backThe UK Supreme Court has recently clarified the English (and Scottish) law on penalties in the (joint) appeals in Cavendish Square Holding BV v Talal El Makdessi ( Cavendish ) and ParkingEye Ltd v Beavis[2015] UKSC 67 ( ParkingEye ). The Supreme Court resisted calls to abolish the rule against penalties altogether, or at least in relation to commercial transactions, and confirmed that the existing law on penalties remains good law. However, their Lordships clarified that the correct test for determining whether a provision is penal is 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 partys interest in the performance of the contract (per Lord Hodge). In clarifying the correct test in those terms, their Lordships emphasized that such a test does not reflect, if it ever did, a mutual exclusivity between a penalty and a genuine pre-estimate of loss. The Supreme Court also confirmed that the rule against penalties applies to forfeiture clauses.
The Facts
In Cavendish, the parties entered into a share purchase agreement ( SPA ) in relation to shares in an advertising and marketing communications company in the Middle East. The sellers were two founding partners of the business, and the buyer was a major international advertising company. The purchase price included a significant element of goodwill; and the payment terms provided for part of the consideration to be deferred and payable in two installments. The sellers agreed to observe certain restrictive covenants ( e.g., non-compete, non-solicitation etc.) aimed at protecting the goodwill of the company. The SPA further provided that upon breach of the restrictive covenants, the sellers would (i) lose their entitlement to the deferred consideration, and (ii) at the buyers option, be required to sell the remainder of their stake in the company at a price excluding any element of goodwill. One of the sellers, Mr Makdessi, breached the restrictive covenants, and the buyer, Cavendish, sought to enforce the above provisions. As a result, Mr Makdessi was to lose more than $44 million. Mr Makdessi admitted breaches of the restrictive covenants, but claimed that the relevant provisions were unenforceable as penalties because they did not represent a genuine pre-estimate of loss.
ParkingEye concerned an 85 parking charge levied against Mr Beavis by a car park manager, ParkingEye Ltd, for exceeding its two-hour free parking limit. One of Mr Beaviss grounds for resisting the parking charge was that it amounted to an unenforceable penalty.
The Correct Test
The Supreme Court judgment is of considerable length and detail, with the three main speeches delivered by Lord Neuberger and Lord Sumption (jointly), Lord Mance, and Lord Hodge (also commenting on Scots law). The main point on which all Law Lords agreed is that the law on penalties remains good law, and that it should neither be abolished (partially or altogether), nor extended to provisions that operate other than on a breach of contract.
However, their Lordships clarified that the relevant test is broader than the question of whether the stipulated sum represents a genuine pre-estimate of loss (as per the second proposition of Lord Dunedin in Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd[1915] AC 79 ( Dunlop ), at [86]). As Lord Mance explained, the dichotomy between the compensatory and the penal is not exclusive. There may be interests beyond the compensatory which justify the imposition on a party in breach of an additional financial burden (at [152]). Similarly, Lord Hodge stated that where the test is to be applied to a liquidated damages clause, a disproportion between the stipulated sum and the highest level of damages that could possibly arise from the breach remains relevant, however, in other circumstances, the contractual provision that applies on breach is measured against the interest of the innocent party which is protected by the contract and the court asks whether the remedy is exorbitant or unconscionable. (at [255], see also Lord Neuberger and Lord Sumption, at [32]).
In arriving at that conclusion, their Lordships emphasized that Lord Dunedin himself recognized that his propositions might be neither helpful nor conclusive in a particular case and that the essential question was whether the relevant provision was unconscionable or extravagant (Lord Hodge at [221], see also Lord Neuberger and Lord Sumption at [22]). Indeed, it was recognized in Dunlop itself that the clause in question (which was upheld) did not purport to be a pre-estimate of loss, its true object being to prevent the disorganization of[Dunlops] trading system and the consequent injury to their trade in many directions (per Lord Atkinson, at [92]). Their Lordships also drew (amongst other things) on the reasoning in a trio of authorities preceding Dunlop: the House of Lords decision in Clydebank Engineering & Shipbuilding Co Ltd v Don Jose Ramos Yzquierdo y Castaneda [1905] A.C. 6, and the two decisions of the Privy Council in Commissioner of Public Works v Hills [1906] A.C. 368 and in Webster v Bosanquet [1912] A.C. 394.
