Demystifying contractual terms for charities: Penalties

Encouraging contractual performance - the carrot or the stick? What are penalties and why are they problematic?

Background: Penalties

We have a long obsession with penalties in this country, caused in no small part by the post-traumatic stress from yet another major tournament defeat at the hands of the dreaded penalty shoot-out!

In contractual terms, a penalty is a clause that imposes a financial consequence on a party for breaching the terms of a contract. It is typically a large sum of money that is not proportionate to the actual loss suffered by that party due to the breach. Instead, it is designed to punish the breaching party, and to deter non-compliance.

This doesn’t sound unreasonable, eh? Well, it is important to be aware that such terms are unenforceable unless three questions set out in Cavendish v Makdessi [2015] UKSC 6 are answered. Those questions are:

• Is the provision in substance a secondary obligation engaged upon breach of a primary contractual obligation (e.g. to pay for goods or services, or to make loan repayments)? If no, the term will be unenforceable.

• If so, is there a legitimate interest of the promisee in having the primary obligation performed (and, if so, what is the nature of it and its extent)? If no, the term will be unenforceable.

• Having regard to the legitimate interest, is the secondary obligation exorbitant or unconscionable in amount of its effect. If yes, the term will be unenforceable.

Whether this test is met in any given situation will depend on its circumstances. That is not a hard and fast rule. For example, in the context of the repayment of commercial loans, it is recognised that lenders have a good commercial justification for charging a higher rate of interest after a repayment default when, having defaulted, the borrower represents a greater credit risk, potentially affecting liquidity.

The relevance of penalties to charities

There are a number of circumstances in which such terms might be relevant to contractual arrangements entered into by charities:

• As the provider of goods or services, a charity may wish to use such terms as a lever to encourage compliance by the service recipient of the payment terms of the underlying goods or services contract. Equally, where the charity is the service recipient, it may be subject to such terms, to encourage it to make payments on time.
• As a member of a collaborative working group, a charity may wish to use such terms to compensate it for loss of opportunity that would be caused to it by another party being in breach of the terms of the underlying collaboration agreement.
• As the provider of repayable funding (e.g. by way of a loan), a charity may wish to use such terms as a lever to encourage compliance by the funding recipient of the repayment terms of the underlying funding agreement. This applies particularly to our impact investment clients. Equally, where the charity is the funding recipient, it may be subject to such terms, to encourage it to make repayments on time.

Recent developments and what does this means for charities?