Two recent decisions are helpful in understanding the English courts' approach to the interpretation of provisions in share purchase agreements. In Cavendish Square Holding BV v El Makdessi ([2015] UKSC 67) the Supreme Court considered whether certain clauses in a share purchase agreement were unenforceable penalty clauses. In Wood v Sureterm Direct Ltd ([2015] EWCA Civ 839) the Court of Appeal ruled on two different interpretations of an indemnity in a share purchase agreement.

Cavendish v El Makdessi

Two individual shareholders in an advertising company based in the Middle East sold a proportion of their shares to the buyer under a share purchase agreement. Under this agreement, the purchase price was payable in stages:

  • An amount was payable on completion of the sale and a group reorganisation;
  • An interim payment was to be paid after agreement of the target's operating profits for 2007 to 2009; and
  • A final payment was to be paid after agreement of the target's operating profits for 2009 to 2011.

The sellers were subject to non-compete covenants in the share purchase agreement. The agreement provided that a seller would lose his entitlement to the interim and final payments of purchase price if he were in breach of those covenants. A breach would also trigger an option enabling the buyer to require the relevant seller to sell his remaining shares to the buyer at a default price.

One of the sellers admitted that he was in breach of his non-compete covenants. However, he argued that the contractual provisions setting out the consequences of his breach were unenforceable, as they were penal in nature. While the trial judge rejected his argument, the Court of Appeal held that these provisions were unenforceable penalties under the penalty rule as traditionally set out in Dunlop Pneumatic Tyre Co Limited v New Garage and Motor Co Ltd ([1914] UKHL 1). This was on the basis that they had no relationship with the measure of loss attributable to the breach. The buyer appealed to the Supreme Court, which reversed the Court of Appeal's decision and held that such provisions were not penal.

In its judgment, the Supreme Court took the opportunity to clarify the law on penalties.

Distinction between primary and secondary obligations

The Supreme Court highlighted that the penalty rule regulates secondary – not primary – obligations. Specifically, secondary obligations are triggered only when another contractual provision is breached. Primary obligations are obligations that arise directly from a contractual provision. Whether an obligation is primary or secondary in nature is ultimately a matter of construction. On the facts, the Supreme Court held that the provisions removing the seller's entitlement to his interim and final payments on breach of his non-compete covenants were "price adjustment clauses" – in particular, they "fix the price, the manner in which the price is calculated and the conditions on which different parts of the price are payable". Such provisions therefore gave rise to primary obligations and the penalty rule did not apply. In terms of the call option, a majority of the Supreme Court judges held that the purpose of such option was to sever the connection between the target and a seller in breach of his non-compete covenants. The call option therefore amounted to a "reshaping of the parties' primary relationship" and did not provide for compensation for a breach of contract. On that basis, the court held that the penalty rule did not apply.

Legitimate interests

The Supreme Court held that the test to determine whether a contractual provision is penal is whether it is a "secondary obligation which imposes a detriment on the contract-breaker out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation".

Specifically, the court noted that the fact that a clause is not a pre-estimate of loss does not, on its own, mean that it is penal. Rather, it is necessary in each case to consider whether:

  • there is a legitimate justification for the clause; and
  • the clause is nevertheless unconscionable or extravagant.

On the facts, the court held that the buyer had a legitimate interest in the sellers' observance of the non-compete covenants, as the sellers' loyalty was essential for the preservation of the target's goodwill. The court also did not regard the relevant clauses as unconscionable or extravagant, as a significant proportion of the purchase price was for the target's goodwill.

Freedom of contract

The Supreme Court acknowledged that the penalty rule interferes with freedom of contract and that it has the effect of undermining legal certainty. On this basis, it held that the courts should be reluctant to identify a clause as penal and should recognise that in:

"a negotiated contact between properly advised parties of comparable bargaining power, there is a strong presumption that the parties themselves are the best judges of what is legitimate in a provision dealing with the consequences of breach."

