Contracts Matter

A marine insurance contract consisted of a policy booklet and a certificate. Part 1 of the booklet contained the insurer's indemnity against liability to third parties. Part 5 contained a "pay first" clause, which required the insured to discharge any third party liability prior to claiming under the indemnity.

As the insured became insolvent before discharging its liability to a third party, the insurer was not obliged to pay anything and the third party recovered nothing.

The Commercial Court held that the pay first clause was incorporated; was not onerous or unusual; and was enforceable.

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The Court of Appeal upheld the Commercial Court decision. The clause was held not to be unusual as caselaw and analysis showed such clauses were common in marine liability policies. Nor was the clause onerous, notwithstanding that it significantly limited the insurer’s liability. The threshold for demonstrating a clause was onerous was high and was unlikely to be met “in commercial contracts where the parties are of broadly equal bargaining power, and where the challenged clauses in question are common form or usual terms regularly encountered in the business.”

The Court of Appeal stated that the principle should now be called the “onerous clause doctrine”:

“where a particularly onerous or unusual term of a contract (an onerous clause) is contained in one party’s standard terms, and where the other contracting party does not actually know of that term, it will not bind the other contracting party unless the party seeking to rely upon it shows that the clause in question (whether individually or as part of the standard terms) was fairly and reasonably brought to the other contracting party’s attention”.

It was suggested that “the onerous clause doctrine could never be applicable in any normal case in which a party has its own professional broker or adviser acting for it in the transaction”

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• Beyond the context of marine insurance contracts, the decision flags the importance of a party seeking to rely on a potentially onerous term to insist that a weaker party has professional legal advice. It also highlights the importance of making sure such terms are not hidden away and are clearly drafted.

London Credit Ltd (LC) agreed to loan £1,881,000 to the third appellant, CEK Investments Limited (CEK), for a period of 12 months. The loan was secured by a debenture over CEK’s assets, personal guarantees from CEK’s directors and third-party mortgages over their family home and several buy-to-let properties. Following drawdown of the loan, LC alleged that a non-occupation covenant had been breached and demanded repayment of the full loan amount, plus default interest.

The main issue revolved around the default interest rate clause in the facility agreement, and whether it constituted a penalty which would render the default interest provision unenforceable. On the first occasion in the High Court, the judge concluded that the default interest did not protect any legitimate interest of LC and was therefore a penalty.

The Court of Appeal reversed this finding, holding that the judge had misapplied the Cavendish test and remitted the penalty issue for fresh determination. The Court of Appeal directed the court to determine "whether, having regard to the legitimate interest in the performance of the primary obligation, the default interest provision is extortionate, extravagant or unconscionable in amount or effect”.

At the start of this lengthy judgment, the judge considered that the events of default could be sensibly grouped into different categories of primary obligations, in order to consider the question of legitimate interests. A lender obviously has a legitimate interest in repayment interest – also in all representations and warranties being true and correct in all material respects (representations interest) and in enforcing obligations for the protection of the security (security interest). On this occasion (in contrast to the initial judgment), the judge also accepted that an unregulated lender has a legitimate interest in seeing a non-residence provision observed (non-residence interest). In principle, a lender also has a legitimate interest in primary obligations that go to preserve a borrower’s ability to repay the debt when due (credit risk interest). However, the judge considered that this is by far the most complex of interests identified, as the term ‘credit risk’ can cover different concepts.

The judge considered that maintaining conceptual clarity between the different interests is useful when it comes to applying the legal test. As Makdessi makes clear:

• the court must carry out the analysis at the point of formation of the agreement, when it is not known which primary obligation or obligations will be breached;
• where the same secondary obligation protects diverse primary obligations representing different legitimate interests in the same way that remains an “ indicia of penalty”; and
• if by reference to any primary obligation the provision is a penalty, it is unenforceable in its entirety.

The judge emphasised that the default rate in this case responded to a variety of defaults and so a variety of interests; if it was extortionate in respect of any of them, the clause fails in respect of all of them.

The initial judgment had determined that the credit risk interest was extortionate and therefore the clause was deemed to be a penalty. On this second occasion, after lengthy legal analysis, the judge determined that the credit risk interest was tied to the sensitivity of this particular re-financing and it was therefore not extortionate for LC to attach an above market default rate to the credit risk interest.

