Penalty clauses are unenforceable - aren't they?

It was never a penalty!

The law has been clear: a clause in a contract imposing a penalty for breach of contract was unenforceable. What was completely unclear was  (1) what amounted to penalty and (2) whether the rule applied beyond the payment of money following a breach of contract. For many years the accepted formulation was that if contract term provided for a payment which was "more than a genuine pre-estimate of loss" it would be an unenforceable penalty; otherwise it was a legitimate "liquidated damages" clause and not a penalty. In more recent years more complex cases have tested the rule, involving more than a straightforward payment for non-performance. the trend seemed to suggest that any clause whose effect was intended to be deterrence rather than compensation was potentially vulnerable to attack as a penalty.

In a judgment today (4 November 2015) these developments of the law on invalid penalty clauses has been rolled back by the Supreme Court. It gave a combined judgment on two cases that could hardly be more different. Cavendish Square Holding v El Makdessi concerned "bad leaver" type clauses  under which Mr El Makdessi, who had sold shares in a company, stood to lose the remaining instalments of the price and to be forced to sell his remaining shares cheap — the last limb alone would cost him $44m — because he had breached non-compete covenants. ParkingEye v Beavis was about an £85 penalty charge for overstaying in a retail car park.

In both cases the Supreme Court said the clauses were not penalties and were valid. 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. Deterrents are allowed, so long as they are not exorbitant or unconscionable, and there is no longer any necessary relationship with the damages that might be awarded by the courts for the breach. Contract writers are likely to become bolder in specifying remedies for breach.

Most “bad leaver” clauses are now probably safe, though still subject to possible equitable relief from forfeiture if the party in breach can provide recompense by other means. 

The £85 parking overstay charge was also held not to be an unreasonable term under the Unfair Terms in Consumer Contracts Regulations 1999 (now Part 2 of the Consumer Rights Act 2015).

The Supreme Court did close one loophole: in deciding whether the clause is a remedy for a breach of contract, the courts will look at the substance of the obligations and not just at how they are expressed. Writing the contract so that there is no breach, but just a conditional obligation, will not get round the rule on penalties if the substance is that one is the primary obligation and the payment is a secondary compensation: so if instead of saying "you must supply the goods; if you do not supply the goods you will pay me £1m" you say "you can either supply the goods or pay me £1m", the court can still decide that the supply of the goods is the primary obligation and the payment is a penalty for breach of it.

The case is a victory for traditional freedom of contract and for certainty, at the expense of the introduction of concepts of fairness, proportionality and the protection of the weaker party into contract law.

Insolvency and consumer credit businesses

A trap for administrators and a workload for the FCA

Consumer credit businesses used to be licensed by the OFT, in a fairly relaxed licensing regime. It included not only consumer credit lenders, but also businesses with a tangential involvement in credit such as credit brokers, debt collectors and debt advisers. Credit brokers include most businesses who introduce consumers to credit providers, such as motor, furniture and electrical retailers. Many large businesses held consumer credit licences for minor activities outside of their main businesses, such as employee loan schemes or other employee benefits.

The Financial Conduct Authority has now taken over regulation of consumer credit, with all the complexity of the financial services regime. Consumer credit businesses have become "authorised persons" (including those who have the transitional "interim permission"). That has many consequences, some of them possibly unforeseen. One of them is the application of the FSMA insolvency legislation to all consumer credit businesses.

A possible major trap is that an appointment of an administrator by the directors of a consumer credit authorised business, or of one that should be authorised, needs the prior consent of the FCA (section 362A FSMA 2000). The directors must obtain the consent of the FCA before filing a Notice of Intention to Appoint Administrators, or if there is no qualifying floating charge holder and therefore no need to file such a notice, the consent must be filed at the same time as the Notice of Appointment of Administrators. Failure to obtain the FCA’s consent renders the administrator's appointment invalid; but the case of Peter Lloyd Bootes and others v Ceart Risk Services Ltd holds that this is a curable defect, so the appointment will take effect when the consent is obtained and filed.  

