England and Wales Court of Appeal (Civil Division) Decisions

IN THE SUPREME COURT OF JUDICATURE
IN THE COURT OF APPEAL (CIVIL DIVISION)
ON APPEAL FROM THE LEEDS COUNTY COURT
(His Honour Judge Hawksworth)

		Royal Courts of Justice Strand London, WC2
		16th January 2003

Thursday, 16th January 2002 J U D G M E N T
1. LORD JUSTICE PETER GIBSON: I will ask Jacob J to give the first judgment.
2. MR JUSTICE JACOB: This is an appeal, with the permission of Mance LJ, from the decision of His Honour Judge Hawksworth. The appellants are Barnet Football Club Ltd, the respondents a company called Jeancharm Ltd who trade as Beaver International. By an agreement dated 7th April 1998 the parties agreed that Jeancharm would be Barnet's suppliers of football kit (shirts for the team, replica kits and the like) for the seasons 1999/2000 and 2000/2001.
3. Clauses 3 and 4 of the Agreement provided as follows:

"3. Beaver hereby undertakes to provide the Club free of charge for use by the team, its managers, coaching and training staff, playing and training goods to the value of £12,000 at trade prices in each season of the contract. This sum to be subject to inflation in line with any price increases, shown on Schedule One, each season. And the club guarantees purchase of 5000 replicas per season.

Schedule to be produced each season no later than end of January and orders to be placed before end of February except that in the first year the order will be placed within one week of the samples being viewed.

The Club agrees to purchase replica shirts from Beaver International at £13.95 each adult size and £12.95 each childrens size.

Any additional goods required by the Club shall be purchased from BEAVER at normal trade prices and in accordance with the Company's trading terms which are Net 45 days subject to the following late payment penalty.

All orders from the club must be in the form of a written purchase order, authorised by the Chairman, and all invoices that are matched to such orders will be settled within 45 days from the invoice date.

Payments will be made by the Club within 45 days, having deducted any relevant penalty clauses or credit notes that are due.

Payment of a correct invoice, more than 45 days after the invoice date, shall incur interest at the rate of 5% per week (pro rata) on the outstanding sum, for the period from 45 days after the invoice date.

...

4. BEAVER agrees to the following penalty clauses.

Training gear deliveries.

If the training kit referred to in Clause 3 is delivered after the due date of June 14, unless otherwise agreed in writing then the Club will be entitled to a late penalty payment of 20 pence per garment per day.

Club shop replica items.

Within 45 days of the date of an official purchase order from the Club unless otherwise agreed in writing. If Beaver have not supplied the complete order, the Club reserve the right on the part of the order not delivered to receive a penalty for late delivery at the rate of 20 pence per garment [per day.

Club shop leisurewear items.

Within eight weeks of the date of an official order from the Club, unless otherwise agreed in writing, if Beaver have not supplied the complete order, the Club reserve the right on the part of the order not delivered to receive a penalty for late delivery at the rate of 20 pence per garment per day."

It is to be noted that the parties agreed that paragraph 4, dealing with late payment, was a penalty clause and described it as such. That is, of course, not conclusive.

4. The two clauses essentially ran, therefore, as follows. If Barnet were late in paying, they had to pay interest at 5% per week. If Jeancharm were late in delivering, they had to pay 20 pence per garment per day. As Mr Kay pointed out in relation to that latter clause, that could be very expensive. He instanced a pair of socks. He did not distinguish between whether each sock counted as one garment or two.
5. The parties started a running account. From almost the beginning there were difficulties with performance one way and the another. The details do not matter. Barnet were complaining about late deliveries and the quality of goods supplied, and Barnet at one point invoked its 20 pence per garment clause.
6. There was a settlement meeting, which itself ended up in dispute before the judge. The judge went into a lot of detail about the parties' various allegations. His findings are not challenged on this appeal. I need not go into them save to note that in the various accountings between the parties Barnet had been given credit for late deliveries at Barnet's 20 pence per garment per day clause.
7. The upshot of the judge's finding is that, after deducting small sums allowed by way of counterclaim and set-off, Barnet were liable in the sum of £5,142 odd. Jeancharm invoked its penalty clause, claiming 5% penalty for late payment down to the date of judgment. Barnet said the clause was a penalty clause in law, as well as being stated to be one in the contract, and thus unenforceable. The judge rejected that and upheld the clause. That took Barnet's liability from £5,000 odd to about £20,000. The 5% per week figure amounts to an annual rate of about 260% percent. So on this appeal the question is whether the interest clause is indeed a penalty clause in the eyes of the common law.
8. I turn to the authorities.
9. The classic statement of the law is to be found in the speech of Lord Dunedin in Dunlop v New Garage [1915] AC 79, particularly at pages 86 and 87:

