Rule against Penalties

Christian Moerch Yiannis Efthyvoulou

Under the common law, there is a rule against penalties in contracts and such clauses are unenforceable. The rule is based on public policy – a party should not be penalized for a breach of contract but shall be liable to compensate the innocent party for its loss caused as a result of the breach of the contract. As a general rule, English law does not recognize punitive damages in tort either – only that you have a right to be compensated for your actual loss.

The question of penalties under English law often comes up in the context of liquidated damages clauses because the courts have traditionally defined penalties by looking at the difference between them and liquidated clauses. A liquidated damages clause is one where the parties agree that in the event of a breach of contract the party in breach shall pay a prescribed sum of money to the non-breaching party, or that in the event of a breach the non-breaching party will forfeit a sum already paid to the other. There are certain advantages of having a liquidated damages clauses, for example, where you have an LD clause you don’t need to wait for the loss to crystallise, you simply have to show the breach of the agreement and there is no need to prove actual loss which can sometimes be difficult and further it eliminates expensive disputes providing the breaching party adheres to the terms of the contract. Liquidated damages clauses are recognised and valid unless the clause constitutes a penalty.

However there are other clauses than liquidated clauses which could constitute a penalty. In principle, the rules governing penalties may apply to clauses which are in substance (though not in form) liquidated damages provisions For example, the courts have confirmed that the rules apply to “take or pay” clauses which require the buyer to pay for a specified minimum quantity of products, whether or not the buyer actually takes all or any of the products

The rule against penalties applies to the transfer of property as well as to the payment of money and to clauses the which could also be treated as forfeiture clauses. For example, there is no difference between a clause that states X fails to pay Y US$100 on a certain in breach of the agreement Y has to pay me US$1,000 and a clause stating Y would have to transfer shares for no consideration – be aware of this so you can spot other clauses than liquidated damages which may potential constitute a penalty. Equally, a clause requiring a defaulting party to transfer property (for example shares) to an innocent party at an undervalue could also be a penalty.

What Constitutes a Penalty Clause – the Legal Test

The law sets out the following test you will need to apply when you need to determine whether a clause constitutes a penalty and will be unenforceable – it requires you to consider (i) does the clause protect a legitimate interest; and (ii) is the clause purporting to serve that interest not out of proportion (by being extravagant, exorbitant or unconscionable)? Where the questions can be answered affirmatively, then the clause in question is unlikely to constitute a penalty and be enforceable.
It should be noted the rule against penalties applies only to secondary obligations and not primary obligations (being a stand-alone contractual obligation, while a secondary obligation is an obligation only triggered as a consequence of a party being in a breach of contract and is intended to provide a contractual alternative to damages).

The law recognises the following considerations are also likely to be relevant in the determination of the status of a clause (i) a presumption that sophisticated parties will know what they are signing up to in terms of what is legitimate in a provision dealing with the consequences of a breach; and (ii) the degree to which such provisions are common place, i.e. used regularly in legal relations in similar contracts.

Under the law, it is clear that “in a negotiated contract between properly advised parties of comparable bargaining power, the initial presumption should be that the parties are the best judges of what is legitimate in a provision dealing with the consequences of a breach”.

Freedom of contract

It should be noted that the rule against penalties has rarely been applied by the courts as they are reluctant to intervene in contractual relationships between experienced commercial parties unless absolutely necessary. The use of the word penalty is not conclusive – even where the parties have used the word penalty the court could find that the clause is a valid but in view of the rule against penalties is seems to make sense not to use the word in your agreement. Where the provision is held to be a penalty clause it will not be enforceable under English law – the innocent party is left to sue on the underlying obligation and the courts will award damages of the amount representing the actual loss, rather than the amount stated in the contract.

Drafting Implications

The application of the rule against penalties depends very much on the wording of the relevant clause and you will need to be very careful when drafting your agreement – ultimately whether a clause constitutes a penalty or not will depend on its context. Below are some examples of potentially problematic clauses in the context of corporate and commercial law:
a) default interest clauses in loan agreements, particularly where the creditor would charge an interest rate in cases where sums are not paid on time;
b) ‘bad leaver’ clauses in shareholder agreements or articles of associations may be held as penalty in cases where they require outgoing employees to give up their shareholdings in a company for less than the market price or ever see their shares being forfeited; and
c) restrictive covenants/non-compete clauses where they restrict a party from taking certain steps following either during or after an agreement is being discharged.

For further information about any matters discussed in this note and how Redfern Legal can assist you, please feel free to contact:

Christian Moerch or

Yiannis Efthyvoulou

Please note that this information is only for information purposes and does not constitute legal advice. As this area of law is complex, we would suggest that you seek legal advice for your specific matter. Redfern Legal will be happy to assist you.