If there is a qualifying floating charge holder, and it makes the appointment, no prior consent of the FCA is required. But all documents in relation to the administration issued to creditors must also be sent to the FCA, and similar requirements apply to other forms of insolvency.

This is yet another thing for insolvency practitioners to look out for before appointment, and a potential source of uncertainty in the validity of appointments. A search of the FCA register should probably be routine (and the separate specialist registers, including the consumer credit register), but even that is not complete protection: if the business should have been authorised, for instance because it introduced consumers to credit providers, the FCA's consent is still needed. Whether the FCA will give timely consents in respect of firms it has never heard of, or precautionary applications for consent, remains to be seen.

Proportionate liability clauses upheld

Need a small slip make you liable for the whole loss?

For many years, businesses have been trying to limit liability according to their fair share of the fault.  Among the first to argue for "proportionate liability" were the big accountants, who are regularly sued over corporate failures because their insurers had deep pockets. The issue frequently arises in the constructions industry, where there are often several firms of contractors and professionals who might share responsibility for a fault or delay.

In most cases, where there are two or more possible defendants, they will be jointly and severally liable for the loss. that means the claimant can sue any or all of them, and recover the whole of his loss from the chosen defendant, leaving the defendants to sort out contributions amongst themselves. that can be very unfair to defendant if the others have gone bust or disappeared. In the very worst cases it can even make claimants careless about the choice of contractors: so long as they have one solid defendant, they need not worry about the competence or financial strength of the others.

"Net contribution clauses" have often been inserted in contracts, but lawyers have doubted whether they worked. Now the Court of Appeal has confirmed that they do - even in consumer contracts.

In West v Ian Finlay & Associates a very simple term was held to work: "Our liability for loss or damage will be limited to the amount that it is reasonable for us to pay in relation to the contractual responsibilities of other consultants, contractors and specialists appointed by you". The clause protected an architect from liability for the part of the claimant's loss fairly attributable to defective work by the (insolvent) building contractor. It survived challenges under the Unfair Terms in Consumer Contracts Regulations and the Unfair Contract Terms Act 1977.

All businesses which could potentially share liability with others should review their contract terms and consider whether they should be using a net contribution clause. That includes most businesses in the construction industry and most professional firms. It remains to be seen whether the same approach can be extended to exclude liability for the defaults of your own sub-contractors.

Consumer credit licences all expire

If you haven't acted, your consumer credit activities are now illegal

All licences granted by the OFT under the Consumer Credit Act 1974 lapse at midnight tonight. That includes the group licence granted to all solicitors.

 

From tomorrow (1 April 2014), consumer credit businesses - including ancillary activities such as credit brokerage and debt collection - require authorisation by the Financial Conduct Authority. If you haven't already applied for interim authorisation, you will need to stop carrying on the regulated activity until you have gone through the application process - likely to take some months.

 

There is no general permission for solicitors, so those engaged in consumer credit activities, including debt collection from consumers, now have to be dual-regulated by the FCA and the SRA (and pay two sets of fees for the privilege). Will consumers be any better off? No, of course not.

Negligence: staying out of the firing line

Shared responsibility in a professional team

Professionals work in teams, formally or informally, on all sorts of projects. Where something goes wrong, it may not be clear that one professional firm is solely responsible.  One professional may have relied entirely on another to do his bit, either by agreement between them or because it naturally fitted in the other's area of expertise; or one may have appointed the other to assist. Successive advisers may have made the same mistake. Two advisers may assume that each other are dealing with an issue. If work or advice has been negligent, the client will be tempted to sue all parties and let them fight it out amongst themselves. It may come down to assessing the contributions to be made by different parties.

In Flanagan v Greenbanks Ltd (t/a Lazenby Insulation) & Cross two successive firms carried out negligent surveys to assess suitability for cavity wall insulation. The Court of Appeal said that both were liable: the negligence of the later survey had not absolved the earlier one of responsibility, nor could the second firm assume that the first had done its work correctly without checking.

Firms can improve their position if sued by including suitable terms in their conditions of engagement - subject always to the usual considerations on limitation and exclusion clauses, especially in consumer contracts. Something like this can help:

"Where other professionals are engaged by you or on your behalf (including any predecessor of ours), we will be entitled to rely on the work and advice of those other professionals and to assume that they have carried out their work with due care and skill and to all relevant standards. We will not be responsible for checking or re-doing their work, or for checking their instructions, assumptions or conclusions, unless specifically instructed to do so, and then only to the extent falling within our area of expertise. We may review or comment upon the work of other professionals where we consider it appropriate but we will not be obliged to so and by doing so we do not assume responsibility for such work. Where we engage or recommend other professionals, our responsibility for their work is limited to selecting professionals whom we believe to be reasonably suitable for the purpose. Where we engage such professionals with ourselves as principals (and not as your agents) our liability for loss or damage arising directly or indirectly from their act or default (including negligence) is limited to the amount we are actually able to recover from them. If we recommend the engagement of other professionals but you decline to do so, we will not be liable for any loss or damage which would have been avoided had such professionals been engaged."

Of course it also helps if the roles of the professional teams are clearly defined, and if each member has a proper definition of its scope of work and terms of engagement. Specifically exclude from your scope of work any high-risk areas you don't regard as part of your role, and adapt your contract terms carefully to each situation.

Consumer credit gets the financial services treatment

The FCA takes over licensing in a whole new style

Any business providing credit to consumers, or introducing sources of credit, needs a consumer credit licence. The requirements and standards have increased gradually since licensing came in back in the 70’s. Back then, almost all applications were granted and hardly any licences were revoked. The OFT has never put much resource into the system and has taken a light-touch approach. That will all change when regulation moves to the financial services regulator, the FCA, in April 2014.[1]

The FCA is a far more demanding regulator. It is used to dealing with large institutions with full-time compliance officers, and the resources to apply detailed, complicated rules. The FCA has the resources to deal effectively with complaints and to make life miserable for those it suspects of transgressions, and it is not known for sympathy with small businesses struggling to comply. Apart from the largest consumer credit businesses, which are already FCA-regulated, consumer credit licence-holders may be in a for a shock.

Until now, the main sanction under consumer credit legislation was the threat that agreements might be unenforceable due to non-compliance. Although a whole industry grew up around this, not many defences based on technicalities were successful. The OFT was unlikely to take action unless the whole business model of the licence-holder was objectionable. The OFT’s expectations were set out in guidance notes, which did not have the force of law.

The FCA has said that it will act very differently. It is used to dealing with individual complaints and sanctioning businesses for isolated non-compliance, as well as looking carefully at the overall suitability of a business. It expects rigid compliance and self-reporting of breaches. Directors and those performing “controlled functions” will be subject to personal sanctions, as they are in other FCA-regulated businesses. The FCA will be translating the OFT’s guidance into enforceable rules. There will also be Principles of Business, High-level Standards and Conduct Standards – in other words, a whole new regulatory environment for businesses to learn and understand.

The FCA does promise some relaxation for lower-risk businesses. Giving deferred payment terms at no cost to buyers of goods and services or introducing them to sources of credit, hiring goods to consumers and not-for-profit debt advice all require licensing at present but are to be the subject of exemptions, and there is to be a new status as authorised representative of an authorised firm, allowing businesses to rely on the compliance of their consumer credit supplier.

All licence-holders have to apply for interim permission from the FCA, with applications stating in September, accompanied by payment of a £350 fee – likely to be the first of many. Full authorisation must be applied for by 2016, and aims to  ensure that regulated firms are well-run, recognise the risks they face and have appropriate strategies, systems and controls in place and the right people in important roles. Individuals who perform key “controlled functions” will be vetted and monitored.

