In a recent judgment, the High Court held that a clause in a settlement agreement requiring immediate payment of all outstanding amounts in the event of a late payment (an acceleration clause) was capable of falling within the penalty doctrine, but an obligation to pay a daily sum accruing pro rata on any outstanding amounts was not: Heritage Travel and Tourism Ltd v Windhorst [2021] EWHC 2380 (Comm).

The court applied the doctrine set out by the Supreme Court decision Cavendish Square Holding BV v Talal El Makdessi [2015] UKSC 67 (considered here). That is, whether the relevant provision was a secondary obligation which imposed a detriment on the defendants that was out of all proportion to the claimant’s legitimate interest in enforcing the defendants’ primary obligations under the agreement. The court held that the acceleration clause in the agreement was a secondary obligation as it was triggered by a breach of a requirement to pay a certain amount by a particular date. However, the separate clause which provided that a daily sum would accrue so long as, and to the extent that, a further amount remained outstanding had to be considered a primary obligation. The fact that the daily sum was payable only to the extent that the further amount was outstanding did not mean the obligation to pay it was triggered by any breach; these provisions merely defined the accrual period.

In light of the conclusion that the obligation to pay the daily sum was a primary obligation, the court declined to express a concluded view as to whether the detriment on the defendants resulting from the clause was disproportionate.

This decision provides a helpful illustration of the circumstances in which a contractual obligation will be susceptible to the rule on penalties, and how it may be possible in some circumstances to avoid the application of the rule by drafting an obligation to ensure that it is not triggered by breach.

Background

The claimants applied to enforce the terms of a settlement agreement appended to a Tomlin Order (the “June Settlement”).

Pursuant to the June Settlement, the defendants were required to (amongst other things) pay:

  • a “First Amount” of €55,002,559.70, payable by 30 June 2020 (clause 3.1(a)); and
  • a “Second Amount” of €69,197,440.30 plus a “Daily Lump Sum” of €139,134 accruing pro rata on the unpaid part of the Second Amount from 27 May 2020, payable by 15 February 2021 (clause 3.1(b)).

The Second Amount was to be discounted to €50,000,000 if payment of that amount was made in full by 31 December 2021 (the “Discounting Provision”) (clause 3.1(c)).

By clause 7.1 of the June Settlement, if the First Amount was not paid in full and on time, the claimants were entitled to serve notice that:

  • the Discounting Provision no longer applied (clause 7.1(a)); and
  • the unpaid amounts of the First Amount and Second Amount were immediately due and payable, including the Daily Lump Sum with respect to any unpaid amount calculated up to 15 February 2021 (clause 7.1(b)).

The defendants did not pay the amounts due under the June Settlement and, on 15 December 2020, the claimants served notice that all outstanding amounts (including the Daily Lump Sum calculated up to 15 February 2021) were immediately due and payable. They then applied to enter judgment against the defendants pursuant to the June Settlement.

The parties agreed that the court should approach the application as if it were an application for summary judgment under Part 24, under which the court can enter judgment if it considers that a party has no real prospect of succeeding in its claim or defence.

The defendants relied on a number of grounds of defence, including an argument that the requirement to pay the Daily Lump Sum was unenforceable as a penalty.

Decision

The High Court (Mr Richard Salter QC sitting as a Deputy Judge) held that the obligation to pay the Daily Lump Sum was not an unenforceable penalty clause, and none of the other grounds of defence advanced had any real prospect of success. The claimants’ application therefore succeeded.

The court first set out the relevant test as to the applicability of the doctrine of penalties contained in Makdessi (referred to above). In applying the test, the question as to whether the obligation to pay the Daily Lump Sum was unenforceable as a penalty must be considered in two stages:

  1. whether the obligation was a secondary obligation arising from a breach of a primary obligation; and
  2. whether the detriment imposed upon the defendants was out of all proportion to the claimants’ legitimate interest in enforcing the primary obligation.

The claimants argued that the obligation to pay the Daily Lump Sum was a primary obligation conditional on whether and to what extent the Second Amount had been paid. The Daily Lump Sum accrued from 27 May 2020 in circumstances where the Second Amount remained outstanding, but there was no obligation to pay the Second Amount on 27 May 2020 or, in fact, on any date prior to 15 February 2021. The Daily Lump Sum could not be considered to be an obligation arising from a breach of a primary obligation because the non-payment of the Second Amount was not itself a breach of the June Settlement.

By contrast, the defendants argued that the First Amount (which was to be paid by 30 June 2020, later varied by the parties to 31 July 2020) constituted a primary obligation and, in the event that the payment was not made, the claimants were entitled under clause 7.1 to give notice declaring that the unpaid balance of the First Amount and/or the Second Amount was immediately due and payable, including the Daily Lump Sum calculated to 15 February 2021 (irrespective of the date of notice). Clause 7.1 was therefore a secondary obligation.

The judge commented that both of these submissions were to some extent correct:

  1. Since there was no obligation on the defendants to pay the Second Amount (including the Daily Lump Sum) before 15 February 2021, the obligation to pay the Daily Lump Sum under clause 3.1(b) had to be considered a primary obligation, as it was not conditional on any breach by the defendants. He recognised that the Daily Lump Sum was only payable while the Second Amount was outstanding, and reduced pro rata if part of the Second Amount was paid. That might give the impression that the Daily Lump Sum was a consequence of breach. However, he concluded that these provisions simply defined the period during which the Daily Lump Sum was to accrue, rather than being the trigger for the obligation to pay the Daily Lump Sum. Accordingly, it did not attract the operation of the rule against penalties.
  2. To the extent that the service of a notice under clause 7.1, consequent on breach, made the defendants liable to pay the Daily Lump Sum calculated up to 15 February 2021, even if that payment obligation had not by then accrued due, that was capable of falling within the scope of the penalty doctrine. However, that did not affect the validity of clause 3.1(b), under which the Daily Lump Sum continued to accrue from day to day until the June Settlement was terminated or the Second Amount was paid, or the obligations under the June Settlement merged into a judgment.

Given his conclusion that the obligation to pay the Daily Lump Sum under clause 3.1(b) was a conditional primary obligation, the judge did not need to consider whether it imposed a detriment on the defendants that was out of all proportion to any legitimate interest of the claimants in enforcing the primary obligations under the June Settlement.

He noted, however, that on the defendants’ calculation the Daily Lump Sum was equivalent to a rate of 6.1% per month or 73% per annum and added: “I cannot on the limited evidence before me say that it is not at least properly arguable that that rate is disproportionate to the Claimants’ legitimate interests.” If he had been required to consider the question of disproportion, it would have had to be fully explored at trial.

Maura McIntosh
Maura McIntosh
Professional support consultant
+44 20 7466 2608
Olivia Walton
Olivia Walton
Senior associate (Australia)
+44 20 7466 2787