In Cavendish Square Holding BV v Talal El Makdessi [2015] the Supreme Court allowed an appeal by Cavendish Square Holding BV against a unanimous decision of the Court of Appeal that two clauses in an agreement for the sale of shares were unenforceable on the ground that they were penalties.  The Supreme Court reviewed the evolution of the current law and held that the two clauses were not penalties and were enforceable.

The Supreme Court also heard a related appeal, ParkingEye Limited v Beavis [2015], in which a clause imposing a parking charge was also held to be enforceable and not an unenforceable penalty.

Facts – Cavendish v El Makdessi

Mr Makdessi was a key figure in the advertising and marketing world in the Middle East. He had founded and was associated with an advertising and marketing group which had become the largest in the region.

The Group’s holding company was Team Y&R Holdings Hong Kong Limited (Company). The shareholders were Mr Makdessi, Mr Joseph Ghossoub and Young & Rubicam International Group BV (Y & RIG), which held 12.6% of the shares in the Company.

By an agreement dated 28 February 2008 (Agreement), Mr Makdessi and Mr Ghossoub (together Sellers) sold 47.4% of the Company’s shares to Y & RIG. These shares were then transferred to Cavendish Square Holding BV (Cavendish) and Cavendish therefore came to hold 60% of the shares in the Company and the Sellers held 40%.

The Agreement was the result of extensive negotiations between highly experienced and respected lawyers. It provided that Cavendish pay the Sellers:

  1. a completion payment of $34,000,000;
  2. a further payment of $31,500,000 into escrow which was to be released in four instalments;
  3. an interim payment based on operating profit for 2007-2009 (“Interim Payment”); and
  4. a final payment based on operating profit for 2007-2011 (“Final Payment”).

Clause 3.3 of the Agreement provided that the total maximum of all payments to the Sellers would be $147,500,000 for the 47.4% share in the Company being sold to Cavendish.  Over half of the consideration payable by Cavendish to the Sellers was attributable to goodwill.

Breach of the Cavendish and El Makdessi Agreement and its consequences

Clause 11.1 of the Agreement provided that each Seller act to protect the goodwill of the Company (given its significance) and clause 11.2 of the Agreement set out a number of restrictive covenants which provided that neither Seller could engage directly or indirectly in certain activities.

By 2010, Cavendish had discovered that Mr Makdessi had breached the restrictive covenants in clause 11.2 of the Agreement because he had engaged in competing activities, including his continuing involvement with a competing company. 

Clause 5 of the Agreement contained the key “Default” provisions which were at the heart of the appeal: 

Clause 5.1 provided that a ‘Defaulting Shareholder’ (defined to include Sellers who breach clause 11.2) would not be entitled to receive the Interim Payment and/or the Final Payment; and

Clause 5.6 provided that Cavendish had a call-option to require a Defaulting Shareholder to sell his remaining shares in the Company to Cavendish for an amount equal to the appropriate percentage of the net asset value of the Company; a value which did not take account of goodwill. 

Accordingly, by being in breach of clause 11.2 (restrictive covenants) Mr Makdessi became disentitled to his share of the Interim and Final Payments (a loss of over $44m).  On exercise of the call option by Cavendish, Mr Makdessi was also liable to have all his retained shares in the Company acquired in return for the appropriate percentage of net asset value.  Mr Makdessi would therefore receive for those shares nothing in respect of goodwill.

Although Mr Makdessi admitted that he had breached clause 11.2, he claimed that clauses 5.1 and 5.6 were penalty clauses and were therefore unenforceable.

Decision of the High Court and the Court of Appeal – Cavendish v El Makdessi

The High Court found in favour of Cavendish, broadly on the basis that the clauses were not penalty clauses because they were commercially justified.  Mr Makdessi appealed to the Court of Appeal.

The Court of Appeal unanimously allowed Mr Makdessi’s appeal holding that the two clauses were unenforceable penalties under the penalty rule as traditionally understood.  

Supreme Court Decision – Cavendish v El Makdessi

Lord Neuberger and Lord Sumption, in their joint leading judgment with which the other Supreme Court Judges agreed or gave concurring judgments, reviewed the development of the penalty rule, describing the penalty rule as an "ancient, haphazardly constructed edifice which has not weathered well".  However, similar rules exist in all other developed systems of law.  It also covers types of contact which are not regulated in any other way.  It should not therefore be abolished (as was argued on behalf of Cavendish) but the Court also held that it should not be extended, at least not by the courts.