Recommended first steps for licensed businesses are to check that your details are correct on the existing Consumer Credit Register and to sign up to FCA consumer credit emails. Any business contemplated consumer credit activities would do well to apply for an OFT licence before April, as otherwise it will be subject to the full rigours of FCA authorisation.

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[1] Financial Services Act 2012 (Consumer Credit) Order 2013

Click to accept

Are website conditions of use binding?

Many websites have conditions of use, supposedly binding the visitor to various conditions. Usually they are of minor importance, but if they are contractually binding, there is no theoretical limit on the obligations that could be imposed. But is there a contract with the visitor?

Probably not, and a recent case[1] strengthens that view, holding there was no consideration even for an online acceptance click. To form a contract there would have to be offer and acceptance, consideration and contractual intention. None of these is likely to be present just in visiting a website.

The case went further. It held that there was no contract even when the consumer set up an account, registered user details and clicked to accept the terms and conditions. The court said there was still no consideration for the obligations of the consumer: the website owner was not obliged to provide him with any service, and could take down the website at any time. A contract only came into being when an actual order was placed.

That is a surprising conclusion, given the minimal requirements to give adequate consideration, so the case may not be reliable as a precedent in other cases. Including some trivial obligation on the part of the website operator could get round the point.

Less surprisingly, the case also says that attempting to make a consumer responsible for all unauthorised use of his account is unfair and unenforceable under the Unfair Terms in Consumer Contracts Regulations 1999 – see my previous post on that subject, On Level Terms.

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[1] Spreadex Ltd v Cochrane [2012] EWHC 1290 (Comm)

On level terms

Terms and conditions for consumer contracts

In June I wrote about the Ashbourne case [1] on consumer contracts, focusing on penalty clauses. But perhaps the biggest impact should be on the way businesses write their standard terms for dealing with consumers.

The Unfair Terms in Consumer Contracts Regulations 1999 caused a major shift in contract law. Until then, unless the OFT intervened, most contract terms meant what they said. There were exceptions for some kinds of exclusion clauses, but most terms did not have to be reasonable or fair. Contract terms for dealing with consumers looked much like business-to-business standard conditions: heavily slanted in favour of the supplier.

Now, most consumer contract terms are automatically unenforceable if they are unfair.

A term is unfair “if, contrary to the requirement of good faith, it causes a significant imbalance in the parties' rights and obligations arising under the contract, to the detriment of the consumer”. All written terms must be in clear and intelligible language. The only terms exempt from a fairness assessment are terms required by law or regulatory requirements, any terms individually negotiated with the consumer, the definition of the main subject matter of the contract, and the adequacy of the price. Even then, the last two must be expressed in clear and intelligible language, and are narrowly interpreted.

Unfairness is judged in the context of the particular consumer’s position, not in relation to consumers generally. The Ashbourne case demonstrated that the courts are prepared to be quite picky in deciding what is unfair, looking at each term individually and the effect it could have. The court held that the following were (or would be) unfair in the context of a health club contract:

·         A long minimum period (1, 2 or 3 years), even with exceptions for contingencies such as unemployment or moving house – “the defendants' business model is designed and calculated to take advantage of the naivety and inexperience of the average consumer using gym clubs at the lower end of the market”

·         A term allowing the supplier to terminate the contract due to the consumer paying late, if the delay was not sufficient to amount to the consumer indicating he or she was no longer intending to be bound by the contract or undermining the supplier’s confidence in his or her ability to pay

·         A term requiring the consumer to pay the whole undiscounted balance for the minimum period if the consumer breached the contract

·         A requirement for a notice of termination to be given in an unexpected manner, in this case to a central office rather than to the club

·         Terms allowing payments to be recovered from the consumer despite representations made to him by the supplier.

What does this mean for your standard terms and conditions, if you deal with consumers? You really have two options.

