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LIQUIDATED DAMAGES AND PENALTIES

A presentation for the Property Litigation Association

on 11 November 2015

by Ben Faulkner and James McCreath

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Ben Faulkner and James McCreath each have busy property practices. Ben has

recently been building his celebrity client base, in what has rather unfairly been referred

to as ‘Gordon Ramsay’s Courtroom Nightmare’, arguing that a signature machine, used

for signing fan photos, couldn’t be used to sign a personal lease guarantee (led by

Jonathan Seitler QC). James meanwhile has been involved in various tricky 1954 Act

renewals, in between trips to the Supreme Court on such diverse topics as sewage and

penalty clauses.

But what really divides Ben and James is the ‘excrementitious’ battle lines that have

been drawn in their multi million-pound standoff concerning discharges of treated and

untreated sewage into the Manchester Ship Canal. Ben says that James (led by

Jonathan Karas QC) is fancifully arguing that there is nothing wrong with pumping ‘foul

water’ and ‘grey water’ into the Canal, whilst James thinks that Ben (led by Michael

Barnes QC) is opportunistically trying to amend his client’s case when the Supreme

Court have already said it’s wrong. In reality, Ben is just desperately trying to avoid

going on a site view.

Ben has been described in Chambers & Partners as “A strong and confident advocate

who is well regarded by peers and clients” but is also said to have ““impressed solicitors

with his ‘tremendous work ethic’” i.e. total lack of social life. Chambers & Partners has

described James as “very…available”. Enough said.

WILBERFORCE CHAMBERS

8 New Square Lincoln’s Inn London WC2A 3QP

Telephone: 020 7306 0102 Fax: 020 7306 0095 Email: bfaulkner@wilberforce.co.uk jmccreath@wilberforce.co.uk

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Scenarios for discussion

Scenario 1

1. Big Property Ltd has identified a potentially valuable development site, but does

not wish to take the risk of developing the site on its own. It identifies Major

Developer Plc as a potential joint venture partner. Major Developer is a

particularly attractive partner for Big Property, as it has plenty of relevant

experience, having just completed a similar development of its own.

2. The parties set up a special purpose vehicle, SPV Ltd, to hold and develop the

site, in which they each own 50% of the equity. They engage major law firms -

Serious City Firm LLP and Top Rank Solicitors LLP – to draw up a joint venture

agreement.

3. The key terms of the agreement include the following:

(1) Given its previous experience, Major Developer agrees to have oversight of the

construction process. Strict deadlines are put in place for various stages of the

development project which Major Developer is obliged to comply with.

(2) Major Developer also agrees to provide all funding for the development, with Big

Property agreeing to reimburse 50% of those costs. Again, the agreement

provides strict deadlines by which Big Property must make certain payments.

Big Property Ltd Major Developer Plc

SPV Ltd 50% 50%

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4. As to (1), one reason for the imposition of strict deadlines in the construction

process was that Big Property is heavily leveraged and relying on bank debt to

fund its share of the development, and so is keen to realise revenue from it as

soon as possible. It is concerned that Major Developer will not be quite as

bothered, as it is able to fund much of the development through equity.

5. Clause 17 provides that, if Major Developer fails to comply with any of the

deadlines, for each week that passes without the relevant stage being completed,

Major Developer will pay Big Property £500,000.

6. (2) was the subject of heated and difficult negotiations. Major Developer was, for

obvious reasons, not happy providing all the funding in the first place, but Big

Property– who as explained above is heavily leveraged –wanted to secure the

liquidity benefit. Major Developer only agreed to it when it was further agreed by

Clause 18 that if Big Property was late making any payments due to Major

Developer, then:

(a) For the first 30 days after the payment was due, Big Property would pay

interest at 15% above base rate.

(b) If 30 days passed without payment being made, Major Developer could

acquire Big Property’s shares in SPV Ltd for a price equal to the funding

contributions Big Property had made to date.

Questions:

(1) Should each of (i) Clause 17; (ii) Clause 18(a); and (iii) Clause 18(b), be treated

as a penalty clause? What are the arguments:

(a) for each being a penalty clause; and

(b) against each being a penalty clause?

(2) If Clause 18(b) is a penalty clause:

(a) What should the Court do instead of enforcing it according to its strict

wording?

(b) Would it make any difference if the value of the contributions paid

happened to equal market price of the shares?

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Scenario 2

7. The parties fall out over the construction of some of the other terms of the

agreement, and Big Property sues Major Developer. The commercial

background is that Big Property is struggling to meet its exorbitant bank debts,

and wants out of this deal as soon as it can.

8. Meanwhile, Big Property has identified a new potential development site, which it

has concluded does not fit its criteria, but which it correctly suspects would be of

interest to Major Developer. Having done some initial work considering the

development of this new site, Big Property is well-placed to assist Major

Developer if it chooses to pursue it.

