A penalty clause in a contract is, in practice, a dead letter; the courts will not enforce it. But what exactly is a penalty clause? What is the difference between a liquidated damages clause, a penalty clause and a forfeiture clause? And how will the courts react when faced with an application for relief from the consequences of a penalty clause or forfeiture provision in a contract?

How does a penalty clause differ from a liquidated damages clause?

A classic penalty clause takes the form of a clause in a contract that requires the promisor who fails to perform their obligations to pay a sum of money by way of penalty or compensation. Penalty clauses are unenforceable. By contrast, as anyone who has dealt with a building contract will know, there is nothing wrong with a provision for ‘liquidated damages’, ie a provision that estimates in advance what loss is likely to result from a particular breach of contract.

What exactly is the difference between a liquidated damages clause and a penalty? The crucial distinction is that a liquidated damages clause represents a genuine attempt at predicting the likely loss in the event of any breach of contract. A penalty clause represents a threat, imposed to secure performance.

A liquidated damages clause is valid and enforceable; the innocent party will recover the amount stipulated, regardless of whether it exceeds their actual loss (or, indeed, whether they have suffered any loss at all).

A penalty will be struck down, leaving the innocent party with a claim for damages for the loss resulting from the breach. There are a number of arguments in favour of provisions like this, even if they do constitute a penalty (see the box below). But the principles of equity do not sit well with the idea of penalty clauses and so the judiciary is quite prepared to strike down oppressive contractual terms that seek to terrorise a party into compliance, on the grounds that they are unconscionable: for example, because they require one of the parties to a contract to pay a disproportionately large sum of money in the event of any breach of contract.

However, clauses that involve the withholding of a sum of money, or the forfeiture or transfer of property, instead of the payment of money, can also have a penal effect on one of the parties to a contract – and the rule against penalties is not confined to promises to pay money. It also affects terms that require a party in breach of contract to transfer nonmonetary property, whether real or personal, to the innocent party.

Penalty clauses relating to non-monetary property

Jobson v Johnson [1989] concerned the sale of shares in a football club. The buyer was under an obligation to re-transfer the shares on a default in payment and the seller could retain instalments of the price. The Court of Appeal decided that the clause was a penalty clause. Dillon LJ observed:

Does it make any difference then, that the penalty in the present case is not a sum of money? In principle, a transaction must be just as objectionable and unconscionable in the eyes of equity if it requires a transfer of property by way of penalty on a default in paying money as if it requires a payment of an extra, or excessive, sum of money… In each case, the clause ought to be unenforceable in equity in so far as it is a penalty clause.

However, cases involving provisions like this do not often come to court, so practitioners will be particularly interested in two recent High Court decisions, both of which concerned contracts for the disposition of an interest in land.

Warnborough Ltd v Garmite Ltd [2006] concerned a sale and purchase, and a mortgage over land. Instead of paying cash for the property in question, the buyer agreed to pay the whole of the purchase price by instalments and, on completion of the property transfer, entered into a legal charge in favour of the seller as security for monthly payments of capital and interest.

The buyer also granted the seller a separate option to repurchase the property for £130,000, ie for exactly the same price that the buyer was paying to acquire the property from the seller. The option was only exercisable if the principal sum outstanding under the charge was at least £65,000 and the payments due under the charge were at least 35 days in arrears.

The option gave the seller the right to set off the whole of the sum currently outstanding under the charge against its obligation to pay the purchase price of £130,000. In effect, therefore, leaving aside any payments of interest under the charge (which the seller was entitled to retain), on completion of the purchase consequent upon the exercise of the option, the parties would be restored to their original positions. The seller would have reacquired the property, and the buyer would have recovered the amount that it had paid for the property to date (having received the balance of the purchase price, after allowing for the set-off that the parties had agreed).

The buyer did fall into arrears, and the seller sought to exercise the option. The buyer resisted the exercise of the option on a number of different grounds. Indeed, the case first went to the Court of Appeal in 2003, when the issue under consideration was the scope of the rule against ‘clogs on an equity of redemption’. Their Lordships expressed the view that the transaction was, in fact, a sale and purchase – rather than a mortgage – and remitted the case to the High Court for further consideration.

The High Court followed their Lordships’ lead and confirmed that the transaction constituted a sale and purchase, in respect of which the rule against ‘clogs on the equity of redemption’ did not apply. The principal issue under consideration in these latest proceedings was, therefore, whether the option was a penalty or forfeiture provision, in respect of which the court could grant relief.

The judge decided that the option was not a penalty because, on the exercise of the option, the parties would be restored to their original positions. The buyer only stood to lose any interest that had already been paid under the mortgage, and this represented a payment for occupation and a fair return on the capital that had been outstanding in the interim.

