In order to discourage a party from deliberately breaching their obligations, it is common to include provisions in contractual documentation requiring the party in breach to pay or forfeit a sum of money. However, in what is recognised as a blatant interference with freedom of contract, under the English common law such a provision will be held to be unlawful as a penalty unless it can either be justified as being (a) a genuine pre‑estimate of the loss the innocent party will incur and thus a payment of liquidated damages, or (b) on a commercial basis. This test was recently considered by the Court of Appeal in Makdessi v Cavendish Square Holdings BV.

The case concerned an agreement for the sale of shares in the holding company of one of the largest advertising and marketing communications groups in the Middle East. The price payable under the agreement included an interim payment and a final payment which were to be calculated on the basis of operating profit after tax and growth rate. The agreement provided that if a seller became a defaulting shareholder, he would not be entitled to the interim and/or final payment (clause 5.1) and could also be required to sell the purchaser his shares on the basis of a specified price which allocated nothing in respect of goodwill (clause 5.6). Although the claimant admitted he had acted in breach of fiduciary duty, and was thus rendered a defaulting shareholder, he contended that both clauses 5.1 and 5.6 were penal in nature and thus unenforceable.

The Court of Appeal noted that, while historically the cases on penalties had proceeded on the footing of a dichotomy between a genuine pre‑estimate of loss on the one hand and a penalty on the other, more recent authority has indicated that this is too rigid an approach. Instead the modern approach is that the fact that a payment on breach may not really be a pre‑estimate of loss does not necessarily mean that it must be penal if there is a good commercial justification for the provision that could show that deterrence of breach was not the dominant purpose of the term. However, in this case the Court considered that the clauses, in the context of the agreement as a whole, were not genuine pre‑ estimates of loss but were instead “extravagant and unreasonable”. The Court also rejected arguments that the clauses were commercially justified, reached as part of a commercial bargain and after extensive negotiation. The Court considered that the amount to be paid under clauses 5.1 and 5.6 was out of all proportion to the loss attributable to the breach, and in such circumstances the provisions went way beyond compensation and into the territory of deterrence. In fact, the claimant stood likely to forfeit sums in the tens of millions in circumstances where the range of activities which might amount to a breach were broad and likely to fall into different categories of seriousness, many of which could not attract compensation in damages anywhere near to what the claimant would forfeit. It was therefore held that the clauses were unenforceable.

This case provides a useful explanation of the principles relating to the rule against penalties and a reminder that where a contract prescribes remedies for breach it will be important to consider proportionality and ensure that the provision does not simply operate as a deterrent. However, the Court of Appeal’s acknowledgment that even if a clause is not a genuine pre‑estimate of loss, it may be saved if it is commercially justified, will be a comfort to contracting parties.

Makdessi v Cavendish Square Holdings BV & Anr [2013] EWCA Civ 1539