The Supreme Court recently provided welcome clarification on the penalty rule, confirming the circumstances in which it is engaged and setting out “the true test” for penalty clauses.

Cavendish Square Holding BV v Talal El Makdessi [2015] UKSC 67 centred on a series of transactions by which Cavendish acquired 60% of a company owned by Mr. Makdessi and Mr. Ghossoub (the “Sellers”). The agreements included restrictive covenants on the Sellers which were subsequently breached by Mr. Makdessi. Cavendish sought to enforce two clauses which were triggered by that breach and which (i) stopped Mr Makdessi from receiving subsequent instalments of the purchase price; and (ii) gave Cavendish an option to purchase Mr Makdessi’s retained shareholding at net asset value (excluding goodwill as refl ected in the initial share price).

In order to determine whether the penalty rule was engaged, the Court considered whether the two clauses were secondary obligations or conditional primary obligations.

  • Secondary obligations arise where a contract requires one party to perform an act and, if he does not perform it, he must pay the other party a specifi ed sum of money. A secondary obligation is capable of being a penalty
  • If the contract does not impose an obligation to perform the act, but simply provides that, if one party does not perform, he will pay the other party a specifi ed sum, the obligation to pay is a conditional primary obligation and cannot be a penalty

The Court held that the clauses in question were among the provisions which determined Cavendish’s primary obligations, that is those which fi xed the price, the manner in which it was calculated and the conditions on which different parts of the price were payable. The Sellers therefore earned the consideration for their shares not only by transferring them to Cavendish, but by observing the restrictive covenants. As such, they were not penalty clauses and were enforceable by Cavendish. In practice it may not always be easy to determine that a clause qualifi es as a primary obligation and so does not engage the penalty rule.

The true test for determining whether a contractual provision is an unenforceable penalty clause was held to be whether the clause is a secondary obligation that imposes on the breaching party a detriment “out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation.”

Whether or not a contractual provision is a penalty clause depends on the relevant facts; how it is drafted; the nature of the parties; and whether they were legally advised.

Cavendish Square Holding BV v Talal El

Makdessi [2015] UKSC 67