Having heard the expert evidence regarding commercial acceptability, the judge concluded the 4% rate was “plainly above the range of market rates but not, in itself, unreasonable," and when assessed against the repayment interest, it was "high, not extortionate" and therefore not penal.

• When drafting default interest provisions, it should be noted that where uniform rates apply to all events of default, each separate default must reflect a need to protect a legitimate business interest, otherwise the entirety of the provision fails.
• The decision confirms that credit risk considerations can justify default rates even for non-payment breaches, particularly where defaults might affect the defaulting party's creditworthiness or ability to meet its obligations. However, this issue is complex and will be fact specific.
• Expert evidence on commercial acceptability remains important, but rates at the upper end of market norms can only survive scrutiny where strong legitimate interests exist and parties with comparable bargaining power were properly advised.

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URE Energy Ltd (URE), a start-up electricity supplier, entered into an initial four-year supply contract with Genesis Housing Association in September 2017 with a view to securing a longer contract in due course. In February 2018, Genesis passed a resolution to amalgamate with Notting Hill Housing Trust, and the merged entity, Notting Hill Genesis (NHG), was formed in April 2018. URE was notified of the proposed amalgamation in March 2018 and raised no objection, continuing to supply electricity and invoice NHG for seven months.

The contract included provisions entitling URE to terminate in certain events, including (at clause 10.2(d)) the right to terminate if Genesis passed “a resolution for its winding up which shall include amalgamation... (other than a solvent amalgamation... approved in advance by the Supplier)".

Following a deterioration in the parties' relationship and NHG's withdrawal from negotiations for a long-term contract in October 2018, URE obtained legal advice and subsequently asserted that the amalgamation had triggered a contractual right to terminate under clause 10.2(d), claiming a termination payment of nearly £4 million. NHG contended that URE had lost its right to terminate by reason of the amalgamation, having affirmed the contract on numerous occasions.

The High Court held that URE had not waived its right to terminate and NHG appealed on points of law relating to waiver by election.

The Court of Appeal allowed the buyers’ appeal, restoring the tribunal’s decision.

With regard to the obligation imposed by clause 14, the Court of Appeal agreed with the High Court that the seller was not under an absolute obligation to have the vessel ready by the cancelling date. However, it held that the agreement imposed an implied obligation to use reasonable or due diligence to deliver the vessel by that date. Sellers’ "negligence" under clause 14 included a failure to comply with this obligation.

The court concluded that the natural and ordinary meaning of "loss" in clause 14 extended to the buyers’ loss of bargain: the buyers did not get the ship they had contracted for at the agreed price. The fact that clause 14 provided for compensation for "all expenses" indicated that compensation for loss was intended to cover something beyond wasted expenditure.

The central issue was whether clause 14 could encompass loss of bargain where the buyers exercised a contractual termination right, rather than terminating for repudiatory breach. The court concluded that it could: clause 14 conferred upon the buyers a right to claim compensation for their loss, including loss of bargain, where they cancelled the contract and could prove that non-delivery resulted from the sellers' negligence or failure to exercise due diligence.

This conclusion was supported by the corresponding provision in clause 13 (Buyers' default), which The Griffon [2013] had construed as conferring an express contractual right to claim loss of bargain damages. The court considered that the structure of Saleform 2012 indicated that clauses 13 and 14 were intended to operate in a similar fashion.

• As a general rule, a party exercising a contractual right of termination for breach is not entitled to damages for loss of bargain unless the breach was repudiatory. However, this decision confirms that the general position may be displaced by an express contractual term. Accordingly, entitlement to loss of bargain damages will depend on the specific wording of the contract in question.
• In rising markets, buyers should carefully review cancellation rights and compensation provisions to determine whether any express contractual entitlement to compensation for loss extends to loss of bargain damages.
• For sellers, the judgment underscores the importance of exercising reasonable diligence to meet delivery deadlines under time-sensitive contracts. Sellers proposing extensions should be mindful that, depending on the wording of the contract, buyers may still claim loss of bargain following cancellation if they can prove that the seller failed to meet the original delivery date due to negligence, though this may be difficult to establish in practice.