In addition, their Lordships found support for their conclusion in a number of more recent cases, and in particular in the commercial justification line of authorities (in particular, Lordsvale Finance Plc v Bank of Zambia [1996] Q.B. 752 ( Lordsvale ), United International Pictures v Cine Bes Filmcilik ve Yapimcilik AS [2003] EWCA Civ 1669 ( Cine Bes ) and Murray v Leisureplay Plc [2005] EWCA Civ 963) ( Leisureplay )). The decision of Colman J in Lordsvaleis of particular note. In that case, the judge upheld a provision in a loan agreement which provided for an increase in the rate of interest following a default in payment. The commercial justification for that provision was that once a debtor defaulted on its payment obligations, it represented a higher credit risk. Lord Neuberger and Lord Sumption stated that the emphasis on justification provides a valuable insight into the real basis of the penalty rule, namely that a damages clause may properly be justified by some other consideration than the desire to recover compensation for a breach (at [26], see also the discussion per Lord Mance at [146], and per Lord Hodge at [222]).
Whilst each of the three main speeches in Cavendish provides its own formulation of the correct test, the essence of the test remains the same. Lord Neuberger and Lord Sumption stated, at [32]:
The true test is whether the impugned provision is a secondary obligation which imposes a detriment on the contract-breaker out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation. The innocent party can have no proper interest in simply punishing the defaulter. His interest is in performance or in some appropriate alternative to performance.
Lord Mance, at [152] said this:
What is necessary in each case is to consider, first, whether any (and if so what) legitimate business interest is served and protected by the clause, and, second, whether, assuming such an interest to exist, the provision made for the interest is nevertheless in the circumstances extravagant, exorbitant or unconscionable. In judging what is extravagant, exorbitant or unconscionable, I consider (despite contrary expressions of view) that the extent to which the parties were negotiating at arm's length on the basis of legal advice and had every opportunity to appreciate what they were agreeing must at least be a relevant factor.
Similarly, Lord Hodge, referring to the overriding test of exorbitance (at [246]), stated, at [255]:
[T]he correct test for a penalty is 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.
Applying the test to the facts in Cavendish, their Lordships concluded that the SPA provisions disentitling Mr Makdessi from receiving the deferred consideration and requiring him, at Cavendishs option, to sell his remaining shares at a value excluding any element of goodwill served to protect Cavendishs interest in measuring the price of the business to its value (per Lord Neuberger and Lord Sumption, at [75] and [82], see also Lord Mance, at [181] and [183]) and protecting the value of the companys goodwill (per Lord Hodge, at [274]).
It is worth pointing out, however, that Lord Neuberger and Lord Sumption concluded that the withholding clause and the option clause in the SPA were primary obligations, as they in effect were price adjustment clauses which were not concerned with providing a pre-estimate of loss (at [74] and [83]). Lord Mance appears to agree with that conclusion (at [183]). However, Lord Hodge construed those provisions as secondary obligations (at [270] and [280]). Given that each of Lord Clarke and Lord Toulson agreed with the analyses of Lord Hodge on the one hand and the other Law Lords on the other hand, the overall position appears to be that the provisions in Cavendish are to be viewed as primary obligations. Whilst this difference of opinion did not in the event result in different decisions as to the enforceability of those clauses, it points to a likely analytical difficulty with which the parties in future cases might expect to have to grapple.
In ParkingEye, their Lordships upheld the 85 parking charge on the basis that ParkingEyes legitimate interest in imposing it was (i) to maximize traffic in the car park for the benefit of the car park owner, the retailers and the shoppers, and (ii) to provide funds for the operation of that parking scheme.
Further Considerations
In addition to clarifying the correct test for penalties, the decision in Cavendishis notable for confirming and clarifying a number of other issues. First, it confirms that the rule against penalties is not restricted in its application to clauses requiring payment of money (such as liquidated damages clauses and take-or-pay provisions[1]), but also applies to clauses providing for withholding of money or property, and to clauses requiring payment of money or transfer of property (Lord Mance at [170], Lord Hodge at [226]-[238]).