9. With Big Property completely over a barrel, the parties agree to settle the claim.

9.1 Big Property agrees to use “best endeavours” to assist Major Developer in

pursuing its development of the new site for a period of 18 months.

9.2 In return, Major Developer agrees to purchase Big Property’s shareholding in

SPV Ltd, for a price equal to the market value of those shares as determined

by an independent valuer.

9.3 Each party agrees to bear its own costs of the claim, subject to Clause 7(b)

below.

10. The shares are to be transferred immediately, but payment is to be staged:

10.1 40% of the price is to be paid immediately.

10.2 The remaining price will be paid in instalments of 10%, payable each three

months. The last payment will therefore fall to be made the day that Big

Property’s obligations to use “best endeavours” expires.

11. Clause 7 of the settlement agreement goes on to provide that if Big Property

breaches its “best endeavours” obligation:

(a) it will no longer be entitled to receive any consideration due after the date

of that breach; and

(b) Big Property will pay Major Developer the costs of the settled litigation.

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Questions:

(3) Should each of Clauses 7(a) and 7(b) be treated as a penalty clause? What are

the arguments:

(a) for it being a penalty clause; and

(b) against it being a penalty clause?

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LIQUIDATED DAMAGES AND PENALTIES

by Ben Faulkner and James McCreath

‘Answer Sheet’

The new legal framework

1. Since we developed the problem questions for this workshop, the Supreme Court

has handed down its judgments in the joined appeals of Cavendish Square Holding

BV v Makdessi and ParkingEye Ltd v Beavis [2015] UKSC 67. This has re-framed

the test for determining whether or not a clause is penal.

Cavendish v Makdessi: the facts

2. The lead appeal was Cavendish v Makdessi. It concerned a share purchase

agreement (“the Agreement”) whereby Cavendish, a holding company within the

WPP Group of companies, purchased a 60% interest in the largest media and

advertising business in the middle east from the founders of that business, Mr

Makdessi and Mr Ghossoub. The vendors retained a 40% interest in the business.

3. The case turned on a number of key features of the transaction.

4. First, the parties to the Agreement were sophisticated commercial parties,

negotiating with the assistance of the best legal advice, and acting on a level-

playing field. There was no element of control, oppression or imbalance in the

transaction. Neither party even remotely acted as a consumer.

5. Second, the purchase price consisted of certain fixed initial payments, and then two

instalments of deferred consideration to be paid a number of years after the

acquisition, the quantum of such payments depending on the profitability of the

business after acquisition. Those two payments were called “the Interim Payment”

and “the Final Payment”. The total purchase price was subject to a cap of

US$147.5m.

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6. Third, much of the value of the company, and hence the purchase price, was

attributable to goodwill, rather than physical assets (as one might expect from a

successful marketing business). The company’s relationships with key clients were

of central importance to its value.

7. Fourth, a considerable amount of the goodwill of the company resided in the

vendors (and particularly Mr Makdessi). As the founder and owner of the business,

it was he who had developed the relationships with key clients and key employees.

In order to protect and retain that goodwill after the sale, the Agreement contained

restrictive covenants in clause 11.2 prohibiting him from competing with the

business, soliciting key employees and so forth for a period after acquisition. If he

did so, he became a ‘Defaulting Shareholder.’

8. Fifth, and crucially, the Agreement spelled out the consequences of becoming a

Defaulting Shareholder in the two controversial clauses.

8.1. Clause 5.1 provided that a Defaulting Shareholder would not be entitled to

receive the Interim Payment and the Final Payment. Note that this is not a

classic penalty – it does not provide for payment of a sum of money on

breach of contract. Rather, it is a ‘withholding clause’, allowing the innocent

party to withhold a sum of money from the contract breaker on breach of

contract.

8.2. Meanwhile Clause 5.6 provided that Cavendish could require a Defaulting

Shareholder to sell it all of the Defaulting Shareholder’s shares. The shares

were to be sold at something called “the Defaulting Shareholder Option Price”

– effectively a net asset valuation which took no account of goodwill. That

had been the subject of detailed negotiations between the parties.

8.3. Again, this is not a classic penalty in the sense of a clause providing for

payment of a sum of money on breach of contract. It is – at its highest – a

‘forced transfer’ clause, requiring the contract breaker to transfer property to

the innocent party at what might be regarded as an undervalue.

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The issues in the Supreme Court

9. Disagreeing with Burton J, the Court of Appeal had held that both clauses were

penal. Cavendish challenged that decision on three grounds:

9.1. The doctrine of penalties is outdated, lacks a coherent rationale, and should

therefore cease to apply, alternatively should not apply to sophisticated

commercial parties negotiating on a level playing field.

9.2. Alternatively, the doctrine should not apply to either withholding clauses or

forced transfer clauses.

