Facts

E-Nik Ltd (the “Claimant”) was an information technology services company, which entered into a contract with the Department for Communities and Local Government (the “Defendant”) to provide consultancy personnel to help with the Government’s information technology systems (the “Contract”).

The term of the Contract was 2½ years and it had not been drafted by lawyers. The relevant terms of the Contract were:

“2. AUTHORITY’S OBLIGATIONS

2.1 The Authority hereby undertakes to purchase minimum of 500 days of Consultancy from the Supplier per year based on project requirement, additional days will be required once the purchased days have been exhausted.

2.2 The Authority shall issue an Assignment Note to requisition Services from the Supplier.

2.3 The Authority shall pay the Supplier fees at the rate of not less than £850 per day but subject to mutually agreed assignment notes for each change request. …

….

3. SUPPLIER’S OBLIGATIONS

3.8  Supplier is obliged to provide concise accounts of resources used on a monthly basis as an excel document which shows work priorities, days used, days remaining and days purchased.”

An issue arose when the Defendant failed to use all the “500 days of Consultancy”. The Claimant invoiced for the balance of the 500 days. The Defendant disputed the invoices issued for those days. The parties both sought summary judgment against the other on the meaning and interpretation of the Contract, including (i) whether the sums allegedly due for unused days were a debt (or damages) and (ii) whether the claim for such sums was for an unenforceable penalty. 

Held

The court decided that the sum allegedly due should be characterised as a debt, not damages. The Defendant had to pay for the 500 days’ worth of services. It follows that the Claimant was entitled to issue an invoice for the balance of the 500 days services. In reaching this conclusion, Burton J found that the Claimant was required to continue to keep services available to the Defendant. This was why the Claimant had to keep account of and update the Defendant about the remaining days. As a consequence, the Defendant was receiving a service for its consideration.

The Claimant then relied upon Jervis v Harris [1996] Ch 195 in support of the proposition that the rule against penalties does not apply to a claim for debt (as the court had found the claim to be).

The Defendant, however, relied upon Burton J’s decision in M & J Polymers Ltd v Imerys Minerals Ltd [2008] EWHC 344 (Comm), in which the court concluded that in principle a “take or pay” clause might qualify as a penalty clause.

Burton J decided that “I am entirely satisfied that in the context where the Claimant had to, and did, keep available the wherewithal to provide the consultancy services as called off throughout the entire term, at rates which… were at or below the rates regularly charged by the Claimant to the Defendant, these clauses were commercially justifiable, did not amount to oppression, were negotiated and freely entered into between parties of comparable bargaining power and did not amount to a provision in terrorem. The Defendant has not produced any evidence to support a converse proposition.”

It follows that Burton J decided that (i) the “take or pay” clause in the Contract could in principle be an unenforceable penalty (although does not expand upon reasons), but (ii) in, this case, the clause was commercially justifiable and not a penalty on the facts.  

Comment

The reasoning of Burton J relating to whether the clause is a penalty is contained within one paragraph of the judgment. However, Burton J’s analysis appears to be based upon the same reasoning in M & J Polymers Ltd v Imerys Minerals Ltd.

The two points for the energy industry, and others, to note are that:

  • in both cases the “take or pay” clause was held to be reasonable and enforceable; and
  • with respect to the judge, the question of reasonableness ought not to have arisen at all, had a different approach been adopted by the court to the distinction between an action for a debt and one for damages.

Reasonableness

The case law on penalties is set out in Alfred McAlpine Capital Projects Ltd v Tilebox Ltd [2005] EWHC 281 (TCC), which confirms that “the courts are predisposed, where possible, to uphold contractual terms which fix the level of damages for breach.  This predisposition is even stronger in the case of commercial contracts freely entered into between parties of comparable bargaining power”. In that case Jackson J surveyed the law on penalties and came to the following conclusions:  

  • A damages provision is not a penalty if it is a genuine pre-estimate of damages;
  • The process of considering whether a pre-estimate is genuine is primarily objective, however the courts have some regard for the thought process of the parties.  
  • A pre-estimate will not be unreasonable, and therefore will be enforceable, unless there is a “substantial discrepancy between the level of damages stipulated in the contract and the level of damages which is likely to be suffered”.
  • The courts are predisposed to upholding fixed levels of damages agreed between parties.  
  • There are very few recent cases where a provision was found to be a penalty and in these cases there was a wide discrepancy between the level of damages stipulated in the contract and the level of damages suffered. 

