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It’s a penalty! Isn’t it? Penalty clauses since Makdessi

Jason Rix

In November 2015 the UK Supreme Court restated the test for penalty clauses in Cavendish v Makdessi. One year on, how is the test being applied by the courts?

There has been much debate around whether provisions are primary or secondary obligations. Members of the court in Makdessi did not agree on this point on the facts.

In Hayfin Opal v Windermere, Snowden J examined a clause which required interest to be paid on unpaid amounts, triggered by a failure to make interest payments within a specified period. Though the parties did not make the point, he said (obiter) that the clause was arguably a conditional primary obligation and therefore enforceable.

Two decisions concerned “bad leaver” provisions for employees. The provisions were similar in each case, but the courts reached conflicting decisions on whether they were primary or secondary obligations. In Richards v IP Solutions, a company’s articles of association included a provision under which a reduced share price was payable to a “bad leaver”. May J said (obiter) that this was a primary obligation agreed between parties for distinct commercial reasons to do with a shareholder leaving the Company. In Gray v Braid Group, a Scottish case which is persuasive but not binding in England and Wales, the court held (obiter) that the employee’s primary obligation was to do his job properly. Only if he breached this did the secondary obligation (the “bad leaver” provision) arise.

These cases suggest there may be some wiggle room for lawyers in arguing that a clause is a primary or secondary obligation.

There have been some useful reminders of established principles relating to penalties. In Edgeworth Capital v Ramblas Investments, Moore-Bick LJ confirmed that the rule against penalties won’t be engaged unless 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.

Richards reiterated the familiar principle that a clause is more likely to be enforceable if it’s agreed in commercial negotiations at arms-length with experts involved, while in Hayfin the parties agreed that an alleged penalty must be tested by reference to the state of affairs at the time of the agreement.

What about commentary on legitimate interests? This was touched upon by Snowden J in Hayfin (obiter). The legitimate interest here was obtaining prompt payment, but he thought that the provision would result in a payment which was many times the amount that would adequately compensate the innocent party for being kept out of its money.

The past year’s cases on penalty clauses are a useful aid for interpreting the Makdessi decision, but question marks remain. Not least how to distinguish between primary and secondary obligations, and how the courts will determine whether a clause is “out of all proportion” to any legitimate interest.

Comments published on Compact Contract do not necessarily reflect the views of Allen & Overy or its clients.

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