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Drafting Penalty Clauses

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Drafting Penalty Clauses

Drafting Penalty Clauses

The decision in Holyoake and another v Candy and others [2017] EWHC 3397 (Ch) has demonstrated that well crafted drafting can get around the rules on penalty clauses.

What is a “penalty clause”?

Penalty clauses refer to provisions in agreements that penalise a party (in the form of a cash payment) for breaching a contract and offers a remedy that is far in excess of alternative damages under common law and bears little relationship to the loss actually suffered. Penalty clauses are often included in contracts as a deterrent to the other party to help ensure they act within the parameters of the agreement.
Penalty clauses in a contract may be held by a court to be unenforceable, as the court considers whether the provision in question goes beyond a reasonable charge and is in fact punitive.

Holyoake v Candy

In the recent case of Holyoake v Candy, the court considered whether various terms in a number of loan agreements constituted penalty clauses. Some of the clauses challenged by the claimant (Holyoake) included:

  1. Repayment of the Loan – a clause requiring Holyoake to pay a fee on early repayment of the loan. This fee included the interest that would have accrued over the full 2 year term of the loan. Due to the size of the loan in this case (£12 million), Holyoake had to pay £5.74 million in interest regardless of when the loan was repaid.

  2. Loan extension fees – clauses requiring Holyoake to pay further fees under a loan extension agreement to the tune of £7.5 million.

  3.  Escrow deed – a clause in a separate escrow deed stated that if the borrower did not repay the debt and did not complete the relevant acquisition of another company, a new debt of £17.74 million would arise. 

In the end, having borrowed £12million from the defendant (Candy), Holyoake had to repay the loan with fees and interest to the sum of over £37 million and so it is clear why Holyoake chose to challenge these provisions.

Decision

The judge held that the clauses above were not reliant upon a breach of contract and so did not trigger the penalty rule as they were not penalties (secondary obligations) but rather primary obligations.

The drafting

Repayment of the Loan – repayment of the loan and the interest due on it (in full) was, in simple terms, the deal Holyoake had agreed to. Whether this was paid back at the end of the term or earlier, the same amount was due and so this could not be intended as punishment but rather payment terms of the loan.

Loan extension fees – the judge confirmed that the penalty doctrine was not available to regulate the price payable under a contract, but only the obligations that arise as a result of a breach. The fee was payable in consideration for an extension of time and this fee was not due as a result of a breach of contract but rather a further term agreed between the parties.

Escrow deed – the effect of the provision was that Holyoake had agreed to pay £17.74 million if he did not refinance or complete the acquisition. However, a failure to refinance and repay the loan or complete the acquisition was not a breach of the escrow deed. As this provision did not operate on a breach of contract (but rather on the failure of a condition in the escrow deed) the penalty doctrine did not apply.

Summary

These findings from the judge illustrate how through careful drafting the penalty rule may be circumvented where the drafter ensures that the obligation in a contract is expressed as a primary obligation of the party or one which is conditional on performance. In this case, if the drafting had been different and required the fees to be payable on a breach and not failing to meet a condition, then this may well have constituted a penalty clause and been held unenforceable. By remaining aware of the subtle difference in the way penalty obligations in contracts operate, it may be possible for such clauses to avoid the protection offered by the penalty doctrine.

If you would like further information on Penalty Clauses or on this topic, you can get in contact with Sean Halliwell or you can give us a call on 0345 070 6000.