In the Autumn 2014 edition of the Bulletin we considered the question of whether large deposits in property transactions could be considered unenforceable penalties. That article considered the effect of the rule against penalties and bemoaned, in the context of deposits, the different legal treatment of penalties, as contrasted with forfeitures and the confusion caused by contrasting legal precedents.
At the end of last year the Supreme Court handed down its judgment in Cavendish Square Holding BV v Makdessi which re-stated the law on penalties, so it is worth revisiting the area to assess where the land now lies. Has Makdessi really changed the approach that parties should take?
Penalties and forfeitures: what are they?
For over 100 years the leading authority on the question of penalties was the decision of the House of Lords as set out by Lord Dunedin in Dunlop Pneumatic Tyre v New Garage and Motor Company  UKHL, a decision focussed upon the difference between a liquidated damages clause and a penalty. Dunlop decided that, where a clause requires the payment of money upon the commission of a breach of contract then, provided the sum payable is a genuine pre-estimate of the loss that might flow from the breach, the clause is an enforceable liquidated damages clause.
However, if the sum payable is not designed to compensate likely loss but rather to deter breach, then the clause is an unenforceable penalty and is automatically void. However, there is a distinction to be drawn between an obligation to pay money upon a breach of contract (a classic penalty scenario), and a provision which envisages the loss of existing rights, such as the benefit of an existing deposit paid towards a purchase price. A contractual provision of this description is not a penalty but a forfeiture, since it operates on sums already paid prior to the breach, rather than extra sums which become payable because of the breach. Although there would seem to be little difference in the practical effect of each type of provision (the contract breaker is out of pocket either way) the legal treatment of them varies markedly.
Whereas a penalty is always void a contractual forfeiture is enforceable come what may, but the Court has jurisdiction to grant relief from forfeiture where the circumstances are such that it would be manifestly unfair to allow the forfeiture to take effect.
The law after Makdessi
The facts of Makdessi concerned the sale of 60% of the share capital of a large media business in the Middle East to the WPP Group of Companies by Mr Makdessi and his business partner Mr Ghossoub. Messrs Makdessi and Ghossoub intended to retain the remaining 40% of the shares. Payment was to be made in instalments over the years following the sale. Importantly the valuation of the business took account of the considerable goodwill that resided in Mr Makdessi in particular, since as founder of the business he had personal relationships with many key clients and employees. In order to protect that goodwill Mr Makdessi became subject to restrictive covenants which prevented him from setting up competing business or soliciting employees. In the event of his breach of those covenants the sale contract provided that as a “defaulting shareholder” Mr Makdessi would (1) lose his entitlement to any instalments of the price that were then outstanding and (2) become obliged to transfer his remaining shares to Cavendish upon valuation terms that were unfavourable to him. In due course Mr Makdessi breached his restrictive covenants, a fact he admitted shortly before the High Court trial, but sought to argue that the defaulting shareholder provisions were unenforceable as they were penal in nature. Cavendish won before the High Court but lost in the Court of Appeal and appealed to the Supreme Court.
In giving its judgment the Supreme Court swept away the existing legal test for the assessment of a penalty and restated it. The Court considered that Dunlop had come to achieve the status of a quasi-statutory code. The test for whether a clause is penal was restated as follows:
“The true test is whether the clause is a secondary obligation which imposes a detriment on the contract breaker which is out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation. The innocent party can have no proper interest in simply punishing the defaulter. His interest is in performance or in some appropriate alternative to performance. In the case of a straightforward damages clause, that interest will rarely extend beyond compensation for the breach…. but compensation is not necessarily the only legitimate interest that the innocent party may have in the performance of the defaulter’s primary obligations.”
A primary obligation is an obligation to do (or refrain from doing) something. An obligation that arises if the primary obligation is not performed is a secondary obligation. In a classic liquidated damages clause the obligation to pay liquidated damages is always a secondary obligation since it only arises if there is a breach of a different obligation of the contract.
The Court emphasised that the notion of “deterrence” did not form part of any assessment as to the penal nature of a clause as there is nothing objectionable about seeking to influence the behaviour of the other party by deterring a breach of contract (contrast the pre-Makdessi law which indicated that deterrence was the hallmark of a penalty). The Court did make clear, however, that if a clause strays into the territory of punishment then that is characteristic of a penalty. The question of whether a clause is intended to punish is to be determined by reference to whether it is “grossly disproportionate” or “unconscionable” when assessed against the innocent party’s interest in enforcing the contract.
All very interesting but what’s the difference?
It is a question of construction of the contract as to whether a particular clause is penal. That is a judgment that the Court has to make as at the time the contract was entered into, and not at any later stage, since what happens after the date of a contract is not of any assistance in the determination of its meaning. However in order to safely avoid a later finding that a particular obligation is penal the parties will have to ensure, when drafting the contract, that the consequences of that clause are not disproportionate or unconscionable compared to the legitimate interest in seeing the contract performed. In my view that can only be done by seeking to assess in advance the likely downside of a breach of contract as compared to the (potentially penal) consequences of the clause in question. As an intellectual exercise that seems to be no different to the putative genuine pre-estimate of loss that the law required before Makdessi. It would seem, therefore, that while the legal approach has changed the commercial approach need not.
Makdessi is an interesting case but it is unlikely to be the last word in this area. Dunlop was the leading authority for 100 years and we doubt the Makdessi test will have such longevity in unrefined form as there is already academic debate about the questions that are left unanswered by the judgment. One area for potential development is the question of the different treatment of penalties and forfeitures. Back in 2014 we focussed upon the difference between the two concepts as the law as it then stood recognised a dichotomy between them. In Makdessi two law lords took the view that there is no reason in principle why a provision cannot be both a penalty and a forfeiture. While future litigation will be required to crystallise the thinking formally it would appear that the approach in future might well be as follows:
- Consider if the clause is penal (applying the new Makdessi test). If it is penal then it is automatically unenforceable.
- If the clause is not penal then consider whether it operates as a forfeiture and, if it does, whether it is appropriate to grant relief against forfeiture
Coming back to the issue of deposits in contracts for the sale of land, it was previously thought that provisions relating to the loss of deposits upon a failure to complete could not be a penalty. It is now clear that this is no longer the case. While it might be thought to be good news for buyers, provided sellers are sensible and go no further than is necessary to protect their position in the contract, the right to retain a deposit will still prove a powerful deterrent against default.