The Supreme Court has today handed down its decision in Cavendish Square Holdings B.V. v. Makdessi[2015] UKSC 67.  In allowing the appeal from the decision of the Court of Appeal ([2013] EWCA Civ. 1539), the Supreme Court has addressed “an issue which has not been considered by the Supreme Court or the House of Lords for a century”, relating to the enforceability of forfeiture clauses and the rule against penalties.  It represents the modern approach to the law relating to contractual penalty clauses, including as it applies to forfeiture clauses, where the Supreme Court has doubted aspects of the decision in Jobson v. Johnson [1989] 1 WLR 1026.

The case will have significant consequences for the oil and gas sector and further analysis will be sent in Law-Nows over the coming days.  In particular, the decision is critical to the interpretation of the default provisions in joint operating agreements.

Facts

Makdessi sold part of his shareholding in an advertising and marketing company (the “Company”) to Cavendish. The share sale agreement (the “Contract”) contained clauses requiring Makdessi to protect the valuable goodwill of the Company, as well as restrictive covenants against competition. If he failed in this regard, he stood to forgo payments for his shares of c.US$ 44 million (“Clause 5.1”), and be required to sell his remaining shares (valued at c.US$ 75 million) at a substantial undervalue “to effect a decoupling” (“Clause 5.6”). During proceedings, Makdessi, who was chairman of the Company, acknowledged that he had been in breach of the clauses and also in breach of his fiduciary duties to the Company. The issue was whether the forfeiture clauses in question were unenforceable on the grounds that they were penalties.

The Court of Appeal Decision

In the Court of Appeal, Cavendish argued that a “commercial justification” could permit the reduced price paid. It claimed that, under the Contract, it would pay the full price for the shares provided that Makdessi abided by the restrictive covenants.  If Makdessi failed, he could be required to accept a discount on the sale shares and to sell his remaining shares without the value of the goodwill he himself was unwilling to protect.  Cavendish argued that the clauses simply reflected what it was prepared to pay and, in the absence of absurdity, the court should not interfere.

The Court of Appeal decided that the clauses were not enforceable.  The parties did not dispute that the law of penalties applied to Clause 5.1.  In respect of Clause 5.6, the Court of Appeal applied Jobson v. Johnson, confirming its application to forfeiture clauses.

The traditional approach of the courts resulted in a dichotomy. It required an identification of the purpose and effect of the clause: if it was to “frighten” a party into compliance, it was an unenforceable penalty; if it was a “genuine pre-estimate of loss”, it was in principle enforceable.

The Court of Appeal decided that this traditional dichotomy was too narrow. More recent authorities showed that the courts are: (i) adopting a broader test of whether the clause was extravagant and unconscionable with a predominant function of deterrence; and (ii) robustly declining to do so where there was a “commercial justification” for the clause.

The Court of Appeal held that, on the facts, the immediacy and disproportionate nature of the remedies available under the Contract were extravagant, going beyond compensation and into the realms of deterrence.  The Court rejected the commercial justification put forward by Cavendish: the effect of the clauses meant that Makdessi would lose sums in the tens of millions of dollars in circumstances where, at law, Cavendish’s loss was nil.

Cavendish appealed.

The Supreme Court Decision

The Supreme Court allowed the appeal. 

Clause 5.1 (the payment reduction clause):

The clause was not a penalty.  Cavendish had a “legitimate interest” in the observance of the restrictive covenants.  A breach of those restrictive covenants, though they may have caused very little in the way of recoverable loss, meant that Cavendish could no longer trust Makdessi.  “Loyalty is indivisible”, said Lords Neuberger and Sumption, and its absence can introduce significant business risk which cannot be measured simply by provable consequences of the breach.  This loss of trust meant that the business was worth considerably less to Cavendish. 

How much less was not a matter for the court to decide; the court could not know, on that hypothesis, what the value of the business was, or what terms of the contract may have been different.  They were matters for the parties who were “sophisticated, successful and experienced commercial people bargaining on equal terms over a long period with expert legal advice” and it was they, not the court, that were the best judges of the degree to which commercial interests should be recognised.

Clause 5.6 (the share forfeiture clause):

The clause was not a penalty.  The same “legitimate interest” justifying Clause 5.1 also justified Clause 5.6.  It was a “perfectly respectable commercial case” for Cavendish not to be obliged to pay for valuable goodwill where Makdessi’s skill and connections were no longer available to the Company – indeed they were being used instead to benefit a competitor. 

Although Clause 5.6 acted as a “deterrent” by intending to influence Makdessi’s conduct after Cavendish bought the Company, it was not “penal”, since the object was not to “punish” – the formula in Clause 5.6 had a “legitimate function” which was nothing to do with punishment and everything to do with achieving Cavendish’s commercial objective in acquiring the Company. It was again of relevance that the parties were commercially sophisticated.

