A recent Court of Appeal decision has highlighted the rule against penalties, demonstrating that a penalty can include not only a requirement to pay a sum but also the loss of the right to a future payment and a requirement to transfer assets at an undervalue: Talal El Makdessi v Cavendish Square Holdings BV  EWCA Civ 1539.
The case shows the risks involved in drafting clauses for payment or forfeiture on breach and the need to carefully consider in each case the tests for what is a penalty and the form of drafting that is used.
The case concerned a share purchase and shareholders’ agreement. Under the agreement, the seller (Mr Makdessi) sold part of his stake in a company to the purchaser (Cavendish). The agreement contained non-compete restrictions on the seller and the consequences of a breach of those restrictions were stated to be that:
- the seller lost his entitlement to the two deferred consideration payments due in relation to the sale of his shares;
- the seller lost a put option to sell his remaining shares in the company to the purchaser at a price determined by reference to goodwill; and
- a call option in favour of the purchaser was instead triggered, which allowed the purchaser to buy the seller’s remaining shares at a price based on net asset value, with no provision for goodwill.
The seller admitted to activities that were a breach of the non-compete restrictions and that he was in breach of his duties as a director of the company. The purchaser sought to withhold the outstanding deferred consideration payments and to exercise the call option over the seller’s remaining shares.
The Court of Appeal (overturning the High Court decision) held that the provisions for forfeiture of the deferred payment and the triggering of the call option were penalties and therefore unenforceable.
A provision for payment, or for forfeiture, on breach is a penalty if its purpose is deterrence rather than compensation. If it is a genuine pre-estimate of loss and therefore a valid liquidated damages provision, or if there is some other commercial justification for the provision, it will not be struck down as penal. The Court of Appeal applied this two stage test in deciding that the provisions were penalties. It held that:
- the provisions could not be regarded as a genuine pre-estimate of loss because they were “extravagant and unreasonable” given the extent of the forfeiture and because a trifling breach would result in the same amount being lost as a more serious breach; and
- the provisions did not serve a justifiable commercial or economic function.
The courts have previously suggested that the rule against penalties should be used sparingly, given that it interferes with freedom of contract, but the Court of Appeal was prepared to rule that the provisions were invalid in this case. Furthermore, the court suggested that, had the provision in relation to the deferred consideration payments been drafted so that payment was conditional on compliance, then the doctrine of penalties might not have applied at all.