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The blog (or its ethos) is on tour in webinar form with Disputes 101 - clause and effect: common contractual conundrums. You can register here to attend the final talk and register here to access recordings of past talks. Each webinar is accompanied by a follow-up blog post. This is the third, “What can’t you agree to do in your contract?”, where we discuss limitations on the freedom of contract, covering the penalty rule, exclusions of liability and “no waiver” clauses.
Beware of a penalty shoot-out
The rule against penalties is rooted in public policy, aiming to prevent contractual provisions that punish the breaching party rather than protecting the interests of the innocent party. The burden of proving that a clause is a penalty falls on the party seeking to escape liability under it.
The leading case on penalties is the UK Supreme Court decision in Makdessi, which established that a penalty clause is “a secondary obligation which imposes a detriment on the contract-breaker out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation.” This means that for a clause to be an unenforceable penalty it must kick in only when another term of the contract has been breached, and impose a detriment on the party in breach which is disproportionate to the legitimate interest of the innocent party.
Usually, the “detriment“ imposed by a clause that operates on breach is a financial one and the clause will be aimed at compensating the innocent party, but it may go further than this. The “legitimate interest“ of the innocent party may be broader than merely being compensated for their loss. Even where a clause is designed to protect legitimate interests, however, it may still be held to be a penalty where it is extravagant and unconscionable. It is fine if the clause is intended to deter breach; what is not allowed is for the clause to punish a breach.
The general rule is that if a clause is held to be a penalty, it will not be enforced beyond the actual loss of the party seeking to enforce the remedy.
The courts have found the following clauses to be enforceable and not a penalty:
A clause in a share sale agreement which stipulated the forced sale of the seller’s remaining shares at a reduced price in the event of breach of non-compete restrictions on the seller: Makdessi.
A contractual right to charge a collection fee of up to 15% of the amounts collected under a receivables finance agreement: BHL v Leumi.
A default interest provision in an advance payment and supply agreement which would accrue on overdue payments at the rate of one month LIBOR plus 12%: Cargill v Uttam.
A provision in a company’s articles which provided that, where a shareholder exited as a “very bad leaver” triggering a transfer of their shares, the price payable for the shares was GBP1: Lee v GSquare Capital.
The following clauses have been held by the courts to engage the penalty doctrine:
A default interest rate in a loan agreement providing for 12% monthly compound interest when compared to the pre-default rate, which was 3% monthly interest on advanced sums: Ahuja v Victorygame. This was an increase of some 400% on the standard rate in the loan agreement.
A clause in a settlement agreement requiring immediate payment of all outstanding amounts in the event of a late payment (an acceleration clause): Heritage Travel v Windhurst.
How, then, can you ensure that your clause is enforceable? The question is one of substance not form, and the court will look at the wording of the clause and the circumstances at the time of contracting. The courts are generally more reluctant to interfere with penalty clauses in commercial contracts where parties are of equal bargaining power and have had the opportunity to negotiate the terms.
Exclusion clauses
Exclusion clauses, also known as exemption clauses, are provisions within contracts that aim to absolve one party from certain types of liability, or limit the circumstances under which liability may arise. Exclusion clauses are subject to both statutory and common law restrictions.
When analysing exclusion clauses in English law contracts, the first step is to determine whether the contract is a business-to-business (or B2B) or a consumer contract. B2B contracts are potentially subject to the Unfair Contract Terms Act 1977 (better known as UCTA), whereas consumer contracts are subject to the Consumer Rights Act 2015.
A B2B contract is subject to UCTA unless it is: (a) an international supply contract; (b) a contract where English law applies only by choice of the parties; or (c) it is one of the types of listed contracts which includes insurance, land, IP and securities contracts.
For B2B contracts subject to UCTA, the parties’ ability to exclude or restrict their liability for negligence, breach of contract, and misrepresentation is curtailed, as follows:
Liability for death or personal injury caused by negligence cannot be excluded or restricted.
Other liability for negligence can be excluded or restricted, provided the exclusion satisfies the requirement of reasonableness.
