An unenforceable penalty?
Permavent v Makin (High Court) [2021]
It is a long-established principle of English law that a provision which constitutes a ‘penalty’ is unenforceable. However, over recent years the courts have gradually chipped away at that principle and this case is the most recent example of the extent to which the courts have been prepared to uphold clauses which would almost certainly have previously qualified as a penalty
Facts:
A dispute evolved between two former business partners as to the ownership of certain patents relating to roofing products. When the parties fell out, Mr Makin purported to terminate a patent licence granted to Permavent in 2009. Ultimately legal proceedings were issued but they were settled by the terms of a Settlement Agreement in September 2017. Under the terms of that settlement there was an assignment of all IPRs coupled with an obligation to make an ongoing quarterly payment to Mr Makin based on sales turnover generated by the new owner from the ‘Easy Roof System’.
The assignor, Mr Makin, agreed not to claim to be entitled to any interest in the Assigned IPRs nor to challenge their validity. If that undertaking was not complied with, the Settlement Agreement provided that the percentage revenue entitlement going forward immediately reduced to zero and previously made payments should be retrospectively adjusted as if no payments had ever been due. The up-front consideration of just in excess of £600,000 should also be repaid.
Mr Makin, towards the end of 2018, filed at the UK Intellectual Property Office notice of an equitable interest in various of the patents. The claimants then ceased making payments and sought a court declaration that no further payments were due and that repayments had to be made. The court found in favour of the claimants. The only matter still to be resolved was whether the provisions regarding the ongoing payments and the repayment constituted an unenforceable penalty.
Decision:
The court summarised the law on penalties as follows:
(1) What legitimate business interest (‘protected interest’) is served and protected by the clauses in question?
(2) Is the detriment imposed as a consequence of the breach unconscionable, exorbitant, extravagant or out of all proportion to that interest?
It is not only the contractual right which is breached which should be considered when determining the proportionality of an alleged penalty clause. The court looked at what it regarded as the broader legitimate interests of the claimant that the clauses sought to protect, not just the losses flowing from the breach which actually occurred. The High Court rejected arguments that the provisions in the settlement agreement constituted an unenforceable penalty.
The proportionality question is determined by construction of the contract as at the date it was entered into, not by reference to the circumstances in which it fell to be enforced. That was of particular importance in this case, where the actual breach committed by Mr Makin was at the lower end of the scale of possible breaches and caused virtually no loss. The burden lies on the party who is arguing that the clause is a penalty to demonstrate that it is.
The detriment imposed by the Settlement Agreement is undoubtedly extremely harsh. The question, however, is not whether the detriment is harsh or even extremely harsh, but whether it is extravagant, exorbitant or unconscionable, as being out of all proportion to the protected interest. The court upheld the clauses in question as not constituting a penalty according to that benchmark.
Points to Note:
- Whereas the courts previously assessed whether the provisions in question were out of proportion with the level of loss likely to be suffered as a result of a breach, here the court followed other recent cases by looking at the wider interest that the party is looking to protect.
- What this and other recent judgments mean is that only very rarely will provisions in business to business contracts now be regarded as being a penalty and therefore, one should assume that they will be enforceable as written. It is therefore much more important to challenge such clauses during the course of negotiations.