Practical implications of penalty clauses in English law

You should therefore review your contractual provisions to ensure that they fall outside the ambit of the penalty rule, and amend any provisions as may be necessary to reflect the change in the law.

The new test applies to clauses in any relevant contract governed by English law, whether in the Gulf Cooperation Council (GCC) or elsewhere.

What is a penalty clause?

Broadly, a penalty clause is a contractual provision which levies an excessive monetary sum unrelated to the actual harm against a defaulting party. Penalty clauses are generally unenforceable under English law.

The penalty doctrine does not simply apply to 'classic' liquidated damages clauses, which stipulate the payment of a sum of money in the event of breach of contract, but may also apply to other clauses which provide for:

• the transfer of assets either for no consideration or at an undervalue;
• forfeiture of a deposit; or
• where the amount due is withheld or shares or other property is removed from a party in breach of its obligations.

In 2015, Supreme Court judges Lord Neuberger and Lord Sumption reformulated the test for penalty clauses as follows:

"[T]he true test is whether the impugned provision is a secondary obligation which imposes a detriment on the contract-breaker 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."

The judges described the penalty clause rule as "an ancient, haphazardly constructed edifice which has not weathered well", but decisively stated that the rule should not be abolished. This is because the rule is a "long-standing principle of English law", which has a "useful role to play in protecting people against some categories of oppressive bargain[s]"; particularly where the parties are of "unequal … bargaining power" and there is a "risk of oppression".

The Supreme Court, which was ruling in two linked cases, reinforced the common law notion of the freedom of contract between properly advised and sophisticated parties. Lord Mance made it clear that if both parties are "well-informed and sophisticated parties" who "carefully negotiated [an] agreement ... at arm's length", there is a "strong presumption that the clause will not be construed as a penalty". Therefore, in commercial contracts, parties should have greater confidence that their contracts will not be deemed unenforceable.

The penalty clause rule applies only to secondary, rather than primary, obligations. Broadly speaking, a 'primary' obligation is a stand-alone contractual obligation, while a 'secondary' obligation is only triggered as a consequence of a party committing a breach of contract and is intended to provide a contractual alternative to damages.

However, regardless of any contractual stipulations, the courts have made it clear that they will comprehensively review the real nature and substance of the transaction when deciding whether it imposes a primary or secondary obligation. Therefore, to ensure that provisions fall outside of the scope of the penalty clause rule, parties should structure provisions as primary obligations while simultaneously reasonably drafting provisions to ensure that they are not deemed a 'disguised' penalty clause and thereby unenforceable.

It may not always be possible or commercially desirable to draft a contractual provision as a 'primary' obligation - for example, because a party wants to retain the ability to pursue common law damages for breach of contract. Where this is the case, and the penalty clause rule is engaged, the courts will consider whether the provision is penal in nature. If the clause is a secondary obligation, the drafter's focus should be on demonstrating that the other elements of the penalty clause test are not satisfied.

Drafting implications in relation to corporate and finance contracts

The Supreme Court held that the application of the penalty rule "can still turn on questions of drafting". It is therefore important to construct contractual provisions that fall outside the penalty clause rule.

Some examples of potentially problematic provisions are:

• 'bad leaver' clauses in corporate agreements (e.g. company articles of association or shareholder agreements), which are commonly used to discharge shares held by managers on private equity transactions, may potentially be penalty clauses where they require departing employees to give up their shares for less than the market price;
• default provisions in oil and gas joint operating agreements such as forfeiture clauses which generally provides that a defaulting joint venture party (such as by failure to satisfy a cash call or provide security) should transfer its interest in the joint venture to the non-defaulting party without any compensation; and
• default interest clauses in loan agreements, where a significantly higher rate of interest is charged that would be payable if all sums were paid on time.

As a general rule of thumb, whether a particular clause is a penalty will hinge on the broader factual and commercial context.

Damian Crosse and Tamim Momeni are commercial litigation experts at Pinsent Masons, the law firm behind Out-Law.com.