It can only be a penalty where the trigger for payment is a breach of contract and not just an occurrence of an event.
Sports clubs amongst others should take note of the Henning Berg v Blackburn Rovers FC 1 case when drafting and seeking to enforce a service agreement involving payments for breach or early termination (as commonly apply to manager’s service agreements and long term supply contracts).
More generally, this case serves as a neat reminder to all on the common misunderstandings of the law on penalties. A contract term is only a penalty if the payment is triggered by a breach of contract and not simply the occurrence of an event which is provided for under the contract.
Background: Liquidated damages and penalty clauses generally
Many have grappled with the dichotomy between liquidated damages clauses on the one hand and penalty clauses on the other.
A valid liquidated damages clause is a genuine pre-estimate of loss compensating a party for a breach of contract.
A penalty clause is where there is no genuine pre-estimate of loss and is extravagant or oppressive (sometimes with its predominant purpose being to deter or punish breach of the contract).
Liquidated damages clauses are enforceable, while penalty clauses are not enforceable.
Recent case law
Recent case law (Cavendish Square Holdings BV v El Makdessi 2) appears to have expanded this assessment of whether a clause is a penalty by introducing the concept of “commercial justification”. For a clause to be a penalty there should be no commercial justification for its inclusion in the agreement. In light of the decision in Cavendish Square Holdings, it can be said that the current test for whether a clause is a penalty is:
- There is no commercial justification for inclusion of the clause
- The clause is extravagant or oppressive (it is not a genuine pre-estimate of loss).
- The purpose of the clause is to deter breach
- The provision was not negotiated on a level playing field
In any event a clause can only be a penalty where it addresses the consequences of a breach of contract. In the House of Lords case of Export Credits Guarantee Department v. Universal Oil Products Company3 Lord Roskill held that a clause that provides for payment of money upon a specific event happening (for example early termination of a contract) which is not a breach of contract (as it is provided for under the terms of the agreement) is not a penalty. He explained [at page 403]:
“.. the main purpose, of the law relating to penalty clauses is to prevent a plaintiff recovering a sum of money in respect of a breach of contract committed by a defendant which bears little or no relationship to the loss actually suffered by the plaintiff as a result of the breach by the defendant. But it is not and never has been for the courts to relieve a party from the consequences of what may in the event prove to be an onerous or possibly even a commercially imprudent bargain.”
In November 2012 Blackburn Rovers’ Managing Director Derek Shaw, signed a service agreement on behalf of Blackburn, appointing Henning Berg as Manager for a fixed term until June 2015. Clause 15.3 stated that:
“In the event that the Club shall at any time wish to terminate this Agreement with immediate effect it shall be entitled to do so upon written notice to the Manager and provided that it shall pay to the Manager a compensation payment by way of liquidated damages in a sum equal to the Manager’s gross basic salary for the unexpired balance of the Fixed Period assuming an annual salary of £900,000.”
In December 2012, Blackburn terminated the agreement with Berg with immediate effect. Berg claimed £2.25m was owed to him under Clause 15.3 representing the remainder of his salary for the fixed term. When this was not forthcoming, Berg issued proceedings against Blackburn for breach of contract in February 2013.
Blackburn initially admitted liability then u-turned, seeking to withdraw its admission of liability based upon the defence that clause 15.3 amounted to a penalty clause and therefore was invalid. Blackburn also mounted the unattractive argument that Shaw acted as a rogue director without the authority to bind Blackburn in the contract (as he was only authorised to enter contracts for up to 12 month terms).
The judge, HHJ Pelling QC, followed the decisions in Export Credits Guarantee Department that payments becoming due on the occurrence of an event provided for under the contract rather than a breach of contract do not amount to a penalty clause. The judge explained:
“In a fixed term contract a party is either entitled to terminate before expiry of the fixed term or it is not. Here it is. Once that is understood the law relating to penalty clauses is entirely immaterial.”
The judge therefore dismissed the first defence. As to the second defence, there was just no evidence to suggest Shaw was not authorised to act as he did and the defence was dismissed. Blackburn Rovers was ordered to pay the outstanding balance due to Berg under the contract.
The judge in this case stated that the law on penalties is often misunderstood. To avoid the penalty debate, early termination clauses such as Clause 15.3 which provide for a payment upon its trigger, should not be described as “liquidated damages”. Damages are only relevant to a breach of contract. A clause can only be a penalty if related to a breach of contract. The payment under Clause 15.3 was a debt and so more accurately described as an early termination payment or similar.
Two further interesting points arise in this case with regard to the judge’s comments on Blackburn’s application to withdraw their admission of liability:
Firstly the judge considered that if Blackburn was given permission to withdraw its admission, a summary judgment application (that would no doubt follow) would be bound to succeed. There was therefore no need to consider further the court’s discretion to allow the application to withdraw. The application was therefore dismissed.
Secondly the case is of particular interest for its warning regarding the courts’ approach to applications for the withdrawal of liability in light of the Jackson civil litigation reforms. The judge warned that the Jackson reforms “radically amended” the Overriding Objective and that the courts’ approach to applications for the withdrawal of an admission of liability will be far more rigorous than before, particularly where formal admissions are made with the benefit of legal advice.