How to miss penalties: A guide to avoiding penalty clauses

How to miss penalties: A guide to avoiding penalty clauses


Author: Ben Howell

Being English, you might think it is our nature to miss penalties, but what you might not realise is that as lawyers we can be just as anxious about penalties as the Premier League's finest.

The issue here, of course, is not about scoring from 12-yards, but about the unenforceability of contractual terms that might be considered penalties.

Penalties: What are they?

If you enter into a contract which specifies that if the other party breaches the agreement they have to pay you a large sum of money, it is possible the court will not enforce that term of the contract because it constitutes a penalty.

Similarly, if the term imposes an obligation that has a similar effect, the court is likely to come to the same conclusion; for instance, it might be that the party in breach is required to sell you something for a lot less than it is worth, or perhaps to sacrifice an expected payment.

Old versus modern approach

When judging if a term was a penalty in older cases, the critical question was: "Does the amount involved represent a genuine pre-estimate of the other party's loss?"

If not, then the term could be considered a penalty. The modern approach, however, is much broader, with the spotlight on whether the term is commercially justifiable in the circumstances of the transaction, or really just intended as a deterrent to breaching the contract.

Cavendish Square Holdings BV and another company v Makdessi [2012]

This recent High Court case involved an unsuccessful attempt to invoke the law on penalties in relation to both a deferred payment for shares and a call option over shares in the future.

The dispute was over several clauses in an agreement for the purchase, from the founder, of a 60% holding in a Middle East advertising and marketing communications group. The buyer attributed much of the value to goodwill, and the consideration was payable in three instalments. There was also an option for the buyer to acquire the remaining shares in the future.

The agreement also included restrictive covenants, which if breached by the founder would result in the cancellation of any outstanding instalments, triggering the option to buy the remaining shares at a discounted price, effectively ignoring the (substantial) goodwill.

The founder breached the restrictive covenants, but argued that the buyer could not cancel the deferred payments or buy the remaining shares at the discounted price, as these terms represented a penalty. However, the judge disagreed, and ruled the terms of the agreement were not penal.

How this affects you: Guidance on avoiding penalty clauses

While the judgment is an illustration of the approach of the courts, and in particular their reluctance to interfere with parties' freedom to contract in commercial transactions, it also provides useful guidance on avoiding the law on penalties, which would result in you having unenforceable contractual terms.

The judge in Cavendish came to his conclusion based on the answers to four questions, which can be used as a starting point to determine whether your proposed terms will be penal:

  • Is there a commercial justification for the terms? For example, bringing an end to the relationship or reducing a payment due to the impact of a breach.
  • Are the terms extravagant or oppressive? For example, if any goodwill is substantially damaged due to the breach, then reducing payment could be justified. However, if a contract with a total value of £1,000 has terms obligating the breaching party to pay £1m this is likely to be viewed by the court as extravagant and/or oppressive.
  • Is the predominant purpose to deter breach? Using the £1m example above, this could clearly be considered a deterrent. On the other hand, if the term in the agreement is clearly geared towards severing a relationship because of a breach rather than asking for such an extravagant payment, then that is likely to be viewed by a court as more acceptable.
  • Are the terms of the agreement being negotiated on a level playing field? For example, if you and the other party are both represented by lawyers, this would go some way to highlighting to the court a level playing field for negotiations.