The Supreme Court rejected the traditional approach to determine whether a contractual provision is a penalty. The traditional concepts of deterrence and genuine pre-estimate of loss were described as unhelpful, the law relating to penalties having become “the prisoner of artificial categorisation”, which resulted from an over-literal reading of the four tests formulated by Lord Dunedin in Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd [1915]. Lord Dunedin’s speech had achieved the status of a quasi-statutory code when determining whether a contractual provision was a penalty, which in the view of the Supreme Court was unfortunate. The four tests included that a provision would be penal if the sum stipulated is extravagant and unconscionable in comparison to the greatest loss following the breach; or if the breach consisted only in the non-payment of money and the provision provided for the payment of a larger sum. The four tests, whilst a useful tool in considering simple damages clauses in standard contracts, are not easily applied to more complex cases.

The fundamental principle is that the penalty rule regulates the contractual remedy available for the breach of a primary contractual obligation.  The relevant contractual remedy for the breach typically stipulates payment of money, but it equally applies to obligations to transfer assets, or clauses where one party forfeits a deposit following its own breach of contract.

The true test of a penalty is whether the provision in question is a secondary obligation which imposes a detriment on the contract-breaker which is out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation. The validity of such a clause depends on whether the innocent party has a legitimate interest in the enforcement of the clause. The innocent party can have no proper interest in simply punishing the defaulter. The interest of the innocent party is in performance or in some alternative to performance. In the case of a straightforward damages clause, that interest will rarely extend beyond compensation for the breach and therefore Lord Dunedin’s four tests (i.e. the conventional approach) would usually be perfectly adequate to determine its validity.

But compensation is not necessarily the only legitimate interest that the innocent party may have in the performance of the defaulter’s primary obligations.  The real question when a contractual provision is challenged as a penalty is whether it is penal, not whether it is a pre-estimate of loss. The fact that the clause is not a pre-estimate of loss does not, without more, mean that it is penal. To describe it as a deterrent does not add anything. A deterrent provision in a contract is simply one species of provision designed to influence the conduct of the party potentially affected and is no different in this respect from a contractual inducement.

Whether such a provision is enforceable should depend on whether the means by which the contracting party’s conduct is to be influenced (i.e. as provided by the provision in question) are “unconscionable” or (which will usually amount to the same thing) “extravagant” by reference to some norm.

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.

The Court of Appeal, in coming to its decision, was constrained by the perceived need to fit any analysis into the framework set by Lord Dunedin's four principles.

In relation to the two key Default provisions, the Supreme Court took the view that Clause 5.1 was a price adjustment clause.  It was not a secondary obligation but a primary obligation and so the penalty rule was not engaged. Although the clause has effect in consequence of a breach of contract, it was in no sense a secondary provision. In any event, the Sellers earned consideration for their shares by (amongst other things) observing the restrictive covenants.  Cavendish had a legitimate interest in the observance of the restrictive covenants, in order to protect the goodwill of the business generally.  The goodwill of the business was critical to Cavendish and the loyalty of Mr Makdessi was critical to the goodwill.  The parties were the best judges of how it should be reflected in their agreement.  In the context of a carefully negotiated agreement between informed and legally advised parties at arm's length, clause 5.1 should not be regarded as extravagant, exorbitant or unconscionable.

A similar analysis and logic applied to clause 5.6.  It was also a primary obligation. It was said to be penal because the formula excluded goodwill from the calculation of the payment price.  It did not represent the estimated loss attributable to the breach.  However, it reflected the reduced consideration which Cavendish would have been prepared to pay for the acquisition of the business on the basis that it could not count on the loyalty of Mr Makdessi.  The clause was only objectionable if it was penal, but the price formula had a legitimate function, which was to achieve Cavendish's commercial objective of severing its relationship with a major shareholder if he breached the restrictive covenants.

The appeal was allowed.

Facts – ParkingEye v Beavis

ParkingEye Limited (ParkingEye) managed a car park on behalf of the owners of Riverside Retail Park in Chelmsford. ParkingEye displayed numerous large, prominent and legible notices throughout the car park, saying that a failure to comply with a two hour maximum stay would “result in a Parking Charge of £85”. On 15 April 2013, Mr Beavis parked in the car park but overstayed the two hour time limit by almost an hour. ParkingEye demanded payment of the £85 charge with a reduced charge if he paid within 14 days. Mr Beavis argued that the £85 charge was unenforceable as a penalty and/or that it was unfair and unenforceable by virtue of the Unfair Terms in Consumer Contracts Regulations 1999.

Decision of the County Court and the Court of Appeal – ParkingEye v Beavis

The County Court rejected the arguments. The Court of Appeal upheld the first instance decision and also rejected the arguments. Mr Beavis appealed.

Supreme Court Decision – ParkingEye v Beavis

Mr Beavis had a contractual licence to park in the car park on the terms of the notice posted at the entrance, including the two hour limit. The £85 was a charge for contravening the terms of the contractual licence, i.e. it was payable on a breach of contract and was not a pre-estimate of damages. This is a common scheme, subject to indirect regulation by statute and the British Parking Association’s Code of Practice. The charge had two main objects: (i) efficient use of parking space in the interests of the retail outlets and their users by deterring long-stay or commuter traffic; and (ii) the generation of income in order to run the scheme.

Unlike in Cavendish v El Makdessi, the penalty rule was engaged. However, the £85 charge was not a penalty. Both ParkingEye and the landowners had a legitimate interest in charging overstaying motorists, which extended beyond the recovery of any loss. The interest of the landowners was the provision and efficient management of customer parking for the retail outlets. The interest of ParkingEye was in income from the charge, which met the running costs of a legitimate scheme plus a profit margin. Further, the charge was neither extravagant nor unconscionable, having regard to practice around the United Kingdom and taking into account the use of the car park and the clear wording of the notices.

The Supreme Court also held that the charge did not contravene the Unfair Terms in Consumer Contracts Regulations 1999, Lord Toulson dissenting.

The appeal was dismissed.

Comment

In Cavendish v Makdessi, the Supreme Court decided that the Default provisions were part of the commercial bargain struck by the parties and were primary obligations so the penalty rule was not engaged. However, the Default provisions were not in any event penalties because Cavendish had a legitimate interest in Mr Makdessi complying with the restrictive covenants in the contract, it being commercially important to protect the goodwill of the business in question. In the context of a carefully negotiated contract between informed and legally advised parties, the provisions in question were not extravagant or unconscionable in their effect and were not penal. They were to do with Cavendish’s commercial objective in acquiring the business.

In ParkingEye v Beavis, the penalty rule was engaged. However, again, ParkingEye had a legitimate interest in charging motorists who exceeded the two hour limit, which extended beyond the recovery of any loss. Deterrence is not penal if there is a legitimate interest in influencing the conduct of the contracting party which is not satisfied by the mere right to recover damages for breach of contract. But, of course, ParkingEye could not charge overstayers whatever it liked. It could not charge a sum which would be out of all proportion to its interest or that of the landowner for whom it was providing the service of the car park. In the view of the Supreme Court, however, there was no reason to suppose that £85 was out of all proportion to ParkingEye’s interests. The trial judge had found that the £85 charge was neither extravagant nor unconscionable having regard to the level of charges imposed by local authorities for overstaying in car parks on public land. The Court of Appeal agreed and so did the Supreme Court.

In this decision, the Supreme Court has looked at the penalty rule afresh and the effect of the rule has been ameliorated, so that what the parties to a negotiated contract have agreed should normally be upheld. This is on the basis that:

  • for straightforward breaches of simple contracts, a genuine pre-estimate of monetary loss should usually still prevent a contractual remedy from being characterised as penal and therefore a penalty as the innocent party’s interest will rarely extend beyond compensation for the breach;
  •  for more complex contractual arrangements or arrangements where the consequence of a breach are harder to quantify and don’t fit within the straightforward framework of breach, loss and recovery of the loss, provided that the innocent party has a legitimate interest in the enforcement of the clause and the detriment to the defaulting party is not unconscionable or extravagant by reference to some relevant norm, the clause should not be regarded as a penalty. There are many contractual scenarios where this could be the case;
  • to be an unenforceable penalty, the provision in question must be a secondary obligation which is triggered in consequence of a breach of a primary obligation and the provision must be penal. The fact that the provision is not a pre-estimate of loss does not, without more, make it penal. The provision would need to impose a detriment to the defaulting party out of all proportion to the innocent party’s legitimate interests in the enforcement of the primary obligation; and
  • although the decision makes it more likely that a court will now enforce contractual bargains, freely made and negotiated, which have consequences on breach which exceed a simple pre-estimate of loss, clarity in drafting the relevant contractual provisions will, as always, be key for practitioners. It might be advisable, for example, to refer to the commercial justification for the consequences of a breach of a primary obligation and that the consequences are proportionate and within the relevant norm(s) applicable to the circumstances.