By JP Sweny, Matthew Brown and Rachel Croft

A number of recent English court decisions have recast the test for determining when a contractual provision may be unenforceable under English law as a “penalty clause”.

The rule against penalty clauses is particularly important in project finance transactions, which typically involve a complex set of commercial contracts and contractual terms that allocate risk between the parties. For example, liquidated damages provisions (often included in construction and supply contracts), “take-or-pay” or “use-or-pay” provisions (often included in offtake agreements, power purchase agreements and agreements for the use of port or transhipment services), and joint venture provisions that require a defaulting party to forcibly transfer its interest in a joint venture, all provide for a pre-agreed contractual outcome. This provision prevents the parties from needing to seek damages or other redress from the courts (or an arbitral tribunal) in certain prescribed circumstances.

Until recently, the general test for determining whether a provision is an unenforceable “penalty” was whether the provision was excessive in its operation, or was intended to deter a breach of the contract by the other party, and/or was not a “genuine pre-estimate” of loss.

However, the recent decisions narrow the scope of the rule against penalties. Sponsors, developers and lenders should consider the following key points from the recent cases when drafting or negotiating project contracts:

  1. A clause will not be deemed to be a penalty clause simply because it does not contain a pre-estimate of loss, or simply because the parties intend to use the clause to deter any breach of obligations. This is an important development for English law-governed commercial contracts that underpin project finance transactions, because certain standard provisions of such contracts might otherwise have been considered as designed to deter a breach. Furthermore, arriving at a “pre-estimate” of loss was difficult in many circumstances — particularly in an inter-linked set of commercial contracts, which often arise in project financings. Softening the test in this respect is a welcome development.
  2. The extent and nature of the negotiations, the sophistication and respective bargaining power of the parties, and the input of legal advice, will be relevant considerations when making any broader assessment of the enforceability of relevant clauses in a commercial contract. The English Supreme Court held in a recent case 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”.
  3. Before the rule against penalties can apply, the court must determine whether the clause in question is a primary obligation (i.e., an obligation that depends on events that are not breaches of contract) or a secondary obligation (i.e., a penal remedy that essentially replaces a claim for damages that might otherwise be available). The rule against penalties does not apply to primary obligations. Whether a clause is a primary obligation or a secondary obligation is a question of substance and not form.
  4. When a clause is deemed to be a secondary obligation, the court will consider whether there was a “legitimate interest” to be protected. The court will then consider whether the means of protection were so “out of all proportion” as to amount to being “extravagant or unconscionable”.
  5. When the clause in question is a liquidated damages clause, a comparison with the quantum of damages that would ordinarily be awarded is still a relevant consideration.

While the English courts appear to have significantly softened the scope of the rule against penalties, they have also recently shown that they remain willing to find commercial contract terms as unenforceable penalty provisions in certain circumstances. For example, the High Court earlier this year held that the terms of a side letter entered into by two commercial parties, which essentially terminated rent reduction arrangements upon a breach of a lease, amounted to a penalty. The High Court made the decision on the basis that the obligation to pay increased rent was a secondary obligation, the lessor had no “legitimate interest” in enforcing the higher rent, and that a retrospective increase to the rent was extravagant and unconscionable.

This general trend in recent English case law should provide greater assurance to sponsors, developers and lenders alike when negotiating or assessing commercial contracts in project financing transactions. However, parties should still take care to ensure that terms establishing pre-agreed outcomes in certain circumstances consider the English courts’ views on penalty clauses.