The court observed that the share purchase agreement was negotiated on that basis, and that this was a relevant factor in determining whether such provisions were unconscionable or extravagant in proportion to any legitimate interest of the innocent party.

Wood v Sureterm

The buyer in Wood v Sureterm purchased an insurance brokerage firm from the sellers. Under the terms of the share purchase agreement, the sellers agreed to indemnify the buyer:

"against all… losses… suffered or incurred, and all fines, compensation or remedial action or payments imposed on or required to be made by the Company following and arising out of claims or complaints registered with the FSA… against the Company, the Sellers or any Relevant Person and which relate to the period prior to the Completion Date pertaining to any mis-selling or suspected mis-selling of any insurance or insurance related product or service."

The indemnity did not provide any restrictions as to who would have to register such claims or complaints with the Financial Services Authority (FSA) (as it then was).

Shortly after completion of the sale, employees of the insurance brokerage firm highlighted possible mis-selling in the period prior to completion; in response, the buyer, together with the firm, carried out a review of its sales process. The buyer and the firm informed the FSA of their findings (as they were required to do so). The FSA considered that the findings illustrated that there had been mis-selling by the broker and the broker agreed to conduct a remediation exercise to compensate customers.

The buyer brought an indemnity claim under the share purchase agreement against one of the sellers for the compensation paid to customers and related costs and expenses incurred in connection with the remediation scheme. The seller argued that on the proper construction of the terms of the indemnity, the indemnity applied only where a claim or complaint had been registered with the FSA in relation to insurance mis-selling – not where the broker itself had referred the issue to the FSA. The buyer argued that it applied to any insurance mis-selling, regardless of how the issue had come to the attention of the FSA.

The High Court supported the buyer's interpretation. However, in response to the seller's appeal, the Court of Appeal reversed the High Court's decision. Lord Justice Clarke concluded that – in looking at the structure of the clause when read as a whole in its original form – the seller's construction of the indemnity was to be preferred. While the High Court did not think that there was a good commercial reason to exclude from the indemnity the situation where an issue was brought to the attention of the FSA by the broker, Clarke held that care must be exercised in using business common sense as a determinant of construction. He noted that the fact that the deal may have been a poor one from the buyer's perspective was not, in his view, a reason to adopt a different interpretation from a natural reading of the actual terms of the indemnity. He added that the seller had given warranties in the share purchase agreement on mis-selling (subject to customary liability limitation provisions); therefore, the buyer's entitlement to recover in respect of mis-selling was not dependent on a claim under the indemnity. In addition, the indemnity was not subject to any time or monetary limit indicating a compromise that had been reached between the parties as to the scope of the indemnity.


Cavendish v El Markdessi provides useful insight into how the English courts apply the penalty rule to provisions in a share purchase agreement. In particular, where such provisions have been negotiated as between properly advised commercial parties, it will be harder to challenge their enforceability on the basis that they are penal. This provides greater certainty for parties to M&A transactions.

Cavendish clarifies that one way to minimise the risk that the penalty rule will be applied is to draft the relevant provisions as primary – rather than secondary – obligations. It is therefore important to ensure that the relevant drafting is sufficiently clear and precise to achieve this. It is also helpful for parties to set out in the agreement the interests that such provisions are intended to protect, in order to assist the courts with their interpretation of such provisions should the courts regard the relevant provisions as secondary in nature. Notably, it is for the courts to determine whether such interests are genuinely legitimate and whether such provisions are extravagant or unconscionable in proportion to the relevant legitimate interest. Accordingly, there is still scope for the English courts to interfere with the bargain struck between the parties.

Wood v Sureterm is a helpful reminder that the English courts will not adopt a particular interpretation of a contractual provision simply because a party has made a poor bargain, and that business common sense should not be used to undermine the natural interpretation of such a provision. Clear drafting is again crucial in ensuring that there is little or no scope for debate on what such provisions actually mean.

For further information on this topic please contact Will Pearce or William Tong at Davis Polk & Wardwell London LLP by telephone (+44 20 7418 1300) or email ( or The Davis Polk & Wardwell website can be accessed at

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