9.3. Alternatively, neither of these clauses was penal on the facts.

10. The appeal was heard by a panel of 7 Justices. There are five judgments in the

Supreme Court: a joint judgment of Lords Neuberger and Sumption, with which

Lords Clarke and Carnwath agreed (and which, save for one exception, can

therefore be regarded as the majority judgment), a judgment of Lord Mance, a short

judgment of Lord Clarke, a judgment of Lord Hodge, and a judgment of Lord

Toulson.

11. The very brief summary is that Cavendish, essentially won on ground three.

Ground 1: Abolition of the doctrine

12. Although none of the Judgments set them out, there were some powerful

arguments for disposing of the doctrine entirely.1 In particular:

12.1. The doctrine, at its core, is a restriction on the parties’ freedom to contract in

precisely the way they want to.

12.2. Of course, the general law is full of examples where freedom to contract is

curtailed in order to protect weaker parties (such as the host of protections

provided to consumers in consumer contracts) or because of public policy

(such as the rule against restrictive covenants in employment contracts, to

name just one). But the law of penalties does not depend upon such factors

existing, and in any event those situations are well catered for by the

separate protections the law provides.

1 Ben has written this paragraph of the note, so this isn’t James blowing his own trumpet, or being

a sore loser on this point.

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12.3. Another cardinal principle is that the Courts will not seek to review the

fairness of parties’ bargains, either at law or equity (see [13]). For example,

the Courts will not question whether one party has overpaid for property they

have bought: if it’s a bad bargain, it’s a bad bargain. However, the doctrine of

penalties does just that: where the Court considers that the penalty is out of

all proportion to the interest it protects (which necessarily involves an

assessment of what a ‘good deal’ was in the first place), it will be struck down.

12.4. In order to keep the doctrine of penalties confined so that it does not infringe

that cardinal principle, the doctrine only applies to secondary obligations (i.e.

those which are engaged once a primary obligation to perform has been

breached). But that itself causes substantial confusion, as the line between

primary and secondary obligations is often far from clear.

12.5. Striking down one individual clause in an agreement while retaining others

risks causing considerable unfairness to the innocent party. Those other

clauses may have been granted as concessions for the allegedly penal

clause, or only have been acceptable as part of an overall deal including that

clause.

13. None of the Justices was prepared to abolish the doctrine. Although the majority

noted that it was “an ancient haphazardly constructed edifice which has not

weathered well…”, and doubted that it would have been invented today had it not

already existed, they noted that it was a long-standing principle of English law, it is

common to almost all major systems of law across the world, and it still had a

useful role to play in regulating contracts, such as those involving professionals and

small businesses, which are not caught by the various statutory protections that

exist for consumer contracts.

14. As to its continued application in commercial contracts, the Court was not prepared

to draw a bright line. But there is enough in the judgment to make clear that the

Courts should be increasingly reluctant to refuse to enforce provisions in contracts

between parties of equal bargaining power on the ground that they are penal. Thus

a majority of four of their Lordships held that “In a negotiated contract between

properly advised parties of comparable bargaining power, the strong initial

presumption must be that the parties themselves are the best judges of what is

legitimate in a provision dealing with the consequences of breach”. (para [35]).

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Meanwhile, all the Judges placed reliance on the equality of arms between the

parties in holding that the clauses were not penal.

15. The Supreme Court also declined an invitation from the Respondent to broaden the

doctrine so as to include provisions that do not operate on breach of contract, as

the Australian High Court has recently done in Andrews v ANZ Banking

Corporation (2012) 247 CLR 205. Thus the Supreme Court reaffirmed the rule that

the doctrine did not apply to primary obligations, but only applied to secondary

obligations (i.e. those regulating the remedies available or consequences of a

breach of primary obligations): see para [13] (avid fans of Commonwealth law may

already know that the Australian High Court is due to re-consider this issue itself in

a case called Paciocco).

16. Of course, that immediately causes difficulties where a secondary obligation is

made to look like a primary obligation in the contract. The Courts will look to the

substance of the clause, and not its form: see para [14]-[15]. The Judgment

contains little guidance of how in practice this is to be applied.

Ground 2: Scope of the doctrine

17. To what kind of clauses does the doctrine of penalties apply? The two clauses in

issue were a ‘forced transfer’ clause and a ‘withholding clause’, and the Appellant

argued that the doctrine could not apply to either, both being in the nature of

forfeitures rather than penalties.

18. The Supreme Court held that the doctrine was not just restricted to clauses

providing for the payment of money. ‘Forced transfer’ clauses, where particular

assets are required to be transferred, are within the scope of the doctrine, so

potentially impugnable as penalties: see para [16]. However, the Supreme Court

held that, if found to be a penalty, a forced transfer clause would be simply

unenforceable (overruling the decision of the Court of Appeal in Jobson v Johnson

[1989] 2 WLR 1026 so far as it decided that such a penalty clause could be

enforced up to the extent of the innocent party’s loss): see paras [84]-[87].

