UK: Penalties In English Law Contracts: The Risks And Their Avoidance

In a judgment issued on 4 November 2015 in relation to the conjoined appeals in the cases of Cavendish Square Holding BV v Talal El Makdessi and ParkingEye Limited v Beavis [2015] UKSC 67, the Supreme Court of the United Kingdom updated the long established English law rules on contractual penalties. Set out below are the key points that decision makers should keep in mind when negotiating clauses that provide for specific remedies for breaches of contract.

WHAT IF A CLAUSE IS A PENALTY?

The English law rule on contractual penalties is strict. If a court concludes that a contractually agreed remedy for a breach of contract is a penalty, the clause will be void and therefore unenforceable. The result? Left with no pre-agreed remedy (and assuming the clause becoming ineffective does not render the entire contract void), the innocent party's recompense will be limited to the damages that (i) are suffered as a result of the breach and (ii) are unable to be avoided by taking reasonable steps to mitigate losses.

WHAT KINDS OF CLAUSES MIGHT BE PENALTIES?

Any clause that operates to the detriment of a party to a contract as a result of his breach of contract could be a penalty (whether or not the detriment can be said to be designed to deter him from breaching the contract). Classic examples of potential penalty clauses include those providing for: (i) the loss of deposits and the withholding of payments, (ii) the deferral or reduction of consideration, (iii) break fees, (iv) liquidated damages, (v) default interest, (vi) the transfer of assets for nil consideration or at an undervalue, (vii) take-or-pay payments and (viii) compulsory buy-outs and other consequences of shareholder default.

WHAT MAKES A CLAUSE A PENALTY?

Whilst at least three of the judges thought that penalty clauses should be differentiated by reference to primary obligations (to which the rule did not apply) and secondary obligations, it is not clear that this was the view of the majority. Furthermore, seeking to make this distinction would not be helpful in all cases as a potential penalty clause in a contract may be both a conditional primary obligation in one circumstance and a secondary contractual obligation in another. The essence of a penalty clause is that the detriment imposed on the party in breach of contract is out of all proportion to the innocent party's legitimate interest in the enforcement of the obligation that has been breached. In other words, to be a penalty, a clause must trigger a disadvantage to a party because of his breach of contract which is exorbitant or unconscionable in the overall context of the particular contract. Thus:

  • In Cavendish, even though triggered by the vendor's breach of restrictive covenants under an SPA, neither the termination of his right to receive very substantial future sums by way of deferred consideration nor the fact that the buy-out price payable to him under the "defaulting shareholder" provisions was much lower than the price he would have received under other provisions of the agreement were seen by the court as consequences that were exorbitant or unconscionable given the importance to the purchaser of ensuring that the restrictive covenants were honoured, with the result that neither provision offended the rule against penalties.
  • Even before Cavendish, provisions in loan agreements increasing interest rates following a default would not fail as penalties where the increases were commercially justified (i.e., to reflect the increased cost of lending to a borrower with greater credit risk) and the primary purpose of imposing them was not to deter the borrower from breach. The decision in Cavendish moves away from the deterrence element of the test (as this was considered unhelpful) and makes it clear that such provisions will be enforceable so long as the increases they impose are not unconscionable or extravagant (and so are commercially justified).
  • Provisions depriving a management shareholder of options or requiring a buy back of stock at nominal value where the employee is a "bad leaver" will normally be effective on the basis that the employee will not have contributed to the value of the business in the manner originally envisaged.
  • Provisions imposing break fees where a contract is terminated for default will be effective so long as the fees are not unconscionable or extravagant in the circumstances (i.e., greater than the highest levels of damages that could possibly arise from the breach). So, for example, a prepayment fee payable under a fixed term debt instrument following a default will be enforceable where the fee is quantified by reference to the discounted value of the interest that the creditor would have received had the debt remained outstanding.
  • Provisions in an investment fund limited partnership (or equivalent) agreement under which an investor who fails to meet a capital call is obliged to sell back his investment at a discount to cost or fair market value (the level of discount usually being in the order of 80-90%) are likely to be effective on the grounds that this mechanism provides a legitimate means by which the interests of the fund (and of compliant investors) are protected.
  • Provisions in agreements under which a deposit placed by the buyer with the seller (or into escrow) will be forfeited if the buyer defaults will not be a penalty so long as the deposit is not excessive. Where the size of the deposit is in line with the market norm for comparable transactions, the forfeiture provision can be expected to satisfy the test and so be effective. However, the fact that the deposit is larger than the norm does not mean that the forfeiture provision will fail as a penalty: if the vendor is able to show special circumstances to justify a larger deposit, the forfeiture provision should still be effective because the special circumstances mean that loss of the larger deposit cannot be said to be unconscionable or exorbitant in the particular circumstances.

WHAT IS THE LIKELIHOOD OF A CLAUSE BEING A PENALTY?

The rule against penalties operates where a contract provides for a remedy for breach which is grossly excessive. Whether a particular clause fails this test will depend on the circumstances existing at the time when the relevant contract was concluded. The fairness of the underlying bargain struck will not be the subject of court review, and a court will start with a strong presumption that the best judges of the appropriate remedy for a breach of a contractual obligation are the contracting parties themselves, particularly where the contract has been freely negotiated between commercial parties with similar bargaining power and with the benefit of appropriate expert legal advice.

WHAT STEPS SHOULD YOU TAKE IN LIGHT OF THE SUPREME COURT DECISION?

The Supreme Court decision has made it less likely now that a clause will be construed as a penalty. In light of this, it should not be necessary to revisit existing provisions that are capable of being construed as penalties. Going forward:

  • Avoid including references in contracts to provisions that might be penalties as constituting a "genuine pre-estimate of loss". Instead, record that the parties have received appropriate legal advice. It may also be helpful to reflect the commercial rationale of the clause in a recital or in the clause itself.
  • Bear in mind that if both parties to a contract have been properly advised and are of a comparable bargaining position there is a strong presumption that a clause will not be construed as a penalty. It is thus beneficial for your counterparty to be properly represented despite the fact that it may make negotiations more difficult.

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.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
Similar Articles
Relevancy Powered by MondaqAI
 
In association with
Related Topics
 
Similar Articles
Relevancy Powered by MondaqAI
Related Articles
 
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Mondaq Free Registration
Gain access to Mondaq global archive of over 375,000 articles covering 200 countries with a personalised News Alert and automatic login on this device.
Mondaq News Alert (some suggested topics and region)
Select Topics
Registration (please scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions