REUTERS | Brian Snyder

Penalty clauses: genuine pre-estimate of loss versus commercial justification

In April this year I looked at the “new test” (set out in Cavendish Square Holdings BV and another v El Makdessi) for determining whether or not a contractual provision is a penalty. Last week, the Court of Appeal overturned the decision at first instance, and struck out the relevant clauses as penalties. In doing so, the court went some way towards clarifying the law on penalties. Although the Cavendish case is not a construction case this decision is relevant to everyone negotiating liquidated damages clauses in construction contracts.

When does the law of penalties apply?

The law of penalties applies where the parties have agreed that, upon a particular breach of contract, the party in breach will pay the other party a sum of money. It also applies to a provision that disentitles the contract breaker from sums otherwise due to him or requires the compulsory transfer of property to the innocent party at nil or an undervalue. It is a blatant interference with freedom of contract and the courts will do what they can to uphold the agreement reached by the parties, but they will intervene if they consider that the amount payable is out of proportion to the loss arising from the breach and is not commercially justified.

The “commercial justification” test

The Cavendish case concerned a complex commercial arrangement in which the director of a company (M) sold his controlling interest in the company but retained a significant number of shares. Under the terms of the agreement, he agreed to forfeit his right to receive the final payments and exercise a put option and also to sell his shares to Cavendish (at what was likely to be an undervalue) if he became a Defaulting Shareholder.

At first instance, the judge found that the relevant provisions were not penal because they were commercially justifiable. Once M became a Defaulting Shareholder the intention was to decouple M from the company and to adjust the consideration for sale of the remaining shares following M’s breach. The judge also considered that the fact that both parties were legally represented during negotiations was a determining factor. His fourfold test as to what constituted a penalty appeared to focus on whether:

  • The clause was commercially justified.
  • The provision was extravagant or oppressive.
  • The predominant purpose of the provision was to deter breach.
  • If relevant, the provision was negotiated on a level playing field.

However, there was no guidance on how the four elements interacted or their relative importance. What if the answer to each of the questions pointed in a different direction, so that a provision which appeared to be extravagant could be justified from a commercial perspective but was not negotiated on a level playing field?

Is there a new test following the Court of Appeal’s decision?

The Court of Appeal’s decision provides welcome clarification on how the various elements fit together. It confirms the recent line of authority that there is no longer a rigid dichotomy between a genuine pre-estimate of loss, on the one hand, and a penalty on the other. It acknowledges that there are provisions which, while they do not reflect a genuine pre-estimate of loss, nevertheless have a commercial justification which means that their predominant purpose is not to deter breach.

So the starting point is to consider whether the relevant provision is extravagant and unreasonable with a predominant purpose of deterring a breach of contract. How do you define what is extravagant and unreasonable in any given case? The answer, unfortunately, is that it depends: each case will turn on its facts.

A clause may be “extravagant” if there is a substantial discrepancy between the level of damage stipulated in the contract and the level of damages which is likely to be suffered. Equally, if there is a range of possible breaches and of likely losses from such breaches and the same sum is stated to be payable for any of these breaches with the effect that the sum provided for is totally out of proportion to some of them, the clause may be penal because its function is to act as a deterrent. This is where the genuine pre-estimate of loss test holds firm: if the sums specified are genuine pre-estimates then they are highly unlikely to be penal.

Even if the payment on breach is extravagant and unreasonable this is not conclusive that it is penal. If there is a good commercial justification for the provision this may be a reason to conclude that deterring a breach was not the dominant purpose of the term. Rather unhelpfully, the court acknowledged that the situations in which a clause “is commercially justifiable but its dominant purpose is to deter [a breach] are not readily discernible”. Again, each case turns on its facts.

Applying the test

In Cavendish, the court found that the clauses in question were extravagant in that they provided for an excessive withholding of payment in the case of breach. While this on its own was not conclusive, the court did not agree with Cavendish that they were commercially justified. M could become a Defaulting Shareholder as a result of a either a minor or serious breach and yet the “penalty” provisions took effect in their entirety regardless of the type of breach or the extent of the consequences of the breach. This led the court to conclude that it went “way beyond compensation and into the territory of deterrence”.