In E-Nik Ltd v Department for Communities and Local Government it was taken into account that the supplier had to keep available the wherewithal to provide the services as required throughout the term of the Contract. Sellers in the energy industry will very often have a similar obligation to keep available the supply as required. Take or pay payments are connected to the contract price that the buyer would pay anyway. They are rarely drafted to provide any uplift (or penalty) element for the seller.

The most important message based on the findings in the two cases above is that, if subjected to any test of reasonableness, the most common “take or pay” clauses appear very likely to be held to be enforceable.

The more interesting question is whether “take or pay” clauses ought to be subjected to a test of reasonableness at all.  It is in the distinction between an action for a debt and one for damages that the problem would appear to arise.

Debt or damages?

If the action is for a debt, the rule against penalties should not arise. This is because penalties only arise upon a breach of contract, and a breach of contract is a requirement of a damages action (and not a debt action). 

Burton J’s judgment in E-Nik Ltd v Department for Communities appears to suggest that in M & J Polymers Ltd v Imerys Minerals Ltd the court decided that the sum due was a debt and not damages, which is not obvious from that decision. A plain reading of Burton J’s reasons suggest that he categorised the claim as a damages claim. Alternatively, that the facts of that case could give rise to a parallel debt and damages claim. This was because, according to the judge, the event that would give rise to a debt claim also “amounts to a breach of duty” (the failure by the buyer to order the product or services).

In E-Nik Ltd v Department for Communities, the judge also appears to have held that the buyer’s failure to order the services was a breach that might allow a parallel debt and damages claim. Although this distinction is not directly addressed, Burton J refers to “the repudiatory failure by the Defendant to call off/request the minimum 500 days’ services”, suggesting that the failure by the buyer to order the product or services is a breach of contract (allowing a claim in damages).

It may be that the judge was not assisted by the Defendant, which naturally sought in its submissions to emphasise the argument that the obligation to take the services only arose upon the Defendant’s request, so as to present the Claimant’s claims as a damages action and allow it to introduce the test of reasonableness.

In the authors’ view, it is unhelpful to hold that a possible parallel damages claim might allow a debt claim to become subject to the rule on penalties. It is unhelpful to hold that if a claim for a debt is contingent on the occurrence of a breach, in parallel with any performance, the rule on penalties applies. The focus ought not to be on a “specified event” (the buyer’s obligation to order the services) but on a “specified obligation” (the seller’s obligation to provide the services). It is the “specified obligation” rather than the “specified event” that is the contractual performance for which the debt is due. 

With respect to the court, this parallel approach blurs the distinction between debt and damages actions. If a claimant can frame his case as a debt claim, he will do so, to get uplifted interest and to avoid arguments about reasonableness of loss and mitigation. If he does so, the rule on penalties ought not to apply. Applying the rule to debts due for goods or services rendered, as well as damages claims, would appear to be without proper legal foundation, as the authors argued in “Enforceability of Take-or-Pay Provisions in English Law Contracts” (2008) 26(6) JENRL 610.

Protective steps

In the interim, energy companies can take the following steps to mitigate the risks arising from these two cases:

  • Where there is no commercial imperative for the buyer to be compelled to take the product, it may be advisable for contracts to make clear that the buyer “may” order quantities of the product, rather than imposing any obligation on the buyer that it “will” or “shall” place minimum orders. If the contract states “may” it should not be a breach of contract to fail to order the quantity.
  • Where a party has made a payment under a “take or pay” provision, having not taken the goods but is entitled, through “make-up” provisions, to take the goods at a later date, it would be extremely difficult to construe the sum paid as arising out of a breach, since the paying party is simply making a payment for the future performance of an obligation.