Penalties and the early termination of fixed-term contracts – Beware!

Penalties and the early termination of fixed-term contracts – Beware!

The recent high profile case of Henning Berg v Blackburn Rovers Football Club has clarified the law on penalties in relation to the early termination of fixed-term contracts. Mackrell Turner Garrett corporate lawyer Maung Aye takes a closer look as this often misunderstood area of law.

The case concerned Henning Berg, a Norwegian former footballer and manager who played for Blackburn Rovers and returned to the club as manager in 2012. He was appointed for a fixed-term contract, which was to last approximately two-and-a-half years.

After just over a month as Blackburn manager (and with only one win), the club exercised its right to terminate the contract for convenience with immediate effect.

Clause 15.3 of the contract stated that: “In the event that the Club shall at any time wish to terminate this Agreement with immediate effect it shall be entitled to do so upon written notice to the Manager and provided that it shall pay to the Manager a compensation payment by way of liquidated damages in a sum equal to the Manager’s gross basic salary for the unexpired balance of the Fixed period assuming an annual salary of….”.

The club first admitted liability, however it later sought to argue that clause 15.3 was in fact a penalty clause and was therefore unenforceable.

English law states that parties to a contract are free to provide that a fixed sum is payable on breach of a contract if the amount recoverable as damages for the breach is not easily predictable. If this fixed sum is a reasonable pre-estimate of the loss, it will be a valid liquidated damages clause.

If, on the other hand, the fixed sum payable on breach of the contract is simply used to deter the other party from breaching the contract, it will be deemed to be a penalty clause and will consequently be invalid

This area of law is often misunderstood. The law on penalties only applies where the trigger for payment of the fixed sum is a breach of contract. If the trigger for payment is any other circumstance, the rule on penalties will not apply. Lord Roskill, in Export Credit Guarantees Department v Universal Oil Products Co stated that:

“…the main purpose of the law relating to penalty clauses is to prevent a plaintiff recovering a sum in respect of a breach of contract committed by a defendant which bears little or no relationship to the loss actually suffered by the plaintiff as a result of the breach by the defendant. But it is not and never has been for the courts to relieve a party from the consequences of what may in the event prove to be an onerous or possibly even a commercially imprudent bargain.”

The judge in the Henning Berg v Blackburn Rovers Football Club case consequently found that as the payment to Henning Berg was due otherwise than for a breach of contract, it could not be classed as a penalty.

This case is particularly important when considering long-term agreements between parties such as outsourcing, construction and service agreements where compensation payments for termination of contracts are common. In circumstances where a party is entitled to terminate a fixed-term contract early for convenience, as opposed to breach, the law on penalties will not apply.

A final point to consider is how to refer to such clauses in a contract. Bearing in mind that damages are only relevant where there has been a breach of contract, referring to such clauses as ‘liquidated damages’ clauses (as Blackburn Rovers did at clause 15.3 of their contract), could result in the clause being subject to the rule on penalties. It may be preferable to describe sums due under such clauses as ‘termination payments’ or ‘termination compensation’ instead.

Maung Aye