19. The position is more complex so far as ‘withholding’ clauses are concerned.

19.1. The majority (albeit possibly not with the agreement of Lord Clarke – see

below) did not decide the question whether or not such clauses were within

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the scope of the doctrine. They expressed themselves “prepared to assume,

without deciding, that a contractual provision may in some circumstances be

a penalty if it disentitles the contract breaker from receiving a sum of money

which would otherwise have been due to him” (para [73]).

19.2. But they went on to hold that “even on that assumption, it will not always be a

penalty. That must depend on the nature of the right of which the contract

breaker is being deprived and the basis on which he is being deprived of it”.

On one side of the putative line, they noted the facts in Gilbert-Ash (Northern)

Ltd v Modern Engineering (Bristol) Ltd [1974] AC 689, in which a clause

permitted the withholding of remuneration due to a sub-contractor on breach,

which they said was plainly a security for the contractor’s claim. On the other,

they posited a clause which may define the primary obligations of the parties

– and they appear to have regarded the permanent forfeiture of the accrued

right to an indemnity in the Court of Appeal decision in The Padre Island

[1989] 2 Lloyd’s Rep 239 as being such a clause (thus appearing implicitly to

accept that the decision in that case that such a clause was a penalty was

wrong).

19.3. Lords Mance and Hodge (with whom Lord Toulson agreed) unambiguously

decided that such a clause could be a penalty. As for Cavendish’s argument

that they were forfeitures, they held that a clause could be both a penalty and

a forfeiture, the correct approach being to ask first whether it was a penalty,

and hence automatically unenforceable, and second, if it was not, whether it

was a forfeiture from which relief could be granted by the Court.

19.4. An ambiguity perhaps arises as Lord Clarke, despite agreeing with the

judgment of Lords Neuberger and Sumption, in his short judgment expressly

agreed with the relevant paragraphs of the judgments of Lords Mance and

Hodge. There perhaps could be a fine argument here as to what the majority

view is, but realistically lower courts are almost certainly to hold that

withholding clauses fall within the scope of the law of penalties.

20. So far as other categories of forfeiture with which property litigators are familiar are

concerned, the Supreme Court was not asked to decide whether the kinds of

forfeiture clauses (such as in a lease) where the contract breaker loses a

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proprietary right2 were within the scope of the doctrine of penalties. However,

nothing in the Judgements suggests that they do fall within the doctrine, and indeed

Lords Sumption and Neuberger indicated that they would not: para [17]. The

reason may be that these kinds of forfeiture clauses are subject to a separate

regime under which relief from forfeiture is available.

21. Although it was not the subject of argument, the Supreme Court gave some

consideration to another related area familiar to all property litigators, the law of

deposits. The Supreme Court made it clear that the doctrine of penalties also

applies to the forfeiture of deposits, since they operate just like a clause requiring a

payment of money, with the deposit standing as security: see para [16].

Ground 3: Whether the particular clauses were penal

22. If the clause is within the scope of the doctrine, is it in fact a penalty clause?

Cavendish has re-cast the test for discerning whether or not a clause is penal.

The legal test

23. Prior to Cavendish, the leading authority on this question, which had stood for over

100 years, was the decision of the House of Lords in Dunlop Pneumatic Tyre

Company Ltd v New Garage and Motor Company Ltd [1915] AC 79. Subsequent

cases have treated as authoritative the four propositions set out by Lord Dunedin

(at 86):

1. Though the parties to a contract who use the words “penalty” or “liquidated damages” may prima facie be supposed to mean what they say, yet the expression used is not conclusive. The Court must find out whether the payment stipulated is in truth a penalty or liquidated damages. This doctrine may be said to be found passim in nearly every case.

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 covenanted pre-estimate of damage (Clydebank Engineering and Shipbuilding Co. v. Don Jose Ramos Yzquierdo y Castaneda).

3. The question whether a sum stipulated is penalty or liquidated damages is a question of construction to be decided upon the terms and inherent circumstances of each particular contract, judged of as at the time of the making of the contract, not as at the time of the breach (Public Works Commissioner v. Hills and Webster v. Bosanquet).

2 as opposed to more general forfeiture clauses found in commercial contracts forfeiting

contractual rights (such as in Cavendish itself), where there is no jurisdiction to relieve from forfeiture.

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4. To assist this task of construction various tests have been suggested, which if applicable to the case under consideration may prove helpful, or even conclusive. Such are:

(a) It will be held to be penalty if the sum stipulated for is extravagant and unconscionable in amount in comparison with the greatest loss that could conceivably be proved to have followed from the breach. (Illustration given by Lord Halsbury in Clydebank Case).

