PENALTY CLAUSES: HOW TO STAY SWEET FOLLOWING CANDY

PENALTY CLAUSES: HOW TO STAY SWEET FOLLOWING CANDY

INTRODUCTION This update looks at the recent case of Holyoake v Candy1 ( Holyoake ), which provided useful guidance on how the English courts interpret the Penalty Rule and how careful drafting can sometimes take a clause outside of its scope. Parties will often agree in advance a specified sum that will be payable in the event of certain breaches of contract. These clauses are known as liquidated damages clauses and are an important feature of engineering, procurement and construction ( EPC ) contracts or operation and maintenance ( O&M ) contracts of the type typically used in largescale energy infrastructure projects and contracts based on the FIDIC, IChemE and MF/1 forms of contract. They are important as they may, where there has been delay, be the clause which allows the project to remain financially viable (and may be an essential term from the perspective of securing financing for the project). However what purports to be a liquidated damages clause may, as a matter of English law, be regarded as a penalty, and would therefore be unenforceable ( the Penalty Rule ). The approach to whether a particular clause is, or is not, a penalty clause, has relatively recently been reviewed in Cavendish Square Holdings BV v Makdessi2 ( Makdessi ). Holyoake offers further insight into the practical application of the Penalty Rule. THE PENALTY RULE The Penalty Rule provides that clauses that are penalties are unenforceable on the grounds of public policy. A penalty clause was traditionally judged by whether it represented a genuine pre-estimate of the potential losses that the party imposing the penalty might suffer as a result of a breach. Although this approach is still relevant in relation to straightforward liquidated damages clauses, the law on penalties was comprehensively reviewed and restated in 2015 by the Supreme Court in Makdessi. Some of the key principles set out in that case were: 1. The Penalty Rule only applies to contractual provisions that are triggered upon a breach of contract. 2. Whether a provision of a contract comes within the scope of the Penalty Rule is a question of substance not form. 3. Where the Penalty Rule is engaged, the test for whether a contractual provision is a penalty is whether the provision is a secondary obligation which imposes a consequence on the party in breach which is out of all proportion to any legitimate interest of the innocent party. To determine this, the court may take into account and give weight to the commercial context of the contract when deciding whether the provision is extravagant, exorbitant or unconscionable. 4. The nature and extent of the negotiation of the contract, the sophistication of the parties and the extent to which lawyers were involved will be relevant to considering whether the provision is extravagant or unconscionable. 5. Whether the purpose of a clause was solely or mainly to deter the other party from breaching the contract is not the defining factor and a clause may be commercially justified and not an unenforceable penalty even if its purpose is to deter a breach of contract. 6. In some circumstances, if and how the Penalty Rule is applied might depend on how the relevant contractual provision is drafted. Consequently, careful drafting may take a contractual provision outside the scope of the Penalty Rule. Under English law, if a court or tribunal determines a clause to be a penalty, the general approach will be that the clause is only enforceable up to the level of the injured party s actual loss. 3 In order to make this assessment, the court or tribunal will apply the usual common law principles for the assessment of damages. With this comes the difficulties regarding causation, mitigation and foreseeability that liquidated damages clauses are trying to avoid. 1 Holyoake and another v Candy and others [2017] EWHC 3397 (Ch). 2 [2015] UKSC 67. 3 Jobson v Johnson [1989] 1 WLR 1026. 02 Penalty clauses: How to stay sweet following Candy

