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Practical Law Dispute Resolution – When is a penalty not a penalty?

Reproduced from Practical Law with the permission of the publishers. For further information visit www.practicallaw.com or call 020 7542 6664.

When is a penalty not a penalty? Jamie Susskind looks at the decision in Hayfin Opal Luxco 3 S.A.R.L. v Windermere VII CMBS plc [2016] EWHC 782.

In Finland, driving fines are proportionate to the wealth of the offender. Thus a rich boy-racer caught speeding in his father’s Ferrari will pay a higher fine than a down-at-heel driver who committed the same offence. Better-off speeders will sometimes pay fines of tens, even hundreds, of thousands of euros.

The principle underpinning this policy, and found in many European countries, is simple: a penalty is only really a penalty if it appreciably punishes and deters the transgressor.

Does the same principle apply to “penalty” clauses in commercial contracts? No, held Snowden J (obiter) in Hayfin Opal Luxco 3 S.A.R.L. v Windermere VII CMBS plc.

Penalty clauses

The legal principles underpinning the penalty clause doctrine were recently restated by the Supreme Court in Cavendish Square Holding BV v El Makdessi. As Lords Neuberger and Sumption explained at paragraph 31, the real question as to whether a clause is a penalty clause is “whether it is penal, not whether it is a pre-estimate of loss”. As such, whether it is enforceable:

“…should depend on whether the means by which the contracting party’s conduct is to be influenced are “unconscionable” or (which will usually amount to the same thing) “extravagant” by reference to the same norm.”

Put differently, at paragraph 32:

“The 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…”(Emphasis added.)

Comment:Hayfin

Hayfin concerneda commercial mortgage backed securitisation transaction. Snowden J found that, from the perspective of the parties at the time of contracting:

“…the almost inevitable result that could be anticipated [in the event of breach]…would be a multiplication of the unpaid amount by a very sizeable factor to arrive at a sum many times the amount that would adequately compensate the innocent party for being kept out of its money.”

As described at paragraph 140, this was “exorbitant (if not extortionate)”.

Snowden J then correctly held (obiter) that the fact that the defaulting party was itself very rich, and potentially able to pay, was irrelevant. Because Cavendish requires the court to consider penalty clauses “by objective reference to some norm”, the identity of the contract-breaker was neither here nor there. All that mattered was whether the secondary liability imposed was proportionate to the innocent party’s legitimate interest in performance of the primary obligation.

For the same reason, other factors were also irrelevant. As set out at paragraph 142, these were:

  • Thefact that the penalty clause was imposed on a “limited recourse basis”.
  • The”source” from which the offending party would pay.
  • Anypromise to limit the claim to “specified funds in the hands of the contract-breaker, if the available amount of those funds would still be capable of paying a wholly disproportionate amount, and payment might deprive the contract-breaker of the ability to pay debts due to other creditors with lower priority.”

Thus, in the English law of contract, unlike Finnish road safety law, it does not matter that the defaulting party “is so rich that he will not notice the difference”.

This means that if a poor party contracts with a rich party, the poor party cannot legitimately protect itself by inserting a penalty clause proportionate to the wealth of the rich party. This is so even if this meant that the rich party could just default on the contract if the hassle of performance exceeded the sum that would be payable in damages.

This may sound unjust, particularly given that exemplary damages (for cases where it has been calculated that the money to be made from his or her wrongdoing will probably exceed the damages payable) are not available in actions for breach of contract: Addis v Gramophone Co Ltd. Nevertheless it accords with the cardinal principle of damages in English contract law: that the innocent party is to be compensated as if the contract had been properly performed – no more or less.

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