(b) It will be held to be a penalty if the breach consists only in not paying a sum of money, and the sum stipulated is a sum greater than the sum which ought to have been paid (Kemble v. Farren). This though one of the most ancient instances is truly a corollary to the last test. Whether it had its historical origin in the doctrine of the common law that when A. promised to pay B. a sum of money on a certain day and did not do so, B. could only recover the sum with, in certain cases, interest, but could never recover further damages for non-timeous payment, or whether it was a survival of the time when equity reformed unconscionable bargains merely because they were unconscionable,—a subject which much exercised Jessel M.R. in Wallis v. Smith—is probably more interesting than material.

(c) There is a presumption (but no more) that it is penalty when “a single lump sum is made payable by way of compensation, on the occurrence of one or more or all of several events, some of which may occasion serious and others but trifling damage” (Lord Watson in Lord Elphinstone v. Monkland Iron and Coal Co.).

On the other hand:

(d) It is no obstacle to the sum stipulated being a genuine pre-estimate of damage, that the consequences of the breach are such as to make precise pre-estimation almost an impossibility. On the contrary, that is just the situation when it is probable that pre-estimated damage was the true bargain between the parties (Clydebank Case, Lord Halsbury; Webster v. Bosanquet Lord Mersey).

24. Two points should be noted in particular about these propositions.

24.1. First, they set up a dichotomy, which has governed the area ever since,

between penalties and genuine and pre-estimates of loss.

24.2. Second, they say that a clause is a penalty if it is “in terrorem” of a party –

which in modern language has been interpreted to mean having a deterrent

purpose.

25. Thus the law on penalties has been dominated by the supposedly mutually

exhaustive concepts of ‘genuine pre-estimate’ (not a penalty) and ‘deterrence’ (a

penalty).

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26. In the last twenty years, there have been decisions in lower Courts that have

struggled with this, and have introduced a concept of “commercial justification”.

Thus in Cine Bes Film Cilik ve Yapimcilik v United International Pictures [2003]

EWCA Civ 1669, Lord Justice Mance noted that “a dichotomy between a genuine

pre-estimate of damages and a penalty does not necessarily cover all the

possibilities. There are clauses which may operate on breach but which fall into

neither category and they may be commercially perfectly justifiable”. But in doing so,

the Courts have continued to treat that “commercial justification” test as part of the

broader ‘deterrence’ test, such that a clause cannot be “commercially justified” if its

purpose is to deter.

27. All this has been swept away by the Supreme Court. The Court considered that too

much emphasis had been placed on the judgment of Lord Dunedin in Dunlop, and

that propositions set out by him as guidelines had come to achieve the force of a

quasi-statutory code. While they considered that those propositions would continue

to be useful in the case of simple damages clauses, the majority re-stated the

underlying test for whether a clause is penal as follows (para [32], and see also

paras [28]-[33]):

“The true test is whether the clause is a secondary obligation which imposes a detriment on the contract breaker which is out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation. The innocent party can have no proper interest in simply punishing the defaulter. His interest is in performance or in some appropriate alternative to performance. In the case of a straightforward damages clause, that interest will rarely extend beyond compensation for the breach, and we therefore expect that Lord Dunedin's four tests would usually be perfectly adequate to determine its validity. But compensation is not necessarily the only legitimate interest that the innocent party may have in the performance of the defaulter's primary obligations.”

28. They also expressly rejected the notion that it was “deterrence” which made a

clause penal. There is nothing illegitimate about a clause seeking to influence the

other party’s conduct by deterring them from breaching the contract. What matters

is not whether its object is to deter, but whether it is to punish: see paras [31], [32]

& [82]. Ascertaining whether a clause is there to punish depends on whether it is

‘unconscionable’, ‘extravagant’ or ‘grossly disproportionate’ in comparison with the

innocent party’s interest in enforcing the contract.

29. Lastly, as set out above, the doctrine does not depend on a finding that advantage

has been taken of one party. However, whether a clause is in fact penal requires an

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assessment of all the circumstance, any advantage will be of material significance.

Equally, if the parties have been on a level playing field, and advised by

sophisticated legal teams, the “strong initial presumption must be that the parties

themselves are the best judges of what is legitimate”: paras [34]-[35] & [82] (and

see para [33]).

30. Lords Mance and Hodge, with whom Lord Toulson agreed, reached very similar

conclusions.

Consequences of a clause being penal

31. As a result of the Supreme Court’s overruling of Jobson v Johnson (see ¶18 above),

it is now clear that the consequence of any kind of clause being a penalty clause is

that it is wholly enforceable: see paras [84]-[87]. The innocent party will be left to

claim damages in the ordinary way.

