C’Mon Ref – That Was Never A Penalty.

Short term loans sometimes provide for fees, charges, and stepped interest clauses not typically found in long term traditional vanilla lending. Such provisions are often triggered by specified events of default. And when so triggered, the effect can be game-changing for the borrower who expects to be able to settle at one level, only then to find, that settlement at an altogether different level is required, and beyond means. In these circumstances, lenders may face challenge, that such clauses amount to penalties, in respect of which English law recognises a long established principle that penalty clauses are void on grounds of public policy.

Last month, the High Court confirmed the status quo on penalty clauses, in Edgworth Capital v Ramblas.

The Law

A penalty clause is one which requires one contracting party to make payment of a sum of money to another, upon a breach of contract, in circumstances where there is no justifiable commercial basis for such payment. A penalty clause is regarded as a penalty where its purpose is to discourage the other party from breaching its duties. A penalty clause is void and/or unenforceable.

A liquidated damages clause is a clause that provides for a payment which amounts to a pre-agreed estimate of losses for breach of contract. A liquidated damages clause is valid and enforceable.

The Facts

The borrowers, Ramblas, entered into a series of financing agreements. Ramblas was an SPV owned by 2 investors. The agreements assisted the borrower in purchasing property in Spain. There was a senior loan, a junior loan, and a personal loan to the 2 investors. The investors breached the terms of their personal loan, which breach triggered default provisions in the junior loan. Edgworth commenced proceedings seeking payment of a fee of 105m Euros arising on default. The defendant disputed the fee, as it exceeded any damages which it might be liable for breaching the junior loan agreement. It was, they argued, a clause void and unenforceable as a penalty. As you would imagine, both parties entered into the agreements freely, and with the benefit of legal advice.

The Decision

The Court considered the facts, and applied four tests first established in 1915 in the case of Dunlop Pneumatic Tyre
1. It’s the facts, not the description, which establishes whether a clause amounts to a penalty or liquidated damages clause – How the clause is labelled is inconclusive,
2. A penalty clause provides for a payment intended to penalise, a liquidated damages clause provides for a payment which is a genuine pre-estimate of damage or loss,
3. The character of a clause is to be determined on the facts and the construction of the document as at the date of the agreement, not the date of breach,
4. To assist in construction, various factors are to be taken into account including,

• Is the sum extravagant and unconscionable relative to the natural loss which flows from the breach
• Does the sum payable arise from non-payment, and if it does, is the amount payable under the clause greater than the unpaid sum which triggered the additional payment
• There will be a presumption of penalty clause , where the payment is by way of lump sum payable on a single default event, or if arising from a series of default events, where some of the series are considered trivial and others serious,
• Is the payment commercially justifiable?
• Are the payments oppressive or wholly disproportionate to the loss suffered as a result of the breach?

And on applying these tests and considering the factual matrix, the court held the rule against penalties did not apply in this case, on these facts, and the borrower was liable to make payment notwithstanding the amount payable.

In arriving at that decision, the court took into account that under the agreement

• The fee was always payable, not just on default
• The true purpose of the fee was to provide consideration for financing not to defer the borrower against default
• The factual matrix, economic climate and context in which the agreement was made was such that the fee represented justifiable commercial consideration for the risks being taken by the lender at that time despite not being a pre-estimate of loss

Lessons for Lenders

• Get your terminology right – whilst the label may not be determinative a poor description may hinder prospects when challenged.
• Ensure any such clauses provide for payment in breach and not breach circumstances
• Payment levels should not be extravagant, disproportionate or above and beyond standard rates, and within market rates