Secondly, insofar as clauses providing for the withholding of money (or property) otherwise due are concerned, such as the withholding clause in Cavendishor the suspend and withhold provisions in a building subcontract in Gilbert-Ash (Northern) Ltd v Modern Engineering (Bristol) Ltd [1974] A.C. 689 , their Lordships confirmed that such clauses, whilst they might be construed as forfeiture clauses, are nevertheless subject to the rule against penalties (albeit that Lord Neuberger and Lord Sumption were not prepared to decide the point in Cavendishat [69]-[73]).
The correct approach to forfeiture clauses is to determine first whether it is penal, and if it is not, then, secondly, to consider whether equitable relief against forfeiture should be granted (per Lord Mance, at [160]-[161] and Lord Hodge, at [227]-[228], with whom both Lord Clarke and Lord Toulson specifically agreed). In this regard, Lord Hodges discussion in relation to non-refundable deposits is especially helpful as it confirms that the rule against penalties might apply to deposits: a deposit which is not reasonable as earnest money may be challenged as a penalty (see [234]-[238], see also Lord Mance at [170]). In practical terms, this decision opens up the possibility for those resisting a forfeiture clause to have two bites at the cherry, first, challenging it as a penalty, and then seeking relief from forfeiture.
Thirdly, whilst resisting the call formally to abolish the rule against penalties as between sophisticated commercial parties, their Lordships gave considerable weight to the fact that the parties in Cavendish were sophisticated business people with the benefit of expert legal advice (Lord Neuberger and Lord Sumption at [75], Lord Mance at [152] and [181], and Lord Hodge at [274] and [282]). This suggests that the parties relative bargaining power and legal advice that they receive will be an important factor in construing an alleged penalty clause. In practice, this will likely mean that in a commercial context, it will become even more difficult to challenge a provision as penal.
Fourthly, their Lordships expressly recognized that parties might seek to circumvent the rule against penalties by careful drafting such that the relevant obligation to pay money (or right to withhold money or property) is expressed as a primary obligation. However, as Lord Hodge explained, in such circumstances the court would be able to rely on the concept of a disguised penalty: where it is clear that the parties have so circumvented the rule and that the substance of the contractual arrangement is the imposition of punishment for breach of contract, the concept of a disguised penalty may enable a court to intervene (Lord Hodge at [258]). Similarly, Lord Neuberger and Lord Sumption stated We do not doubt that price adjustment clauses are open to abuse, and if clause 5.1 were a disguised punishment for the Sellers breach, it would make no difference that it was expressed as part of the formula for determining the consideration (at [77]). These warnings make it clear that the potentially difficult distinction between primary and secondary obligations is one of substance and not form, and that it cannot be resolved, at the negotiations stage, simply by means of careful drafting.
Practical Implications of a General Nature
Drafting considerations
There are a number of practical implications of the renewed emphasis on the legitimate interest and its proportionality to the remedy for breach of contract. The question that the parties and their advisors need to ask themselves is whether the relevant provision (be it a liquidated damages clause, take-or-pay provision, price adjustment clause or other) imposes a detriment on the contract-breaker out of all proportion to any legitimate interest of the innocent party (per Lord Neuberger and Lord Sumption, at [32]). It may make sense for transactional lawyers to encourage their clients to include contractual language that identifies explicitly what interest is sought to be protected by such provisions and then include the parties acknowledgement that it is a legitimate interest. The decisions in Dunlop, Cavendish, Lordsvaleand other commercial justification cases might prove helpful in identifying and articulating the legitimate (non-compensatory) interest in any specific case. However, this is not a closed category and the relevant interest in each individual case will depend on the circumstances of the transaction.
Whilst such express identification of interest and acknowledgement will not be conclusive, they might help create the necessary presumption and assist the court in construing the relevant obligation and determining whether or not it is a penalty: a strong initial presumption must be that the parties themselves are the best judges of what is legitimate (per Lord Neuberger and Lord Sumption, at [35], see also [15]).
Further, given the considerable weight that the Supreme Court attributed in Cavendish to the relative bargaining power of the parties and the legal advice they received, it might also be helpful to record (either in the provision itself or in the recitals) that the parties negotiated at an arms length and with comparable bargaining power (if that is the case), and that each party received appropriate legal advice. Again, this will not be conclusive, but such language might further assist the court in construing the provision in question as being non-penal.
