As businesses focus on minimising financial risks, Vertex Law, the Kent-based corporate law firm, is advising companies in all sectors to check their contracts to make sure they do not contain commercially unjustifiable ‘penalty’ clauses, which could result in costly legal battles.
There is increasing evidence that businesses facing penalties for breaches of contract are challenging the sums of money involved and calling on the courts to decide whether they exceed a genuine pre-estimate of damages.
Craig Bowers, lawyer in the Vertex Law commercial team, said: “Under English law, freedom of contract generally allows parties to agree and negotiate the content of a contract between them – even if it is unduly onerous against one of the parties.
“However, a contract clause including the payment of a fixed sum if the contract is breached, if excessive, could be viewed as a ‘penalty clause’ and, as such, legally unenforceable.
“But even that ruling would not stop companies taking legal action for the actual damages or financial losses incurred.”
Craig is raising the issue with his clients following the recent case of E-Nik Ltd v Department for Communities and Local Government (DCLG).
E-Nik, an information technology service company, had a contract with DCLG to provide 500 days of consultancy per year at a rate of not less than £850 per day. A dispute arose when E-Nik’s invoices were unpaid.
In court, DCLG counsel argued that the clause obliging it to either use or pay for a set number of consultancy days was a ‘penalty clause’ and, as such, unenforceable.
This argument was rejected by the court as E-Nik had to incur the costs outlined in the clause to keep its consultancy resources available to meet the demands of the contracted number of days whether they were used by DCLG or not.
“In this case the ‘take or pay’ clause was commercial justifiable and did not constitute a ‘penalty clause’ so it was enforceable,” said Craig.
“But businesses must be aware that even when a clause is found to be a ‘penalty clause’, nothing prevents a claimant from still bringing a legal claim for its actual damages. This could be a very expensive exercise.
“The solution is to ensure that all breach of contract clauses which require a defaulting party to pay a sum of money to the other party should contain well-drafted, genuine pre-estimates of damages and must be commercially justifiable.”