Harsh and Damaging – Commercial Bargain or Unenforceable Penalty?

If something is harsh is it a penalty? Further Guidance on the interpretation of Penalty Clauses - Permavent Ltd & Anor v Makin

The recent case of Permavent Ltd & Anor v Makin has provided additional information to contracting parties about what will constitute a penalty clause. In English law, it has long been understood that ‘penalty clauses’ (clauses that impose a “penal” secondary obligation on a contracting party for breaching a primary obligation), would not be enforceable, and this remains the case.

There was a significant shift in interpreting what constituted a penalty clause following the Supreme Court decision of Cavendish Square Holding BV v Talal El Makdessi [2015]. This case clarified that the test to decide if a clause was a penalty was not the previously stated “whether the clause was a genuine pre-estimate of loss” but rather “was the clause penal” by reference to the aims of the contracting parties when the contract was signed. This test, while good for commercial parties’ freedom of contract, has inevitably generated further case law, and it is perhaps somewhat surprising that it has taken time for the point to be considered .

While Permavent relates to a clause aimed at protecting intellectual property rights, the principle is applicable across commercial disputes, including property and construction disputes.

The clause in dispute was contained in a Settlement Agreement which resolved an earlier dispute. As part of the settlement, Mr Makin was to receive a quarterly payment calculated by reference to gross turnover and licensing fees related to the intellectual property (“the ERSP”).

Clause 2.10 prevented Mr Makin from challenging the ownership or validity of Greenhill’s (a third party) IP rights. If he breached this clause, the consequences were set out in Clause 2.11 as follows:

“the ERSP would immediately be reduced to zero per cent, and no further ERSP would become due;the ERSP would be adjusted retrospectively such that any amount of ERSP previously due would no longer be payable, and Mr Makin would have to repay any ERSP previously paid to him; and Mr Makin would be liable to pay the sum of £616,667 to Greenhill.”

In simple terms, Clause 2.11 meant that by breaching Clause 2.10, Mr Makin lost any entitlement to past or future payments arising out of the Settlement Agreement.

In breach of the clause, Mr Makin sought to register an equitable interest in some of the patents related to this Settlement Agreement. The Claimant, in turn, sought to enforce their rights under the clause.

The issue which fell to be decided by the High Court was whether the relevant clause was an unenforceable penalty. The High Court decided that it was not, and therefore the clause was capable of enforcement.

In making this decision, Zacaroli J had to decide whether the detriment to Mr Makin was “extravagant, exorbitant or unconscionable, as being out of all proportion with the protected interest.”

He decided that a challenge to the Claimants’ IP rights in the manner they had tried to guard against could have had far-reaching, long term consequences. Accordingly, it was permissible for the Claimant to seek to protect itself in a way that went beyond seeking compensation for losses flowing directly from breach of the relevant obligations.

It is an important point to note for parties engaged in commercial contracts. Where a contractual clause seeks to protect a party’s rights or interests, and breach of those rights,the party could have wide-reaching consequences and cause damage beyond what could ordinarily be claimed as a genuine pre-estimate of loss. They may be entitled to protect those rights by imposing severe secondary obligations on a party - provided that the secondary obligation imposed is proportionate to the primary obligation it is seeking to protect.

The judge also referred to the impact of legal advice. It was suggested that in a commercial contract, where both parties are legally represented, such clauses are likely to be enforceable. The parties, by virtue of their legal representation, should be aware of the consequences of each clause in the contract - particularly where those consequences are severe.

Contractual freedom between commercial entities is of mutual benefit to the parties, particularly where those parties are represented by solicitors. The freedom to contract (or to resolve disputes), particularly in complex commercial arrangements, allows parties to seek innovative solutions to difficult or complex contractual problems. In turn, this freedom can help prevent disputes before they arise or prevent their unnecessary escalation.

At BWL, our solicitors provide friendly, reliable and competent advice, and will discuss your dispute during a free consultation.

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