Case law: Court clarifies when a contractual obligation is a 'penalty' and therefore unenforceable
A contractual party seeking to avoid obligations imposed on the other side on breach of contract being treated as penalties, and therefore unenforceable, should frame them as 'primary obligations', or ensure that if framed as 'secondary obligations', they are proportionate to the other party's interest in the performance of the relevant primary obligation.
This update was published in Legal Alert - April 2018
Legal Alert is a monthly checklist from Atom Content Marketing highlighting new and pending laws, regulations, codes of practice and rulings that could have an impact on your business.
A company bought a property for development for £42m. The beneficial owner of the company borrowed £12m personally from a lender to help fund the purchase. The terms of the loan agreement required the beneficial owner to repay £37m to the lender overall, because the contract provided for additional payments, including:
- Interest on the loan (which had to be repaid in full if the loan was repaid early)
- A fee payable because the beneficial owner extended the term for repaying the loan, and switched to paying by monthly instalments
After paying out these, and other costs, the project made a loss. A dispute arose, and the beneficial owner argued that the additional payments were 'penalties' and therefore unenforceable.
A contractual clause is a penalty, and unenforceable, if:
- it imposes financial consequences for the breach of a 'primary obligation' in the contract (ie, it is not itself a primary obligation but a 'secondary obligation')
- which causes a detriment to the party committing the breach that is out of all proportion to any legitimate interest of the innocent party in the enforcement of that primary obligation
The High Court set out the following principles:
- An obligation under a contract can only be a penalty if it is a secondary obligation – an obligation triggered by a breach of a primary obligation, and does not stand on its own. The doctrine of penalties therefore only applies to breaches of primary obligations
- The question of whether the obligation is a primary or secondary obligation depends on its substance, not its form. However, as the doctrine applies only to breaches of primary obligations, its application can depend on how the relevant obligation is framed and on how the obligation is drafted
- If an obligation is a secondary obligation, so that it could be a penalty, the test of whether it is in fact a penalty is:
- whether and what legitimate business interest it serves and protects, and
- assuming there is such an interest, whether the relevant obligation is ‘in the circumstances extravagant, exorbitant or unconscionable’ having regard to the innocent party's interest in the performance of the contract
The Court therefore recognised that in some cases the application of the doctrine may depend on how the relevant obligation is framed in the contract. If an obligation is framed so that it is itself a primary obligation, it cannot be a penalty.
Applying these principles to the facts, the Court ruled that:
- The obligation to pay all the interest that would have accrued by the end of the loan if the loan was repaid early was a primary obligation. This was not a secondary obligation, only triggered by a breach of a primary obligation, because repaying the loan early was not a breach, but permitted by the contract
- Similarly, the obligation to pay a fee to extend the repayment period for the loan, and pay by monthly instalments, was not a secondary obligation, triggered by breach of a primary obligation either. If the extension fee became payable, the agreement was that it would be credited against the amount of the debt. The Court found that this obligation was framed as a primary obligation, because the fee was payable in return for an extension of time to pay the debt, and it could not therefore amount to a penalty
The Court therefore ruled that none of the obligations complained of amounted to an unenforceable penalty.
- Parties to a contract who want to avoid a contractual obligation being treated as an unenforceable penalty, should draft it as a primary obligation of the contract (and not a secondary obligation triggered only on breach of another, primary obligation in the contract); ensure that a specific benefit is provided in return for any interest payments payable under the contract; and/or ensure any secondary obligation in the contract is proportionate to the other party's interest in the performance of the relevant primary obligation.
Case ref: Holyoake v Candy  EWHC 3397
Disclaimer: This article from Atom Content Marketing is for general guidance only, for businesses in the United Kingdom governed by the laws of England. Atom Content Marketing, expert contributors and ICAEW (as distributor) disclaim all liability for any errors or omissions.
Copyright © Atom Content Marketing