Post on 30-May-2018
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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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Key elements of a valid take or pay provision
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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Key elements of a valid take or pay provision
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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Key elements of a valid take or pay provision
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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Key elements of a valid take or pay provision
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?