own losses but also the damages that he owes Angela in respect of her losses. Might these circumstances be “special” enough to enable Charlotte lawfully to insist upon David paying, say, a 20% deposit? Charlotte’s ability to forfeit a £25,000 deposit will not go far to meet the loss of the £100,000 deposit she has paid Bruce and the loss of Bruce’s £200,000 deposit which Angela will forfeit and which will form part of Bruce’s claim against Charlotte. Can it be said that, in these circumstances, if Charlotte took a £50,000 deposit from David, this would be “out of all proportion” to her legitimate interest?

Hodge LJ’s ruling that “a deposit which is not reasonable as earnest money may be challenged as a penalty” might suggest that there may be circumstances in which a 10% deposit can exceed what is reasonable. It is common for buyers who cannot afford to pay a 10% deposit to convince very willing sellers to accept a 5% deposit. In such a case, the seller often insists that the contract obliges the buyer to pay another 5% of the price if the buyer fails to complete; topping-up the deposited sum to 10%. Does the topping-up requirement after default has occurred “… impose a detriment on the contract-breaker out of all proportion to any legitimate interest…” of the seller? In determining the seller’s legitimate interest will the Courts now distinguish between different types of seller? For example, will a vulnerable seller in a residential chain, such as Charlotte; be treated as having a greater “legitimate interest” than the executors of a will selling the testator’s now empty home, whose losses attributable to non-performance by the buyer may be limited to interest and wasted costs?

The Supreme Court’s decision clearly enlarges the circumstances in which an innocent party will succeed in countering a contract-breaker’s assertion that the penalty falls on the wrong side of the line. In the long run, once the new enlarged approach has been digested by the property industry, Cavendish may be seen as quite a turning point.