UK: Penalty Clauses In Commercial Agreements Following El Makdessi v Cavendish Square Holdings

Last Updated: 23 February 2014
Article by Rebecca Gardner and Zachary Brown

It is common for parties to commercial agreements to agree mechanisms for resolving breaches of their agreement without having to resort to legal proceedings. Typically this is done by incorporating provisions, such as forfeiture or compulsory buy-back clauses, into a contract which are activated upon one party's breach of its terms. In such a situation, it is important for the parties to ensure that such provisions could not be characterised as penalties so as to render them unenforceable. This issue was considered in the case of El Makdessi v Cavendish Square Holdings BV and another [2013] EWCA Civ 1539 ("El Makdessi"), where the Court of Appeal was asked to review an earlier decision by the High Court on the question of whether clauses in a Share Purchase Agreement ("SPA"), which were activated in response to the seller's breach of restrictive covenant, constituted unenforceable penalties.

Penalty clauses versus liquidated damages clauses

It is a long-established rule of law that a clause which is deemed to be a penalty will be unenforceable. In determining whether a clause is a penalty, the courts often use liquidated damages clauses (which are enforceable) as a point of comparison. A liquidated damages clause is a "genuine pre-estimate of loss", the main purpose of which is to compensate the innocent party for breach of the terms of an agreement. A penalty clause, on the other hand, functions to punish or deter a party from breaching the terms of an agreement and may bear no relation to the actual loss suffered by the aggrieved party.

Background

Mr Makdessi ("M") was a key figure in the Middle-Eastern advertising and marketing world who sold part of his advertising group to WPP, retaining a 20% holding. According to the SPA, the purchase consideration was payable partly on completion and partly by way of future instalments linked to the group's operating profits. M was also granted a put option in respect of his remaining 20% shareholding.

The SPA contained extensive restrictive covenants preventing M from competing with the group after the sale and provided that if M breached the restrictive covenants he would forgo the instalments linked to future profits and the put option, as well as being required to sell his remaining 20% stake at a discounted value (referred to as the "Consequences of Breach"). After completion, the purchasers pursued M for breach of the restrictive covenants contained in the SPA and, in response, M alleged that the Consequences of Breach constituted penalty clauses which were unenforceable.

Decision

The High Court initially ruled that the Consequences of Breach were not penalties and that they could be enforced. However, the Court of Appeal overturned this decision, ruling that the Consequences of Breach did constitute penalties and were therefore unenforceable against M. In reaching its decision, the Court of Appeal highlighted the fact that the clauses did not represent a genuine pre-estimate of the buyer's loss because any breach of the restrictive covenants, however insignificant, meant that M had to suffer the full force of the penalties, forgoing all future payments and the put option and being forced to sell his remaining shareholding at a substantial discount. The clauses therefore bore no proportionate relationship to the actual loss suffered by the aggrieved party.

Nonetheless, the court stated that, in general, when considering whether a clause is penal a lack of proportionality in the clause's effect is not necessarily conclusive. A clause which does not represent a genuine pre-estimate of loss may be enforceable provided it has sufficient commercial justification.

In El Makdessi, the buyer alleged that the clauses were commercially justified because (1) they adjusted the consideration payable to M based on the loss of goodwill which followed his breach of the restrictive covenants, and (2) they effected a clean break between the parties by forcing the sale of M's remaining shareholding. However, the Court of Appeal considered this justification to be insufficient when compared to the disproportionate impact of the clauses. The court concluded that the main purpose of the clauses was to deter M from breaching the restrictive covenants and, if he did so, to penalise him for that breach. The clauses therefore constituted penalties which were unenforceable.

Conclusions

The judgment in El Makdessi reiterates that the courts have moved beyond a simple application of the "genuine pre-estimate of loss" test when assessing whether a clause may be a penalty. Even where a clause is not based on a genuine pre-estimate of loss, the courts may refrain from characterising it as a penalty where the clause has a clear commercial justification.

It is also worth bearing in mind that the court in El Makdessi suggested that it might have been possible to avoid the application of the doctrine of penalties in that case if the SPA had been drafted so that the buyer's obligation to pay the deferred consideration was conditional upon the seller complying with the restrictive covenants, rather than providing for payment to fall away as a response to the seller's breach of restrictive covenant.

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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