A recent High Court decision  has provided a useful reminder of when the rule against penalties may apply to a fee payable to a bank under finance documents.
What is a penalty clause?
A clause in an agreement may provide for the payment of a sum of money if there is a breach of that agreement. Such a clause is penal where the amount of the payment is not a genuine pre-estimate of loss, but rather a deterrent to discourage the other party from deliberately breaching its obligations.
What is the rule against penalties?
Where a breach of a contractual duty triggers a payment of money which is not a genuine pre-estimate of loss, the relevant provision is likely to be unenforceable as a penalty unless it is commercially justifiable and its main purpose is not to deter the breach.
For example, a liquidated damages clause which provides for a disproportionate sum to be paid by the defaulting party on a breach of contract, and goes far beyond the loss that the non-defaulting party could expect to suffer as a result of such contractual breach, is unlikely to be enforceable.
What happened in this case?
A number of banks entered into financing arrangements with a group of companies and individuals to finance the acquisition of a property in Madrid. One such arrangement was an “upside fee agreement”: in return for a lender arranging the facilities, one of the corporate borrowers would pay a fee to that lender on the occurrence of certain “payment events”.
The court determined that a “payment event” had occurred: breach of cross default provisions entitled the lender to accelerate that loan, the repayment of which was a “payment event” for the purposes of the upside fee agreement. Therefore, the upside fee had been triggered.
Did this payment amount to a penalty?
The judge decided that the €105m upside fee was not a penalty and was therefore enforceable. He gave two main reasons for this finding:
- firstly, the fee was always intended to be part of the borrower’s overall obligations: even if the loan was repaid over the term of the agreement, the fee would still have been triggered at some point, and so the payment event in question simply accelerated the obligation; and
- secondly, the fee was not triggered by a contractual breach of the duty of the borrower to the lender: the lender was entitled to accelerate the loan because of a breach of cross default provisions in the loan agreement, triggered by a breach of other contractual arrangements by different contractual parties. The rule against penalties only applies to breach of a duty owed by the party seeking relief to the party seeking to enforce the clause.
In addition, the judge was satisfied that, even though the fee was not a genuine pre-estimate of loss, the fee was commercially justifiable because the financing was in effect a bridging loan in challenging commercial circumstances and the purpose of the fee was the charge for arranging this financing rather than a deterrent.
A useful reminder
The judge’s decision is a helpful reminder that careful drafting is important to ensure that the commercial reality of a transaction is upheld in court and to avoid the application of the rule against penalties to genuine finance charges.
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