Paying the penalty

The recent High Court case of FW Aviation (Holdings) 1 Ltd v Vietjet Aviation Joint Stock Co [2025] EWHC 928 (Comm) considered whether termination sums payable under certain leasing arrangements constituted an unenforceable penalty.

Introduction

There is a celebrated Supreme Court decision concerning a parking charge notice (PCN) for £85 issued by a car park operator on behalf of a shopping centre. The motorist had overstayed the two hours which they had paid for and argued that the PCN charge was out of all proportion to the loss suffered by the car park operator and the centre. The Court concluded that “there may be interests beyond the compensatory which justify the imposition on a party in breach of an additional financial burden. What is necessary in each case is to consider, first, whether any (and if so what) legitimate business interest is served and protected by the clause.” In this case PCN charges of this magnitude were necessary to deter motorists from abusing the car parking to maintain a turnover of custom for the shopping centre. This is an easy-to-understand illustration of the doctrine of “legitimate interest” which has developed in this area of contract law. The amounts in dispute in the FW Aviation case were of an altogether different order of magnitude, running to more than US$100 million!

Facts

The leases in question were Japanese Operating Leases with Call Option (JOLCO) in respect of several aircraft. These are specialised tax leases where an aircraft is held by a joint venture company (lessor). Japanese equity investors put in 25% of the cost of the aircraft and 75% is raised from lenders who are granted an aircraft mortgage over the aircraft. The aircraft is leased to the airline which is granted a call option to purchase the aircraft at the end of the term. The lease is partially assigned by the lessor to the lenders. Tax benefits accrue to the equity investors over the period of the lease, and these are shared between the investors and the airline, thus allowing the airline to fund the acquisition of the aircraft at a much lower cost and without putting in its own capital. The rentals service the debt and provide the investors with their expected return.

If the airline defaults under the lease, the lease can be terminated, and the airline becomes liable to pay a default termination sum at a rate which makes the lenders whole and provides the investors with their anticipated return on investment. If the default termination sum is payable within 30 days, the airline takes title to the aircraft. If it fails to do so, the lenders can enforce their mortgages to take possession of the aircraft and sell them. This is exactly what happened when the airline defaulted and, as well as losing the aircraft, the lessor claimed the full termination sum from the airline. The airline argued that the obligation to pay the full termination sum in these circumstances was a penalty provision and therefore unenforceable.

In essence, the airline’s argument was that it had not been able to pay the default termination sum within 30 days and therefore if the claim for payment was upheld, it would in effect pay the full value of the aircraft but lose the aircraft as well. This was penal and any termination sum payable should be offset against the value of the aircraft. The finer legal points of the argument were that, in the case of a pecuniary loss, compensating the loss should be sufficient and that there was no wider legitimate interest which needed to be protected.

Judgement

The judgement, which is long and complex, can be broken down into several key points:

• Applying the principles in the Supreme Court case of Makdessi v Cavendish Square Holdings [2015] UKSC 67, the test is whether the provision in question “imposes a detriment on the contract-breaker out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation “.
• There are, accordingly, two parts to the test: whether the provision supports a legitimate interest; and if so, whether the clause imposes a detriment on the contract-breaker out of all proportion to such interest.
• On the question of “legitimate interest”, the Court considered that preventing the collapse of the tax structure was a legitimate interest that needed to be protected.
• Expanding on this: If the airline defaulted in relation to its rental obligations, the lessor would, in turn, default in its obligations under its loan. That would lead to the lenders’ acceleration and enforcement against the aircraft which would, in turn, collapse the whole structure leading to the loss of the tax benefits, as well as immediate cash flow problems, for the investors. It follows that the provision was intended to protect those wider interests in the case of default. As to legitimate interest in particular, the scheme established by the provision reflected the parties’ (including the airline’s) expectation that there should be protection for the parties whose capital was at risk in the transaction (namely the lenders and the Japanese equity investors) whilst allowing the airline to fund the acquisition of the aircraft without the use of its own capital and at a significantly lower cost than other forms of commercial financing.
• The default termination sum did not constitute a penalty. Applying the principles in Makdessi, the default termination sum provision protected the legitimate interests of lenders and the Japanese investors in recovering their significant capital and did not impose on the airline a detriment out of all proportion to those interests. The protections built into the provision were legitimate and were neither “extravagant, exorbitant or unconscionable “ nor “wholly disproportionate” to the interests sought to be protected. Instead, they represented the balancing of the interests of the financing parties (who had risked their capital) and the airline (who had not) in light of a wide range of uncertain and unpredicted downside scenarios.
• The Court also noted that, where a contract has been freely negotiated between parties of comparable bargaining power, it is significantly less likely that a provision will be deemed to be a penalty. The airline was very experienced in leasing aircraft and fully understood the nature and terms of the JOLCO arrangements.
• It also noted that the burden of proving that a provision is a penalty falls on the party asserting that the provision is unenforceable and that burden will not be lightly discharged.

Comment

This case, of course, has wider application and serves as a useful reminder that the law on penalties has moved on from the 20th century. The notion that a provision should represent a “genuine pre-estimate of loss” and operate to compensate the innocent party for its loss is no longer the only consideration. There may be valid circumstances where there is a wider legitimate interest to be protected, and the courts will uphold such protection if it is not “a detriment on the contract-breaker out of all proportion to any legitimate interest”. Whereas, at one time, such provisions were not supposed to operate “in terrorem”, deterrence is now considered a legitimate interest in certain circumstances. It follows that, when drafting this sort of provision, there is more scope to be bold, not with a view to enriching the client but if there is a wish to deter a particular outcome or protect a wider legitimate interest.

It is also interesting to note that, at the time of negotiation, the airline must have taken comfort from the provision which allowed them to pay the default purchase option sum and take title to the aircraft. However, the reality in a default situation is that it will not be practical to exercise such option. Indeed, their counsel argued that this option was “largely illusory”. When drafting, it is always a good idea to think through the reality of the various scenarios which may arise.

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