penalty rules (session 5)

8/9/2019 Penalty Rules (Session 5)

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Session 5:

Penalty Rules


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Overview

Take or Pay Clauses and the Law on Penalties

y Penalty clauses

y Take or pay clauses

y Can a take or pay provision be unenforceable as a penalty?

M & J Polymers Ltd v Imerys Minerals Ltd [2008] EWHC344 (Comm)

- a cause for concern, or simply a restatement of the law?

y Key elements for a take or pay provision to be valid

y What type of take or pay clause might be construed as a penalty?


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Other contexts of the rule on penalties

y Liquidated damages

y Forfeiture provisions in JOAs

y Treatment of deposits on asset deals

y Indonesia Dewa case?


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The Law on Penalties: basic principles

A contractual provision which stipulates that a contract-breaker shall pay a

fixed sum of money to the other party upon breach of the contract may beheld to be a penalty or liquidated damages

Penalty fixed sum is irrecoverable

potentially damages instead

Liquidated damages fixed sum is recoverable

Test for penalty (Dunlop Pneumatic Tyre v New Garage Motor Co Ltd [1915]

AC 79):

1. Payable upon a breach of contract;

2. Operates oppressively and in terrorem of offending party;

and

3. The amount payable is not a genuine pre-estimate of loss


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The Law on Penalties: recent cases

The General Trading Company (Holdings) Limited v Richmond Corporation

Limited [2008] EWHC1479 (Comm)

A provision entitling the innocent party to withhold payment rather than

force the party in breach to make a payment could be a penalty

But the clause was commercially justifiable, did not amount to

oppression and was between parties of comparable bargaining power

Tullett Prebon Group Limited v Ghaleb El-Hajjali [2008] EWHC 1924 (QB)

A provision in an employment contract for payment of a certain sum

(50% of basic net salary + 50% of signing bonus) in respect of a failure

to take up employment was not a penalty

The parties were of equal commercial bargaining power, the innocentpartys actual loss was likely to exceed the sum stipulated and the

breaching party had legal representatives who had alerted him to the

relevant clause


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Take or pay clauses

Key features

Purchaser is obliged to either take delivery of a minimum quantity of

product or pay a specified amount (often the contractual price for the

minimum quantity of product)

Potentially benefits both supplier and purchaser:

Supplier is guaranteed a regular income stream Supplier is able to bring a debt claim for the pay element if

the purchaser fails to take

Purchaser commits to pay for a minimum quantity to guarantee

a regular but flexible supply

Supplier should be aware that (if the purchaser fails to take) it can onlyclaim the pay element it has no right to claim any consequential losses

Impact may be ameliorated by make-up/shortfall provisions


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Take or pay clauses

Take or pay provisions are often contained in long term contracts

There may be significant price volatility in underlying commoditymarkets

Risk of buyer dissatisfaction over time

Disgruntled buyer may seek to strike out clause on the basis that

it is unenforceable as a penalty


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Take or pay legal issues

Can a take or pay provision be unenforceable as a penalty?

Traditional view: correctly drafted provision does not fall foul of the law onpenalties

M & J Polymers Ltd v Imerys Minerals Ltd [2008] EWHC 344 (Comm):

Judge ruled that law against penalties could apply to take or payprovision:

M & J Polymers supplied dispersants to Imerys Minerals

"Article 5.3. During the term of this Agreement theBuyer will order the following minimum quantities ofProducts: []"

"A

rticle 5.5. Take or pay: the Buyers collectively willpay for the minimum quantities of Products asindicated in this Article at 5.3 [] even if they togetherhave not ordered the indicated quantities during therelevant monthly period"


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Take or pay legal issues

M & J Polymers Ltd v Imerys Minerals Ltd (cont.)

Following purported termination of contract by IM, M&J claimed forIMs shortfall under the take or pay provision

IM asserted that the take or pay obligation amounted to a penalty

Mr Justice Burton found that as a matter of principle, the ruleagainst penalties may apply [to this take or pay Clause]

However, in the circumstances, the take or pay provision was nota penalty: the take or pay provision was commercially justifiable,did not amount to oppression, was negotiated freely and entered

into between parties of comparable bargaining power, and didnot have the predominant purpose of deterring a breach of

contract nor amount to a provision in terrorem


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Where does this leave us?

M & J Polymers Ltd v Imerys Minerals Ltd (cont.)

The decision has caused some concern regarding the wider application of

the law on penalties to take or pay clauses

A buyer seeking to avoid an unfavourable price in the contract has

grounds to rely on M & J Polymers to challenge its take or pay obligation

Next steps in the law?

Unlikely to provide improve prospects of challenging take or pay

obligations provided the provision is carefully drafted

Coneco v Foxboro (CA, unreported) 24/2/92: it is not in doubtthat, by appropriate drafting, the pitfall of penalty can often be

avoided

Form arguably more important than substance?


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Where does this leave us?

