Developments in contract: penalty clauses

The principles

• A contractual clause that obliges a party to pay an amount to its counterparty if it breaches the contract may be unenforceable as a penalty.
• If the payment is a genuine pre-estimate of loss it will be a liquidated damages clause and enforceable, even if the estimate of loss turns out to be inaccurate.
• A key consideration as to whether a clause is a penalty is whether it imposes a free-standing primary obligation, or a secondary obligation that arises on breach of a primary obligation.

Recent developments

The rule against penalties survived the decision of the Supreme Court in Cavendish Square Holding v Makdessi but it will only be engaged if the term in question is not a “primary obligation” (damages payable on breach being a secondary obligation). As Lord Neuberger and Lord Sumption said in Makdessi “[t]he penalty rule regulates only the remedies available for breach of a party’s primary obligations, not the primary obligations themselves”.

The significance of this reformulated test is apparent from the recent decision of the Court of Appeal which applied the Makdessi test as to whether a term was a primary or secondary obligation. In Edgeworth Capital v Ramblas Investments, a dispute arose as to whether an “upside fee” payable if borrowers defaulted in repayment of their loan was a penalty. It far exceeded any loss the lender would suffer as a result of the underlying breach of contract, but the Court of Appeal dismissed the argument that it was a penalty. The fee had “nothing to do with damages for breach of contract”. It was instead “payable on the happening of a specified event”. It was thus a primary obligation and the rule on penalties was not engaged.

The result in the Edgeworth Capital case can be understood from the way in which the three interlinked agreements involved were drafted. In substance, the payment in question was triggered by a breach of contract, but not a breach of the contract under which the upside fee was payable. By making payment of that fee conditional upon an event of default arising under a separate agreement, the parties had made it a primary obligation.

What this means

This highlights that appropriate drafting can still help to avoid the rule against penalties being applicable at all, as has always been the case. If the obligation to pay can be framed as a primary obligation that arises on a specified event, rather than a secondary obligation triggered by a breach, the rule against penalties will (probably) not be engaged.

The fact that what is in effect a penalty clause may be enforceable or unenforceable depending upon how it is drafted was acknowledged by the Supreme Court in Makdessi as being a matter of substance not form, but in practice, this decision demonstrates the continued significance of how the obligation is drafted.