The High Court case of Edgeworth Capital (Luxembourg) S.A.R.L and another v Ramblas Investments B.V  is a useful reminder of the application of the rule against penalty clauses.
Edgeworth Capital (Luxembourg) S.A.R.L and Aabar Block S.A.R.L (the Claimants) claimed €105,201,095.89 as a fee due under an Upside Fee Agreement (UFA) made with Ramblas Investments B.V. (Ramblas). The UFA was part of a suite of financing agreements entered into in relation to the purchase of property in Madrid and the fee was, in essence, a charge payable to a bank for the provision of an associated loan.
Breaches of contract by other parties to one of the loan agreements triggered cross-default provisions under another related loan agreement which resulted in the Claimants seeking payment of the substantial fee due under the UFA.
Ramblas disputed the claim on grounds which included that the substantial “upside” fee for which Ramblas was allegedly liable far exceeded any liability for damages arising from the breach of the relevant loan agreements and was therefore unenforceable as a penalty or disguised penalty. The Claimants relied on the fact that the doctrine of penalties only applies in the event of a breach of duty owed to the other party and argued that this was not the case.
The Upside Fee Agreement
The UFA provided that the fee was payable when certain ‘Payment Events’ occurred. One of the Payment Events was the mandatory or voluntary repayment of a related loan. In addition to arguing that the fee was a penalty and therefore unenforceable, Ramblas also argued that a breach which triggered a cross-default and an obligation to repay the related loan was not a Payment Event within the terms of the UFA as only an actual repayment of the loan constituted a Payment Event. This argument failed and the Court held that, on the wording of the UFA, Payment Event covered both a repayment “which is made and a repayment which falls to be made”.
Penalty clauses – the law
A contractual provision which states that a fixed sum is payable upon breach of contract is commonly used to avoid the uncertainty and difficulty associated with proving the damage suffered as a result of a breach. If the fixed sum is a genuine pre-estimate of loss that is likely to flow from the breach, the clause will be regarded as a valid liquidated damages clause. However, if the purpose of the provision is to deter the other party from breaching the contract and it lacks commercial justification, the doctrine of penalties will apply.
The courts recognise the utility of liquidated damages clauses and that to hold them to be penal is an interference with freedom of contract. The courts are, therefore, predisposed to uphold clauses which fix the damages for breach.
The doctrine of penalties was recently restated by the Court of Appeal in Makdessi v Cavendish Square Holdings BV  as follows:
“The underlying rationale of the doctrine of penalties is that the court will grant relief against the enforcement of provisions for payment…in the event of breach, where the amount to be paid or lost is out of all proportion to the loss attributable to the breach. If that is so, the provisions are likely to be regarded as penal because their function is to act as a deterrent.”
In Export Credits Guarantee Department v Universal Oil Products Co  Lord Roskill commented on when a clause was not a penalty:
“The clause was not a penalty clause because it provided for payment of money upon the happening of a specified event other than a breach of a contractual duty owed by the contemplated payor to the contemplated payee.”
In this case, the High Court summarised the doctrine as:
- a clause will be a penalty where it is extravagant and unconscionable with a predominant function of deterrence;
- a clause will not be a penalty if it is a genuine pre-estimate of loss; and
- even if it is not a genuine pre-estimate of loss it will not be a penalty where it is commercially justifiable and it can be shown that its predominant purpose is not deterrence.
Determining whether a clause is a penalty will be a matter of construction for the courts in each case. Consideration will be given to any evidence provided to show how the fixed sum was arrived at and the wording used by the parties (although the word “penalty” or “liquidated damages” is not determinative). A pre-estimate does not have to be right to be reasonable. The fact that it may result in an overpayment is not fatal and the parties are allowed a generous margin.
The Court held that the relevant clause was not a penalty because:
- the essence of the fee was that it was a charge payable for the provision of a loan. The fact that the trigger for a Payment Event was an event of default involving a breach of a related loan agreement made no difference to the amount payable. Exactly the same fee would be payable if the trigger had been an event of default which did not involve a breach;
- given the challenging commercial circumstances in which the financing agreements were concluded there was clear commercial justification for a large fee being charged. That was the bargain made; and
- if the rule against penalties did apply to the clause, the Court would have held that even though the fee was not a genuine pre-estimate of loss, the clause was nevertheless commercially justifiable and its predominant purpose was not deterrence. As such it would not be a penalty.
Ramblas was therefore liable to pay the Claimants the fee claimed together with interest.
The case is a reminder that:
- the courts will be reluctant to hold a clause to be unenforceable where valid commercial reasons exist for the amount involved;
- careful drafting is required to avoid a clause being regarded as a penalty;
- the doctrine of penalties is engaged where the payment is linked to a breach of duty; and
- an obligation to pay an amount which is not a genuine pre-estimate of loss may still be commercially justifiable if its predominant purpose is not deterrence.