THE PENALTY RULE AND ITS POTENTIAL WIDE APPLICATION TO CONTRACTS
The penalty rule imposes that clauses that are “penalties” are unenforceable on the grounds of public policy. The general rule is that a penalty clause is a clause that does not represent a genuine, pre-estimate of loss following a breach of the contract. (i.e. the amount specified is not related to the actual loss), however, this general rule is only now applicable in straight forward liquidated damages cases. This is because the cases of Cavendish and El Makdessi and Parking Eye Ltd v Beavis in 2015 comprehensively re-wrote the law on penalty clauses stating, among other things, that:
- a penalty clause is applicable only to a breach of contract;
- whether a provision comes under the penalty rule is a matter of substance and not of form;
- the test is now whether the clause imposes a disadvantage to the contract breaker in breach of a primary obligation that is out of proportion to any legitimate interest of the innocent party in the performance of that obligation. In the assessment of the proportionality adequate weight must be given to the commercial context of the contract, as well as to the negotiation undergone through and the sophistication of the parties; and
- whether or not the purpose of a clause was solely or mainly to deter the other party from breaching the contract, a clause with this purpose may well be deemed to be enforceable, as a party relying on the penalty clause does not now have to suffer a loss if the clause is predominantly to deter a breach of contract.
The extent to which this ruling is important is that in many sectors, such as engineering, procurement, construction and operation maintenance, clauses pre- determining the amount of damages to be awarded in case of certain breaches of contract are very common, and they are often what makes the contract financially viable. Therefore, careful consideration will be needed when determining pre liquidated damages, as it is ultimately up to the court in how they view the clause.
The court has now applied these principles to the provisions in a loan agreement and its supplemental agreements in Holyoake and Candy and illustrates how the penalty rule can be avoided.
The claimant, Mr Holyoake, had purchased a commercial property in London with the intention of converting it for residential use. The property was purchased through three personal loans, one of which was an unsecured personal loan of £12 million from one of the defendants, the CPC Group Ltd (“CPC”). Shortly after entering into the loan, CPC claimed that Mr Holyoake was in default because he had overstated his financial worth. Therefore, Mr Holyoake entered into a series of supplemental agreements to restructure the loan with CPC. He subsequently defaulted on the loan and, in order to repay it, sold the property without carrying out the planned work.
THE COURT CASE
Mr Holyoake proceeded to bring a claim for loss of profit and damages against CPC, claiming that certain provisions in the loan and supplemental agreements were unenforceable because they were penalties. In particular he challenged the following points as being penalties:
- a clause requiring the borrower to pay the whole of the interest that would have accrued by the end of the period of the loan, a sum of nearly £6 million on early repayment of the original £12 million loan.The court concluded that as the clause was triggered by the claimant exercising his option to repay the loan and not by a breach of a contract, the sum paid was part of his primary obligation under the contract, and therefore not in scope of the penalty rule;
- provisions in the loan extension agreement that required the borrower to pay certain extension fees. The court held that the fees paid were not a penalty, but rather a consequence of the fact that the claimant chose to extend the loan as he needed a longer term to make the repayment;
- a clause in an escrow deed, providing that a new debt of £17.74 million would arise if the claimant did not complete an associate sale and purchase agreement in respect of the property. The court held that the trigger of the new debt was the failure to complete the sale and purchase agreement and to repay the loan, so that it arose from what was deemed to be a condition of the escrow agreement, and not as a consequence of a breach of it.
This case illustrates that in certain circumstances it is possible to avoid the application of the penalty rule by carefully drafting clauses, stating them as primary obligations or conditions on performance instead of as secondary obligations. This is because the clauses imposing monetary payment were drafted as a consequence of conditions triggered by the lender instead of as conditions triggered by a breach of contract and therefore means that the conditions fell outside of the scope of the penalty rule. For instance, the redemption sum of £4 million was phrased as one option of repaying the loan, and not as a penalty for early repayment. Similarly, the fees charged to extend the loan were drafted as a consequence of the lender’s choice to extend the loan, and not as a penalty for Mr Holyoake not being able to repay the loan. The key point being that the penalty rule only applies to secondary obligations which are triggered by a breach, and not to primary obligations.
However, although the courts are taking a more commercial approach, parties should still pay due consideration to the application of the penalty rule as careful drafting may be an effective tool for excluding the extent to which the penalty rule applies to an obligation.
For more information on or any guidance or advice in drafting your commercial contracts, Cleveland & Co external in-house counsel, your specialist outsourced legal team are here to help.