Application to the facts of Cavendish

32. So far as the particular clauses in issue were concerned, all of the Justices agreed

that neither Clause 5.1 nor Clause 5.6 was penal.

33. As for Clause 5.1 (the withholding clause):

33.1. The majority regarded Clause 5.1 not as a liquidated damages clause – i.e.

not as an exclusive alternative to common law damages – but as a provision

going to price, providing that the price would be adjusted in certain

circumstances. Indeed, it was still technically possible for Cavendish to sue

for common law damages for the breach. It was thus “in no sense a

secondary provision”: para [74] & [76].

33.2. Nevertheless, the Court went on to consider whether it was of a penal nature.

It is not obvious why it has done so given the finding that the penalty doctrine

applies only to secondary obligations, but it appears perhaps to have done so

for two overlapping reasons: (i) to confirm that it was not a secondary

obligation disguised as a primary obligation (see para [77]); and (ii) to assess

whether it was penal in the event that that analysis demonstrated that it was

in substance a secondary obligation.

33.3. The majority considered that given the critical importance of goodwill to

Cavendish in valuing the business, it plainly had a legitimate interest in Mr

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Makdessi observing the restrictive covenants which went beyond recovery of

the loss, and the business was clearly worth less to Cavendish with the risk

that he would not observe them than without. They also considered that there

was no juridical standard for valuing how much less the business was worth

in such circumstances – there was no way to know what price Cavendish

would have paid for the business without the restrictive covenants, or what

other provisions of the Agreement might have been different – but rather this

was quintessentially a matter for negotiation between the parties: para [75].

They thus concluded that Clause 5.1 was not a penalty.

34. As to Clause 5.6 (the forced transfer clause):

34.1. The majority considered that the same interest above justified it; an interest in

ensuring that the price which Cavendish paid for the retained shares matched

the value which the sellers were contributing to the business. That was a

legitimate function which the parties were best placed to value: see para [82].

34.2. But further, the Court considered that a contractual provision conferring an

option to acquire shares for commercial reasons other than compensating for

breach was a primary obligation, not a secondary obligation, even if it

operated on breach, and hence was outside the scope of the law of penalties:

para [83].

Summary: Where are we now?

35. A few propositions can be stated with confidence about the law of penalties as it

stands after Cavendish:

35.1. The law of penalties does not apply to ‘primary’ obligations, even where the

occasion for the application of the obligation is a breach of contract. What is a

primary obligation, and what is a secondary obligation, is a question of

substance, and not of form.

35.2. The law of penalties is no longer about whether or not a clause is a

“deterrent”, nor is it about whether or not a clause is a genuine pre-estimate

of loss (unless the interest being protected is simply an interest in being

compensated for breach).

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35.3. The focus now is on the discrepancy between the detriment imposed on the

contract breaker and the ‘legitimate’ interest of the innocent party in the

enforcement of the contract.

35.4. In cases involving sophisticated parties negotiating on a level-playing field,

there is a strong presumption that they are best placed to value those

interests: para [35].

36. But there are also a number of questions which remain opaque, and which

subsequent cases are going to have to confront and develop:

36.1. What is a primary obligation, and what is a secondary obligation? Indeed, the

Court left open the possibility of a ‘disguised penalty’: that is, a provision

which looks like a primary obligation but is in fact a concealed ‘penalty’ –

when and how this might apply remains a mystery.

36.2. What is a ‘legitimate’ interest in performance?

36.3. How will the Courts go about valuing those ‘legitimate’ interests?

36.4. When will a clause be “out of all proportion” to such a legitimate interest?

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The problems

Scenario 1

Questions:

(3) Should each of (i) Clause 17; (ii) Clause 18(a); and (iii) Clause 18(b), be treated

as a penalty clause? What are the arguments:

(a) for each being a penalty clause; and

(b) against each being a penalty clause?

Clause 17

Arguments for being a penalty clause

Arguments against Our view

This is a secondary obligation: it provides for the consequences for the failure to perform primary obligations. Therefore the doctrine applies.

Could this be categorised as a primary obligation, because in effect it adjusts the payments being made between the parties?

It is difficult to say that it is a price adjustment clause. It is secondary obligation.

The only obvious legitimate interest for it to protect is receiving compensation for delay.

Big Property’s interests in complying with deadlines might go far beyond compensation for loss: a lack of liquidity might imperil its very existence; Big Property has its reputation to protect.

Depending on the facts, Big Property may have good reasons, aside from compensation for delay, to have the project delivered on time

The ‘value’ of that interest ought to be readily calculable – it is the extra interest exposure which Big Property will face as a result of a failure by Major Developer to comply with deadlines.

Big Property’s wider interests will be very difficult to value. The costs of delay also might be difficult to calculate where there is a complex construction schedule or complex financing arrangements. These are sophisticated parties negotiating on a level playing field, and hence the parties are the best judges of what those interests are worth.

