The law on penalties pre-Cavendish

Before the case of Cavendish Square Holding B.V. v. Talal El Makdessi [2015] UKSC 67, the law on penalties (i.e. contractual terms that are not enforceable in the English courts because of their penal character) was somewhat unclear. The general formulation of the old pre-Cavendish test was that, in order to be recoverable, LDs had to be a "genuine pre-estimate of loss".

It has, importantly, always been the case that the penalties doctrine only applies to LDs (or other provisions) that are payable upon a breach of contract (i.e. to secondary, not primary, obligations). The English courts will not interfere in the parties' primary obligations, which are a matter for negotiation.

By way of example, the consensus in relation to "take or pay" provisions was (and, as noted below, remains) that they could not be penalties because they did not involve the payment of damages for breach of contract. Rather, the right to take or pay was an alternative method of performance by the buyer and therefore amounted to a primary obligation.

Cavendish

Cavendish clarified the test in relation to penalties and altered the test from the former "genuine pre-estimate of loss" to the following:

1. Is the relevant term a secondary obligation engaged by breach of a primary contractual obligation?
2. What is the nature and extent of the legitimate interest of the innocent party in having the primary obligation performed?
3. Having regard to that legitimate interest, is the secondary obligation exorbitant or unconscionable in amount or in its effect?

Notably, in Cavendish the majority of the Supreme Court held the two relevant provisions to be primary, not secondary, obligations, and therefore the penalties doctrine did not apply:

1. The first was a provision that would involve the seller giving up its right to future payments. This was held to be a price adjustment clause, not a secondary obligation.
2. The second gave the buyer an option to purchase all the seller's remaining shares at a discounted price. This was held to be a severance clause, not a secondary obligation.

Cavendish also made reference (obiter and in passing) to "take or pay" provisions in oil and gas contracts, referring to them as "contingent primary obligations", as opposed to secondary obligations concerning damages for breach. This is likely because, as noted, the buyer has a choice about whether to take the gas and pay for it, or just pay for it.

There have been a number of cases in recent years that have bolstered and confirmed the Cavendish test. They have helped to illustrate how the different limbs of the Cavendish test work.

Substance over form

The courts have continued to take the approach in Cavendish where the substance of the clause is evaluated in the context of the deal. For example, in GPP Big Field and other v. Solar EPC Solutions [2018] EWHC 2866 (Comm), the references to "penalty" in the clause were only held to be "equivocal indications"; it was the substance of the clause that was relevant (and the provisions were held by the court not to be penalties). Thus, even where a provision is described as a penalty, an English court will not necessarily find it to be so, but will instead apply the Cavendish test.

Primary and secondary obligations

As a starting point, the courts have followed the approach reaffirmed in Cavendish, where it is first determined whether the obligation in question is primary or secondary. Different cases have taken different approaches to which obligations they characterise as primary and secondary.

For example, the case of Vivienne Westwood Limited v. Conduit Street Development Limited[2017] EWHC 350 (Ch) involved a lease and a side letter between the claimant and the defendant for a clothing and fashion store. The effect of the side letter was that, notwithstanding the terms of the lease, the defendant agreed to accept yearly rent at a lower rate. The parties agreed that, in the event of a breach of any of the terms of the side letter and/or lease, the defendant was able to terminate the side letter and charge the higher rent in the lease retrospectively. Applying the Cavendish principles, it was held that the claimant’s obligation to pay the higher rent in the lease was a secondary obligation, engaged once the primary obligation in the side letter to pay the lower rent had been breached. Accordingly, the penalty rule was engaged.

The case of Holyoake v. Candy [2017] EWHC 3397 (Ch) further illustrates the point. This was a case involving a loan from Candy to fund the purchase of a property by Holyoake. The clauses in question were all held to be primary obligations:

1. A redemption charge on early repayment was not a penalty, even though it required Holyoake to repay the entire £12 million plus two years' interest if he made early repayment at any stage, because it did not arise upon a breach of contract but rather upon Holyoake exercising a right to repay early.
2. A term in an escrow deed, which provided that, if Holyoake failed to make repayment and failed to complete a related SPA, a new debt would arise for the full amount of the £12 million plus interest, i.e. £17.74 million, was also held not to be a penalty because it arose not upon a breach but upon a failure of a condition.
3. Extension fees in the Extension Agreements, by which Holyoake agreed to pay a fee for the right to an extension of time to pay and, if he made repayment by a certain date, would be credited against his overall debt, were held to be primary obligations, because they were simply the price that Holyoake paid for the right to pay later.

Is the secondary obligation exorbitant or unconscionable?

The courts will consider this limb of the Cavendish test in the full context of the deal structure. By way of illustration, in Vivienne Westwood it was held that given that the increased rent was payable in addition to interest and costs incurred as a result of the breach (and was payable both prospectively and retrospectively), it was exorbitant and unconscionable.

