When is a penalty not a penalty?Print publication
Nick Lees, a partner in Walker Morris’ Commercial Dispute Resolution team, examines recent case law which is starting to clarify, in practical terms, when contractual clauses may or may not amount to unenforceable penalties.
The penalty rule…
Contracting parties frequently wish to pre-emptively protect themselves against the breach of their counterparty. Parties therefore often agree, within their contractual arrangements, the consequences that will flow from a party’s breach. However when doing this, parties must beware of the common law rule which provides that, to the extent that such a clause is a penalty, it will be unenforceable.
In Cavendish and ParkingEye  the Supreme Court explained that a penalty is a contractual provision that imposes a detriment on the party in breach of a primary obligation which is out of all proportion to any legitimate interest of the innocent party in the performance of that obligation. Breaking that down, there are three tests which can help to determine whether a provision amounts to an unenforceable penalty. Last year, the Vivienne Westwood case  helped to clarify how those tests operate in practice:
- The ‘threshold test’ – is the penalty rule engaged at all? In English law, the court will not generally interfere with a party’s ‘primary’ contractual obligation to do something, but it can regulate the ‘secondary’ liability that may be imposed when a party breaches that obligation. The penalty rule is only engaged at all, therefore, if the provision in question imposes a secondary liability for breach of a primary obligation. (In Vivienne Westwood, the landlord had done a deal, by way of offering a rent concession in a side letter, to attract the tenant to its premises. The tenant had entered into the lease and the side letter simultaneously, but could not be under two different rent obligations at the same time. The true, primary obligation was to pay the reduced rent as per the side letter deal and so the obligation to pay the higher lease rent was a secondary liability that only arose in the event of a breach of contract. The initial ‘threshold test’ was therefore met, and the penalty rule was in play.)
- The ‘legitimate interest test’ – does the clause serve to protect any legitimate interest? A clause that is potentially penal in nature may nevertheless be allowed if it serves to protect a legitimate interest of the innocent party in the performance of the primary obligation.
- The ‘exorbitance test’ – if so, is the provision out of proportion to the protection of that interest, by being extravagant or unconscionable?… so long as the provision in question is not exorbitant or unconscionable in amount or effect as against the legitimate interest which it serves to protect, then it may not amount to a penalty.
…and examples of its practical application
In the last couple of months, the High Court has applied the penalty rule in two different practical scenarios.
In Holyoake v Candy  a borrower argued that various clauses in loan documentation were unenforceable penalties. The clauses in question included:
- A provision requiring the borrower to pay a redemption figure on early repayment of the loan, where the redemption sum included the whole of the interest that would have accrued by the end of the period of the loan.
- A provision in an escrow deed that if the borrower did not repay the debt and complete the relevant sale/purchase agreement, a new debt would arise.
- Provisions requiring the payment of certain fees under a loan extension agreement.
The High Court found that the clauses were not unenforceable penalties. That was because, in each instance, the clauses in question were not ‘secondary’ obligations triggered by a breach of contract – the penalty rule was, therefore, never engaged at all.
In ZCCM Investments Holdings plc v Konkola Copper Mines plc  a settlement agreement allowed the defendant to make payments to the claimant in instalments. The agreement contained an acceleration clause which provided that, in the event of breach by the defendant, all unpaid sums due to the claimant would have to be paid within five business days, failing which interest would accrue at the rate of LIBOR plus 10%. When the defendant failed to make a payment and the claimant sought to rely on the acceleration and enhanced interest clause, the defendant argued that it was an unenforceable penalty. Disagreeing with the defendant and upholding the clause, the High Court confirmed:
- There was nothing extravagant, exorbitant or unconscionable in requiring a commercial party under the terms of a settlement agreement to pay immediately the full amount of the loan in the event of any non-compliance with its terms.
- The claimant had a legitimate interest in requiring strict compliance with the settlement agreement.
- The defendant knew what it was signing up and the agreement was an arms’ length contract that had been entered into by the defendant with the benefit of expert legal advice.
- It was reasonable for a claimant to require increased interest in the event of a defendant’s default and there was nothing to suggest that the particular enhanced interest rate was extravagant.
Since the Supreme Court restated the rule against penalties in Cavendish and ParkingEye, any practical application of the rule is of interest as it can help contracting parties and their professional advisers to negotiate and complete contracts with a greater understanding of the terms that are likely to be, or not to be, enforceable.
In addition, the Holyoake case highlights, in particular, that, subject to the proviso that it is the substance of a clause (as opposed to just its form) which matters, parties can circumvent the penalty rule by clever drafting.
Anyone negotiating contractual terms should bear in mind the following practical advice:
- The modern approach embraces more flexibility, which is apparently starting to result in fewer clauses being found to be unenforceable penalties.
- More than ever before, careful drafting can help parties to pre-emptively protect themselves against certain breaches of contract, in particular:
- Parties should consider framing contractual obligations so as to ensure that they are primary obligations to which the penalty rule does not apply, as opposed to secondary provisions which merely set out consequences of breach.
- Parties may wish to specify, in the contract itself, the commercial context and why the particular clause provides reasonable and proportionate protection of a legitimate interest.
- Legitimate interests which can justify a particular provision may be commercial in nature, but they may also take into account wider social, economic or consumer considerations.
- The courts should now be more reluctant to characterise a clause negotiated between commercial parties and/or parties that are legally advised as a penalty.
- Businesses would be well advised to review their existing and standard contracts in case any terms can now be improved upon (and in case any provisions which still fall foul of the rule against penalties can be identified and addressed accordingly).