Cavendish Square Holding BV v El Makdessi [2015] UKSC 67

In its long awaited judgment, the UK Supreme Court has today declined to abolish the rule against penalties.  The judgment gives helpful guidance about the types of clauses to which the rule applies and the test for determining whether a clause is penal.

Perhaps of most interest to commercial parties is the Court's view that "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 a breach".

Background

In English contract law, penalty clauses are not enforceable.  This rule has caused many difficulties over the years to contracting parties when negotiating contracts, as well as being a fertile ground for disputes.  The present case has been eagerly awaited, as it is the first time the UK Supreme Court has had the opportunity to consider the rule against penalties and its application in a modern day commercial context.

Why is this case important?

Contractual provisions which are susceptible to being penalties are a very common feature in commercial agreements.  Common examples include:

  • Liquidated damages provisions in construction/project contracts used as a means to avoid complex, time-consuming and costly disputes about what damages are payable for commonplace breaches (typically delay and plant performance shortfalls);   
  • Exit provisions in a joint venture/shareholders' agreement where a non-defaulting party can buy out a defaulting party at a discount;  
  • Provisions in sale and purchase agreements on M&A deals where deferred consideration is potentially not to be payable where the seller is in breach of contract; and  
  • Liquidated damages provisions in commercial contracts used as agreed financial remedies for breaches of late delivery or minimum commitment (take-or-pay) provisions in supply contracts.

However, the usefulness of including such provisions will be diminished where there is uncertainty about their enforceability, a circumstance which in itself can lead to the sort of disputes which these clauses may have been intended to avoid.  The 100 years which have passed between the seminal case of Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd [1915] AC 79 and today's judgment have seen great changes in the way business is conducted and the ever more sophisticated nature of commercial arrangements.  As a result, the UK's top court has had to consider whether the rule against penalties should still apply today.  The short answer was that it does, but that its application is now to be understood against the background of the Supreme Court's findings.     

The facts

Mr El Makdessi ("EM") agreed to sell some of his shares in his advertising business to Cavendish. The agreement contained a restrictive covenant prohibiting EM from being involved in a competing business for a certain period of time. The contract provided that if EM breached the restrictive covenant, Cavendish did not have to pay the remaining instalments of the purchase price and that Cavendish had a call option to require EM to sell the remainder of his shares to Cavendish at a lower price based on net asset value. Subsequently, Cavendish discovered that EM had breached the restrictive covenant. EM admitted that he had breached the covenant but argued that the contractual right for Cavendish to withhold the instalments and acquire the shares was a penalty and unenforceable.

The High Court held that the clauses were not penalties, however, the Court of Appeal overturned the High Court decision.

The Supreme Court decision

The Supreme Court held that the clauses were not penalties. The Court drew a distinction between "primary obligations" (i.e. the terms to be performed under the contract) and "secondary obligations" (i.e. those that come into play once a breach occurs e.g. to pay a certain sum). Primary obligations are not subject to the rule against penalties, whereas secondary obligations are. The Court considered that the clauses relieving Cavendish of the obligation to pay the remaining instalments, and requiring EM to sell the remaining shares at a lower price, acted as "price adjustment" provisions and were equivalent to other primary price calculation clauses in the contract. As such, they were not unenforceable penalty clauses.

The Court's decision neither abolishes nor extends the scope of the rule against penalties. However, the judgment contains useful guidance on when remedies agreed between contractual parties are likely to be held unenforceable. The key points are:

  • Application of the rule is not confined to payments of money on breach, such as liquidated damages. For example, it also applies to clauses involving the withholding of payments of money and clauses requiring the party in breach to transfer property.  
  • The test of whether a clause falls foul of the rule against penalties is "whether the sum or remedy stipulated as a consequence of a breach of contract is exorbitant or unconscionable when regard is had to the innocent party's interest in the performance of the contract" (i.e. whether the agreed remedy is wildly disproportionate compared with the contractual breach against which it protects).  
  • There is a strong presumption that sophisticated commercial parties, with similar bargaining power, who are properly advised, should be able to agree what the appropriate remedy should be in the event of a breach.

How will it affect me?

This judgment will give more leeway to commercial parties negotiating contracts to decide what the consequence of a breach should be, and greater confidence that what they agree will be enforceable.  Negotiating parties should now focus on considering whether the clause proportionately protects a legitimate business interest, and is not extravagant or unconscionable in effect, and focus less on whether the clause provides for a "genuine pre-estimate of loss", or whether the clause is an unenforceable "deterrent".

The case also highlights that careful drafting can remove a provision from the grasp of the rule against penalties in the first place. For example, it can be beneficial to structure a clause such that compliance is a condition which must be met in order for a payment to be made (therefore a "primary obligation") rather than withholding of the payment being a consequence of a breach of an obligation (therefore a "secondary obligation"). Importantly, the case now removes the previous uncertainty as to whether the rule against penalties would be abolished or extended - the answer is neither.