Take-or-pay provisions – a penalty clause?

United Kingdom

In a case handed down at the end of February(1), a Commercial Court judge in the UK was asked to consider, for the first time, whether a claim based on a take-or-pay provision in a sale and purchase agreement should fail because it was a "penalty clause".

The judgment is a surprising one and will raise concern in the energy industry.

What are take-or-pay provisions?

Take-or-pay provisions are commonly found in the energy industry - in gas sales contracts, power purchase agreements and other energy agreements. Similarly, "send-or-pay" provisions are also common in transportation agreements.

They require a buyer to take a minimum quantity of the product or service to which the contract relates. The buyer is required to pay for this minimum quantity, whether or not he takes it.

What is the English law rule against penalty clauses?

The rule against penalties prevents the enforcement of clauses that operate as a penalty against the party in default.

For example, where a contract stipulates that a specified sum is payable upon breach of an obligation by a party to that contract - but the sum stipulated is not a genuine pre-estimate of loss suffered due to that breach - the clause will not be enforceable.

However, because the rule against penalties is an anomaly within the English law of contract, which generally allows parties to freedom to agree clauses, the courts are predisposed to enforcing clauses and only rarely find that they are a penalty. This predisposition is particularly strong in commercial contracts freely entered into between parties of comparable bargaining power.

M&J Polymers v Imery Minerals: What was the case about?

M&J Polymers was a supplier of chemical dispersants to Imery Minerals under a long-term supply contract. The contract contained a provision requiring the buyer to order a minimum quantity of chemicals and a take-or-pay provision.

The take-or-pay provision stated that the buyer would "pay for the minimum quantities of Products as indicated in [the minimum order provision] even if they together have not ordered the indicated quantities during the relevant monthly period."

In the High Court, Burton J was asked, amongst other things, to resolve whether the sum owing under the take-or-pay provision was unenforceable as it offended the rule against penalties.

Counsel for the seller, M&J Polymers, argued that the claim under the take-or-pay provision was a debt because the sum arose upon the happening of a "specified event" rather than a breach of an obligation by the buyer. If the sum was a debt, rather than damages, the rule against penalties could not apply.

It was common ground between the parties that any take-or-pay payments that would have fallen due after termination of the contract could only be claimed in damages. This dispute was limited to the payments that had fallen due prior to termination of the contract.

Burton J decided that take-or-pay provisions could, in certain circumstances, amount to a penalty clause.

What is most surprising is that the judge held that the sum due under the take-or-pay provision arose as damages for failure to order the minimum quantity. It was not a claim for a debt. The judge found that the "specified event" set out in the take-or-pay provision was the same event that gave rise to a breach of obligation, namely not ordering sufficient product.

From this analysis Burton J was "satisfied therefore that, as a matter of principle, the rule against penalties may apply." However, he found that in this case the take-or-pay provision did not offend the rule against penalties, as:

  • the judge noted that contractual provisions are rarely struck down as a penalty
  • the take-or-pay provision was commercially justifiable and did not amount to oppression
  • the take-or-pay provision was negotiated and freely entered into between parties of comparable bargaining power, and did not have the predominant purpose of deterring a breach of contract

Why is the case important?

Two aspects of the judgment are of interest to energy industry companies, their investors and the lawyers advising them.

The first is the finding that a breach of any take-or-pay provision, drafted in a similar manner to the one considered by the judge, gives rise to an action in damages not debt.

The second is the judge's comments as to when take-or-pay clauses are likely to be treated as penalty provisions and held to be unenforceable.

Take-or-pay provisions - debt or damages?

Burton J first considered the seller's, M&J Polymers, submission that its claim under the take-or-pay payments was a debt as it arose out of a "specified event" and not out of any breach of contact by the buyer.

To analyse the impact of this judgment, it is necessary to distinguish between a claim for a debt and a claim for damages.

"A debt is a definite sum of money fixed by the agreement of the parties as a payment by one party in return for the performance of a specified obligation by the other party or upon the occurrence of some specified event or condition; damages may be claimed from a party who has broken his contractual obligation in some way other than a failure to pay such debt."(2)

Addressing this point, Burton J stated that he did not see "how a payment obligation can arise under [the take-or-pay provision] in a case other than where there has been a breach of the obligation to order under [the minimum order provision]. If the goods are in fact ordered, then they will be delivered, and the price will be due quite irrespective of [either provision]."

In the judge's analysis, the obligation of the buyer to pay under the take-or-pay provision arose due to a breach of its obligation to order the minimum quantity. Therefore, the seller's claim was a damages claim, which was subject to the rule on penalties. Many take-or-pay provisions are coupled with an obligation on the buyer to order a certain quantity and would fall within the scope of the judge's reasoning.

With respect to the judge, it does not follow that it is a sound approach to construe the take-or-pay provision as a clause that only operates because of a breach of the obligation to order the minimum quantity. Nor is it necessary to construe the interrelation of the minimum order provision and the take-or-pay provision in a way that makes a claim by a seller under the take-or-pay provision a damages claim.

