Gwendoline Davies and Daniel Newbould examine some of the thorny issues around the rule against penalties in commercial contracts.
Q: When is a clause not a clause?
A: When it is void following the rule against penalties.
Anyone involved in the negotiation and completion of commercial contracts should be aware of the rule against penalties. The rule provides that, to the extent that a clause is a penalty, it will be unenforceable. A clause will be a penalty if it provides for payment of a sum and the predominant purpose is to deter a party from breaching its contractual obligations. A clause will not be unenforceable, however, if the payment stipulated amounts to a genuine pre-estimate of loss arising in the event of breach. These latter, inherently compensatory, provisions are known as liquidated damages clauses and can have the distinct benefits of precluding the need to litigate when a breach of contract does occur and of providing certainty of exposure.
So, how does one determine whether a 'payment on breach' provision is a penalty or a valid liquidated damages clause, and what should you watch out for when negotiating or reviewing your contracts? Established and recent cases explain:
- Terminology is inconclusive. Regardless of phrasing, it is the nature of the payment stipulated which determines whether it is in truth a penalty .
- A clause will be a penalty if the sum stipulated is extravagant and unconscionable in comparison with the greatest loss that could conceivably be proved as flowing from the breach .
- Payment of a single sum in the event of multiple or different breaches of varying severity gives rise to a presumption of a penalty .
- Determining whether a clause is a penalty is a matter of construction to be resolved by considering the pre-dominant function of the clause at the time the contract (or the provision in question) was entered into .
- Penalties may not always be in the form of a typical money payment – they could involve other benefits in kind.(For example, the transfer of shares or the release of contractual obligations ; or the forfeit of a sum otherwise due .)
Case law also affords some interesting exceptions:
- The rule against penalties is an anomaly because it is a limit on the freedom of parties to contract as they see fit. Where a provision is freely negotiated between two commercial parties of equal bargaining power, therefore, the courts may be reluctant to find that a clause is void .
- Commercial justification can be crucial. Even if the effect of a clause is penal, the provision might be saved depending on the commercial circumstances. In the recent case of Edgeworth Capital v Ramblas Investments , a clause providing for the payment of a large fee was held not to be a penalty because the payment became due in various commercial circumstances, not just in the event of breach, and because inclusion of the fee was justified in a contract which was completed in a challenging economic climate.
- Even liquidated damages clauses which are calculated with reference to a genuine pre-estimate of loss are vulnerable to attack if they operate in a way which is penal. In a shipping case heard just last month , the High Court considered a traditional demurrage clause in a shipping contract which specified liquidated damages to be paid if shipping containers were used for longer than intended. However the contract was not time limited and when the breach occurred, the aggrieved party chose to affirm the contract and continue claiming liquidated demurrage damages even though it was not suffering any continued loss. The Court held that the fact the clause could operate in this way meant that it was penal in nature. Interestingly the Court also held that (applying case law ) as a matter of public policy it was not open for a party to affirm a contract following breach and claim continued payment if it had no legitimate interest in the continuation of the contract (which was the case given that the aggrieved party was not suffering any loss and it was clear the breaching party could not perform).
Don't fall foul of the rule against penalties: top tips
- Calculate carefully and retain evidence of the method by which you have determined the payment/benefit in a liquidated damages clause. This can help to demonstrate that the clause is a genuine pre-estimate of loss.
- Build-in a safeguard – consider including a repayment provision for overpaid sums in the event of breach.
- Don't apply one liquidated damages provision for multiple and differing breaches.
- Where appropriate, include liquidated damages provisions which work to the benefit of both parties in the event of either's breach.
- Don't be tempted to slip a liquidated damages clause in your/your client's favour in amongst boilerplate provisions. Courts are less likely to interfere with provisions which have been properly negotiated between even parties.
- Negotiating via legal advisers can help to address any issues regarding parties' respective bargaining positions.
- Obtain and retain evidence on file of the commercial, not just the legal, background to negotiation and completion of the contract. Commercial justification can sometimes save an otherwise unenforceable penalty.
- Insurance can be often obtained where a liquidated damages clause provides advance certainty of exposure in the event of breach of contract. As well as financial assurance, insurance has the additional benefit that it can help to convince the court that the stipulated damages were commercial, proportionate and therefore not a penalty.
- Be careful before trying to ride the gravy train by affirming a contract in the event of a repudiatory breach. If a contract has, in reality, come to an end with no further performance possible and there is no on-going loss then a Court may be adverse to enforcement of liquidated damages provisions which take effect as a windfall.
 Dunlop Pneumatic Tyre Co Ltd v New Garage Motor Co Ltd  AC 79
 Lordsvale Finance plc v Bank of Zambia  QB 752; (Unaoil Ltd v Leighton Offshore  EWHC 2965 (Comm))
 El Makdessi v Cavendish Square Holdings BV & Anor  EWCA Civ 1539
 Workers Trust and Merchant Bank Ltd v Dojap Investments Ltd  AC 573
 Robophone Facilities v Blank  3 All ER 128; Phillips Hong Kong Ltd v Attorney General of Hong Kong (1993) 61 BLR 49
 Edgeworth Capital (Luxembourg) S.A.R.L. & Anor v Ramblas Investments B.V.  EWHC 150 (Comm)
 MSC Mediterranean Shipping Company S.A. v Cottonex Anstalt  EWHC 283 (Comm)