As noted above, the Supreme Court recognized that parties might seek to draft around the rule against penalties by expressing the relevant right to withhold money or property or obligation to pay money or transfer property as a primary obligation. Whilst it is important to bear in mind the Supreme Courts warning about disguised penalties, it might nevertheless be possible (and indeed advisable) in some instances to express such provisions as primary obligations arising, for example, upon the occurrence of an objectively ascertainable trigger event rather than as a secondary obligation arising upon breach of a primary obligation. It might also be helpful to try to integrate (such as through cross-referencing) the relevant right or obligation with other primary obligations, such as price determination formulae. However, as noted above, such drafting might be of little assistance if, in substance, it seeks to disguise a penalty: the purpose of the penalty rule depends on the substance of the term and not on its form or on the label which the parties have chosen to attach to it (per Lord Neuberger and Lord Sumption, at [15]).
What about existing contracts?
The reasoning of the Supreme Court in Cavendish makes it clear that clauses drafted to reflect a genuine pre-estimate of loss (such as typical liquidated damages clauses) will continue to be enforceable and Lord Dunedins test in Dunlop will remain applicable. Lord Neuberger and Lord Sumption explained at [32] that In the case of a straightforward damages clause, that interest will rarely extend beyond compensation for the breach, and we therefore expect that Lord Dunedin's four tests would usually be perfectly adequate to determine its validity. Lord Hodge made the same point at [255], and Lord Mance at [152]. In essence, Lord Dunedins test must be understood as a specific expression of the broader test as formulated in Cavendish.Therefore, insofar as straightforward liquidated damages clauses are concerned, the advice and drafting should proceed on the basis that Lord Dunedins test continues to apply. In more complex or unusual cases, it is possible that a party might have a further or alternative non-compensatory interest. In those cases, Lord Dunedins test might not apply. However, in all cases the overall test of exorbitance as formulated in Cavendish will apply.
Dispute Resolution
Cavendishwill have a number of practical implications for dispute resolution. The broader test of exorbitance will likely mean that those provisions that might traditionally have been considered penal on the basis that they do not represent a genuine pre-estimate of loss could nevertheless be held enforceable because they reasonably protect a legitimate interest. Given that the legitimate interest is not a closed category and will depend on the facts of the specific case, litigants might in the future be more hesitant to raise a penalty defense, whilst those relying on such clauses are likely to feel more confident that they will be upheld.
In terms of pleading a penalty, particularly in complex cases, the Cavendishtest will now frame the relevant issues of fact and law. Insofar as existing authorities are concerned, the cases on which the Supreme Court relied in reaching its decision will likely be of considerable assistance: in particular Clydebank, Hills, Dunlop(especially Lord Atkinsons speech) and the more recent line of authorities on commercial justification, including Lordsvale, Cine Besand Leisureplay.As explained above, Lord Dunedins propositions will remain applicable to straightforward liquidated damages clauses, although, it is possible that the parties might want to approach even such clauses using the broader language of the Cavendishtest.
The distinction between primary and secondary obligations, and the related question of disguised penalties, will likely prove to be a fertile ground for argument, given that the Supreme Court itself was split on whether the relevant provisions in Cavendishwere primary or secondary in nature. This potentially difficult distinction might be further blurred by careful drafting, with the practical result that even ostensibly primary obligations (such as conditions precedent or subsequent) might become vulnerable to attack as disguised penalties.
The Cavendishtest will likely result in a broader scope and nature of evidence gathering and disclosure, as the relevant enquiry is not restricted to the question of whether the stipulated sum is a genuine pre-estimate of loss. Similarly, the broader test in Cavendishmight mean that a wider range of questions than before might require expert evidence, such as market practice on setting a particular level of liquidated damages or operation of retention provisions in construction contracts.