The court also acknowledged that what is meant by the terms “extravagant” and “unconscionable” and how these concepts fit with the concept of deterrence was ambiguous. It preferred to use the terms “extravagant and unreasonable” as more reflective of the modern world. In addition, the court concluded that whether or not the parties are legally represented will be relevant, but not determinative of whether a clause is a penalty.

What implications does this have for those negotiating construction contracts?

We asked this question following the first instance decision in this case and our advice to clients negotiating liquidated damages clauses in construction contracts remains the same: liquidated damages should be calculated to reflect your genuine expectations of your losses. As Christopher Clarke LJ said in his judgment in this case, “If the clauses are genuine pre-estimates they can scarcely be penal”. In cases where it is impossible to determine in advance what these losses might be, clients should consider whether general damages may offer a more appropriate remedy than liquidated damages. It also remains important to identify at the outset which categories of loss the liquidated damages are intended to cover, as this helps to avoid later arguments about attempting double recovery and is less likely to result in parties inserting a liquidated damages clause into the contract when general damages may be a better solution.

In commercial contracts, clauses that provide for payment of a sum which is much higher than the innocent party’s likely losses in the event of breach may not be penal if they are commercially justified. However, this approach is not without risk and depends on whether the court agrees with your interpretation of “commercial justification”. Don’t forget, the law of penalties is engaged where an obligation to make payment or the entitlement to withhold it is triggered by a breach of contract and in many contracts the law on penalties can be avoided altogether by restructuring these provisions so that payment/forfeiture is conditional on a positive obligation rather than dependant on a breach.

3 thoughts on “Penalty clauses: genuine pre-estimate of loss versus commercial justification

  1. Just a thought, but might a penalty be found to be commercially justified in cases where, there being no significant disparity between the bargaining position of the parties, the penalty is expressly linked to a demonstrably inflated contract price which is reflective of an overwhelming desire to achieve a specific outcome in the contract? The risk of failure might be oppressive but, equally, the reward for success is extravagent …

  2. It is clear from the Court of Appeal judgment that each case of this kind turns on its facts, as was acknowledged by Clarke LJ. But what I have distilled are three general principles that apply to how a court will frame its analysis of contractual clauses alleged to be penal.

    1 The question whether a clause is a penalty must be judged at the date of the agreement in which it is contained. If it is not penal at that date, it cannot become so as a result of later events.

    2 If a clause is found to be a genuine pre-estimate of loss in the circumstances in which it is expressed to operate contractually, it will not be penal, and that is the end of the matter.

    3 However, if it is found to be ‘extravagant and unreasonable’ or ‘unconscionable’, the court can then go one to decide whether there is sufficient ‘commercial justification’ for the clause for it not to be penal. Again, each situation must be judged on its facts, but Clarke LJ said:

    “Nowadays, when a term which provides for excessive payment on breach may be valid if it has proper commercial justification, the term “unconscionable” would perhaps more appropriately be used for a clause which provides for extravagant payment without sufficient commercial justification. Such a clause is likely to be regarded as penal and deterrence is its predominate (sic) function, on the basis that if it requires excessive payment and lacks commercial justification for doing so, there is little room for any conclusion other than its function is to deter breach or, to put it positively, to secure performance.”

    “It is … difficult to assess any question of penalty without considering whether the provision is extravagant, and, if it is, whether there is a commercial justification. I venture to thing that difference in approach [by judges in cases that were cited by Clarke LJ] may not be as marked as it might appear provided that (a) undue significance is not given to the discrepancy between the amount payable under the clause and the loss that might be sustained on breach – the significance of the discrepancy may depend on how closely the justification relates to the nature or extent of the loss; (b) no presumptions are treated as irrebuttable; (c) proper account is taken of the desirability of upholding bargains freely entered into and of any commercial justification for allegedly penal clauses, before deciding that the predominant of the clause is deterrent and that it is penal.”

    Expressed another way, the ‘commercial justification’ test is not an alternative to the ‘genuine pre-estimate’ test, but one that may rescue an otherwise penal clause that has failed the ‘genuine pre-estimate’ test from being held as an unenforceable penalty clause. Even more shortly summarised, some penal clauses are enforceable.

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