The Supreme Court has given an important ruling on the law of penalties, taking the opportunity to reformulate the penalty rule. The judgment is relevant to contracts generally, but for private equity funds it will be of most relevance in the context of bad leaver provisions and their enforceability.

Background

Commercial contracts often include a clause agreeing that a set amount of money will be paid or a set remedy may take effect if the contract is breached, rather than just leaving it for the courts to determine damages. A party hoping to rely on such a provision will need to ensure that it does not constitute a penalty (which would be unenforceable). The penalty rule can apply to provisions requiring the transfer of shares or other assets for below market value, such as bad leaver provisions.

In Cavendish Square Holding BV v Talal El Makdessi [2015], Mr Makdessi sold a controlling stake in a large advertising and marketing company to Cavendish (via another group company), but retained a minority stake and agreed to certain restrictive covenants to prevent him competing with the company. Part of the consideration payable to Mr Makdessi was deferred and structured as an earnout.

The share purchase agreement contained default provisions which meant that a breach of restrictive covenants by Mr Makdessi caused him to cease being entitled to receive the earnout payments and also gave Cavendish an option to acquire his remaining shares at a reduced price (which did not include the value of the goodwill in the business).

Mr Makdessi breached the restrictive covenants but argued that the sanctions were unenforceable penalties. The court at first instance ruled in favour of Cavendish; but the Court of Appeal subsequently held that the clauses were unenforceable penalties (which we considered in our March 2014 edition of Private Equity Perspectives).

The decision

The Supreme Court has reversed that position, taking the view that the contractual default provisions were enforceable and not penalties. The penalty rule did not apply as the provisions were held to concern primary rather than secondary obligations (in particular, as a price adjustment mechanism).

The Supreme Court also took the opportunity to revisit the principles underlying the penalty rule, “an issue which has not been considered by the Supreme Court or by the House of Lords for a century”.

The traditional test, distinguishing between contractual sanctions designed to act as deterrents and those which aim to provide compensation for loss based on genuine pre-estimates, was found to be unhelpful. In the leading judgment, it was stated that

“The true test is whether the impugned provision is a secondary obligation which 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”.

The validity of a clause providing for the consequences of a breach of contract depends, to some extent, therefore on whether the innocent party can be said to have a legitimate interest in the enforcement of the clause – this may extend beyond mere monetary compensation but a contractual remedy will not be upheld where the adverse impact of the remedy significantly exceeds the innocent party’s legitimate interests.

There is therefore a new emphasis on legitimate interest in determining whether or not a provision is an unenforceable penalty and this can extend to wider commercial interests.

At the same time, the Supreme Court recognised the importance of the circumstances in which a contract was made. In a negotiated contract between properly advised parties of comparable bargaining power, the strong initial presumption must be that the parties themselves are the best judges of what is legitimate in a provision dealing with the consequences of breach – and are therefore more likely to be held to the negotiated position, where that reflects the legitimate interests of the parties.

Application to bad leaver provisions

Enforcement of a bad leaver provision in articles or investment agreements could, if challenged, therefore involve the following questions:

  1. Does the bad leaver provision constitute a secondary (or ancillary) obligation which is triggered by breach of a primary contractual obligation?
  2. What are the legitimate interests of the company and/or shareholders?
  3. Is the resulting reduction of value being paid to the bad leaver (for example, when compared to a good leaver) “out of all proportion” to those legitimate interests?
  4. Would the parties constitute “properly advised parties of comparable bargaining power”?

This judgment and the reshaped test are a useful development in the context of negotiating and seeking to enforce bad leaver provisions.

Consequences for bad leaver provisions

The Court of Appeal decision in favour of Mr Makdessi had led to some uncertainty about the extent to which bad leaver provisions would be enforceable, when triggered by the manager’s breach and if the reduction in value to the departing manager was disproportionate to the loss suffered by the breach.

Whilst there are still potential risks in those circumstances, the greater recognition of the wider legitimate interest of the parties and their commercial intention, together with the strong initial presumption that these provisions are to some degree proportionate to the legitimate interests (if the parties are of comparable bargaining power) make this judgment a welcome development.

When negotiating bad leaver provisions, the questions raised above should be borne in mind. Careful structuring and drafting may help avoid the rule on penalties being engaged at all or at least demonstrate the legitimate interests concerned, with a view to improving the enforceability of the provisions.