UK: Fully Negotiated Remedies Can Still Amount To A Penalty

Last Updated: 2 January 2014
Article by Mark Alsop

Facts

Cavendish, a WPP, company agreed in April 2008 to buy from Mr Makdessi and another 60% of their shares in a group of companies founded and owned by them (the Company). The negotiations took 6 months; the parties were represented by City solicitors.

The price was to be paid in 4 instalments. The first two instalments were paid on or shortly after completion. The latter two were due to be paid in the years after completion and were to be calculated as a multiple of after tax profits for post-completion periods. There was a maximum payment of $147.5m. All payments included a considerable amount for goodwill – more than 50% of the initial instalments and 77% if the maximum payment was made.

The sellers had a put option under which they could serve notice on Cavendish requiring it to buy their remaining shares in the Company at a price which included the value of goodwill.

Restrictive covenants to protect Cavendish

The agreement contained post-completion covenants against competition, solicitation of clients, diverting business away from clients and employing senior employees. The High Court found that the covenants were not in unreasonable restraint of trade, a decision that was not appealed.

The agreement stated that, if Mr Makdessi were in breach of the restrictive covenants, he would not receive the third or fourth payments and could be required to sell his remaining shares in the Company to Cavendish for a price based on net asset value, i.e. excluding goodwill ("the breach remedies").

What happened

With Cavendish's agreement, Mr Makdessi ceased to be an employee, but continued to be a non-executive chairman until July 2009 and was a non-executive director until he was removed in April 2011.

By December 2010, Mr Makdessi was deemed by Cavendish to have acted in breach of the restrictive covenants and to be in beach of his fiduciary duties to the Company as director. He was doing this by:

  • continuing to provide services to a competing company called Carat in which he had held a 49% stake (including assisting it in diverting the Company's clients to it) and
  • setting up rival advertising agencies in Lebanon and Saudi Arabia which had poached or tried to poach a number of the Company's customers and employees.

Mr Makdessi settled the breach of fiduciary claim with the Company for $500,000. Cavendish then sought an order from the court that Mr Makdessi was not entitled to the remaining payments and was obliged to sell his shares in accordance with the call option which Cavendish had exercised. It also claimed damages for loss of value of shareholding, but abandoned the argument on the grounds that this was "reflective loss" – a principle of public policy which states that, where a shareholder is owed a duty by a third party who also has a duty to the Company, the shareholder cannot recover for his loss in the value of the Company, as per House of Lords case of Johnson v Gore Wood.

Arguments

Mr Makdessi's primary defence was that the breach remedies were penal. Two reasons were that any loss suffered was irrecoverable under the reflexive loss principle, so no figure greater than zero could be a genuine pre-estimate of loss: and that there were four separate restrictive covenants, all of which attracted the same draconian remedies, however serious the breach.

Cavendish argued that the breach remedies were not designed to provide compensation on breach, even though they did operate on breach. The appropriate test was whether the clauses had a commercial purpose/justification and lacked a predominant intention to deter. The purpose of the provisions depriving Mr Makdessi of the last two payments was to adjust the price that Cavendish was prepared to pay if Mr Makdessi was unable to keep to the covenants. The call option to buy the shares at net asset value had the commercial purpose of swiftly decoupling Makdessi from the Company in circumstances where he had shown himself unprepared to abide by the covenants.

The High Court found in favour of Cavendish for much the same reasons as were advanced by Cavendish.

Decision

The Court of Appeal held unanimously that the remedies available to Cavendish were penal and unenforceable. Its reasoning was as follows:

  1. More recent authority indicated that approaching cases on the footing of dichotomy between a genuine pre-estimate of loss and a penalty was too rigid an approach. The cases showed the court adopting a broader test of whether the clause was extravagant and unconscionable with a predominate purpose of deterrence; and robustly declining to do so in circumstances where there was a commercial justification for the clause.
  2. The Court considered whether the breach remedies were extravagant, not because the answer was to determinative as to whether the clauses were penal, but because, if the clauses were genuine pre-estimates, they could scarcely be penal. They were not genuine pre-estimates.
  • When the agreement was made, Cavendish's damages for breach of the restrictive covenants were likely to be zero because they would be reflective of a loss to the Company. Any estimate other than zero would be excessive, and therefore extravagant.
  • Leaving that aside, there was no proportionate relationship, even rough and ready, between the breach which triggered the operation of the remedy and the amount withheld. A provision under which Mr Makdessi should forfeit all the outstanding price even for a trifling breach was extravagant.
  1. However, that was not necessarily conclusive. A commercial justification may mean that a clause which was not a genuine pre-estimate of loss was not penal. However, the court did not accept that the breach remedies were commercially justified as being there to protect the goodwill whose existence formed a major part of the price. Their effect was that Mr Makdessi stood likely to forfeit sums in the tens of millions of dollars in circumstances where the law precluded any recovery at all by Cavendish. The agreement prescribed a form of double jeopardy because Cavendish had the remedies provided for by the clauses and Mr Makdessi remained liable to the Company. The consequences of breaching any of the four different covenants was likely to be very wide and to fall into different categories of seriousness, many of which could not affect compensation anywhere near the value of what Mr Makdessi would forfeit or lose. That seemed to go way beyond compensation and into the territory of deterrence. The fact that the terms adjusted the consideration and decoupled the shares did not provide the answer as to whether the provisions were penal; the important consideration was the terms on which they did so.
  2. The breach remedy of forfeiting future payments was not saved by reason of the fact that the agreement could have been drafted differently to make payment conditional on compliance, in which case the law of penalties might not have been engaged. There were many cases that showed that a different structure would have worked but did not save the provision in question.

Comment

This case has many things to say about the drafting of prescribed remedies when things go wrong in a contract, and the implications are not easy to work through. When drafting an IT services contract on behalf of multiple group customers, for instance, think carefully about the service credit regime – are they proportionate, who can claim them and for what? And make sure that a service provider cannot end up liable twice for the same loss.

Ideally, all relevant clauses should be reviewed in light of this decision and principles worked out for drafting such clauses in future agreements.

Note that:

  • It is no longer enough to assume the courts will not interfere in an agreement negotiated between parties of equal bargaining position having the benefit of legal advice.
  • Mr Makdessi did not come to the litigation with clean hands, but nevertheless the Court did not bend over backwards to satisfy what might be regarded as the innocent party.

It will be interesting to see whether this case goes to the Supreme Court. In the meantime, it has to some extent clarified the law on penalties, following various recent High Court decisions that have not always set out the law consistently. In particular, the move away from genuine pre-estimate of loss towards commercial justification has been confirmed.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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