Commercial Contracts and Penalty Clauses

Commercial Contracts and Penalty Clauses

How does the rule against penalty clauses in commercial financial arrangements work in practice?  The expert commercial litigation lawyers at Bahamas law firm ParrisWhittaker are highly experienced in advising and representing commercial parties on their contractual terms.

The courts in the UK have recently ruled1 on the important issue of penalty clauses, and the correct construction and interpretation principles in commercial financial agreements.

What was the background?

The claimants started proceedings against the defendants for breach of an upside fee agreement (UFA) which formed part of a suite of finance agreements between them and RBS bank. The agreements transferred various rights and obligations to the claimants, and the finance documents included senior, junior and personal loan agreements.  The alleged breach was caused as a result of breaches under the personal loan triggering cross default provisions in the junior loan. 

Critical to the defendant’s liability was the interpretation and construction of the definition of 'payment event' (had it occurred upon the outstanding amount of the junior loan becoming due and payable as a consequence of the breach of the personal loan?); and whether the fee clause in the UFA (if payable) was unenforceable as a penalty.

What did the court decide?

The court interpreted the clauses on their plain, commercial construction (even though it said the contractual wording of the fee clause could have been clearer).   As such, a payment event had occurred and the clause allowing for a fee was not unenforceable: the court said it was a penalty or disguised penalty. 

The ruling shows how suites of finance documents are interconnected, and illustrate how the courts will look at the commercial realities to justify the size of fees negotiated by commercial parties.

The ruling means payment trigger clauses can be drafted to allow for payment to be made in a number of circumstances, not all of which require a breach of the agreement.  The question that may arise, however, is whether a future breach triggers the financial consequences.  The rule against penalties will only apply if the relevant clause is triggered by a breach of duty owed by the party claiming relief to the party seeking to enforce the clause. 

What’s clear is that the courts appear generally reluctant to strike out clauses in commercial agreements as penalties where their main aim is not to deter a breach - and there are commercial reasons to justify the size of the fee.   

What does this mean?

Negotiating and drafting commercial contracts must be undertaking with great care, particularly in order to avoid the rule against penalties.  Seek specialist legal advice as early as you can to protect your commercial interests when negotiating commercial contracts.

How can we help?

The commercial litigation lawyers at Bahamas law firm ParrisWhittaker have years of experience advising commercial organisations on their commercial contracts and the potential effects of their terms.  If you are negotiating the terms of a commercial contract, contact us straightaway for urgent, strategic advice.

1 Edgeworth Capital (Luxembourg) S.A.R.L. and another v Ramblas Investments B.V [2015] EWHC 150 (Comm)