Précis - The case of Imam-Sadeque v BlueBay Asset Management (Services) Ltd [2012] provides a useful summary of the case law on the penalty doctrine.

What?

The Claimant in the case of Imam-Sadeque v BlueBay Asset Management (Services) Ltd [2012] argued that a forfeiture of a bonus was an unenforceable penalty.

So What?

During the decision, the Court considered the case law on the penalty doctrine which is considered below.

The Claimant was employed by the Defendant. On leaving his employment he entered into a compromise agreement, which provided that if he complied with the terms of both the compromise agreement and his employment contract during a period of garden leave he would be deemed to be a “good leaver” and therefore entitled to financial awards under deferred incentive plans (the “bonus plans”).

The Claimant was found to be in repudiatory breach of the compromise agreement, the employment contract and an implied duty of fidelity by assisting in setting up a competitive business, recruiting an employee of the Defendant to work for that business and disclosing confidential information to that business.

One of the arguments that the Claimant ran to try to claim that he remained entitled to the bonus plans despite the repudiatory breach, was that the forfeiture of the bonus plans was unenforceable as a penalty. In making a decision on this claim the Court considered and summarised the case law on the penalty doctrine, which is helpful in a commercial context. In summary, it concluded the following:

  • The doctrine renders unenforceable a contract term under which a contract breaker is required to pay a sum upon breach which is regarded as a penalty. A penalty does not have to be a sum of money; it can also be the transfer of property or money’s worth. The doctrine also extends to terms which provide that the contract breaker is to forfeit sums to which he is entitled, or would otherwise have been entitled, from the innocent party.
  • The doctrine does not apply to cases where a sum is payable on an event other than breach.
  • Contract terms whose predominant function is to deter breach of contract, rather than to compensate the innocent party in the event of a breach, fall within the category of unenforceable penalties.
  • However, the two-fold categorisation of deterrence or compensation is not a rigid test to be applied in all cases; there are clauses which may fall into neither category but which are commercially justifiable. The Court did not regard the commercial justification test as different from the classic test of whether or not the clause was “extravagant or unconscionable… in comparison with the greatest loss that could conceivably be proved to have followed from the breach”.
  • When considering the commercial justification test:
    • it will be easier to justify a provision for the payment of a single sum on any breach (where the potential breaches and their consequences may be of different severity) where the loss which might foreseeably be caused by the breach may be difficult to quantify or prove or where it might not otherwise be recoverable in law, as in that circumstance rendering the clause unenforceable would involve injustice to the innocent party;
    • the Court must take account of all the terms of the bargain, the circumstances of the parties and the other terms of the contract. The relative sophistication and bargaining power of the parties are also relevant.

The Court held that the compromise agreement did not attract the application of the penalty doctrine. That agreement did not provide that the Claimant would forfeit his interest in the bonus plans upon breach of the agreement. Rather, it conferred a conditional benefit on him in relation to his interest in the bonus plans and that benefit never accrued because he failed to fulfil the condition, i.e. performance of the agreement.