The High Court has ruled in the recent case of M&J Polymers Ltd v Imerys Minerals Ltd (2008) that ‘take or pay’ provisions could in principle be deemed unenforceable penalty clauses. Under UK contract law, parties cannot enforce terms which seek to punish breach of contract. Any damages payable in the event of a breach should not exceed a compensatory level or they may be held unenforceable by the courts.

In supply agreements, ‘take or pay’ clauses impose an obligation on the buyer to pay for a minimum quantity of goods, whether or not this amount is actually taken or desired. This can be a useful mechanism to ensure a minimum level of cash flow to a supplier who can then rely on this when making commitments to purchase raw materials for instance.

M&J Polymers contracted to supply dispersants, which are chemicals used in the breakdown of clay and other materials, to Imerys Minerals. It was agreed that, during the term of the contract, the buyer would order minimum quantities of dispersants. A separate contract term contained a ‘take or pay’ clause, which stated that the buyers must pay for the minimum quantities of products, even if these quantities had not been ordered.

The court stated that in principle a ‘take or pay’ provision could amount to a penalty clause but it did not in this particular case. If the goods were ordered, payment would be due irrespective of the ‘take or pay’ clause. However, if the requisite amount of goods was not ordered the fact that the buyer has to pay regardless could be considered a penalty for breaching the obligation to order a minimum quantity.

However, the clause in this case was upheld for a number of reasons. Firstly, it was deemed to be commercially justifiable. The predominant purpose of the clause was not to deter a breach of contract but to provide the supplier with a level of stable business. Secondly, there was no indication of either of the parties being subject to oppression. The contract was freely negotiated between parties of comparable bargaining power.

It should be noted that the contract in M&J Polymers v Imerys Minerals did not frame the ‘take or pay’ obligation in the conventional manner as there was a separate obligation to order minimum quantities followed by the requirement to pay even if these quantities were not ordered. It is common for 'take or pay' clauses just to require a minimum level of payment. The courts are yet to consider a case involving the more conventional format.

Nevertheless, the approach taken in this case suggests that even although there is now a possibility that a 'take or pay' clause may be held unenforceable, as long as no party to the contract is in an oppressed position, there should not be any problem. This is in line with a general reluctance on the part of the courts to interfere with freedom of contract in business matters.

This means that the judgment should have limited impact on 'take or pay' clauses used in supply agreements, for example, in the utilities industry. However when such clauses are being negotiated, care should be taken to ensure they are commercially justifiable and that no particularly onerous obligations are imposed. Otherwise, the recent judgement suggests the court might refuse to enforce such a clause if these conditions are not met.

07 October 2008

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