Contractual liability can be excluded or restricted (except where one party deals on the others’ standard terms of business, when liability for breach of contract can only be excluded or restricted if it satisfies the requirement of reasonableness).
A term is a fair and reasonable one to be included having regard to the circumstances which were or ought reasonably to have been known to or in the contemplation of the parties when the contract was made.
Whether a term is fair and reasonable is both contract and fact specific, and involves the court engaging in a multi-factorial assessment. Examples in the case law of clauses that have been upheld as fair and reasonable include:
An exclusion of liability for breach of implied terms, but not express terms.
An exclusion of liability for negligence, but not gross negligence or fraud.
An exclusion of liability for indirect loss, but not direct loss.
Clauses shortening the period of time for bringing claims from the statutory limitation period.
In contrast, examples that have been rejected as not fair and reasonable include:
A delay in payment for goods having the effect of excluding all other rights in respect of the goods.
Liability caps that were considered too low relative to the value of the contract.
Extreme shortening of limitation periods e.g. requirement to give written notice of defect within 7 days.
B2B contracts outside of the scope of UCTA are still subject to common law restrictions, including that:
A party cannot rely on an exclusion clause if its terms or effect have been misrepresented to the other party: Curtis v Chemical Cleaning.
The common law also subjects exclusion clauses to arguably stricter rules of interpretation than other contractual terms, because the courts assume that, in the absence of clear words, the parties do not intend to derogate from the normal rights and obligations the common law provides and imposes.
“No waiver” provisions
The starting point is that any right that exists under a contract can be waived by the party that holds that right. All that is needed to establish waiver is clear and unequivocal evidence that the party whose right it is has agreed not to enforce it. But contracts will often contain a “no waiver” clause which provides that any delay in enforcing or failure to enforce a right under the agreement (for example the right to terminate for breach) does not result in the loss of that contractual right. The purpose of such a clause is to prevent inaction from amounting to an unequivocal representation that the inactive party will not be enforcing a particular right.
The problem is that there are circumstances where reality overcomes fiction and the courts will find that there has been a waiver, despite the “no waiver” provision.
In Tele2 v Post Office, the Court of Appeal refused to uphold a standard “no waiver” provision because the Post Office’s continued performance of an agreement for 11 months without protest amounted, in the court’s view, to an affirmation of the contract and that they had elected to waive their right of termination.
Closely connected to this position on no-waiver clauses is the position regarding no oral modification clauses, that is clauses that state that a party's right to enforce an obligation can only be waived if such waiver is expressly granted in writing.
The UK Supreme Court case of MWB v Rock involved a no-oral-modification clause (which it upheld) and set out the following test:
First, you need to show an unequivocal representation that what is alleged to be a waiver is valid notwithstanding its informality.
Secondly, you have to do so by reference to something more than what is alleged to constitute the waiver.
The question of what the courts will and won’t hold to be a waiver is difficult to follow in the abstract, so it helps to consider some examples of the courts’ view on “no waiver” provisions:
A claimant had not waived its right to enforce the provisions of a settlement agreement because there was no agreement or clear statement by the claimant indicating a waiver: A v B.
A “no waiver” clause did not prevent a waiver created by positive statements indicating that rights would not be exercised, despite the inclusion of a standard “reservation of rights” statement in without prejudice correspondence: Lombard v Skyjets.
Mere delay in serving a notice of default, especially when coupled with a “no waiver” clause, did not constitute a waiver of contractual rights: Prakash v Peter Beck.
An oral waiver could not be relied on when the contract, in this case a facility agreement, explicitly provided that any waiver must be in writing: Little v Olympian Homes.
Where a contractual clause specified that any waiver must be in writing, for there to be a waiver there must be words or conduct demonstrating an unequivocal representation that the waiver was valid, despite the lack of written waiver: Barclays v VEB RF.
So, the current state of the law is that “no waiver” clauses raise the bar for establishing that there has been a waiver, but they don’t always operate to ensure that there can be no waiver under any circumstances. Where there’s clear conduct constituting a waiver, a “no waiver” clause may fail to preserve a party’s rights.
