A purchase price adjustment triggered by any breach of restrictive covenants can be an unenforceable penalty clause
Makdessi v Cavendish Square Holdings BV & Anor (Appeal)  EWCA Civ 153
A provision in an SPA adjusting the purchase price following the seller’s breach of a restrictive covenant, however material, can be an unenforceable penalty clause.
Mr Makdessi agreed to sell part of his advertising group to Cavendish for a sum payable in instalments. The SPA imposed restrictive covenants (including non-compete provisions) on Mr Makdessi and his fellow shareholder, purportedly to preserve goodwill in the group. Any breach of the covenants would result in:
- outstanding instalments of the purchase price being cancelled; and
- the defaulting shareholder’s remaining shares being on offer to Cavendish for net asset value (rather than a valuation reflecting the significant goodwill in the group).
Mr Makdessi argued that these provisions were unenforceable as penalties.
Cavendish argued that the provisions were part of a commercial bargain that the parties had reached after extensive negotiations using experienced legal advisers, and that they fulfilled a commercial purpose. Most of the purchase price was attributable to goodwill, and a breach of the covenants would be likely considerably to reduce the value of that goodwill.
The Court of Appeal found that the clauses were unenforceable penalties. They weren’t genuine pre-estimates of loss, and weren’t commercially justified.
The court seems to have been influenced by the arbitrary nature of the provisions. The consequences of Mr Makdessi making one unsuccessful attempt to solicit business in breach of the covenants (a ‘trifling breach’) would be the same as if he enticed away the entire senior management of the group. But the losses would vary according to the nature, extent, duration and success of his activity. There was no nexus between the breach of contract and the loss – the consequences for Mr Makdessi could amount to millions, even if Cavendish would have no recoverable losses for breach of contract. Cavendish’s commercial explanation didn’t justify this disproportionality.
In assessing whether the provisions were enforceable, the court used a two-step approach.
- Is the provision a genuine pre-estimate of loss? (If the amount to be withheld or paid over is indeterminate, or disproportionate to the greatest conceivable loss, it’s unlikely to be a genuine pre-estimate.)
- If the provision is not a genuine pre-estimate of loss, is it commercially justified (does it fulfil a ‘justifiable commercial or economic function’)? If not, it will be an unenforceable penalty. If it is commercially justified, it will be enforceable (even though it isn’t a genuine pre-estimate of loss).
Take care when linking purchase price and valuation to a party’s compliance with an agreement (not just in SPAs – similar principles could apply in eg a joint venture agreement). A penalty payment or revaluation that is unconnected to the potential loss may be unenforceable, unless the court considers it is commercially justified.
Cavendish will appeal to the Supreme Court, although the hearing date has not yet been set.
Court clarifies what is ‘reasonable notice’ to terminate a contract
Hamsard 3147 Ltd (t/a Mini Mode Childrenswear) v Boots UK Ltd  EWHC 3251 (Ch), 31 October 2013
The High Court has listed the factors to consider when deciding what is ‘reasonable notice’ for terminating a contract. The decision doesn’t create new law, but it will be useful when interpreting a ‘reasonable notice’ clause, or when a contract is silent on termination.
Hamsard had contracted to supply children’s clothes to Boots. The contract wasn’t in writing and the trading relationship had been inherited from previous arrangements between other parties. Hamsard ran into financial problems and Boots terminated the contract on nine months’ notice. Both parties accepted that the contract could be terminated on reasonable notice, but Hamsard argued that ‘reasonable’ meant 18 months (referring back to a previous agreement).
The court set out five factors for deciding what is ‘reasonable’, summarising previous case-law:
- it will always depend on the facts – so other cases are of limited help;
- the circumstances and practices of the parties’ trade may be relevant;
- it should be judged at the time notice is given;
- the circumstances at the time of the contract are also relevant, to show ‘the common purpose of the parties’; and
- it will depend on how formal the relationship is.
Here, the contract was informal, short-term, and constantly changing. Nine months was reasonable.
Although this case is useful guidance when deciding on a reasonable notice period, there’s no substitute for including clear contractual wording on termination rights. The dispute also shows how important it is to document any trading relationship your business inherits – eg following corporate restructurings.
New employment rules on changing service providers
The new TUPE regulations came into force on 31 January 2014. This is part of the government’s commitment to cut employment law red tape.
The regulations introduce some important changes:
- for a TUPE service provision change to take place, post-transfer activities must be ‘fundamentally the same as the activities carried out previously’;
- pre-transfer collective consultation (where the transferee, with the transferor’s consent, meaningfully consults with the transferring employees) can count towards collective redundancy consultation obligations; and
- changing an employee’s workplace location after a transfer can be an ‘economic, technical or organisational’ reason and won’t automatically be unfair.
BIS has published guidance on TUPE generally, including the new regulations (the Collective Redundancies and Transfer of Undertakings (Protection of Employment) (Amendment) Regulations 2014)
Draft EU trade secrets law – lobbying is under way
The EU Commission has proposed a draft directive to harmonise member states’ laws on trade secrets. Currently, each EU country has different rules protecting business know-how against misuse by third parties. Having some certainty about the law should be helpful for businesses that trade across Europe – but the current draft raises some concerns.
In particular, the proposal contains wide language allowing the use of others’ trade secrets:
- ‘for the purpose of fulfilling a non-contractual obligation’; or
- ‘for the purpose of protecting a legitimate interest’.
It’s unclear what these carve-outs are aimed at. Depending how the directive develops, we might need to consider how we draft NDAs and other confidentiality obligations.
The draft directive is still at an early stage, so there’s still time to influence its content. We’re speaking directly to the EU institutions to try to protect the interests of our clients. If trade secrets are central to your business and you have concerns, we can include these in our discussions at the EU – direct evidence of what businesses see in practice is often the most persuasive factor in getting legislative change. We may also be able to set up meetings for you with the Commission, representatives from the member states, key MEPs, and trade associations.
For more information, see the EU Commission’s website.