It could well be difficult to calculate the value of the interest protected, and significant latitude should be given to commercial parties.

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A failure to comply with some deadlines is likely to cause much less damage to Big Property than a failure to comply with others, yet the £500k in each case remains the same. Big Property will have invested different amounts at different times, and so a delay, even of a given period, will cause it different losses.

There is nothing objectionable about having a fixed consequence for breach. Indeed, a key purpose is to avoid getting drawn into complex quantification arguments.

The ‘one size fits all’ nature of the clause is a powerful factor in favour of it being a penalty, but it should not any more be regarded as determinative.

Indeed, some failures might be entirely ‘remediable’, in the sense that it will be possible to bring the project ‘back on track’ before Big Property suffers any loss. In such a case £500k will be purely punitive.

Big Property is still entitled to try to influence Major Developer’s conduct by this Clause. Delay in the process, even if not in the actual result, will still prejudice Big Property.

The case would be clearer if the payments were only due for a delay after the eventual completion date for the whole development. This is probably the strongest factor in favour of it being a penalty.

The instruction of experienced solicitors is only a presumption and not determinative

The parties are on a level playing field and have instructed experienced solicitors. There is a strong presumption that there is no penalty.

The Courts will be more reluctant to conclude it is a penalty, given the level playing field and solicitors. But the point is not determinative.

£500k per week is excessive There is no basis for saying that this is “out of all proportion” to Big Property’s losses

This will depend on the facts: it will depend on the financial scale of the development. It could well be determinative.

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Clause 18(a)

Arguments for being a penalty clause

Arguments against Our view

Again, this is clearly a secondary obligation. An obligation to pay enhanced interest can be treated in just the same way as an obligation to pay money Even if this could be presented as an agreement altering the price of credit, there is reason to believe that it is actually a disguised punishment for breach. The increase in ‘price’ is so excessive that it can only be explained as punitive in intention.

This is a primary obligation: it is about the price of credit, not regulating the consequences of breach.

It is more arguable that it is a primary obligation than Clause 17. However, it is still not easy to classify the payment of interest as part of the ‘price’ of the deal.

Major Developer’s interest in enforcement of deadlines for payment can only extend to being compensated for loss, which would include only a normal rate of interest

Major Developer is extending credit to Big Property, and as such has a perfectly good commercial interest in imposing higher prices for credit on a party that is late paying than on one that pays in time: the former is a greater credit risk. Indeed, Major Developer may have real concerns that Big Property will become insolvent. The transaction is unsecured, so Major Developer has a particular interest in keeping all sums owed to it as low as possible

Quite often a clause providing for enhanced interest will legitimately “overcompensate” without particular reason. Matters of credit risk are matters for the parties and a substantial divergence would be necessary before it could be concluded that the clause is not a genuine agreement as to price. Here, for example, the particular risk of Big Property’s leveraging may well justify the clause.

Interest at 15% above base rate is plainly “out of all proportion” to the loss which Major Developer – which is an equity investor – might suffer.

Sophisticated commercial parties are the best judges of how much that interest is worth.

This is likely to be a highly factual question. How much could Major Developer make with the money if it invested it elsewhere? Is that dramatically lower than 15%?

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In any event, the focus should not now be on loss, but on the value of Major Developer’s interest, which as above could be wider merely than loss.

Clause 18(b)

Arguments for being a penalty clause

Arguments against Our view

This is a ‘forced transfer’ clause, which is capable of being a penalty. It is a secondary obligation, as it is engaged upon a breach of primary obligations. It is not a price adjustment clause, because the value of the underlying asset (SPV Ltd) is in no way affected by Big Property’s delay in payment (unlike in Cavendish)

This is a primary obligation: it is a right that has been granted to Major Developer, which can be exercised in certain circumstances. It is in effect a term about the basis on which Major Developer was willing to enter into and remain in joint venture with Big Property, as opposed to ‘going it alone’

This is a really difficult issue and is likely to be a key battleground, turning on the particular facts and wording of the clause.

There is no legitimate interest to protect here: Major Developer is getting far more than compensation for late payment (depending on the value of the shares at the time).

If Big Property is so late in payment then Major Developer will have serious concerns that (i) Big Property is unable to pay; and (ii) it simply can’t continue to work with Big Property. In such circumstances there is a legitimate interest in dissolution of the relationship. This is a fair way to achieve that. This is simply one of the commercial terms on which Major Developer was prepared to go into a joint venture with Big Property. It was not prepared to do so in

Again, this will be fact sensitive, but we prefer Major Developer’s arguments.

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circumstances where it was not receiving prompt payment from Big Property. That is a legitimate commercial approach.

