What’s so bad about…penalty clauses?

Earlier this week I found myself looking in detail into a limitation clause for a university client. It included provision that if X does not happen, Y will be obliged to pay a sum of money. Caught on the horns of the dilemma of whether to add yet more redline to the draft or whether to advise the client that the clause would be unenforceable as being a penalty clause (and so could be ignored), I sought refuge in case law. Two cases stood out. A recent one about yachts and an old one about tyres. And they suggest that there is more flexibility in the system than you might think.

In short, yes, as the undergraduate lawyer’s mantra goes, penalty clauses are bad. According to the older case (Dunlop Pneumatic Tyre Company Limited v New Garage and Motor Company Limited from July 1914), a penalty clause is unenforceable where it is used to deter breach and “in terrorem of the offending party”. The clause cannot be a means of securing performance but it can be a means of allowing a party to buy the right to do a particular act. A sum that is “extravagant and unconscionable in amount in comparison with the greatest loss that could conceivably be proved to have followed from the breach” is likely to be a penalty. But that case shows that a clause that is a genuine pre-estimate of damage is entirely acceptable. Even if the consequences of the breach are such “as to make precise pre-estimation almost an impossibility”. Dunlop had a series of price maintenance agreements in place with their distributors. These agreements dictated the minimum sales price for the Dunlop tyres and covers. Any product that was sold or offered for sale entitled Dunlop to a payment of 5l (quite a chunk of cash in pre-decimal money). Dunlop would suffer if any one of their distributors undercut the others because this would disrupt their efficient business. It did not matter that it was well nigh impossible to predict the actual loss that would flow. Rather, the parties were entitled to reach a bargain to assess damages.

The more recent case concerned a contract to build a super yacht (Azimut-Benetti v Healey from September 2010). Times are hard and the contract was cancelled shortly after being signed. Under clause 16.3 of the contract, on lawful termination of the contract, the yacht builder could claim 20% of the contract price by way of compensation for its estimated losses. As the total price was Eur38m, this equated to Eur7.6m (quite a chunk of cash in post-decimal money). The question arose whether the predominant contractual function of the clause was to deter a party from breaking the contract. The Court accepted that clauses ‘in terrorem’ are bad but also noted that the Court should not be too keen to intervene and should have an eye to what the parties have agreed. The evidence showed that the purpose of the clause was not to serve as a deterrent but that it was commercially justifiable as providing a balance between the parties’ interest. It was highly relevant that both parties had the benefit of expert representation and the contract was freely entered into.

So, penalty clauses are bad and will be unenforceable. Whether a clause is a penalty clause depends upon its purpose and that is a matter of construction in each case. But even if it is difficult to assess the loss that will follow a breach, the parties’ attempts to do so may still be enforceable where the clause is commercially justifiable. Also, the courts have been reluctant to intervene, especially where the contract is between equals and is freely entered into. Which is good to know because it gives businesses more scope to regulate their own relations.

One point to bear in mind, however. The cases discussed refer to contracts between businesses. Since 1994 and the Unfair Terms (Consumer Contracts) Regulations, all contracts with consumers have to be fair (broadly speaking). The Courts will be much more willing to intervene in a consumer contract and are much more likely to strike out any clause that looks even a little bit like a penalty.