Session 5:

Penalty Rules
Overview

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Other contexts of the rule on penalties

 Liquidated damages

 Forfeiture provisions in JOAs

 Treatment of deposits on asset deals

 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 be held 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 innocent party’s 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 only claim 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

commodity markets

• 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 on penalties

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

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

– M & J Polymers supplied dispersants to Imerys Minerals

» "Article 5.3. During the term of this Agreement the Buyer will
order the following minimum quantities of Products: […]"

» "Article 5.5. Take or pay: the Buyers collectively will pay for the
minimum quantities of Products as indicated in this Article at 5.3
[…] even if they together have not ordered the indicated
quantities during the relevant 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 for IM’s

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 rule against penalties
may apply” [to this take or pay Clause]

• However, in the circumstances, the take or pay provision was not a 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 did not 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 doubt that, 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 minimum

sum”, but no express obligation to purchase services to this value

• “should the aggregate value of all invoices delivered by CONECO

to FGB […] in the first year of this Agreement not amount to the
agreed minimum sum […], FGB will pay CONECO the difference
between the above-mentioned aggregate value and the […] agreed
minimum 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 specified event 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 order
the 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 delivery of and shall
pay for, or shall pay for if not taken delivery of, a quantity of Gas which at a
minimum shall be equal to the Annual Take or Pay Quantity

– 11.2 In respect of each Contract year the Annual Take or Pay Quantity shall 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 Adjusted ACQ shall be the ACQ for that
Contract Year after the deduction of the aggregate of the following quantities of
Gas arising in respect of that Contract Year: [any Shortfall Gas / Carry Forward
Gas / gas not delivered by the 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 “in terrorem”

• The Privy Council in Philips Hong Kong Ltd v Att.-Gen. of Hong Kong(1993) 61 Build LR 41
at 58 cited with approval the view of the Supreme Court of Canada that “the power to strike
down a penalty clause is 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 Indian domestic airline and a
lessee of aircraft. If lessor delivered any of the aircraft late, it had to pay a penalty of
$US 8,500 per day

• Held: “to strike down an agreement made between two substantial parties 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 Ltd v Barnet Football Club Ltd [2003] EWCA Civ 58:

• Agreement regarding the supply of football garments for sale to the public. If
the manufacturer delivered the garments late, it had 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 such when 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 supplier’s 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 where a clause was
struck down as a penalty that he had been able to note, there was a
“very wide gulf between (a) the level of damages likely to be suffered
and (b) the level of damages stipulated in the contract”

» Jeancharm: penal sum was four times the seller’s likely loss.

• To be judged at the time the contract was entered into

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 Example of a clause that might be construed
as a penalty
• The Contract stipulated annual minimum purchase volumes

• “[The Buyer’s] 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 Buyer’s] requirements
for [goods] until [the Buyer’s] 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 construed
as a penalty
• The take or pay sum is arguably payable on the occurrence of a
breach of the minimum purchase obligation: the take or pay comes
into play if the Buyer “fails to purchase at least 95% of the minimum
volume levels”

• The clause arguably operates oppressively: if the Buyer fails to

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

• The sum stipulated is arguably not a genuine pre-estimate of the

Seller’s likely loss: given that the Buyer is only obliged to purchase 95%
of the minimum volume level, the obligation to pay a sum equivalent to
100% of the minimum volume level potentially overcompensates the Seller

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Questions?

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