There can be no question that there will be some circumstances in which that detriment might be “out of all proportion” to the loss suffered by Major Developer as a result of the failure to pay on time, eg if Big Property fails to make a very small payment at the end of the project when its shares are worth a great deal.

Sophisticated commercial parties such as these are best placed to value those interests. It is impossible for the Court to determine what other conditions Major Developer might have imposed had it not achieved agreement on this term. Even if it falls to the Court to question this clause, it cannot be said that it imposes a detriment “out of all proportion” to Major Developer’s interests. Big Property is fully compensated for its contributions: the net effect of the clauses is to create a situation in which it as if the joint venture had never existed.

It is not possible to say bluntly that Major Developer’s desire to terminate the joint venture in circumstances where it is not receiving prompt payment is a legitimate commercial interest. It may be in some circumstances – e.g. if Big Property fails to make a very significant payment – but there will be other circumstances, e.g. as above, a failure to make a small payment at the

There is nothing objectionable about having a fixed consequence for breach.

Again, there will be ‘one size fits all’ considerations, but they will not be determinative. Those arguments will be stronger here than in Clause 17, because it will probably be easier to quantify Major Developer’s loss where payment is late.

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very end of the project, where that is not a legitimate interest, but rather appears to be an excessive punishment for breach. As the clause is capable of having this effect, it should not be enforced.

(4) If Clause 18(b) is a penalty clause:

(a) What should the Court do instead of enforcing it according to its strict

wording?

(b) Would it make any difference if the value of the contributions paid

happened to equal market price of the shares?

This issue has now been settled by the Supreme Court’s overruling of Jobson v

Johnson: the clause will not be enforced at all.

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Scenario 2

Questions:

(4) Should each of Clauses 7(a) and 7(b) be treated as a penalty clause? What are

the arguments:

(a) for it being a penalty clause; and

(b) against it being a penalty clause?

Clause 7(a) and (b)

Arguments for being a penalty clause

Arguments against Our view

This is a ‘withholding clause’ and is therefore within the scope of the doctrine

The Supreme Court assumed, but did not decide, that it was within the scope of the doctrine

Our view is that the Supreme Court did decide that it was within the scope of the doctrine: see ¶19 above.

This cannot be construed as a price adjustment clause: the parties have agreed the price for the shares in SPV Ltd as the market value. The value of SPV Ltd is unaffected by whether or not Big Property uses best endeavours in respect of the new development.

This is a price adjustment clause: ‘earning’ the agreed price for the shares and the settlement of the litigation requires Big Property both to transfer the shares and to comply with the best endeavours obligation. In other words, the value of the new development is substantially reduced if Big Property does not use best endeavours to assist

We think that this is probably a price adjustment clause and is therefore a primary obligation. It is very similar to Cavendish and the fact that the value of the SPV is no different is besides the point: the value of the total package in the settlement agreement is reduced.

Major Developer does not have a legitimate interest in the best endeavours clause beyond being compensated for breach: that clause does not affect the value of the shares being sold.

Major Developer has a key interest in securing Big Property’s cooperation. Without it, the value of the new development may be substantially reduced.

We consider that there is a key legitimate interest to protect.

The only legitimate interest which Major

It is very difficult to quantify the loss that Major Developer

We think that Major Developer’s arguments are

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Developer can therefore have is compensation for breach of the best endeavours clause.

has suffered, and very difficult questions of causation will be raised. A key purpose of the clause is to avoid having to undertake that difficult exercise.

potentially the better ones, depending on the relative values of the two developments and Major Developer’s chances of progressing the new development with Big Property’s assistance.

Big Property was ‘completely over a barrel’. There was no level playing field.

Big Property still acted independently, and upon advice of experienced solicitors. It did not matter that it was in an economic bind (which was of its own making) and that that factor should certainly not count against Major Developer.

The relative bargaining positions will be relevant, but unlikely to sway the balance here.

The 60% reduction in payment is out of all proportion to the damage. Having to pay costs bears no relationship with the damage either.

It fairly reflects the loss suffered.

Again, this will be mainly a question of fact.

Clause 7(b) does not relate to any legitimate interest: its only purpose can be to punish Big Property for a breach by requiring it to pay the costs of the litigation.

This is simply one of the terms on which Major Developer was willing to settle. The parties could have agreed that Big Property should pay the costs of the litigation, and the fact that they in effect made that payment conditional on the non-performance of the best endeavours obligation does not mean that it is a penalty, rather it is a primary obligation.

On the present state of the law Major Developer’s arguments are likely to be the better ones: costs were always an issue that had to be dealt with in the negotiations and this is the way the parties choose to do so. It is a primary obligation outside of the doctrine. See for example the facts of Cine Bes. However, this exemplifies the difficulties in distinguishing between primary and secondary obligations. Why is it that a cash payment of £500k should be treated any differently from an obligation to pay costs of £500k?