Penalty or no penalty? Protecting parties to commercial contracts

20 Jul 2019

In the footballing world the introduction of VAR (Video Assistant Referee) has caused hot debate, even more so in the UK given its imminent introduction to the Premier League.

Fifa explains that the role of VAR is to ensure that no clearly wrong decisions are made in conjunction with the award or non-award of a penalty kick. Whilst the jury is still out on the effectiveness of Fifa’s attempts to ensure fairness and consistency within the game, what mechanisms are in place in the commercial world to ensure parties to a contract are not penalised?

The penalty rule

It is a settled principle of English law that contractual penalty clauses are unenforceable. The purpose of the penalty rule is to prevent one party to a contract relying on a clause that calls for a payment in the event of a breach, the sum of which is an exorbitant sum compared to what would ordinarily be recovered under common law.

Parties to commercial contracts will be used to seeing liquidated damages clauses in their terms, but when are such terms caught by the penalty rule?

Since 1915 the widely accepted test for determining between enforceable liquidated damages clauses and unenforceable penalty clauses was that laid down by Lord Dunedin in Dunlop Pneumatic Tyre Co Ltd v New Garage & Motor Co. Ltd [1915] A.C. 847 (“Dunlop”).

In his judgment, Lord Dunedin formulated 4 tests that could prove helpful in determining if a clause was penal, the most recognisable being: “The essence of a penalty is a payment of money stipulated as in terrorem of the offending party; the essence of liquidated damages is a genuine covenanted pre-estimate of damage”.

In other words, is the clause under scrutiny a genuine pre-estimate of loss, or are the sums being demanded unreasonable when considering what would be payable applying the ordinary rules on damages?

This rule was cited and relied upon in many cases on this topic for almost 100 years, until the Supreme Court took the opportunity to review the test in Cavendish Square Holdings BV v El Makdessi; ParkingEye Ltd v Beavis [2015] UKSC 67; [2016] AC 1172 (“ParkingEye”).

The Supreme Court in ParkingEye rejected the test formulated in Dunlop, suggesting that somewhat unfortunately the courts had been applying the test too rigidly, creating a “quasi-statutory code”. After an extensive review of the authorities, a majority of the Supreme Court stated that the true test of whether a clause is penal was:

The true test is whether the impugned provision is a secondary obligation which imposes a detriment on the contract-breaker out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation. The innocent party can have no proper interest in simply punishing the defaulter. His interest is in performance or in some appropriate alternative to performance.

It is clear from the new test that parties attempting to rely on a liquidated damages clause will need to demonstrate that they have a legitimate commercial interest when attempting to enforce the clause. Whether the commercial interests relied upon are legitimate or not, will fall to be determined on a case by case basis.

No foul, no penalty

As discussed above, one aim of VAR is to ensure that penalties are not awarded when there has been no foul. So what is the position in the commercial world when there has been no breach of contract?

It is not uncommon for terms & conditions to a fixed term agreement to include liquidated damages clauses. A good example is the telecommunications industry, where contracts for the supply of the telephone lines and related services usually run for an agreed fixed term.

Standard terms & conditions of the supplier will usually contain clauses that deal with early termination. If the supplier relies on a clause that allows them to terminate the contract early, usually as a result of a breach such as non-payment of invoices, they often require the customer to pay a fee to cover sums that would have been due if the contract had run the full length of the term. Arguably, in such cases this clause is open to challenge as a penalty clause and the supplier will therefore need to persuade the court that it is in fact an enforceable liquidated damages clause on the application of the above test.

The same terms & conditions will, however, also usually contain a clause that allows a customer to terminate the contract early. As with the earlier clause, in most cases the customer will be required to pay a fee representing the full sum payable under the contract. Would this clause be subject to the penalty rule? Not according to the High Court decision in Berg v Blackburn Rovers Football Club & Athletic plc [2013] EWHC 1070 (“Berg”).

Berg concerned a claim by the former manager of the defendant football club for payment of £2.25 million, which he claimed was due following early termination of his service contract. The defendant initially admitted liability, but subsequently made an application to withdraw the same so that it could argue 2 defences. One of these was that the clause that the claimant relied upon was an unenforceable penalty.

When determining whether the defendant had an arguable defence, Judge Pelling QC held: “A sum of money payable under a contract on the occurrence of an event other than a breach of contractual duty is not a penalty.”

The Judge went on to assess the clause at issue, holding that the termination of the contract was not a breach, but rather the defendant exercising its right and therefore could not be subject to the penalty rule.

Conclusion

The above cases are a useful reminder for parties to commercial contracts to review clauses dealing with liquidated damages clauses.

Berg in particular, should act as a warning that a termination clause may not always be a liquidated damages clause and therefore open to challenge as a penalty. On the other hand, it could be a useful authority to parties relying on clauses to claim payment of a determined sum when the other party has exercised a right to terminate the contract early.

If you require assistance with a commercial contract, Trethowans LLP can help. Our commercial contract solicitors have years of experience helping a broad range of clients ensure that their best interests are protected. Contact us today on 0800 2800 421.