"1. Though the parties to a contract who use the words 'penalty' or 'liquidated damages' may prima facie be supposed to mean what they say, yet the expression used is not conclusive. The Court must find out whether the payment stipulated is in truth a penalty or liquidated damages. This doctrine may be said to be found passim in nearly every case.

2. The essence of a penalty is a payment of money stipulated as in terrorem of the offending party; the essence of liquidated damages is a genuine covenanted pre-estimate of damage (Clydebank Engineering and Shipbuilding Co. v. Don Jose Ramos Yzquierdo y Castaneda (1)).

3. The question whether a sum stipulated is a penalty or liquidated damages is a question of construction to be decided upon the terms and inherent circumstances of each particular contract, judged of as at the time of the making of the contract, not as at the time of the breach (Public Works Commissioner v. Hills (1) and Webster v. Bosanquet (2)).

4. 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:

(a)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. (Illustration given by Lord Halsbury in Clydebank Case. (3))

(b) 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 (Kemble v. Farren (4)). 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 -- a subject which much exercised Jessel M.R. in Wallis v. Smith (5) -- is probably more interesting than material.

(c) 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. (6)).

On the other hand:

(d) 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 (Clydebank Case, Lord Halsbury (1); Webster v. Bosanquet, Lord Mersey (2))."

Later cases have emphasised that a court should be careful not to strike down as a penalty a clause negotiated between willing parties who have similar bargaining strengths. Thus in Robophone Facilities Ltd v Blank [1996] 3 All ER 128 at page 142 Diplock LJ said this:

"The court should not be astute to descry a 'penalty clause' in every provision of a contract which stipulates a sum to be payable by one party to the other in the event of a breach by the former."

He also pointed out, as is common ground here, that the onus of a showing such a stipulation is a penalty clause is upon the party who is sued on it.

10. Most recently, penalty clauses were considered by the Privy Council in Phillips Hong Kong Ltd v The Attorney General of Hong Kong [1993] 61 BLR 41. In that case the Privy Council considered decisions from Australia and Canada. But, as I read the decision, it did not depart from the law as laid down by Lord Dunedin in Dunlop.
11. Mr Kay suggested that following Phillips and the Australian decision (referred to) the law had moved on from what was stated by Lord Dunedin to the extent that it had virtually abandoned it. In particular, he suggested that one should look at the contract as a whole, look at the risks being undertaken by both sides and ask whether the clause was an appropriate clause, having regard to the risk undertaken by the opposite party. Here, for instance, he said that his clients were at very considerable risk if they were in late delivery, having regard to the 20 pence per garment per day clause, and that should be balanced against the interest for late payments.
12. I can find nothing in the Phillips case that suggests a departure of that gigantic nature from the law as laid down by Lord Dunedin. Lord Dunedin indicated that the question of whether or not a clause was a penalty clause depended upon whether it could be regarded as a genuine pre-estimate of the damage caused if there was a breach. Mr Kay's formulation abandons that entirely.
13. If one goes to Phillips, a passage from the joint decision of Mason and Wilson JJ in the Australian case, AMEV-UDC Finance Ltd & Austin [1986] 162 CLR 1770, is quoted by Lord Woolf in the advice to Her Majesty and reads as follows:

