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Does my commercial contract contain penalty clauses? Does my commercial contract contain penalty clauses?

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Dec 21

Does my commercial contract contain penalty clauses?

Written by Matthew Hill
Head of Dispute Resolution

DDI: 01423 724611
M: 07590 021148
E: matthew.hill@raworths.co.uk

Many commercial contracts include a provision which requires compensation to be paid, by one party to another, in the event that certain terms are not complied with.  But are you obliged to make payment under such a provision where a breach has arguably caused no discernable harm or where the amount being sought appears to be excessive?

In summary, the answer will depend on the circumstances, and specifically on whether the provision has been imposed to safeguard the legitimate business interests of your opponent and, if so, whether it can be said to do this in a fair and reasonable way.

In some cases, it may be possible to have disproportionate compensation provisions declared unenforceable, particularly where they have been effectively imposed on you because of a lack of bargaining power at the time the contract was agreed.

Where a contractual provision is held to be void you may still find yourself liable to pay compensation under common law rules, but you will have the comfort of knowing that in this case the amount you have to pay will reflect the losses that your breach has actually caused.

What type of contractual provision should you look out for?

The most common type of provision requiring the payment of compensation upon a breach of contract is known as a ‘liquidated damages’ clause.  Here, there is a requirement that where a party fails to do something that they have contractually agreed to do, they must pay the other party a pre-agreed sum which may or may not be based on a pre-estimate of the losses that a particular breach is likely to cause.

Liquidated damages clauses are routinely included in business contracts to provide certainty about what the consequences of a breach of contract will be, with the intention that this should reduce the likelihood of a disagreement arising.

However, what many business owners do not realise is that a liquidated damages clause will only be enforceable where it can be shown that it does not amount to a penalty clause.

What would amount to an unenforceable penalty?

It is necessary to consider the clause in question and consider three matters.

Primarily, can the clause be regarded as a secondary obligation as opposed to a primary obligation?

In other words, is it an incidental clause or, alternatively, a clause that is triggered only where there has been a failure to comply with a principle contractual obligation?  It is only secondary obligations that can be challenged under the penalty clause rule.

Secondly, is there evidence to suggest that it has been included in order to protect the legitimate business interests of your opponent, or does it simply appear to have been inserted to inflict punishment where a breach of contract occurs?

In one recent case, a clause provided that, if restrictive covenants in a business share sale agreement were not observed the seller would lose the right to payments of £44 million and the buyer could purchase the remaining shares at a reduced price.  This was deemed by the Court to be justified on the basis that the clause had been included to protect the buyer’s legitimate interest in ensuring that the terms of the restrictive covenants were observed because a large part of the price paid for the business related to goodwill, the value of which would be significantly diminished if the non-compete provisions were ignored.

Thirdly, given the nature of any business interests that the clause appears to seek to protect, can the requirements imposed be said to be proportionate or are they plainly extravagant, exorbitant, or unconscionable? If they are proportionate, then the clause is likely to be enforceable. However, if they are disproportionate then there is a chance that the clause will be disallowed.

A recent example of a provision that was found to be disproportionate arose in the context of an employment contract which required an employee to repay recruitment costs related to their appointment because they had elected to leave their role within 12 months of being hired.  The repayment sought was in excess of £5,000, which equated to 21 per cent of the employee’s annual salary and took no account of the income they had generated or the fact that they had remained in their role for 11 months before choosing to leave.

While the provision was not declared to be a penalty in this case, given that the trigger for the repayment was not a breach of contract but rather the employee’s own decision to depart, the Employment Tribunal made it clear that had this not been the case the clause would have been unenforceable due to its penal nature. This was because the clause attempted to pass on normal recruitment costs, restrict the employee’s ability to leave within a year of joining, and require them to pay a sum that was out of all proportion when compared with their salary and the income they had generated during the time they were in their role.

The need for specific advice in each case

This is a complex area to navigate, so it is essential that legal advice is taken to find out where you stand and so you can devise a strategy that enables you to push back against a punitive contractual claim, but in a constructive and commercially sensible way.

Details about how to contact our Dispute Resolution team can be found by clicking this link

Published on 13 December 2021

This article is for general information only and does not constitute legal or professional advice. Please note that the law may have changed since this article was published.

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