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.