"But equity and the common law have long maintained a supervisory jurisdiction, not to rewrite contracts imprudently made, but to relieve against provisions which are so unconscionable or oppressive that their nature is penal rather than compensatory. The test to be applied in drawing that distinction is one of degree and will depend on a number of circumstances, including (1) the degree of disproportion between the stipulated sum and the loss likely to be suffered by the plaintiff, a factor relevant to the oppressiveness of the term to the defendant, and (2) the nature of the relationship between the contracting parties, a factor relevant to the unconscionability of the plaintiff's conduct in seeking to enforce the term. The courts should not, however, be too ready to find the requisite degree of disproportion lest they impinge on the parties' freedom to settle for themselves the rights and liabilities following a breach of contract. The doctrine of penalties answers, in situations of the present kind, an important aspect of the criticism often levelled against unqualified freedom of contract, namely the possible inequality of bargaining power. In this way the courts strike a balance between the competing interests of freedom of contract and protection of weak contracting parties: see generally Atiya, The rise and Fall of Freedom of Contract (1979), especially Chapter 22."

14. Mr Kay particularly relies upon item (2) identified by Mason and Wilson JJ:

"... the nature of the relationship between the contracting parties, a factor relative to the unconscionability of the plaintiff's conduct"

and elevates that to the leading principle for deciding whether or not a clause is or is not a penalty. But, immediately following that passage, Lord Woolf said this:

"It should not be assumed that, in this passage of their judgment, Mason and Wilson JJ were setting out some broader discretionary approach than that indicated as being appropriate by Lord Dunedin. On the contrary, earlier in their judgment they had noted that the 'Dunlop approach' had been eroded by recent decisions and they stated that there was much to be said for the view that the courts should return to that approach."

15. It boils down to this, that since Dunlop the courts have continued to apply the rule in Dunlop but have held that one should be careful before deciding whether or not a clause is a penalty when the parties are of equal bargaining power. There was no abandonment of the rule that the clause must be a genuine pre-estimate of damage.
16. That one can have an increased rate of interest as a valid clause in some circumstances appears from the decision of Colman J in Lordvale Finance plc v Bank of Zambia [1996] QB 752. In that case there was an uplift of 1% for late payment of a debt. That was held to be a genuine pre-estimate on the basis that it indicated that the borrower was a risky borrower. There is nothing in the decision which suggests that anything other than what Colman J called a "modest increase" would do. Here we have an increase which, Mr Kay frankly accepted, is not the sort of rate which would be upheld if it was by a money lender under the Consumer Credit Act or anything of that sort. It is immodest.
17. I turn to the second way in which Mr Kay sought to justify this clause. He suggested that the parties contemplated from the outset that Barnet would normally pay and would pay on time, that neither side expected that there would be much in the way of a delay (if there was any delay at all) and that it was not a large contract. (He rather accepted his client football club is not one of the leading clubs in the land.) He suggested, therefore, the parties contemplated from the outset that the amounts involved would always be very small. Therefore, the administrative costs dealing with the various problems which might arise under the money account would be fairly compensated by the 260% rate of interest. So the clause should be regarded as a genuine pre-estimate of damage. He was very much making bricks without straw. There is no evidence about any of these matters.
18. For my part, I would have thought that, on any basis, 260% is an extraordinarily large amount to have to pay for the suggested administrative costs, even if the sums involved were relatively small. It is purely a matter of speculation, and certainly the clause goes wider than that and covers comparatively large debts too. What we have in this case alone takes a bill of £5,000 to £20,000.
19. I think this is a penalty clause in the Dunlop sense and unenforceable. I would allow the appeal.
20. LORD JUSTICE KEENE: I agree. Mr Kay has laid great stress on whether this clause is unconscionable when seen in the context of the contractual terms as a whole. It is quite clear from the authorities that the concept of a penalty clause is not confined to situations where one party had a dominant bargaining power over the other, although it may, of course, often apply in such a situation: see the decision of the Privy Council in Phillips v Hong Kong Ltd where the opinion was delivered by Lord Woolf, in particular the passage at the foot of page 58:

"Except possibly in the case of situations where one of the parties to the contract is able to dominate the other as to the choice of the terms of a contract, it will normally be insufficient to establish that a provision is objectionably penal to identify situations where the application of the provision could result in a larger sum being recovered by the injured party than his actual loss." (Emphasis added).

