Penalty clauses - recent cases

It is often difficult for contract drafters to know whether a term which provides for financial consequences of a certain event will be construed as a liquidated damages clause or a penalty clause. There have however been a number of recent judgments in the High Court which have provided some guidance on the court's approach to this issue.

The law on penalties – a reminder

The general rule is that if the clause is a liquidated damages clause it is enforceable and the sum set out in the clause is recoverable. If, however, it is a penalty clause it will not be enforced beyond the actual loss of the innocent party.

In Dunlop Pneumatic Tyre Company v New Garage and Motor Company [1915] AC 79 the House of Lords set out the requirements to be considered when examining a potential penalty clause:

• Whether a provision is to be treated as a penalty is a matter of construction to be resolved by asking whether, at the time the contract was entered into, the predominant contractual function of the provision was to deter a party from breaking the contract (in which case it is a penalty) or to compensate the innocent party for breach with a genuine pre-estimate of damage (in which case it is a liquidated damages clause).
• A clause will be construed as a penalty clause if the sum specified is "extravagant and unconscionable" in comparison with the greatest loss that could have been proved to have followed from the breach.
• A clause is likely to be a penalty if the breach of contract consists only of not paying a sum of money, and the amount stipulated as damages is greater than the sum that ought to have been paid.
• There is a presumption (but no more) that a clause is a penalty when "a single lump sum is made payable by way of compensation, on the occurrence of one or more or all of several events, some of which may occasion serious and others but trifling damage". 
• An agreed payment clause is not a penalty merely because a precise pre-estimation of loss is impossible.

In addition to the above, in order for a provision for payment to be penal, it must provide for payment upon breach of contract (see Export Credits Guarantee Department v Universal Oil Products Co [1983] 1 WLR 399). This requirement was in issue in recent judgments in the bank charges litigation, The Office of Fair Trading (OFT) v Abbey National plc and others:

OFT v Abbey National plc and others [2008] EWHC 875 (Comm) and [2008] EWHC 2325 (Comm)

In this litigation various banks sought declarations that their unarranged overdraft charges were not "capable of amounting to" penalties which would have been unenforceable at common law. They sought this on the basis that the charges were not payable on breach of contract by their customers.

In its first judgment, handed down in April 2008, the court accepted this argument in relation to the banks' current terms. Smith J noted that when a customer gives instructions to make a payment without having the necessary funds or a pre-arranged facility to cover the payment, he is taken by the banks to be requesting "unarranged overdraft facilities" rather than being in breach of contract. The customer is not deemed to be under a contractual obligation to ensure that funds are available or under any prohibition from giving instructions for payment without having the necessary funds or facility to cover the payment. As such the charges were not capable of being a penalty because they could not be construed as a penalty for breach of a commitment by the customer. In arriving at this conclusion Smith J said:

"Undoubtedly the law about penalties does not apply if the obligation is to pay for a service or upon an event other than a breach, even if the service is supplied or the event takes place against the background of or accompanied by a contractual breach, and even if the service would not have been provided or the event would not have occurred but for the breach…If an obligation to pay is penal, it must require payment upon the breach itself".

In a second judgment handed down in October 2008 the banks sought declarations that certain historic terms were not capable of being penalties. (They did not ask the court to consider at this stage whether, if the terms were capable of being penalties, the amounts levied were more than a genuine pre-estimate of loss.) Applying the principles of his first judgment, Smith J found that most of the terms in question were not capable of amounting to penalties. In arriving at his conclusion the judge set out the questions to be asked when ascertaining whether a term or charge was capable of amounting to a penalty at common law, namely:

• Is the term, a breach of which triggers a charge, truly contractual (as opposed to being merely advisory or exhortatory)?
• If so, does the term impose an obligation or prohibition on the customer?
• If it does, is a relevant charge payable upon its breach?

The court accepted the OFT's argument that the court must look at the "substance of the arrangements" when determining the above questions. However, it rejected the OFT's interpretation of the provisions which would involve a significant and unjustified departure from their literal wording. In order to determine the meaning and effect of written provisions the test is to ask what the words, in their context, would mean to a reasonable man.

The requirement that, in order to be penal, the provision for payment must provide for payment upon breach of contract was also relevant in the case of M&J Polymers Ltd v Imerys Minerals Ltd:

M&J Polymers Ltd v Imerys Minerals Ltd [2008] EWHC 344

This case involved the question of whether the rule against penalties could apply to a 'take or pay' clause (a clause which provides that the purchaser is obliged to ether take delivery of a minimum quantity of product or pay a specified amount). Burton J expressed surprise that, given the prevalence of 'take or pay' provisions in commercial contracts, the matter appeared not to have been brought before the court previously. He held that, as a matter of principle, the rule against penalties could apply on the basis that the payment obligation only arose once the buyer had breached its obligation to order products under the contract in question.

However, on the particular facts presented to him, Burton J concluded that the clause "was commercially justifiable, did not amount to oppression, was negotiated and freely entered into between parties of comparable bargaining power, and did not have the predominant purpose of deterring a breach of contract nor amount to a provision 'in terrorem'". Accordingly, the clause was ruled not to contravene the rule against penalties and was therefore upheld.

Other recent cases

There are two other recently reported cases in which the law on penalties was considered:

In General Trading Company (Holdings) Limited v Richmond Corporation Limited [2008] EWCH 1479 it was held that a provision entitling the innocent party to withhold payment (rather than force the party in breach to make a payment) could be a penalty. However, on the facts, the clause in question was held not to be a penalty on the basis that it was commercially justifiable, did not amount to oppression and was between parties of comparable bargaining power.

In Tullett Prebon Group Limited v Ghaleb El-Hajjali [2008] EWHC 1924, a provision in an employment contract for payment of a certain sum (50% of basic net salary plus 50% of signing bonus) in respect of a failure to take up employment was held not to be a penalty. In reaching this decision, the court found that the parties were of equal commercial bargaining power, the innocent party's actual loss was likely to exceed the sum stipulated and the breaching party had legal representatives who had alerted him to the relevant clause.

Comment

Historically the courts have shown a reluctance to strike out clauses as penalties on the basis that to do so would constitute an interference with the principle of freedom of contract. This reluctance has been all the more prominent in respect of commercially justifiable clauses contained within contracts entered into between parties of comparable bargaining power. These recent cases, on the whole, show a continuation of this policy.

Although Burton J's ruling in M&J Polymers appears to open up "take or pay" clauses to attack, it will not necessarily lead to improved prospects of challenging such clauses provided they are carefully drafted. This case and the judgments in the OFT case are a reminder that contract drafters should, if possible, ensure that provisions are drafted in such a way so as to make the sum payable on an event which is not a breach of contract. By appropriate drafting, and ensuring that the payments provided for are commercially justifiable, the risks of provisions being construed as penalties can be mitigated.