Penalty clauses are unenforceable under both English and Singapore law. A distinction has traditionally been drawn between liquidated damages clauses and penalty clauses: while the former provides for a genuine, predetermined compensation for a breach of contract and is upheld, the latter goes beyond compensation, seeks to deter parties from breaching a contract by penalizing that party and is unenforceable (see the seminal case of Dunlop Pneumatic Tyre Company Limited v New Garage and Motor Company Limited1).

In recent times, courts have adopted a more liberal approach, recognising that a ‘commercially justifiable’ reason could prevent a clause from falling foul of the ‘penalty’ rule even if the clause did not represent a genuine pre-estimate of the loss suffered, provided it was not intended as a deterrent against a potential breach. This approach was demonstrated in Lordsvale Finance plc v Zambia2 where Colman J accepted that a clause in two facility agreements (which provided for a 1% increase in the interest rate payable by a borrower in the event of a default) was legitimate and enforceable and subsequently endorsed in later cases3 as a recognition that the traditional stance towards penalty clauses could be softened. Dunlop and Zambia have found acceptance in our Singapore courts4.

Zambia heralded a lessening discomfort in drafting clauses which might otherwise have tripped the ‘penalty’ threshold, giving greater credence to the belief that the courts are reluctant to interfere in commercial bargain-making. In the context of a share sale, it is not uncommon for parties to agree that in the event of a seller breach of a material covenant, the buyer would be entitled to, for instance, exercise a call over the seller’s remaining shares at a discount or ‘put’ its shares to the seller at a premium, the discount or premium often computed against fair market value.

The recent English case of Talal El Makdessi v Cavendish Square Holdings5 has, however, highlighted that the courts are unlikely at any time soon to further whittle down the rule against penalties. In Makdessi, the English Court of Appeal unanimously overturned the lower court’s decision and held that certain ‘default’ clauses in a share sale and purchase agreement (which applied in the event of a breach) were unenforceable as penalties. The case involved a share sale under which one of the sellers, Makdessi, retained 40% of the shares in the company and the buyer (Cavendish) held 60%. Makdessi admitted to breaching the restrictive covenants which had been imposed to protect the goodwill of the company, the parties having acknowledged that goodwill was instrumental in pricing the sale.

The “default” clauses under scrutiny provided that upon a breach by the seller of the restrictive covenants:

the seller would forfeit his ability to exercise a put option at a price determined by reference to goodwill;

the seller would forfeit two deferred consideration payments due and owing to him; and

Cavendish would be entitled to call on the seller’s remaining shares at fair market value, without reference to goodwill which would have been a significant difference to the price.

The Court accepted that “the law of penalties is a blatant interference with freedom of contract”6 yet held that the ‘default’ clauses were unenforceable penalties, reasoning that:

it was extravagant and disproportionate to provide for the same consequence to follow, regardless of the severity of the breach (which could have been minor or short-lived) in question, taking into account especially the discrepancy in the range of losses that could have followed from a breach of any of the restrictive covenants; and

that the ‘default’ clauses served no commercially justifiable purpose but were instead intended primarily to deter the seller from breaching the restrictive covenants.

Whereto from here?

Commentators will likely agree that Makdessi does not represent new law but simply an application of existing principles and that the Court was hard pressed, on the facts, to determine otherwise. On one hand, the company had received an amount of $500,000 from the seller in settlement of a breach of fiduciary claim. On the other hand, Makdessi stood to forfeit millions of dollars through the operation of the ‘default’ provisions against the Court’s finding of no recoverable loss suffered by Cavendish. The ‘default’ provisions were clearly intended to deter the seller from breaching the agreement.

Makdessi nonetheless serves as a useful reminder that careful attention should be paid when drafting default or exit provisions which are triggered by a breach of contract, to ensure there is a clear commercial justification for these provisions, as opposed to the primary purpose of deterring a breach. In some cases, proper construction and drafting of the underlying rights and obligations can mitigate this risk. As observed by the Court in Makdessi, had the deferred consideration provisions been crafted differently as being conditional on the seller’s compliance with certain terms of the agreement (as opposed to the seller losing an entitlement to these payments upon a breach), these clauses might have avoided being struck down as unenforceable.

The enviable task of balancing the need to strike down unconscionable, disproportionate penalties against parties’ freedom to contract falls ultimately to the courts. We will likely see further developments in this area – the Australian High Court in Andrews v Australia and New Zealand Banking Group Ltd7 recently suggested that a provision could be penal even if it was not triggered by a breach of contract. In the interim, contracting parties and practitioners alike would be well advised to remain vigilant and guard against being shown a ‘red-card’.