His Lordship went on to explain that one can have a range of losses that could have reasonably been contemplated when the contract was made.

21. It is perfectly clear from that passage that the Privy Council there was recognising that the situation where one party is dominant is not exhaustive of those contracts where a penalty may be identified. Indeed, were it otherwise, the concept would have little relevance in most commercial contracts, as Mr Kay himself recognises. That case also rightly rejected the proposition that there is some broader discretionary approach to be applied: see Lord Woolf at page 58 in the first paragraph.
22. The test, in my judgment, remains one of ascertaining whether the provision is a genuine pre-estimate of loss or is a penalty for non-performance of the contractual obligation, as was established in Dunlop and as Phillips, more recently, has endorsed. The first type of provision is essentially compensatory in nature. The second is there to deter the party in question from breaking the contract by providing for a punitive level of payment. If one applies that test to the present case, one is bound to conclude that on its face an interest rate of 260% per annum would seem to be penal in nature. The evidence below did not establish that it was a genuine pre-estimate of loss, nor did the judge make any such finding.
23. In those circumstances, I cannot see how this clause can be seen as having anything other than a deterrent function. I conclude that it is unenforceable as a penalty.
24. I too would allow this appeal.
25. LORD JUSTICE PETER GIBSON: I also agree. As we are differing from the judge below, I add a few comments of my own.
26. The judge's approach was this. He referred to what had been stated in Chitty on Contracts, 28th Edition, page 1326, paragraplh 27-102 where the views of Dickson J in the Supreme Court of Canada in the case of Elsey v J G Collins Insurance Agencies Ltd (1978) 83 DLR (3d)1 at page 15 was cited. Dickson J said:

"... the power to strike down a penalty clause is a blatant interference with freedom of contract and is designed for the sole purpose of providing relief against oppression for the party having to pay the stipulated sum. It has no place where there is no oppression."

The judge said:

"In this case it is clear that there was no such oppression."

He explained that by reference to the fact that the parties were of equal bargaining power, and he referred to the interest rate clause as being a kind of quid pro quo for the late delivery clause. In my judgment the judge's approach was wrong. One is not concerned with the general position of the parties vis-à-vis each other. This is not a case of duress. Nor do the arguably penal terms of the late delivery clause justify the penal interest clause.

27. The principles that are relevant, in my judgment, for distinguishing a penalty provision, with which the courts will interfere from a valid contractual provision for a payment or payments in the event of default by a party are these:

(1) the court looks at the substance of the matter, rather than the form of words, to determine what was the real intention of the parties;

(2) the essence of a penalty is a required payment in terrorem of the party in default, as distinct from being a genuine pre-estimate of loss resulting from the default;

(3) the question whether a provision for payment on default is a penalty is a question of construction of the contract, and that is assessed at the time of the contract and not at the time of the breach;

(4) if the required payment is extravagant and unconscionable in amount in comparison with the greatest loss that could conceivably be established as the consequence of a default, it is a penalty.

28. It follows, therefore, that the court is concerned to construe the contract to see whether the intention of the parties at the time of the contract was to deter the paying party from falling into default. If it can be seen that the provision is a genuine pre-estimate of the loss that will result from the default, then there can be no penalty.
29. In my judgment, it is plain from the magnitude of the interest rate that in this case there was no genuine pre-estimate of loss. It may be that, as Mr Kay argued, the parties thought that if the purchaser was going to be allowed a damages clause for late delivery of the goods to be ordered, then the vendor should be given a very large rate of interest in the event of late payment. But, in my judgment, the authorities show that one concentrates on the relevant clause said to be a penalty, and, on the application of the test so clearly laid down in Dunlop, in my judgment it is plain that in this case the interest clause far exceeds anything that could be said to be a genuine pre-estimate of actual loss and amounts to a penalty.
30. For these, as well as the reasons given by my Lords, I too would allow this appeal.
Order: Appeal allowed with costs. The costs below, if not earlier agreed, to be remitted to the Circuit Judge.