Does your commercial contract protect you?
The message from a number of recent decisions from the English courts, in particular the Supreme Court, is clear: if you’ve struck a bad bargain, don’t expect the court to help you out. The importance of knowing your contract – where you are protected, where you may be exposed – is as high as ever.
Freedom of contract
Parties are, as it was once memorably put, masters of their contractual fate. It is in the parties’ hands to determine the outcome of their contract. If the deal struck turns out to be less favourable than either one of the parties anticipated, the court will be slow to intervene.
Two recent decisions from the Supreme Court emphasise this point. In both Arnold v Britten and others and Marks and Spencer plc v BNP Paribas Securities Services Trust Company (Jersey) Limited and another, the court was invited to imply terms into the parties’ contracts. In both it declined. Terms will only be implied into a contract in limited circumstances: where it is (1) necessary to give business efficacy to the contract, or (2) so obvious it goes without saying.
The contract is paramount. The Supreme Court held firm to this principle in Cavendish Square Holding BV v Talal El Makdessi and Parking Eye Limited v Beavis. These jointly-heard cases concerned the rule on penalty clauses. In each case, the court upheld the clause which had been challenged as contravening the rule. As the Supreme Court commented, “the strong initial presumption must be that the parties themselves are the best judges of what is legitimate in a provision dealing with the consequences of breach.”
In reaching its decision, the Supreme Court rewrote the long-standing rule on penalty clauses:
- The old test – whether the relevant clause was a genuine pre-estimate of loss and therefore compensatory, or aimed at deterring a breach and therefore penal – has been substituted for a broader test. That is, whether the clause is out of all proportion to the innocent party’s legitimate interest in enforcing the counterparty’s obligations under the contract.
- The question of whether there is a penalty at all does not bite on primary obligations, such as providing or paying for services under a contract, but is confined to secondary obligations. These are the obligations triggered by breach of the contract, such as an obligation to pay a specified sum of damages. The new, broader test outlined above is limited to assessing clauses concerned with these obligations.
Both of these changes arguably have the effect of increasing the likelihood that a clause devised as a deterrent, unless out of all proportion to the interest it protects, will be enforceable. This was the case in the Parking Eye dispute, where Mr Beavis was obliged to pay a fine of £85 for overstaying the time permitted in a car park in Chelmsford. That sum was not designed to compensate the car park operator Parking Eye for a particular quantified loss, but rather to protect its interest in managing the car park efficiently and making a profit from it.
What is the lesson to take from this? Do not automatically assume that a clause that looks penal on its face will be unenforceable. Equally, if you are drafting a contract and want to deter breach of it, you can include a clause designed to do this, provided it is proportionate and you can point to a legitimate interest underpinning it.
Are there any limits to the power of the written contract?
The general rule is that the court will look to what has been reduced to writing in a contract to determine parties’ rights and obligations. Contracts are commonly drafted to reinforce this, in particular through the use of entire agreement and anti-oral variation clauses.
There are circumstances, however, where the court will look outside the contract. An entire agreement clause, for example, will not be effective to prevent the rectification of a unilateral or common mistake in circumstances where a contract is not a true representation of what was actually agreed by the parties.
Another example is where the parties have conducted themselves in a certain way and they may be prevented from arguing a position contrary to this. Estoppel by convention, as this doctrine is known, has certain key requirements: the assumption in question must be communicated between and shared by the parties and it must be relied upon so that it would be unconscionable for a party to act contrary to it.
The risk of a party raising an estoppel by convention argument can be mitigated by the inclusion of an express exclusion of pre-contractual representations. However, it remains open to the court to limit the effect of such an exclusion.
Finally, the Court of Appeal decision in MWB Business Exchange Centres Ltd v Rock Advertising Ltd demonstrates that anti-oral variation clauses will not necessarily prevent a contract being varied by less formal means. In that case, the court enforced an oral agreement between the parties, notwithstanding a clause in their contract specifying that variations were to be in writing and signed.
The important point to take from the above is this: do not fall into the trap of thinking that the actions and conduct of you and your counterpart are irrelevant and anything beyond the written word simply falls away.
So what should you do?
- The key is to prepare a carefully and clearly drafted contract. If it has been drafted as you would like, this will stand you in good stead to any challenge from a counterparty, since the court will be slow to intervene.
- Think carefully about how liability in the contract is to be defined. On the enforcing side, do you want to set a fixed sum payable on breach or a maximum sum for any damages? As discussed above, under the reformulated test on penalties, this will need to be proportionate to the interest at stake but does not need to be a pre-estimate of loss.
- A clause which is drafted as a primary obligation (what a party must do to perform the contract) rather than a secondary one (what a party must do in the case of breach of the contract) will likely not engage the rule on penalties. Bear in mind, however, that the court will look to the substance rather than simply the label of a clause.
- On the paying side, do you want restrictions on the other party’s entitlement to damages, such as an exclusion of liability or limit to the damages that will be paid, or a combination? You will need to be aware of the application of the Unfair Contract Terms Act 1977 (which imposes limits on the extent to which liability for breach of contract may be excluded). The court, if invited to do so, will construe the relevant clause narrowly to determine whether, for example, it has been validly incorporated into the contract and is free of ambiguity.
- Include entire agreement clauses and consider using anti-oral variation clauses. There are potential limits to their scope, as discussed above, but there is still merit in their inclusion. In particular, they will make it more difficult to show that anything said or done but not included in the contract was intended as a variation of the agreement. The evidential bar for an aggrieved party is set higher.
- Review existing contracts. Are there areas where you may be exposed or where the protection you think is in place could be subject to challenge? Consider seeking to amend the contract if so.
- Document any discussions of amendments to the contract. If you are the party resisting changes to the contract, remember that the presence of an anti-oral variation clause will not necessarily be effective to prevent the contract being varied by less formal means.
This article was written by John Sykes and Simon Heatley. For more information, please contact John at firstname.lastname@example.org or +44 (0)20 7203 5131 or contact Simon at email@example.com or +44 (0)20 7203 5088
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