The dust has barely settled since the Supreme Court’s decision in Cavendish Square Holdings v Makdessi and penalty clauses are already being revisited by the courts.
The current test for the enforceability of penalty clauses as set out in Cavendish focuses on whether the clause is a secondary obligation and if so, whether the detriment caused to the contract breaker is out of all proportion to any legitimate interest the innocent party may have in the enforcement of the primary obligation (see my earlier blog post on Cavendish for a quick discussion of the decision).
Hayfin Opal Luxco 3 SARL & another v Windermere VII CMBS plc and others dealt with commercial mortgage backed securitisation arrangements and considered (in obiter) whether a clause requiring payment of interest on any underpaid interest amounted to a penalty. The defendant argued that the requirement that the obligation to pay interest at the Class X rate (which was regularly in excess of several thousand percent per quarter) on any underpaid interest payments was unenforceable as a penalty clause. The claimant argued that as the interest due was zero during various periods and as such there was no disproportionate detriment to the defendant in those circumstances, thus rendering the interest provision enforceable.
The claimant did not dispute that the clause imposed a secondary obligation but the court still questioned whether the clause amounted to a secondary obligation and therefore whether the rule against penalties could even apply. Additionally, the court reinforced that the second limb is an objective test; the court will not take into account whether the alleged penalty clause actually acts a deterrent but rather whether, objectively, the detriment is out of all proportion to any legitimate interest. In simple terms, it will not matter to the court in answering this question whether the contract breaker is so rich that he will not notice that it is extravagantly disproportionate.
Whilst the case was decided on a different point and the penalty clause argument was addressed in obiter only, Hayfin v Windermere highlights the importance of the first limb of the test: whether the clause is a secondary obligation and not a primary obligation.