In Pencil Hill Limited v US Citta Di Palermo S.p.A [1], the High Court considered whether a Swiss arbitration award should be enforced in England where it included an award in respect of a penalty, such clauses being unenforceable under English law as a matter of public policy. Malcolm Simpson considers the judgment and the practical implications.

Background and penalty clause

The claimant (Pencil Hill) sold financial rights (deriving from “registration rights” of a football player) to the defendant Italian football club (Palermo) for a total price of €10 million.

Under a contract made in April 2012 (the April Agreement), Palermo agreed to pay Pencil Hill, on certain fixed dates, a total of €6.72 million in two instalments of €3.36 million Euros. A further €1 million became due under an agreement made in August 2012 (the August Agreement).

Clause 4 of the April Agreement provided:

In the case [Palermo] fails to pay any of the instalment[s] agreed, then, all the remaining amounts shall become due and as penalty [Palermo] will have to pay an amount equal to the amount pending IE [Palermo] will pay the double of the pending amount at the moment of the fail on the payment.

Clause 6 provided:

any question aris[ing] from this agreement will be submitted to the [Court of Arbitration for Sport (“CAS”)] according to Swiss Private law. The file shall be conducted in English and decided by a panel composed by three members.

The sum of €6.72 million was not paid and Pencil Hill filed for arbitration, claiming €6.72 million and the clause 4 penalty sum under the April Agreement, together with €1 million due under the August Agreement.

The arbitration award

Palermo was directed to pay €9.4 million (plus interest), comprising €6.72 million due under the April Agreement, €1 million due under the August Agreement and a reduced amount (in place of the clause 4 penalty) of €1.68 million, which was 25% of the claimed penalty. Under the Swiss Code of Obligations, a judge must reduce a contractual penalty which is considered excessive. In this case, the arbitral panel found the original penalty to be “disproportionate and unfair”. The reduced penalty was upheld by the supervising Swiss court on appeal.

Enforcement in England

Pencill Hill sought to enforce the award in England. The issue for the court was whether it should refuse to allow enforcement of the reduced penalty sum on the ground that to do so would be contrary to public policy.

Section 103 of the Arbitration Act 1996 (the Act) deals with enforcement of arbitration awards in the English courts, mirroring the relevant provisions of The Convention on the Recognition and Enforcement of Foreign Arbitral Awards (the Convention), to which the UK is a contracting state. The Act applied to the award in this case because Switzerland is also a signatory.

We have come to expect an arbitration-friendly approach from the English courts and they have a general duty under section 103 of the Act to enforce Convention awards. The Convention is intended to ease the enforcement process and the grounds for refusing enforcement are therefore limited to an exhaustive list, including that enforcement may be refused under section 103(3) “if it would be contrary to public policy to recognise or enforce the award”.

The judge pointed out that the Act is founded on a number of principles set out at section 1, including (at section 1(b)) “the parties should be free to agree how their disputes are resolved, subject only to such safeguards as are necessary in the public interest”. The Act is to be construed with the section 1 principles in mind.

The rule against contractual penalties

The UK Supreme Court recently restated the English law on penalty clauses in Cavendish Square Holding BV (Appellant) v Talal El Makdessi; and ParkingEye Limited v Beavis [2]. Parties wishing to pre-emptively protect themselves often agree what are known as liquidated damages clauses, which specify in advance the consequences that will flow from a party’s breach. Liquidated damages clauses usually provide for the breaching party to pay a pre-determined sum of money to the innocent party. However, to the extent that such a clause is a penalty, the common law rule against penalties provides that it will be unenforceable.

In this case, the judge noted that the Makdessi decision explains in the clearest terms that the rule against enforcement of penalties is a rule based on public policy. In Makdessi, Lord Hodge described the correct test for a penalty as “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”.

The parties’ arguments

Both parties accepted that, in considering whether to refuse enforcement, it is English public policy that is at stake and not the public policy of any other country.

Palermo accepted that the test to be applied is a “rigorous one”. It argued that the nature of the penalty clause was “sufficiently injurious” to justify refusal. Makdessi makes it clear that the rule against penalties is firmly a matter of public policy and, even after reduction of the amount of the penalty by the arbitral panel, there remained a penalty which the English courts should not enforce.

Pencil Hill submitted that allowing enforcement involves a balance between, on the one hand, the desirability of finality in international arbitration and on the other, public policy considerations concerning penalties. There is a hierarchy of public policy considerations and the domestic public policy requirement to refuse to enforce penalties was insufficient to tip the balance against enforcement.

It relied on the fact that a Swiss court had upheld adjustment of the penalty so that, in the eyes of that court, the “penalty” was no longer “excessive”. The parties had agreed on a governing law – Swiss law – which would allow (and which resulted in) a rewriting of the penalty clause and had agreed that disputes should be dealt with by arbitration in the same jurisdiction – Switzerland.

Conclusion

Having considered the various authorities on this issue, the judge ruled that the award should be enforced in its entirety. It was clear that there is a strong leaning towards the enforcement of foreign arbitration awards and the circumstances in which the English courts may refuse enforcement are narrow. He found that the “scales are tipped heavily in favour of enforcement” – the public policy of upholding international arbitration awards outweighed the public policy of refusing to enforce penalty clauses [3].

The judge observed that if the public policy arises by the application of “domestic principles”, then enforcement of a contract performed out of the jurisdiction will not necessarily be refused. In Westacre Investments Inc. v Jugoimport-SDPR Holding Co and others [4], it was decided that if a contract fell into that category, it would need to be established that performance was contrary to the public policy of the place of performance before the English courts would refuse to enforce it: “It is legitimate to conclude that there is nothing which offends English public policy if an arbitral tribunal enforces a contract which does not offend the domestic public policy under either the proper law of the contract or its curial law [procedural law of the arbitration], even if English domestic public policy might have taken a different view.

This was in contrast to the position where the public policy arises by the application of “universal principles”. In Lemenda Trading Co. v African Middle East Petroleum Co Ltd [5], it was held that where a contract infringes a “universal principle of morality” it would not be enforced by the English courts no matter what its governing law or the law of the place of performance might be. Examples are contracts based on “universally condemned activities” including “terrorism, drug trafficking, prostitution or paedophilia”.

In this case, the rule against enforcement of penalties did not protect a “universal principle of morality” and was not so clearly “injurious to the public good” that enforcement should be refused. It was necessary then to go on to consider the position under the governing law as applied by CAS and the Swiss supervising court. It was particularly important to note that the parties had chosen a governing law which empowered its courts to interfere with a penalty by reducing it, so that the payment obligation was no longer objectionable under the governing law.

The judge found that there was a second strong reason to enforce in this case; the variation of the payment obligation changed the nature of the obligation in the eyes of Swiss law, from a penalty to a non-penalty. This meant that, rather than upholding a penalty, Swiss law had removed a penalty and replaced it with an obligation to pay a sum which it regarded as neither exorbitant nor unconscionable.

WM Comment

While the judgment does not go so far as establishing a general principle on this issue, it confirms the arbitration-friendly approach of the English courts. Practically, parties should be careful to ensure that any liquidated damages clauses are suitably drafted to avoid falling foul of the governing law of the contract.