UK: Penalty - Not Such A Dirty Word After All!

Last Updated: 15 April 2013
Article by Vanessa Barnett and Mark Alsop

Contracts with bite

Nothing focuses the mind on contractual performance than potential bite of a “penalty”. It’s a phrase frequently bandied around in negotiations, reflecting a commercial desire for certain contractual remedies for specified contractual breaches (for example, not meeting a delivery date or slippage on milestones).

Such clauses are commonly known as a “liquidated damages clauses". Their beauty is that they provide certainty at the time the deal is done of what the remedy will be for a specifically identified breach. Also, because they are a very mechanical way to receive compensation without the need to prove loss suffered or mitigate it, they are well liked by customers in contracts.

Of course, where there is beauty, there is also a beast. Liquidated damages clauses are enforceable only if they do not amount to a legal penalty. The magic is finding that middle ground where there is enough bite but the sanction is not so outrageous as to be declared a legal penalty.

It was traditionally the case that the specified remedy had to be a “genuine pre-estimate of loss” if it was not to be robbed of its bite by being a penalty.

However, the attitude of the courts is shifting in favour of extending the occasions when liquidated damages clauses in business to business contracts are upheld. In other words, the courts are starting to sanction liquidated damages clauses with significantly “gnarlier” bites!

View from the courts

There have been four recent cases on the subject, involving three different judges. The judges did not all speak with one voice, but the trend is clear. As in other areas, such as the enforceability of exclusion clauses, the court’s stated approach in business to business transactions is to be most reluctant to strike down liquidated damages clauses which have been freely negotiated between parties of equal bargaining position.

The lessons from these three cases are:

  • Is “genuine pre-estimate of loss” still the primary test to determine whether the amount specified is valid or not?

These days, the answer seems to be no. Instead, the courts have moved more tothe middle ground, with the issues being:

  • Whether there was commercial justification for the provision. The courts will look at the overall arrangements and determine how the liquidated damages provision fits into that.

An example comes from a recent case where an individual vendor of shares was under non-compete covenants during the eight years over which instalments of the purchase price were payable. The purchase price was largely based on the value of goodwill. The agreement provided that if he breached the covenants, the sale price of his remaining shares would based on net asset value excluding goodwill (worth considerably less). He challenged this as being a penalty. The court made the point that this was a commercially justifiable arrangement; the primary value of the company was in its goodwill, the delayed payment for goodwill and restrictive covenant to protect that goodwill balanced each other and the mechanism speeded up the process of decoupling the parties if things went wrong. Note that there was no need to show that the revised share value was a “genuine pre-estimate of loss”.

  • Whether the remedy was excessive. Here the courts are looking not so much for a genuine pre-estimate of loss but for a sum that is not greater than the highest possible damages that could conceivably be proved to have followed from the breach. Bear in mind that it is for the party relying on the penalty doctrine to show that there was no justification for the remedy – something that the courts have stressed is a “heavy burden”.

  • Whether the predominant purpose was to deter breach. Deterrence is the evil which, by way of public policy, gave rise to the doctrine of penalties. Where the purpose of a clause is to deter breach (i.e. it is punitive as opposed to a genuine attempt to recover compensation), it is likely to be construed as a penalty. All the same, even if the level of liquidated damages is sufficiently high to have a deterrent effect, as long as the purpose is to compensate rather than secure performance, then the provision should still be upheld. In the above case, the Judge found that the primary purpose of the transfer at a lower share price was to achieve decoupling rather than to deter.

  • Whether the provision was negotiated on a level playing field. This reflects the reluctance of the courts to interfere in business contracts.

  • Whether the penalties rule catches only remedies specified to apply on breach, or also remedies available on other occasions?

Here, another occasion is often a debt, for instance a minimum payment provision under a contract. Can a high minimum payment obligation be challenged as a penalty? The answer has traditionally been no; the doctrine is confined to remedies that apply on a breach, something confirmed in a recent case. But another judge, who presided in several of the recent cases, said in each that the doctrine applies just as much to a debt claim as to a damages claim (although on the facts in all cases he held that the provision was commercially justified). One to watch.

One formulation of the penalty principle approved judicially is: “A penalty clause is a clause which, without commercial justification, provides for payment of forfeiture of a sum of money, or transfer of property by one party to the other, in the event of a breach of contract, the clause being designed to secure performance of the contract rather than to compensate the payee for the loss occasioned through the breach.” As can be seenabove, this does not quite encompass all the issues considered recently.

Keeping the bite legal - checklist

To minimise the risk of a liquidated damages provision being found to amount to a penalty, consider the following:

  • The remedy should not be aimed at deterring breach. Vital. (And yes, it’s not a secret that deterrence is a common beneficial side effect!)

  • Make sure that the remedy is commercially justifiable. Keep records to show how the remedy was arrived at. Offer alternatives. Preferably make sure the remedy is fully negotiated

  • Try to rephrase wording so that the liquidated damages and other specified remedies arise on an event other than breach. For instance, draft a “take andpay” clause as an obligation to make minimum payments (a debt claim if not done)rather than an obligation to order minimum quantities (a breach claim if not done). This may not work (as explained above), but it can do no harm.

  • Liquidated damages may be more suitable (and thus commercially justifiable) where the loss caused by breach is likely to be difficult to ascertain. The courts take the view that, where loss is easily ascertainable, there is less harm to the innocent party in striking out a penalty clause because the party can make an ordinary claim for damages.

  • The amount payable should not be a fixed sum regardless of number of breaches or severity of breach. Such a payment is unlikely to be commercially justifiable for each breach.

  • Liquidated damages should not be larger than the maximum loss likely to arise as a result of breach.

  • Beware high interest charges for late payment. They are quite capable of amounting to penalties if they do not satisfy the usual tests for liquidated damages.

And if you’re on the other side of the deal?

Duck and dive all you like, but they are here to stay – so it’s more a matter of crafting the breach as narrowly as you can and the liquidated damages as parsimoniously as you can.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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