The first is to continue as before with potentially unfair terms, but to accept that many of them will be unenforceable against consumers. Most companies selling primarily to business buyers will probably do this – if you are a consumer business, what’s the point of using terms you know are unenforceable? So long as you give way quickly and do not build a business model based on unfair terms (as Ashbourne did) you should be reasonably safe from action by the OFT, unless you are in a particularly sensitive sector such as (at the moment) health clubs.

Otherwise, reassess your terms for dealing with consumers. Consider having separate terms for consumer and business sales. Have your terms drafted so that they are fair in the context of your particular business. Unfortunately that is not an easy thing to do, and it is likely to increase the legal costs of drafting your terms. Your lawyer can no longer use a standard form, or write the terms with minimal knowledge of your business. You need to work with him to decide what is fair in circumstances, and to adapt your business model if necessary.

Then you both need to make sure the terms are in plain and intelligible language. The requirement is probably different depending on the target audience – are your consumers likely to be educated and technically astute? Important terms should be given prominence, perhaps with bold type or capital letters – though every term is important if it happens to cover the issue that arises. The more you try to explain things, the longer and more unintelligible the contract gets. The OFT then says that the time available to the consumer to read the contract affects its fairness [2].

The OFT publishes a general guide to making contract terms fair and a selection of guides for particular industries. In January 2012 the Financial Services Authority published guidance "Unfair Contract Terms: improving standards in consumer contracts" which is helpful even to other industries, particularly in discussing clauses that allow the business to vary the contract, and the benefits of setting out valid reasons for making changes. It stresses that give the business wide discretion are likely to be unfair, and the importance of plain English.

And while you are reviewing your contracts, don’t forget the consumer’s cancellation rights![3]

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[1] OFT v Ashbourne Management Services {2011] EWHC 1237. The Court’s order is at http://www.oft.gov.uk/shared_oft/consumer-enforcement/ams/order.pdf

[2] http://www.oft.gov.uk/shared_oft/reports/unfair_contract_terms/oft311.pdf at pages 10-11

[3] Especially under the Consumer Protection (Distance Selling) Regulations 2000 as amended or the Cancellation of Contracts made in a Consumer’s Home or Place of Work etc. Regulations 2008

Revised 13 February 2012 to note the FSA guidance.

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.

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[1] Alfred McAlpine Capital Projects v Tilebox [2005] EWHC 281

[2] OFT v Ashbourne Management Services {2011] EWHC 1237

[3] Financings Ltd v Baldock [1963] 2 QB 104

[4] Workers Trust & Merchant Bank v Dojap Investments [1993] AC 573

[5] Section 49(2) Law  of Property Act 1925

[6] MIDILL (97PL) v Park Lane Estates

[7] Perpetual Trustee Company v BNY Corporate Trustee Services and Butters v BBC Worldwide

[8] Borland’s Trustee v Steel Bros [1901] 1 Ch 279

A decent website?

Advertising code extended to all websites

The Code of Advertising Practice is being applied to all websites from 1 March. I blogged this week about the legal requirements for your website, but now it also has to follow the Code if it directly promotes products or services to consumers (including businesses) in the UK. That includes a Facebook page or LinkedIn company page.

You may think that all your promotional material is already legal, decent, honest and truthful, but do you hold documentary evidence to prove all claims that are likely to be regarded as objective? Is it clear that opinions are not intended to be objective claims?

For a start, very few law firm websites don’t claim to be a “leading” practice!

Some parts of the Code go beyond the content of advertisements: for instance products ordered must generally be delivered in 30 days, and the CAP duplicates and extends some parts of the Distance Selling Regulations, and brings in general obligations to treat customers fairly – and appears to apply them to business-to-business sales. Of course it does not have the force of law – its terms are enforced by the Committee of Advertising Practice through advertising industry sanctions, so it does not give customers direct contractual rights. But an adverse finding could be highly embarrassing. Remember, many complaints come from competitors!