Summary

Where a company, pursuant to a promissory note, advanced a sum of $2 million for the purchase of a property that was subject to a first legal charge in favour of a bank and a clause in the note provided that the amount advanced would become repayable if the bank did not grant permission for a second charge in favour of the company, as had occurred, there was a defence with a real prospect of success that the clause as a matter of construction could be treated as a penalty clause.

Facts

The applicant company (C) applied for summary judgment on its claim against the respondent (D). D had been employed as the chief executive officer of an entity within C's group. He had approached C to discuss the possibility of C assisting him with funding to buy a property. D agreed a transaction with C to the effect that D would sell all his shares in the company to C for $2 million. However, it was said that the shares had little, if any, commercial value and that the consideration for the sale of the shares was the agreement of C to enter into a promissory note to ensure that D had funds to purchase the property. C asked D to enter into a five-year employment contract and both parties agreed that the advance made would be repaid by D if he ceased to be employed by an entity in C's group before the expiry of the term of the employment contract. C sought security over the property to secure payment if D had no way of repaying the $2 million. C was aware that a charge over the property would only be a secondary charge but relied on D when he said that the funds advanced under the note would be used to pay down the relevant bank's first charge, thereby increasing the equity available in the property for C's security. As the property was already subject to a first legal charge in favour of the bank, the charge in favour of C could not be granted without the bank's permission. To facilitate the provision of the money to D in advance of the bank granting permission, C suggested an amendment to the note to insert clause 3.12 which stated that the amount advanced to D would become repayable if the bank did not provide written consent within 60 days of the date of the note. The granting of the permission for the charge by the bank was a condition precedent to the continuation of the transaction represented by the note. The bank refused permission and subsequently a demand was made for the repayment of the advanced sum. C refused to pay. D submitted that the note failed to comply with the Law of Property (Miscellaneous Provisions) Act 1989 s.2, in particular s.2(3), and that clause 3.12 was an unlawful penalty clause. C submitted that the circumstances of the case were such that a constructive trust arose for the purposes of s.2(5) of the Act and the agreement was, therefore, enforceable, despite any non-compliance with s.2. C argued that clause 3.12 did not involve any breach of a contractual obligation placed upon D and, in the absence of any breach, the rule against penalties did not arise.

Held

(1) Although the note was not signed on behalf of C for the purposes of s.2(3) of the 1989 Act, D had agreed in a signed document to grant a charge over his property and C relying on that signed agreement had acted to its detriment in advancing the $2 million. Although a clause in the note was said to be void by reason of s.2 of the Act, that clause could be severed. If that clause did not exist, the other clauses would have served the purposes of the note. Also, C had a clear right to invoke s.2(5) of the Act by reason of a constructive trust arising from the circumstances of the case, Kinane v Mackie-Conteh (2005) EWCA Civ 45, (2005) WTLR 345 followed. Accordingly, D had no real prospect of success on that point. (2) Whether a provision was to be treated as a penalty was a matter of construction to be resolved by asking whether at the time the contract was entered into the predominant contractual function of the provision was to deter a party from breaking the contract or to compensate the innocent party for breach, Lordsvale Finance Plc v Bank of Zambia (1996) QB 752 QBD applied. There was no reason in principle why a contractual provision, the effect of which was to increase the consideration payable under an executory contract upon the happening of a default, should be struck down as a penalty if the increase could in the circumstances be explained as commercially justifiable, Lordsvale applied. In the circumstances, the issue as to whether clause 3.12 was a penalty clause should be dealt with at the trial, United International Pictures v Cine Bes Filmcilik ve Yapimcilik AS (2003) EWCA Civ 1669, (2004) 1 CLC 401 considered.

Application refused