There are two separate obligations in most take-or-pay contracts.

First, there is the obligation upon the seller to make the goods available for delivery to the buyer. Second, is the obligation upon the buyer to take up and/or pay for the goods. Both of these obligations create a benefit for the other party in security of purchase and/or supply.

In the M&J Polymers case, it was not denied by the buyer that the seller had made the chemicals available for purchase. The seller had therefore performed the service to the buyer that was required by the contract. Normally, a seller that has performed the contractually agreed service to the buyer becomes entitled to be paid.

This right to payment is a debt; it is not a damages claim.

Compliance by the seller with its obligation to make the goods available to the buyer creates a debt. This happens regardless of whether the buyer complies with its obligation to take up the minimum quantity or not. The buyer still benefits from the seller performing its obligation and having the option of taking up the goods if it wishes to do so.

At least two take-or-pay/send-or-pay provisions have been referred to the House of Lords.

In both Total Gas Marketing v Arco British and others(3) and in Amoco (UK) Exploration Company v Teesside Gas Transportation Limited and Another(4), no issue was raised as to these provisions acting as a penalty.

This may be because the sum due to a seller under take-or-pay provisions has the essential hallmarks of a debt. Namely, the payments are a definite sum of money fixed by the agreement of the parties as a payment by one party in return for the performance of a specified obligation by the other party.

This construction is consistent with Lord Hoffmann's speech in the House of Lords in Amoco v Teesside Gas(5), where he referred to "the income stream from the send-or-pay payments"(6) suggesting that this income stream was a debt.

Take-or-pay provisions - when are they reasonable?

As a matter of practice, take-or-pay provisions in energy industry contracts will almost always be negotiated between commercial parties and will be commercially justified. Consequently they are highly unlikely to be found to be a penalty, even if the rule on penalties does apply.

This is because even where damages clauses are subject to the rule on penalties it is extremely rare for a court to find that a commercially negotiated provision is a penalty.

Also, in considering the general purpose commercial parties entering into take or pay provisions it is evident that:

"long-term take-or-pay contracts contribute to the realization of upstream investments, especially in the case of non-EC gas producers. Without these contracts the huge amount of finance of new gas investments may not become available and the security of supply would be jeopardized."(7)

Looking into the background facts of M&J Polymers as to why the parties agreed to include a take-or-pay provision, the judge held that the "Buyers want[ed] to ensure a regular and reliable supply of the Products and the Supplier [to] … guarantee such supply under the terms and conditions of [the] Agreement."(8)

From the evidence, it also appears that M&J Polymers' suppliers of acrylic, a product necessary for the manufacture of the chemicals which was in short supply at the time that the contract was entered into, insisted that M&J Polymers entered into of long term supply contract with them. M&J Polymers was therefore exposed to make payments to its own suppliers that it sought to cover through the take-or-pay provision. M&J Polymers was not prepared to produce and store the chemical without knowing that Imerys would take-or-pay for an agreed quantity.

The judge agreed that it was reasonable for it to take this approach.

Indeed, in more complex contractual structures than the one the judge was asked to consider, take-or-pay provisions are often back-to-back, ensuring security and certainty of supply through the supply chain, making it easier to gain project finance upstream.(9)

It appears likely that the reasons for the take-or-pay provision included security of supply for both parties, as well as M&J Polymers' supplier, and in doing so guaranteed upstream revenues.


The judge's conclusion that the take-or-pay provision that he was asked to consider was not a penalty must be correct.

However, with respect to the judge, had he favoured the interpretation that the take-or-pay payments fell due upon the provision of the seller's contractually-agreed performance, he would have been more in tune with commercial practice. Had he done so, he could have held that the sum claimed under the take-or-pay provision was a debt not damages and was not subject to the rule on penalties.

In the meantime, three points arise out of the judgment:

  • Care should be taken to ensure that any take-or-pay provision is commercially justified, having regard to factors such as the minimum quantity and commercial circumstances of the parties, particularly the commercial circumstances of seller and its reliance (if any) on a steady and reliable revenue stream.
  • Where there is no commercial imperative for the buyer to take the product, it may be advisable for contracts containing take-or-pay provisions to make clear that the buyer "may" order quantities of the product, rather than imposing any obligation on the buyer that it "will" or "shall" place minimum orders.
  • Where it is desirable that the buyer does take the product (which is often the case), even if a take-or-pay provision is capable of being a penalty clause, in most infrastructure contracts it would be very surprising indeed if take or pay provisions were considered to be a penalty.

This is because in most contracts, as Burton J found, they will be commercially justified, particularly where the seller has made significant investment in assets.

Ben Holland is a partner and Phillip Ashley is a solicitor in the London office of CMS Cameron McKenna. They specialise in energy disputes.