Generally speaking the courts won’t force someone to comply with a penalty clause in a commercial contract if the terms of the clause are excessive. (A penalty clause is a provision that imposes an excessive sanction on a party that breaches the contract.)
The reluctance on the part of judges to enforce penalty clauses marks a departure from the overarching principle that businesses should be free to agree whatever contractual terms they like. Because of this departure the courts set a high bar when it comes to deciding if a penalty clause is in fact disproportionate. Here at ParrisWhittaker in the Bahamas we advise a range of businesses on their contractual arrangements and keep a close eye on legal developments to ensure our expertise is as up to date as possible.
In Permavent v Makin (2021) the English High Court reiterated that while penalty clauses are unenforceable, even an extremely harsh set of sanctions might not amount to a penalty clause. The case is an important one and is likely to have legal authority in the Bahamas because judges here are inclined to follow many decisions of the English courts. We examine the case and the implications for commercial contracts below.
Liquidated Damages v Penalty Clauses
When entering any kind of commercial agreement it makes sense to anticipate circumstances in which one party doesn’t fulfill its side of the bargain.
In addition to a well-drafted force majeure clause your contract should contain a liquidated damages clause that sets out clearly who pays what in the event of a breach. Such clauses are extremely useful because each side is clear at the start of the contractual relationship what happens if they don’t comply with the contract. Liquidated damages clauses also provide the basis for a quick resolution of any dispute without the need for the innocent party to prove or quantify losses flowing from the breach by the other party.
Having said that, great care is required when drafting a liquidated damages clause. If you go too far and create a penalty regime that’s disproportionate to the potential breach it could be interpreted as an unenforceable penalty clause.
The Makdessi Test For Penalty Clauses
In 2015 in the case of Cavendish v Makdessi the English Supreme Court clarified the nature of penalty clauses. First it said the clause must be a secondary obligation of the contract (that is, a clause that is only invoked following a breach of a primary obligation of the contract). Second, consider if the sanction envisaged by the clause so ‘extravagant’ that it goes way beyond protecting the innocent side’s ‘legitimate interest’? If both these conditions are fulfilled then the clause will be an unenforceable penalty clause.
By referring to ‘legitimate interests’ the Supreme Court in Makdessi allows those seeking to enforce a disputed clause greater leeway because it’s possible to argue the clause is protecting something more than just monetary loss. Intellectual property for example, or a particular customer base.
Makin 2021: A Clause Can Impose Harsh Penalties – But Still Be Enforceable
It’s worth looking at the facts of Permavent v Makin (2021) and the decision as it relates to penalty clauses. Briefly, Mr Makin and a Mr Yeremeyev sold roofing products together through various entities, including a company known as Permavent Limited. In the course of his work Mr Makin developed what turned out to be a lucrative product (the Easy Roof System) and licensed it to Permavent for sales and marketing purposes.
Ultimately the two men fell into a dispute about how the business should be run and, in the course of terminating his business relationship with Mr Yeremeyev, Mr Makin attempted to prevent Permavent from selling the Easy Roof product. Permavent believed it owned the intellectual property over the product and applied for an injunction to enable it to continue selling the product to its customers.
Before the injunction application reached court the two sides negotiated a compromise: Mr Makin agreed to sign over the rights to the Easy Roof System in return for a considerable sum of money. Crucially the settlement contract stated that if Mr Makin asserted any rights over the Easy Roof System he would be obliged to repay all of the financial compensation he had received.
Mr Makin did subsequently try to claim ownership of rights over the Easy Roof System and Permavent asked the court to uphold the clause obliging Mr Makin to return the monies he had received.
The High Court agreed that the clause was harsh. The judge indicated however that the question wasn’t whether the penalty is ‘harsh or even extremely harsh’, but whether it is ‘extravagant, exorbitant or unconscionable’ and out of all proportion to the actual loss suffered by the innocent party (Permavent).
In the circumstances the court found the clause was a legitimate attempt to protect the Permavent business from damage caused by Mr Makin’s actions. If he was not curtailed Mr Makin could potentially decimate the Permavent business by preventing it from actually selling its product. In the court’s view it was crucial too that before signing the settlement agreement Mr Makin had received professional, independent legal advice so he should have realised the ramifications to him of breaching it.
How We Can Help
Great care should always be taken when entering into contracts with commercial partners to ensure that the contract – including any sanctions for breach – will be enforceable. From our point of view as experienced contract lawyers there are various approaches we can take to make your contracts as robust as possible. For example we can specify exactly what your legitimate interests are so that they can be protected and ensure that your contractual priorities are expressed as primary obligations to get around the Makdessi test that could result in a clause being viewed as a penalty clause. We’d also highlight within the contract that each side received independent advice and was fully aware of the consequences of breaching any tern of the agreement.
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For clear, practical advice on all aspects of commercial contracts schedule a meeting with a lawyer at ParrisWhittaker today.
