When is a cancellation clause enforceable?

In the current economic climate, schools may wish to review all their outgoings in order to ensure that they are utilising limited funds in the most efficient manner. This may mean that a school wishes to terminate an agreement which, for example, may not be providing the return on investment which was originally anticipated.

In such a scenario, the cancelling party may be met with a demand by the other to pay a cancellation fee. The fee is often calculated by reference to a cancellation clause contained within the original agreement entered into between the parties.

However, is a cancellation fee always payable in this scenario?

Not necessarily.

In brief, in order for a cancellation clause to be enforceable – i.e. for there to be a right to recover a cancellation fee – , it has to comply with the following criteria:

• There has to be a legitimate purpose behind the clause
• It has to represent a genuine pre-estimate of the enforcing party’s direct loss – i.e. it has to be proportionate
• The clause is not a primary obligation – e. a main condition of the agreement that a party is required to perform

If the cancellation clause does not comply with all of the above criteria, it may be deemed to be a penalty clause.  Such a clause is unenforceable, which means that any cancellation fee calculated by reference to it is not payable. This is even the case when the parties have entered into a written agreement which contains the cancellation clause.

A practical example of a penalty clause

An example of where this issue was recently considered by the court was in a claim brought by a ratings agency against a school.

By way of brief background, the school instructed the ratings agency in March 2017 to act on its behalf in respect of an appeal to the classification of several properties in the 2017 Ratings List. The parties entered into a written agreement which, amongst other things, contained a cancellation clause which stated that the ratings agency was entitled to charge a cancellation fee (equivalent to 2% of the current rateable value of the property) should the school terminate the agreement.

When no substantive progress had been made by the ratings agency in respect of the ratings appeal by January 2020, the school terminated the agreement on the basis that the services had not been carried out within a reasonable timeframe or to an adequate standard.

As a result, the ratings agency issued an invoice for payment of a cancellation fee.  In accordance with the provisions of the cancellation clause, the cancellation fee was equivalent to 2% of the current rateable value of the property in question. When the school refused to pay the invoice, the ratings agency issued legal proceedings.

As part of its defence, the school raised the argument that the cancellation clause relied upon by the ratings agency was, in fact, a penalty clause and that, as a result, the invoice was not payable.  In particular, the school’s defence was based on the following:

• The cancellation fee was c.225% higher than the fee which would have been payable if the ratings agency had actually submitted an appeal which resulted in the estimated ratings reduction being achieved
• The cancellation fee was not a genuine pre-estimate of any loss suffered by the ratings agency as a result of the agreement being terminated due to the fact that the ratings agency was, in effect, being paid more than double the fee it would have been paid had the work been completed
• The cancellation fee was unconscionable and had been designed by the ratings agency to prevent parties from seeking to terminate the agreement

The claim proceeded to a final hearing, at which the court was asked to consider as a preliminary issue whether the cancellation clause was a penalty clause.

After hearing the evidence, the court found that the cancellation fee sought by the ratings agency was unconscionable. This was mainly due to the fact that, even on the rating agency’s own evidence, the cancellation fee was significantly higher than the amount which would have been payable had the rating agency obtained the estimated ratings reduction.  The court found that there was no legitimate interest behind such a calculation being upheld.

As a result, the court determined that the cancellation clause was a penalty clause and, accordingly, was unenforceable. The rating agency’s claim for payment of the cancellation fee was therefore dismissed.

Due to the cancellation clause being found to be a penalty clause, the court was not required to consider whether the services had, in fact, been carried out within a reasonable timeframe or to an adequate standard.

Conclusion

The above case illustrates that there are occasions in which a cancellation fee is not payable, even when the existence of the cancellation clause upon which the fee is based is not in dispute and forms part of the agreement entered into between the parties.  There may also be other scenarios in which a cancellation fee is not properly payable, for example if the cancellation clause represents an unfair contractual term.

Therefore, when faced with a claim for payment of a cancellation fee, schools should seek legal advice if the fee appears to be out of all proportion to the work carried out or if the fee appears to have been sought with an illegitimate purpose, for example to keep the school locked into the agreement indefinitely regardless of performance.  There may also be other reasons why a cancellation fee is not properly payable, for example if it represents an unfair contractual term.