Practical implications in an energy context
Liquidated Damages
Liquidated damages ( LDs ) play an important role in incentivizing performance and compensating for non-performance in many types of contracts for energy projects, such as construction contracts, power purchase agreements and gas sale and purchase agreements. LDs in such context usually fall broadly into the categories of delay LDs and performance LDs. In providing for a pre-agreed quantum of damages for each relevant period of delay or performance shortfall, the main purpose of LDs is to provide certainty of outcome in the event of contractual non-performance without the innocent party needing to prove its loss or substantiate the extent of damages. The rule on penalties undermines that certainty insofar as gives the court the right to interfere with the parties freedom of contract in agreeing to predetermined outcomes for contractual breaches. Parties often seek to mitigate against such interference by including an acknowledgement by the parties that LDs amounts represent a genuine pre-estimate of loss even though the courts have made clear that such acknowledgement does not preclude a finding that LDs are penal.[2] Recognizing that the courts will focus on substance over form, more sophisticated parties seek to assist the court by setting out the basis of calculations for the LDs amounts even if commercial considerations in some cases preclude sharing the calculations themselves (such as a desire not to share the relevant internal rate of return). Furthermore, often at the urging of lenders who like to leave nothing to chance, parties sometimes further protect themselves against the uncertain effects of an LDs clause being struck down as penal by including a so-called rescue clause following the LDs clause, which provides that general damages apply in the event of the LDs being found to be invalid, void or otherwise unenforceable.
Cavendish makes clear that liquidated damages need not necessarily reflect a genuine pre-estimate of loss provided that that they seek to protect legitimate interests in the commercial context of the transaction and that the amount of LDs is proportional to such interest and neither extravagant, exorbitant nor unconscionable. In energy transactions, parties seeking to take advantage of the extra latitude for LDs given by the new test would be well advised not only to explain the calculation of LDs but also include an explanation, and acknowledgement, of the proportionality of such LDs to a legitimate interest.
Energy M&A transactions commonly employ corporate agreements such as non-disclosure agreements and exclusivity agreements that often provide for LDs for breach of certain confidentiality and exclusivity provisions. LDs in such context can be less readily justified as a genuine pre-estimate of loss. This meant that corporate energy lawyers often attempted to draft around the penalties rule in such context by making payment of such LDs a primary obligation applicable upon the occurrence of specific triggers rather than as a secondary obligation arising upon breach of a primary obligation. We now know from Cavendishthat such approach is not failsafe given the courts focus on the substance over form. As such we recommend also in the context of these standard corporate agreements that parties seeking to take advantage of LDs include contractual provisions explaining the calculation of the LDs and an explanation, and acknowledgement, of how such LDs are proportional to a legitimate interest. The legitimate interest in the context of such agreements should be fairly easy to articulate, and is likely to include the protection of confidential information and trade secrets, as well as the value of the company that might be reduced or destroyed in the event of disclosure of such confidential information to an unauthorized party.
Take-or-pay clauses
The energy industry makes extensive use of take-or-pay clauses, which require the payment of a minimum amount for quantities of energy irrespective of the amount of energy actually taken. These appear in offtake contracts such as gas sale and purchase agreements, LNG supply or throughput agreements and power purchase agreements. Until recently most energy lawyers did not see any issues with the enforceability of such clauses under English law because of a view that the amount due for not taking a minimum quantity of energy constituted a debt rather than a monetary consequence of the breach of a primary obligation and hence did not engage the penalties rule. However, following the 2008 decision in M & J Polymers[3]and the 2012 decision in E-NIK[4], it became clear that take-or-pay clauses could potentially constitute penalties even if in both of those cases Burton J held that the clauses were commercially justifiable and therefore not penalties. Following those decisions, likely the first under English law to consider whether take-or-pay clauses constitute penalties, some lawyers and commentators concluded that the prudent approach was to avoid engaging the penalties rule by drafting the obligation to make the minimum payment as an alternative to taking and paying thereby avoiding engaging the penalties rule. While this drafting approach remains prudent, as noted above, Cavendish confirms that the court will look behind such clever drafting to the substance of the arrangement. Therefore, it seems clear that even if drafted in such a manner as to include options of performance rather than a payment upon a breach, the penalties rule may still be engaged. With that in mind, energy lawyers should keep in mind that the new legitimate interest test will apply to take-or-pay clauses under English law and may consider explicitly stating such interest in the relevant clause. For example, where the offtake contract relates to a project funded by project finance, the parties may refer to a legitimate interest in certainty of revenue for the seller and its lenders.
