In our last briefing, we referred to the Supreme Court’s ruling in Cavendish Square Holding BV v El Makdessi and ParkingEye Ltd v Beavis, which reformulated the law on penalty clauses. The High Court in Hayfin Opal Luxco 3 SARL & another v Windermere VII CMBS plc [2016] EWHC 782 (‘Hayfin’) has now made a further statement on the enforceability of such clauses, which set out to agree the payment of a sum (the ‘secondary obligation’) on breach of a contractual obligation (the ‘primary obligation’). The enforceability of clauses providing for the repayment of sums or for the payment of an agreed sum in the event of breach will have particular significance for financial services firms.

Read the full case report here.

What is a penalty clause?

In essence, where the parties to a contract agree to a sum being paid where a primary obligation is breached, this sum can either be enforceable as a liquidated damages clause (an assessment of the loss to be suffered in the event of breach) or unenforceable as a penalty clause. If the clause is a penalty clause, the innocent party’s recourse is to sue for damages rather than to enforce the contractual term. Unfortunately, the line between what is a liquidated damages clause and what is a penalty clause has become blurred over time. Clearly, if an agreed sum is so extravagant as to have no link with what could be the maximum loss suffered by the injured party, this is likely to be a penalty clause. However, sometimes a clause might be enforceable where it is commercially justifiable and it is here that the waters have become muddied.

Penalty clauses ‘re-formulated’: Cavendish

The Supreme Court in Cavendish and ParkingEye, two joined cases, noted that the penalty rule was ‘an ancient, haphazardly constructed edifice which has not weathered well’. A new test was put forward so that a clause would be classified as a penalty if:

  • the sum was extravagant and unconscionable in amount in comparison with the greatest loss that could conceivably be proved to have followed from the breach
  • the breach resulted only in the non-payment of money and the clause provided for a sum greater than this
  • the sum was payable in a number of events of varying seriousness (although this is a presumption that is rebuttable in certain circumstances)

A clause should not be treated as a penalty clause only because it is impossible to precisely pre-estimate the true loss.

The Supreme Court recognised that liquidated damages clauses are sometimes set at a higher sum because the effect of the breach on business is potentially more far-reaching than just the monetary loss. This is termed ‘commercial justification’. The Supreme Court held that this was a justifiable basis for a penalty clause and that the new test for a liquidated damages clause should be whether the secondary obligation imposes a detriment on the contract-breaker which is out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation.

Hayfin: ability to pay is irrelevant

In Hayfin the High Court had to consider the interpretation of rights attaching to a ‘Class X Note’ in a commercial mortgage-backed securitisation structure, in particular whether an interest rate provision was void as a penalty. The case was decided on another point but the court considered whether, if the underpayment of the Class X Interest Amount (as defined in the relevant agreement) in any relevant interest period triggered an obligation to pay interest at the Class X interest rate, that provision would be void as a penalty. If this clause were to be enforceable, the unpaid sum would be multiplied by a sizable factor which would be many times more than would compensate the innocent party. The court referred to the law as re-stated in Cavendish and, whilst it did not rule on whether the clause fell foul of the penalty rule, it noted that whether a clause was a penalty could not depend on the ability of the contract-breaker to pay. Equally, the innocent party could not argue that because the contract-breaker could easily afford to pay, he should do so.

Drafting points for liquidated damages clauses

  • decide whether the sum payable is a genuine pre-estimate of loss or whether it is a sum which is otherwise commercially justifiable
  • if the sum is a genuine pre-estimate of loss, ensure that the figure has been calculated as accurately as possible
  • if the sum is commercially justifiable, consider what your legitimate interest in the performance of the contract is and specify this
  • be clear as to what your primary and secondary obligations are: do not confuse these. Repayment must only occur on the breach of a primary obligation
  • do not include provision for payment of the stipulated sum on the occurrence of a number of events of varying gravity
  • ask yourself: is this sum exorbitant or unconscionable? If it is, it will be a penalty clause