03 June 2011

On the Spot

Penalty clauses under attack  

Any law student knows that penalty clauses are unenforceable. If a contract says that you have to make a payment if you breach the contract, that is a penalty – unless it is a genuine pre-estimate of the innocent party’s loss. The rationale is that a penalty clause is simply to intimidate a party and ousts the court’s authority to fix fair compensation. In most cases the law does not stop you breaching a contract, so long as you are prepared to pay damages to compensate the other party. The parties can't agree their own forfeits to punish contract-breakers.
Historically the courts have been reluctant to say that freely-negotiated clauses were unenforceable penalties. Liquidated damages clauses are common in construction contracts and many other contexts, and have often been upheld. In a 2005 case, the judge could only find four reported cases in which penal clauses had been struck down [1]. Only clear and obvious penalties seemed to infringe the rule. There had to be a wide gulf between the amount payable and the loss suffered by the claimant.

Now that seems to be changing. Clauses which have quite subtle penal effects are being successfully challenged as penalties. In particular, requiring one party to perform its obligations whilst the other is released has been found to be objectionable.
In a consumer protection case relating to health club memberships [2], the judge held that it was a penalty to oblige a party to pay the full price for the service over the remainder of the fixed-term contract, after the innocent party had terminated the contract for breach by the client.

There were two groups of contracts under consideration in the case. Some said that the payments for the remainder of the term could be claimed if the club terminated the contract following any breach by the member, however minor. That was a penalty. The court followed an earlier case that said that if a breach was not sufficient to amount to repudiation of the contract by the party in breach, the innocent party could terminate if the contract allowed them to, but they could then only claim payments up to the date of termination, and anything further was a penalty [3]. “Repudiation” means the breach was serious enough to demonstrate that the party no longer intended to be bound by the contract; the contract itself can define, within reason, what breaches will be repudiation. So an elephant trap is created: if the contract allows termination for something that is not repudiation, or fails to define repudiation correctly, the obligation to make payments relating the post-termination period is unenforceable, even if the actual breach is very serious.
Other contracts considered by the court only allowed the club to terminate for a breach of contract that did amount to repudiation. The court said that in those cases the estimate of loss was reasonable: the judge was satisfied that the club would have minimal marginal costs in providing the facilities and could not replace a member with another (clubs are never full), so if the club had sued the member for damages, the damages would been based on the fees for the rest of the fixed term. But the judge still found that absence of a discount for early payment turned it into a penalty. Only when the club added a formula to discount the payment at a high interest rate did the judge hold that it was not a penalty.

The decision makes it very hard to write an agreed damages clause without a lot of technical drafting. Many kinds of clause could potentially be attacked, including:

·         Default interest rates, if they exceed the cost of funds to the innocent party; often the rate is set above the debtor’s cost of borrowing, to deter late payment
·         Clauses that deprive a party of its rights or benefits under the contract without receiving any credit in return for the other party being relieved of its obligations
·         Forfeiture of deposits
·         Contracts for sale of an asset for a price paid in instalments, where ownership does not pass until the last instalment is paid
·         “Golden parachute” clauses in employment contracts, or pay in lieu of notice clauses requiring payment for very long notice periods
·         Timing differences such that a party does not get what it has paid for.
Deposits in property transactions are a special case. A deposit not exceeding 10% of the price has been held to be reasonable, even though it exceeds the likely loss due to the buyer pulling out, because it is in line with the traditional concept of “earnest money”. But a deposit of 25% was held to be fully returnable (less compensation for any actual proven loss) [4]. The court has a statutory power to order repayment of a deposit in property transactions [5], but rarely does so [6]. The court also applied the same principles to a deposit on sale of the shares in a property-owning company, and they would probably be applied to sales of other assets, at least where the effect of a deposit is similar. But the ideal a “non-returnable deposit” is strictly limited, and could well be ineffective in other circumstances. Pre-contract deposits are particularly vulnerable.
One trap for parties and their lawyers could be where one kind of payment is dressed up as another. I have seen agreements, for instance, in which the sale price of a small company is converted into an inflated level of salary for the selling director. The contract might provide that the salary continues to be payable even if the director dies or ceases to be employed, or that a large termination payment is to be made to him. What if the buyer then sacks the director? He can claim that anything in excess of normal employment compensation is a penalty and unenforceable.
A final related point: many lawyers seem unaware of the anti-deprivation rule on insolvency, which says that a provision to deprive a person of his assets on insolvency is void. Contracts often say that they can be terminated on the insolvency of either party, without any thought as to the justice of that for the creditors of the insolvent party. There is some uncertainty about how wide the principle is, and it has been interpreted quite narrowly by the Court of Appeal [7], including a finding that the termination of a licence on insolvency does not infringe the principle. It has been held that company articles requiring share to be sold at full market value on insolvency are valid, but would not be if the price were less than a shareholder would get on other compulsory sales [8]. But it remains the case that a clause that requires the assets of an insolvent person or company to be dealt with otherwise than in accordance with the insolvency legislation will not be effective.
I expect to see more cases on penalties and the anti-deprivation rule, and some may come as a big surprise to the contract parties. Beware of contracts that purport to give any kind of windfall in the event of a breach.


  1. In an important case the Court of Appeal has held that "bad leaver" share price discounts may well be void as penalties http://www.bailii.org/ew/cases/EWCA/Civ/2013/1539.html

  2. The development of the law on invalid penalty clauses has been rolled back by the Supreme Court https://www.supremecourt.uk/cases/docs/uksc-2013-0280-judgment.pdf. The test for a penalty is now "whether the sum or remedy stipulated as a consequence of a breach of contract is exorbitant or unconscionable when regard is had to the innocent party’s interest in the performance of the contract", which will allow far more aggressive terms than some of the cases suggested. “Bad leaver” clauses are probably safe, though still subject to possible relief from forfeiture.


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