The judge dismissed the buyer’s argument that the option amounted to a penalty because it was only entitled to recover the price that it had paid for the property, ie it stood to lose any increase in value. The judge observed that the property might have increased or decreased in value in the interim, and ruled that the fact that the property might have increased in value was irrelevant because the question of whether a clause was a penalty was to be judged as at the date of the contract, and not at the date of any breach of that contract (see Dunlop Pneumatic Tyre Company Ltd v New Garage & Motor Co Ltd [1915]).

Was the option to purchase a forfeiture provision?

The judge also considered another possibility: that the option to repurchase constituted a forfeiture provision. The judge accepted that the provision was capable of operating as a ‘forfeiture’ because, if the option was exercised, the buyer would have to transfer the property back to the seller – and then went on to ask himself whether he should exercise the Court’s inherent jurisdiction to grant relief from forfeiture.

The courts will grant relief if the essentials of the bargain can be secured and it would be fair and just to do so:

… in appropriate and limited cases… where the primary object of the bargain is to secure a stated result which can effectively be attained when the matter comes before the court, and where the forfeiture provision is added by way of security for production of that result [Lord Wilberforce in Shiloh Spinners Ltd v Harding [1973]].

The judge noted that the right to forfeit was not, essentially, to secure the payment of money; that was the function of the legal charge that the buyer had executed on completion of the original transfer. The true nature of the transaction was that of sale and purchase, rather than a mortgage. The judge went on to conclude that it would, therefore, be impossible to grant relief from forfeiture. This was because it was impossible to make an order that would reflect the essentials of the parties’ bargain. The parties had agreed that the seller would be entitled to repurchase the property – to deal with as it wished – if certain conditions were not met, and it would be impossible to achieve this by granting relief from forfeiture to the buyer.

Nor was this a contract for the sale of land by instalments, where instalments that had already been paid were liable to forfeiture, because all the payments of capital made by the buyer would have to be returned to it under the terms of the option for repurchase. So the option had been validly exercised and the seller’s claim was successful.

The decision was swiftly followed by Meretz Investments NV v ACP Ltd [2006]. The facts of the case were complex. Suffice it to say that the dispute concerned a plan to construct a number of penthouse units within the roof space above a block of flats. The project triggered several different disputes and resulted in the High Court decision in First Penthouse Ltd v Channel Hotels and Properties (UK) Ltd, Channel Hotels and Properties (UK) Ltd v Tamimi [2003].

The High Court decision in these latest proceedings focused on a number of important points of law relating to a mortgagee’s power of sale, which are beyond the scope of this article. But the case provides further reassurance about the use of options to reacquire property, because one of the subsidiary issues in the current proceedings concerned a leaseback option in favour of the freehold owner of the building. The developer argued that the predominant function of the leaseback arrangement was to impose a penalty for any failure to complete the development on time. The parties both agreed that a term in a contract that provides for the transfer of property from one party to another on breach of contract is capable of being a penalty, but the judge ruled that, absent some element of oppression, it would be a blatant interference with the parties’ freedom of contract if he were to characterise this clause as a penalty and to refuse to enforce it.

The judge said that there was nothing inherently oppressive in a contractual term that precluded one party from enjoying contractual benefits when it was not adhering to its own obligations under the contract, and noted the following points. The right to a leaseback was limited to the undeveloped parts of the roof space. There was no question of the landlord being able to take over the parts that had already been developed. The development timetable was not fixed in stone and the developer was entitled to mandatory extensions of time arising out of matters over which it had no control. In addition, the developer had only paid a nominal amount for the grant of the development lease. So the landlord’s only hope of a return from the building was tied to the development, which made it necessary for the landlord to be protected against any failure to complete the development.

The judge also observed that development agreements and leases are usually capable of termination if a developer fails to develop. In some cases equity may be able to relieve against forfeiture; in other cases not. But a forfeiture clause may have been inappropriate in this case because of the possible intervention of purchasers of individual penthouses, whose interests might have been adversely affected by the inclusion of such a clause. Indeed, the very presence of a forfeiture clause might have deterred potential purchasers, or their prospective mortgagees. The judge concluded, therefore, that the leaseback provision was not a penalty.

Conclusion

Both these latest decisions confirm that the courts will do their best to adhere to the legal maxim that ‘contracts must be respected’. But each case will be decided on its own specific facts, by reference to the contract in the particular case, and practitioners would be well advised to steer clear of oppressive contractual provisions that could constitute a penalty or forfeiture clause.  © Property Law Journal