A reminder of the rule against penalty clauses

In the recent English case of Edgeworth Capital (Luxembourg) S.A.R.L. and another v Ramblas Investments B.V.[2015] EWHC 150 the UK High Court held that the rule against penalties did not apply to a fee payable for the provision of financing, because the fee was payable in various circumstances, not just in the event of a breach.

The decision demonstrates that the rule against penalties only applies in the event of a breach of a contractual duty owed to the other party. The Court noted that this restriction of the rule has been criticised over the years, on the grounds that it may lead to the rule being avoided by skilful drafting.

Background
A penalty clause is a clause which, without commercial justification, provides for the payment of a sum of money in the event of a breach of contract, the predominant purpose of which is to discourage a party from deliberately breaching its obligations. Such clauses are void on public policy grounds. On the other hand, liquidated damages clauses, whereby parties agree at the outset pre-determined estimates of losses to be incurred for the failure to meet certain contractual obligations, are valid and enforceable.

In both England and Ireland, Lord Dunedin’s four tests, as set out in Dunlop Pneumatic Tyre Co Ltd v New Garage Motor Co Ltd [1915] AC 79, have proved to be useful benchmark for the courts in establishing what amounts to a penalty:

  1. Terminology used by the parties is not conclusive.  The court must find out whether the payment stipulated is in truth a penalty or liquidated damages.
     
  2. The essence of a penalty is a payment of money stipulated as in terrorem of the offending party; the essence of liquidated damages is a genuine pre-estimate of damage.
     
  3. The question of whether a sum stipulated is a penalty or liquidated damages is a question of construction to be decided upon the terms and inherent circumstances of each particular contract, judged at the time of the making of the contract, not as at the time of the breach.
     
  4. To assist this task of construction various tests have been established which may prove helpful or even conclusive, including: 
    • It will be a penalty if the sum stipulated for is extravagant and unconscionable in amount in comparison with the greatest loss which could conceivably be proved to have followed from the breach.
       
    • It will be a penalty if the breach is due to failure to pay a sum of money, and the sum stipulated is a sum greater than the sum which ought to have been paid.
       
    • There is a presumption that it is a penalty where a single lump sum is made payable by compensation, on the occurrence of one or more of several events, some of which may occasion serious and others trifling damage.
       
    • A sum will not automatically be a penalty because an accurate pre-estimate of damage was impossible at the time.

The courts also tend to look beneath the agreement, in order to determine whether the clause is commercially justifiable.  The recent UK case of El Makdessi v Cavendish Square Holdings B.V. [2013] EWCA Civ 1539 further shows that the fact that clauses in an agreement are freely negotiated at arm’s length, with the benefit of legal advice, will not prevent the Court from concluding that they are unenforceable penalty clauses, if on the facts they are oppressive or wholly disproportionate to the loss likely to be suffered by the breach (see our Legal Update of 7 January 2014).

Facts
The claimants claimed approximately €105 million as a fee due under an UFA made with the defendant corporate borrower (Ramblas). The UFA was part of a suite of financing agreements entered into in relation to the purchase of property in Madrid.  Ramblas was a special purpose vehicle owned by two individual property investors.

The financing arrangements for the acquisition of the property included:

  1. A Senior Loan Agreement for €1.575 billion
  2. A Junior Loan Agreement for €200 million
  3. A Personal Loan of €75 million entered into by the two individual property investors.

The claimants were not a party to either the Junior Loan or the UFA at the time of execution, but there was a subsequent transfer of the rights and obligations under the Junior Loan, the UFA and the Personal Loan from the bank to the claimants.

Breaches of contract by the two individual property investors under the Personal Loan triggered cross-default provisions in the Junior Loan, entitling the claimants to accelerate the Junior Loan. The claimants then commenced these proceedings seeking payment of the substantial fee of €105 million, due under the UFA, against Ramblas.

Ramblas disputed the claim, contending that the fee for which it was allegedly liable far exceeded any damages for which Ramblas could possibly be liable for in respect of a breach of the Junior Loan Agreement, and was therefore unenforceable as a penalty or disguised penalty.  The claimants relied on the fact that the doctrine of penalties only applies in the event of a breach of duty owed to the other party, and argued that this was not the case here.

Decision
The Court held that the rule against penalties did not apply and accordingly, that Ramblas was liable to pay the claimants the fee claimed of approximately €105 million.

Whether the Fee was unenforceable as a penalty or disguised penalty
The Judge noted firstly, that after the first anniversary date, the fee in the UFA was always going to be payable. Therefore, even if Ramblas had performed the Junior Loan according to its terms and repaid the loan, the fee would have been payable, and there would have been no suggestion at that point that it was a penalty. The effect of the triggering event was merely to advance the time for payment of the fee. The Judge stated that: “it would be perverse if Ramblas was somehow placed in a more advantageous position by breaching rather than performing the Junior Loan”.

Secondly, the court noted that the fee was not triggered in this case by any breach of duty by Ramblas.  The relevant “Event of Default” was a breach of duty by the two individual property investors. It held that it was well established that the rule against penalties only applies if the clause in question is triggered by a breach of duty owed by the party claiming relief to the party seeking to enforce the clause party (following Export Credits Guarantee Department v Universal Oil Products Co [1983] 1 WLR 399).

Finally, the purpose of the fee clause was not deterrence but consideration for the provision of financing.

On these grounds the Court ruled that the rule against penalties was inapplicable.

Commercially justifiable
The Judge further commented that even if the rule against penalties had applied, he would have held that even though the fee was not a genuine pre-estimate of loss for breach, the clause was commercially justifiable, as there were real risks for the bank in advancing the substantial financing at the time.  The loan was made in challenging commercial circumstances, in the days preceding the collapse of the Lehman Brothers.  As such, it was not a penalty.

This finding highlights the significance of the commercial reality of the transaction at the time the contract is made, in determining whether a clause amounts to a penalty. 

Comment
This decision serves as a reminder of the rule against penalty clauses.  It shows that where clauses are carefully drafted to provide for payments in circumstances not amounting to a breach of contract, they may be valid and enforceable. The decision is likely to be of persuasive authority should a similar case come before the Irish courts.

For further information please contact Davinia Brennan at dbrennan@algoodbody.com or your usual contact at A&L Goodbody.

Date published: 10 March 2015