In the case of ZCCM Investments Holdings plc v. Konkola Copper Mines plc [2017] EWHC 3288 (Comm), by contrast the court held that there was nothing extravagant, exorbitant or unconscionable in requiring a commercial party under the acceleration clause in a settlement agreement to pay immediately the full amount of the loan in the event of any non-compliance with its terms.

Similarly, in GPP, the court held that the delay damages did not exceed a genuine attempt to estimate in advance the loss which the first claimant would be likely to suffer from a breach, and that that sum was not in any way extravagant or unconscionable in comparison with the legitimate interest of the first claimant in ensuring timely performance.

Same penalty for different breaches

It has previously been noted that one factor that may be indicative of a clause being penal is if it requires the same sum to be paid upon a number of different events, some of which might be more serious than others.

This was an issue in the GPP case, which concerned LDs under several EPC contracts for the construction of solar power generation plants. The relevant clause provided for LDs of £500 per day per MWp, even though each of the plants had a different output, and there was a difference of over 30% in the expected electricity prices recorded in the various contracts. Although the £500 figure was a round sum to be paid irrespective of the effect of the delay in question, the court held that it is in the nature of LDs that they are often used in cases where precise prediction of the likely loss is difficult, and are therefore frequently expressed in round figures. Further, the sum was payable only on a single type of breach – failure to achieve commissioning of the plant by a specified date. However, the court held that the fact the loss resulting from that breach may vary in amount depending on the circumstances at the time does not of itself give rise to any inference that the sum agreed to be paid is a penalty, provided that it is not extravagant and unconscionable.

The benefit of legal advice

The general position of the courts is that, where contracts have been entered into between commercially experienced entities, there is a strong presumption that the parties are the best judges of the commercial implications of the damages they have agreed and the court should therefore be slow to interfere in this process. This principle is reinforced in situations where the contracts have been drafted with the assistance of legal expertise. This was stated clearly in Cavendish and has been reaffirmed since.

In ZCCM, for example, the court held that the claimant had a legitimate interest in requiring strict compliance with the settlement agreement, that the defendant knew what it was signing up to and the agreement was an arm's-length contract that had been entered into by the defendant with the benefit of expert legal advice.

Similarly, part of the reasoning in GPP that the LDs were not penal was based on the fact that the parties were experienced and sophisticated commercial parties, of equal bargaining power, which were well able to assess the commercial implications of the clause they had agreed.

Impact of Cavendish on take or pay provisions

We do not think that take or pay clauses should be drafted differently in light of Cavendish. It remains the case that a properly drafted clause which provides that the buyer can take and pay or just pay is likely to be construed by an English court as a primary obligation that is not subject to the penalties rule, although no case to date has held this definitively.

One way to mitigate the risk of a take or pay clause being held to be penal would be to draft the provisions in a way that offsets the potentially harsh effects of the provisions on the buyer (i.e. requiring the buyer to pay full price for gas that it is not actually taking and that the seller could potentially dispose of elsewhere). Such mitigation mechanisms could include the common "make-up" rights for the buyer, where the buyer can reclaim the gas for which it paid at a later date or the "take or pay" price being set at a discount to the prevailing contract price.

Forfeiture under JOAs

Finally, it is worth noting that, in an oil and gas context, the English law doctrine of penalties is also frequently invoked in relation to "forfeiture" provisions in joint operating agreements. These typically provide that a party in default of its obligation to pay cash calls will, if the default remains unremedied, be required to assign its participating interest to the other parties (or forfeit such interest), often in return for minimal (or no) compensation. Parties in default frequently seek to resist this remedy on the basis that it is a penalty.

As with take or pay clauses, there has to date been no English law case that has addressed such forfeiture provisions. However, applying the Cavendish test, the following tentative conclusions can be drawn: 

1. As noted above, JOAs will frequently be negotiated by sophisticated parties of equal bargaining power with the benefit of legal advice. The starting point for any court will therefore be that there is a strong presumption that it should not interfere in the terms of their contract.
2. Although such provisions have traditionally been seen as secondary obligations (on the basis that they operate upon a breach of the primary obligation to pay cash calls), there may be an argument that they are primary obligations, perhaps comparable to the forced transfer provisions in Cavendish.
3. It is likely that the non-defaulting parties can show a legitimate interest in the enforcement of the primary obligation of a party to pay its share of costs. This will encompass the need to share risk, the need to fund the ongoing costs of the project and the need to remove defaulting parties quickly and effectively to avoid severe consequences for the overall project.

1. Dentons provides this update for general information purposes only. It does not constitute legal advice and you should not rely on it for that purpose. Dentons does not accept any liability for its use. ↩