Coneco v Foxboro: Contract for the provision of engineering services

The contract contained a definition of the term agreed minimumsum, but no express obligation to purchase services to this value

should the aggregate value of all invoices delivered by CONECO toFGB [] in the first year of this Agreement not amount to theagreed minimum sum [], FGB will pay CONECO the difference

between the above-mentioned aggregate value and the [] agreedminimum sum

Substantive difference between Coneco and M&J Polymers?


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Key elements of a valid take or pay provision

Sum is not payable upon the occurrence of a breach of contract

No express obligation to purchase a minimum quantity

Option to take agreed amount or pay

Export Credits Guarantee Dept v Universal Oil Products Co [1983]

1 WLR 399: HL held the clause was not a penalty because it

provided for payment of money upon the happening of a specifiedevent other than a breach of a contractual duty

Coneco v Foxboro: Weight was given to the fact that the parties

have been very careful to draft it so as not to impose an obligation

on the defendant to place orders

Compare M&J Polymers : During the term of this Agreement the

Buyer will orderthe following minimum quantities [] (emphasis

added)


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Give purchaser option of taking x or paying y

11.1 In respect of each Contract Year the Buyer shall take deliveryof and shall pay for, or shall pay for if not taken delivery of, a quantityof Gas which at a minimum shall be equal to the Annual Take or PayQuantity

11.2In respect of each Contract year the Annual Take or PayQuantityshall be a quantity of Gas equal to [insert]% of the Adjusted

ACQ applicable to such Contract Year

11.3 In respect of each Contract Year the AdjustedACQshall bethe ACQ for that Contract Year after the deduction of the aggregateof the following quantities of Gas arising in respect of that ContractYear: [any Shortfall Gas / Carry Forward Gas / gas not delivered bythe Seller due to Force Majeure or similar]

P. Roberts, Gas Sales Transportation Agreements (Sweet &Maxwell, 2004), p. 389

No express obligation on purchaser to take x, failing which it must pay y


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Provision not oppressive or interrorem

The Privy Council in Philips Hong Kong Ltd v Att.-Gen. of HongKong(1993) 61 Build LR 41 at 58 cited with approval the view of theSupreme Court of Canada that the power to strike down a penalty clauseis a blatant interference with freedom of contract and is designed for the

sole purpose of providing relief against oppression for the party having to

pay the stipulated sum. It has no place where there is no oppression.

Indian Airlines v Gia International Ltd (2002) EWHC 2361:

Lease agreements for the lease of aircraft between a major Indiandomestic airline and a lessee of aircraft. If lessor delivered any of theaircraft late, it had to pay a penalty of $US 8,500 per day

Held: to strike down an agreement made between two substantialparties operating in the international aviation market would be a

blatant interference with the freedom of contract where although there

might have been hard bargaining it did not even come close to

oppression


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Jeancharm Ltdv

Barnet Football Club Ltd [2003] EWCA Civ

58:

Agreement regarding the supply of football garments for sale tothe public. If the manufacturer delivered the garments late, ithad to pay a penalty of 20 pence per garment per day

Although the clause was found to be a penalty, it was noted

that caution was required before categorising a clause as suchwhen the parties were of equal bargaining power

Equal bargaining power?

Make-up provisions (if paying for more than annual minimum)

Carry-forward rights (if taking more than annual minimum)

Shortfall provisions?


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Genuine pre-estimate of loss

Is an obligation to pay the seller 100% of the contract price a genuine pre-estimate of suppliers loss?

What would be a genuine pre-estimate?

In Alfred McAlpine Capital Projects v Tilebox Ltd [2005] BLR

271, at 280, Jackson J pointed out that in the four cases wherea clause was struck down as a penalty that he had been ableto note, there was a very wide gulf between (a) the level ofdamages likely to be suffered and (b) the level of damages

stipulated in the contract

Jeancharm: penal sum was four times the sellers likely loss.

To be judged at the time the contract was entered into


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Example of a clause that might be construedas a penalty

The Contract stipulated annual minimum purchase volumes

[The Buyers] annual purchase volume may not fall below 95% of the

minimum volume levels specified unless its total purchase of[goods] during

a specific year is less than the contractual minimum volume levels. If this

occurs, [the Seller] will default to 100% share of [the Buyers] requirementsfor [goods] until [the Buyers] demand again exceeds the minimum contract

volume levels. If[the Buyer] fails to purchase at least 95% of the minimum

volume levels in any year, the Buyer shall pay to the Seller an amount equal

to the price of the [goods] times the minimum volume levels less the amount

of[goods] that[the Buyer] actually purchased for the year."


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Example of a clause that might be construedas a penalty

The take or pay sum is arguably payable on the occurrence of abreach of the minimum purchase obligation: the take or pay comesinto play if the Buyer fails to purchase at least 95% of the minimumvolume levels

The clause arguably operates oppressively: if the Buyer fails to

purchase at least 95% of the minimum purchase volume levels in anyyear, it has to take or pay an amount equal to 100% of therelevant minimum volume level

The sum stipulated is arguably not a genuine pre-estimate of theSellers likely loss: given that the Buyer is only obliged to purchase 95%of the minimum volume level, the obligation to pay a sum equivalent to100% of the minimum volume level potentially overcompensates the

Seller


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Questions?

penalty rules (session 5)

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