HOLYOAKE V CANDY In Holyoake, one of the issues that the court considered was whether, applying the principles set out in Makdessi, certain clauses in various loan, escrow and extension agreements were penalties and therefore unenforceable. The judge held that, as a matter of form and substance, the relevant clauses were not unenforceable penalties. The case is especially interesting given the judge s express acknowledgment that it may be possible to use careful drafting to take a contractual provision outside the scope of the Penalty Rule. Although the focus of the case is residential property, it is of equal application to energy sector contracts which contain what could be interpreted as penalty clauses. Factual Background The Claimants had purchased a property (the Property ) with the aim of converting it for residential use. The Claimants raised the purchase price through three loans, one of which was an unsecured personal loan to Mr Holyoake (one of the Claimants) of 12 million from one of the Defendants, CPC Group Limited ( CPC ). However, soon after this loan was entered into, CPC alleged that Mr Holyoake was in default because he had overstated his financial worth. In order to avoid the proceedings being threatened by the Defendants, Mr Holyoake entered into a series of supplemental agreements to restructure the loan. Mr Holyoake then defaulted on the loan and CPC issued proceedings to secure repayment. In order to repay CPC, the Claimants sold the property without carrying out the development. The Claimants then brought proceedings against the Defendants to recover the amount repaid to CPC, lost potential profit from the development and damages. This amounted to a claim for 132 million. The Claimants alleged, amongst other things, that certain provisions in the loan and various supplemental agreements were unenforceable penalties. The following clauses are some of those that were challenged by Mr Holyoake (the borrower under the loan): 1. A clause that required the borrower to pay a sum (the Redemption Amount ) on early repayment of the loan. The Redemption Amount was the whole interest that would have accrued by the end of the two year period of the loan. This ( 5.74 million) added to the 12 million loan meant that the borrower was required to pay 17.74 million on early repayment of the loan. 2. Clauses in certain loan extension agreements that required the borrower to pay certain extension fees (the Extension Fees ). 3. A clause in an escrow deed which provided that if the borrower did not repay the debt and did not complete an associated sale and purchase agreement in respect of the Property, a new debt (of 17.74 million) would arise (the Escrow Amount ). 1. The Redemption Amount The relevant provisions in the loan agreement provided that the borrower would repay 17.74 million (including interest) in respect of the 12 million loan whether the loan was repaid at the end of the two-year term or if he chose to repay it earlier. The judge decided that this clause and the payment of the Redemption Amount were triggered by the borrower exercising its option to repay the loan early; not on a breach of contract. The judge therefore determined that the requirement to pay the Redemption Amount was, both in substance and form, part of the primary obligations of the borrower and, as a result, not within the scope of the Penalty Rule. www.dlapiper.com 03

2. The Extension Fees The judge determined that the requirement to pay the Extension Fees under the extension agreements was in consideration for the lender extending the time in which the borrower could repay the loan. Mr Holyoake agreed to the Extension Fees because he needed the extension. The payment of the Extension Fees was drafted as a primary obligation, payable in any event under the various extension agreements, and not on default. The judge held that as a matter of form therefore [these provisions] did not operate on a breach and did not engage the penalty rule. Nor in my judgment did [they] do so in substance either. 3. The Escrow Amount Mr Holyoake did not actually repay the 17.74 million under the original loan agreement (or under a later supplemental loan agreement). Instead he agreed in an escrow deed that if he did not repay the debt and did not complete a sale and purchase agreement (by which the property would be purchased by the lender, the SPA ), a new debt of 17.74 million would arise. It was held that the repayment of the debt and the completion of the relevant SPA were conditions of the escrow deed, and therefore the clause was triggered by a failure to fulfil certain conditions and not on a breach of the escrow deed. This brought the obligation outside of the Penalty Rule. The judge acknowledged that this may be the result of clever drafting. CONCLUSION The judgment in Holyoake v Candy illustrates that it is possible, in certain circumstances, to effectively avoid the Penalty Rule by careful drafting, for example, by expressing an obligation to pay as a primary obligation or as an obligation which is conditional on performance. However it is also clear that the court will always be alive to the fact that what matters is substance over form, and the judge in Holyoake v Candy noted in his decision that if the penalty rule is to have practical value, it should not be too easy to circumvent by drafting. Commercial parties, especially those looking to include or rely on liquidated damages clauses, must continue to give due consideration to the Penalty Rule when negotiating the consequences of a breach of contract. The English courts are, however, taking a more commercial approach to the interpretation of agreed remedy clauses and careful drafting can ensure that the Penalty Rule is not triggered. If parties follow the guidance contained in this article, it should enable them to stay sweet following Candy. CONTACTS James Carter Partner T +44 333 207 7965 james.carter@dlapiper.com Chloe Mears Associate T +44 20 7796 6203 chloe.mears@dlapiper.com Simon Collier Senior Associate T +44 333 207 7995 simon.collier@dlapiper.com Hugh McCrea Trainee Solicitor T +44 207 153 7591 hugh.mccrea@dlapiper.com 04 Penalty clauses: How to stay sweet following Candy

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