Penalty Shootout: The English Court Provides Welcome Clarification on Test for Penalty Clauses

In a recent decision, the English Court provided welcome clarification on when contractual clauses can fall foul of being a penalty and therefore be unenforceable.

The Facts

The decision arises from the first quantum trial in a long-running dispute between FW Aviation (Holdings) 1 Limited (FWA) and VietJet Aviation Joint Stock Company (VietJet) over certain aircraft leasing arrangements.

The dispute concerned four aircraft which were leased to VietJet under a Japanese Operating Lease with Call Option (JOLCO) structure. Under the JOLCO structure, the original lessor purchased each asset using a mixture of Japanese equity and debt finance and leased them to special purpose vehicles controlled by VietJet, which were granted purchase options over the aircraft. Each lease was supported by security held by a trustee or agent (the Security Trustees).

When VietJet failed to make rental payments in October 2021, the Security Trustees sought to terminate the leases. Shortly thereafter, FWA acquired the lenders’ rights under the leases and appointed itself Security Trustee in order to enforce certain security rights.

At a first phase trial to determine liability, FWA successfully argued that it had acquired the contractual rights on which it sought to rely. FWA subsequently recovered possession of the aircraft and resold them, but various issues of quantum remained.

The Parties’ Positions

FWA sought to enforce a contractual provision in the leases which required VietJet to pay an early termination fee totalling more than US$180 million for the four aircraft upon an event of default (which included the non-payment of rent). VietJet argued that the clause was penal and thus void, on the basis that FWA only had a pecuniary interest in the clause and the termination fee was not a genuine pre-estimate of loss. VietJet claimed that the enforcement of the termination fee would generate a windfall for FWA, which had already recovered the aircraft and would now obtain a further sum in excess of their legitimate interest in being compensated for their financial loss.⁴

The Decision

The Court rejected VietJet’s argument that the clause provided a substantial and unjustified windfall to FWA. The termination fees were primarily intended to allow FWA to compensate the equity investors for the loss of the tax advantages which they would have received but for the early termination of the leases, and to protect against a situation where the proceeds from the recovered aircraft (which would need to be readied for onward sale or re-leased) were insufficient to make both FWA and the investors whole. Requiring VietJet to pay the full termination sum was therefore proportionate to the protection of FWA’s legitimate financial interests.  

The judgment expressly rejected the suggestion that cases concerning the assessment of penalties ought to be categorised as either one where the innocent party has a pecuniary interest or one where the innocent party has some other interest in performance. In fact, the Court found that legitimate non-pecuniary interests often exist beyond the recovery of money.

The test for determining whether a clause is an unenforceable penalty remains as set out by the English Supreme Court, namely a court must consider (i) whether the clause protects a legitimate interest of the innocent party in enforcing performance and (ii) whether the detriment imposed by the secondary obligation of payment is proportionate. However, the Court accepted that whether the clause is a genuine pre-estimate of loss still remains a relevant consideration when applying this broader test.

Comment

The English Court has clarified the application of the still relatively new legal framework for the assessment of penalty clauses. This additional certainty is to be welcomed, not least because parties may often seek to rely on damages clauses to protect both pecuniary and non-pecuniary contractual interests.

Although it is not the standalone test, in practice if a damages clause in a contract provides for payment of a genuine pre-estimate of loss it will be valid. However, even if it is not a genuine pre-estimate of loss, a court must still apply the broader two stage test before determining whether the clause is a penalty.

Parties may take comfort from the judgment when considering enforcing their contractual rights to termination fee payments. However, whether such clauses are penal in nature will turn on the circumstances of each case, and they should be carefully considered by the party seeking to rely on them before entering a contract.