Common law rules on penalty clauses
Leading House of Lords Authority
Banks frequently adopt express terms that provide for specific sums of money to be paid by a customer. One example occurs in the event of default by a borrower. Such a term is vulnerable to being treated as a penalty clause and therefore void. The leading case on penalty clauses is the House of Lords decision in Dunlop Pneumatic Tyre Co. Ltd. v. New Garage and Motor Co. Ltd in which Lord Dunedin said that the relevant clause first needs to be construed. He went on:
“To assist this task of construction various tests have been suggested, which if applicable to the case under consideration may prove helpful, or even conclusive. Such are: It will be held to be penalty if the sum stipulated for is extravagant and unconscionable in amount in comparison with the greatest loss that could conceivably be proved to have followed from the breach, it will be held to be a penalty if the breach consists only in not paying a sum of money, and the sum stipulated is a sum greater than the sum which ought to have been paid. This though one of the most ancient instances is truly a corollary to the last test. Whether it had its historical origin in the doctrine of the common law that when A. promised to pay B. a sum of money on a certain day and did not do so, B. could only recover the sum with, in certain cases, interest, but could never recover further damages for non-timeous payment, or whether it was a survival of the time when equity reformed unconscionable bargains merely because they were unconscionable…is probably more interesting than material.
There is a presumption (but no more) that it is penalty when "a single lump sum is made payable by way of compensation, on the occurrence of one or more or all of several events, some of which may occasion serious and others but trifling damage" (Lord Watson in Lord Elphinstone v. Monkland Iron and Coal Co.).
On the other hand it is no obstacle to the sum stipulated being a genuine pre-estimate of damage, that the consequences of the breach are such as to make precise pre-estimation almost an impossibility. On the contrary, that is just the situation when it is probable that pre-estimated damage was the true bargain between the parties…”
Lordsvale Finance – a common-sense approach?
The penalty clause argument was advanced in Lordsvale Finance v. Bank of Zambia. The syndicated loan to the defendant provided for an additional margin of 1 per cent to be paid in the event of default by the defendant. The judge considered that such a clause could constitute a penalty clause, so the only question to be asked was whether it was a genuine pre-estimate of prospective loss, or was in terrorem the borrower. A long history of case law was considered going back to 1725. Most of the cases had treated any uplift in interest on default as a penalty. Some of the clauses had been retrospective, some had been prospective. The judge adopted a common sense view, not totally supported by the precedents, that herein lay the relevant distinction and he declared that a clause which was retrospective, i.e. levied the additional interest backdated to the start of the loan, would have all the indicia of a penalty. Where, however, the default interest clause is prospective, the judge said the fact that the borrower’s credit-standing has deteriorated as a result of the default must be taken into account. The judge conceded that the 1 per cent uplift in the rate of interest payable could not be described as a genuine pre-estimate of prospective loss, but that it could be described as “commercially justifiable”. He held it to be a valid term, reserving his position on a clause that provided for an “exceptionally large” increase. Making an open display of the kind of pragmatic thinking that often is discernible only reading between the lines of court judgments in commercial case decisions, the judge also declared quite bluntly:
“It would be highly regrettable if the English courts were to refuse to give effect to such prevalent provisions while the courts of New York are prepared to enforce them. In the absence of compelling reasons of principle or binding authority to the contrary there can be no doubt that the courts of this country should adopt in international trade law that approach to the problem which is consistent with that which operates in that nation which is the other major participant in the trade in question. For there to be disparity between the law applicable in London and New York on this point would be of great disservice to international banking.”