Jobson v. Johnson doubted

The Court of Appeal simply treated Clause 5.6 as unenforceable, and declared that Makdessi was not obliged to sell his shares. The Supreme Court held that that could not be right, since the severance of the shareholding connection was legitimate and commercially sensible.

If such “severance” were to stand, the complication was that, unlike a damages clause, there is no fallback position at common law, since the courts cannot rewrite the pricing formulae for the shares. 

Makdessi argued that this complication could be overcome by the reasoning in Jobson v. Johnson.

In that case, the Court of Appeal was presented with a clause which provided that, in default of payment of an instalment under a share purchase agreement, the buyer would be required to re-transfer shares at a set price.  That set price was much lower than that which the buyer had paid.  It was held that the penalty clause was unenforceable to the extent that it provided for compensation for the innocent party in excess of its loss – or, conversely, that it was enforceable on a “scaled down” basis – i.e. only to the extent of any actual loss suffered.    

The decision has been used as authority for the proposition that the penalty rule could apply to an obligation to transfer assets upon a breach of contract (i.e. forfeiture).  In Makdessi, the Supreme Court stated that such a proposition was acceptable in principle where the court could simply decline to enforce the penalty, leaving the innocent party to its right to claim damages for breach at law.  This was the case on the facts of Jobson v. Johnson, where the share transfer clause acted as security for the payment of the price and, in principle, the innocent party, Johnson, had other rights (judgment for the amount of outstanding instalments and/or take the shares). 

However, the Supreme Court in Makdessi held that a penalty clause could not be “partly enforceable” and, insofar as the Court of Appeal in Jobson v Johnson is to be treated as a penalty case, it was “wrong” in the “scaling down” approach to the form of relief. 

Even if Jobson v. Johnson was correct on the form of relief, it could not come to Makdessi’s aid.  Clause 5.6 of the Contract was not mere security for the performance of the restrictive covenants.  Clause 5.6, in conferring an option to acquire the shares – not for compensation for breach, but for commercial reasons (which might include breach) – was a “primary obligation”, whereas the share transfer clause inJobson v. Johnson was a “secondary obligation”, operating only upon default.

Comment

The Supreme Court has held that a “legitimate interest” can be used to justify a clause in a contract and thereby prevent a finding that the clause is unenforceable under the rule against penalties.  The test appears to be somewhat easier to meet that the “commercial justification” test identified by the Court of Appeal, since the two appellate courts have reached opposing decisions on the enforceability of the clauses in question.

The treatment of Johnson v. Jobson will have significant ramifications for contracts containing forfeiture clauses, particularly those concerning obligations protected by a “legitimate interest”.  The clause will either be unenforceable as a penalty clause or enforceable as a part of the commercial bargain between the parties.

Of great significance also is the stress that the Supreme Court has placed upon the desirability of enforcing negotiated contracts between properly advised parties of comparable bargaining power, where the court stated that there must be a strong initial presumption that the parties themselves are the best judges of what is legitimate in a provision dealing with the consequences of breach.

The decision will have significant impacts on a number of sectors and industries, in a wide range of contracts and so more targeted Law-Nows will be sent out over the coming days on these issues.

Significance to Oil & Gas Contracts

The decision has a significant impact on one of the most fundamental contracts in the industry: the joint operating agreement (“JOA”). 

The question of whether forfeiture clauses found in joint operating agreements fall foul of the rule against penalties has been a topic of debate amongst oil and gas lawyers for many years.

The decision of the Supreme Court will be of significant assistance in understanding the approach a court might take to those JOAs (typically the more modern ones based upon Oil and Gas UK 2009 and/or AIPN 2012 standards) where the ultimate remedy for default is a “compensated sale”, i.e. a purchase of the defaulting party’s interests with a discount.  It is likely arguable that such remedies are at the option of each innocent party and are from that perspective akin to the purchase rights of Cavendish in Makdessi – they are “primary obligations”, with the arguable “legitimate interest” of protecting the joint venture.

However, for older-style JOAs where the ultimate remedy for default is forfeiture of the defaulting party’s interest (without compensation), it is arguable that such a remedy is intended to be a “secondary obligation” to secure the payment of cash calls and other sums due under the JOA.  In principle, the innocent parties would continue to have their other rights.  As such, it remains uncertain the extent to which the “legitimate interest” test might be used to justify such a forfeiture provision.

There are a host of other issues to consider from this decision in the context of JOAs and we will provide further Law-Nows on those issues over the coming days.

The judgment is located on the Supreme Court website here.