Freedom of contract is one of the fundamental strengths of English law. Contracting parties enjoy a high degree of certainty that the English courts will uphold the deal they have struck, which in part explains why so many parties choose English law to govern the terms of their contracts.

However, this contractual freedom is not completely without limit. One circumstance in which the English courts will intervene and render a provision unenforceable is when it is adjudged to be a "penalty". The rule against penalties has long been in play in English contract law, and is underpinned by principles of morality and public policy considerations, to try and prevent a contract breaker suffering consequences which are disproportionate to the breach.

In a financing, the rule against penalties arises most frequently in the context of a default interest clause, but can also rear its head in other circumstances relevant to a financing transaction.

We are beginning to see a rise in the number of defaults occurring, so now seems a good time to review some of the recent cases on penalties.

What is a penalty?

In 2015 the Supreme Court famously reformulated the test for when a provision constitutes an unenforceable penalty in the case of Cavendish Square Holding BV v El Makdessi; ParkingEye Ltd v Beavis¹ ("Cavendish Square"). 

For a century before Cavendish Square the leading authority on penalties² had suggested that a contractual provision triggered upon a breach of contract would be a penalty if it was not a genuine pre-estimate of the loss likely to flow from the breach. It was a test which contracting parties and courts found hard to navigate.

In Cavendish Square, the Supreme Court judges did not all articulate the test for a penalty clause in exactly the same way.

• Two judges³ (with the agreement of a third) held that a penalty was "a secondary obligation which imposes a detriment on the contract-breaker out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation".
• Another judge⁴ proposed a two stage test, with the first step being to identify what, if any, legitimate business interest is protected by the clause. The second step is then to decide whether the sanction for breach is "extravagant, exorbitant or unconscionable".
• The fifth judge⁵ referred to the sum or penalty needing to be "exorbitant or unconscionable when regard is had to the innocent party's interest in performance of the contract".

Despite these slight variations in approach, the Cavendish Square decision certainly seemed to make it harder to challenge a clause as an unenforceable penalty than it had been under the previous "genuine pre-estimate of loss" test.

Default interest clauses

Almost all loan agreements (and most other contracts providing for periodic payments) will include a default interest provision. A default interest provision will provide that a borrower who fails to make a scheduled payment must pay to the lender an additional amount by way of interest on the overdue sum. Before Cavendish Square, lenders would commonly plump for a small uplift (of between 1% and 3%) to the contractual interest rate, on the basis that a modest increase such as this was likely to be immune from challenge as an unenforceable penalty. 

Since Cavendish Square, despite the reformulation of the penalties test, there have been no obvious industry wide moves by lenders to increase the modest pre-Cavendish Square default interest rates. However, some recent cases do suggest that the courts are likely to uphold higher default rates when the circumstances and market evidence justify them.

In ICICI Bank UK Plc v Assam Oil Co Ltd⁶ the court held that a default rate of 4% was not a sum which was out of all proportion to ICICI's interest in the contract being performed and therefore was not a penalty.

Stephenson Harwood litigation partner Sue Millar advised ICICI Bank on this case.

In ZCCM Investment Holdings plc v Konkola Copper Mines Plc⁷ a default rate of LIBOR plus 10% in respect of unpaid amounts under a Settlement Agreement was held not to be a penalty. The judge observed that it was reasonable for ZCCM to require increased rates of interest upon default, on the basis that a borrower in default is not the same credit risk as a prospective borrower. The judge also stated that he had seen no evidence to suggest that the agreed rate of LIBOR plus 10% was "evidently extravagant", noting that the 5% rate which had been suggested by Konkola's barrister was "less than the current judgment rate". Furthermore, evidence had been shown to the judge that rates of up to 14% were paid in respect of ZCCM's shareholder loans.

More recently, in Cargill International Trading Pte Ltd v Uttam Galva Steels Ltd⁸ the High Court held that Cargill was entitled under the terms of a contract to default interest at a rate of one-month LIBOR plus 12% p.a., applying the two limb test for penalty clauses which had been proposed by Lord Mance in Cavendish Square. The High Court found that the disputed provision protected a legitimate interest of the party on the basis that charging a higher rate of interest on an advance of money after default was commercially justifiable due to the greater credit risk posed by defaulters. The rate was also not found to be exorbitant or unconscionable. Significantly, the court noted that "the most important evidence is market evidence" and was satisfied that LIBOR plus 12% was comparable to the commercially available rate for comparable companies.

Company voluntary arrangement ("CVA") terms cannot be penalties

The rule against penalties can also be invoked by insolvency practitioners, looking to swell recoveries for unsecured creditors.

In Wright and another (Liquidators of SHB Realisations Ltd) v The Prudential Assurance Company Ltd⁹ a CVA had allowed BHS to pay reduced rents to its landlords. The CVA had included a "spring back" provision which provided for the full rents to be payable with retrospective effect if the CVA was terminated. When liquidators were subsequently appointed over BHS (following a failed administration process, which had itself followed the failed CVA) they claimed that the CVA spring back clause was a penalty and that the landlords could not therefore claim the full amount of rent due to them as an administration expense.

The judge held that a CVA is not a contract and therefore the rule against penalties could not apply to it. However, the court went onto explain that even if the rule against penalties had applied to the CVA term, it would still not have been a penalty. The judge observed "For the purpose of the law of penalties, the Landlords … had a legitimate commercial interest in the CVA's success or failure and it could not be said to be an exorbitant, extravagant or unconscionable provision for them to be returned to their pre-CVA position if the CVA should fail".

Can you avoid a penalty by drafting?

It has long been acknowledged that the rule against penalties should be engaged only upon a breach of contract. In Cavendish Square this was reaffirmed. However, application of the penalty rule can depend on whether the relevant obligation is framed in the contract as a conditional primary obligation, or a secondary obligation. 

This distinction was explored in Holyoake v Candy¹⁰ (a dispute involving a development finance transaction). In this case the court upheld a number of fees and payments which had been challenged as penalties on the basis they constituted primary, rather than secondary, obligations.

Some have pointed to Holyoake v Candy as showing the ability to "draft around" the rule against penalties. However, this is unlikely to be the case in all circumstances.  In Holyoake v Candy, echoing observations made by certain Supreme Court judges in Cavendish Square, the judge acknowledged that if the penalty rule is to have practical value it should not be too easy to circumvent it by drafting. He said, "I can see the force of the argument that there is no real difference in substance between a provision which says "you will pay me £x in reduction of your debt but if you do not pay on time, the debt will increase by £x" and a provision which says "you will pay me £x, and if you pay me on time, the debt will reduce by £x"."  Furthermore, the judge admitted he had reached his conclusion on the fact that one of the challenged fees was not a penalty "with some hesitation".

The good news for lenders is that, since Cavendish Square, the likelihood of a clause in a typical financing being struck down by the courts as an unenforceable penalty seems to have reduced.  Arguably, therefore, there may be less need to draft around the rule against penalties in any event.