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Avoiding ‘Penalty Clauses’ – Ensure your Contract Terms are Firm but Fair

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Ince

Written By:

Theresa Grech

Partner and Head of Corporate (Cardiff)

Ince


A ‘penalty clause’ is essentially one which imposes a detriment on a party to a contract should they breach a primary obligation of the contract which is out of all proportion to any legitimate interest of the other innocent party.

Some examples where the rule against penalties will apply are as follows:

  • To clauses where a breaching party agrees that, upon a breach of contract, it will pay the innocent party a specified sum of money;
  • To clauses which disentitle the breaching party from receiving a sum which would otherwise be due to him under the contract;
  • To clauses which require a transfer of property by a party who has breached the contract to the innocent party, either at undervalue or for nothing at all.

If a court on construction decides that a clause is a ‘penalty clause’, then the strict legal position is that although the clause remains in the contract, it will be unenforceable beyond the innocent party’s actual loss.

The overarching principle in law is that businesses are generally free to agree whatever contract terms they like, so the court’s reluctance to enforce penalty clauses are a move away from this principle. However, the courts will always judge each case on its facts,  so if you are protecting ‘legitimate interests’, even very harsh terms can be considered enforceable.

This was demonstrated in the recent case of Permavent Ltd v Makin (2021) which notes several lessons business owners can learn when drafting their contract terms.

What were the facts of the case?

Makin had entered into a settlement agreement with Permavent, under which Makin had assigned certain patents to them. In the settlement agreement, Makin agreed to a clause to the effect that if Makin interfered with or disputed the title to these assigned patents, then Makin would receive no further payments under the agreement, would be liable to repay sums paid to him by Permavent, and any future payments due to him would be forfeited.

After the settlement agreement concluded, Makin sought to register an interest in the patents in breach of the settlement agreement. Permavent brought proceedings against Makin for breach of the settlement agreement. Makin argued that that this was a penalty clause.

What was the decision in the court?

The court rejected that this was a penalty clause. Although the clause was described as “undoubtedly extremely harsh” it was not out of all proportion to the interests of Permavent protected by the clause, due to the importance of the patents to Permavent’s business and the potential of significant harm if Makin were to challenge the patents (as set out in the settlement agreement).

What should business owners note from this case?

In this case, the judge took into account that Makin had received legal advice in relation to the settlement agreement, and that he was therefore aware of the consequences of his breach of the agreement.

It also demonstrates the importance the courts are willing to give to the intellectual property rights of a company (IPR) in determining whether onerous clauses designed to protect the IPR are penalty clauses.

Great care should be taken and legal advice should be sought when you are entering into contracts to ensure that the terms, and crucially any sanctions which you wish to impose on a party for breach of the contract, are enforceable.

The above does not constitute legal advice nor is it complete list of issues to consider pre-sale.

Should you need any help in drafting or reviewing a contract,  please do not hesitate to contact Partner & Head of Corporate at Ince (Cardiff), Theresa Grech, on 07849 834082 or [email protected]  or your usual contact at Ince.