Withheld payments and retention
Construction contracts, offtake agreements and other agreements commonly used for energy projects commonly contain provisions which entitle one party to withhold payments if the other party does not fulfill a contractual obligation. Common examples in construction contracts include giving an owner a right to withhold payments if a contractor does not maintain its insurance policies and bank guarantees in accordance with contractual requirements, or a contractor does not comply with its reporting obligations in a timely manner. As noted above, Cavendish makes clear that the rule on penalties is engaged in such context, i.e. that the rule of penalties applies not only to specified sums being paid but also to sums withheld upon contractual breach. In each of the foregoing construction contract examples, it is difficult to establish the true loss of the innocent party. For example, if a contractor fails to deliver a health and safety plan on time, has there been any loss before an accident occurs? Lord Dunedins fourth test in Dunlop made clear that failure to show loss alone did not make the provision penal. Under the Cavendish test, care should be taken in drafting provisions allowing for withholding payments that they are in proportion to a legitimate interest. The drafting consequence of the Cavendishtest might be to allow for the withholding of payments due in whole, or in part, in proportion to the interest of the innocent party affected. Therefore, in a construction context where cash is king, it may be a penalty to withhold an entire payment of twenty five million dollars ($25,000,000) due for one months invoice for late delivery of a health and safety plan but not to withhold one million dollars ($1,000,000) of such amount to incentivize timely delivery of such plan.
The Cavendish test for penalties will also apply to the classic withheld payment in a construction contract, namely retention, according to which, during construction of a project, owners may retain portions of each progress payment to a contractor that will remain under the owners control until completion of the project. Owners using retention in construction contracts should be aware that the Cavendish test for penalties will apply to both the amount of retention and the conditions for its release. However, provided such amounts and conditions are proportional to an owners legitimate interest in seeing a contractor complete an assignment on time, on budget and as guaranteed, then such provisions are unlikely to be penal.
Termination payments in offtake agreements
Offtake agreements, particularly in project-financed projects, often contain provisions for buy-out of the plant assets following termination for a price that depends on the reason for the termination. The parties should be mindful of the Cavendishtest when negotiating such provisions, including when agreeing the applicable discount rate for the calculation of such payments.
Waiver Fees
Energy projects commonly deploy project finance, and project finance documentation contains a number of different applicable fees most of which are similar to fees in other finance transactions. Many of these fees (such as pre-payment, mandate fees and commitment fees) do not apply on contractual breach and as such do not engage the penalties rule. However, one category of fees which receives more attention in a project finance context is waiver fees, through which lenders seek to receive pre-agreed compensation for the extra time they spend on waiver requests (which are common in project finance, particularly during the construction period). By definition, waiver fees apply on a contractual breach and as such would engage the penalty rule. Project finance borrowers often see the waiver fees as duplicating existing fees which already allow lenders to recover certain administrative costs and may now use the Cavendish test to challenge the legal basis of such fees.
Conclusion
The penalties test formulated in Cavendishand its application to the facts in the Cavendishand ParkingEyeappeals (in both cases the alleged penal provisions were upheld) suggest that in the future it will be more difficult to challenge provisions as penalties. This will likely be especially the case in the context of complex commercial transactions, where the parties are often highly sophisticated and rely on expert legal advice. Nevertheless, as the rule against penalties remains part of English law, parties should continue to be careful with drafting provisions that might fall foul of the rule.
[1] Following the decisions in M & J Polymers Ltd v Imerys Minerals Limited [2008] EWCH 344 (Comm) and E-NIK Ltd v Department for Communities and Local Government [2012] EWHC 3027 (Comm), it became clear that take-or-pay clauses could potentially constitute penalties.
[2] See, for example, Unaoil Ltd v. Leighton Offshore Pte Ltd [2014] EWHC 2965 (Comm) discussed in Laura Kane, Alex Blomfield, A Cautionary Tale: English Courts Further Depart from a Traditional Approach to Liquidated Damages in Unaoil v Leighton, Energy Newsletter, November 2014.
[3] M & J Polymers Ltd v Imerys Minerals Limited [2008] EWCH 344 (Comm).
[4] E-NIK Ltd v Department for Communities and Local Government [2012] EWHC 3027 (Comm).