Practitioners in the industry will be aware that model form JOAs, such as those provided by Oil and Gas UK or the Association of International Petroleum Negotiators, contain forfeiture clauses for participant default (with varying degrees of optionality).  Following the Court of Appeal decision in Jobson v Johnson [1989] 1 WLR 1026, a forfeiture clause will be unenforceable under English law if it amounts to a penalty. 

The recent decision of the Court of Appeal in Makdessi v. Cavendish Square Holdings B.V. [2013] EWCA Civ 1539 (“Makdessi”) is the first significant application of Jobson v. Johnson, since that decision was handed down in 1988.  Makdessi has reaffirmed the application of the law of penalties to forfeiture clauses but also highlights the new approach of English law in enforcing claims that are “commercially justified” as not amounting to a penalty.  The new approach indicates that the traditional description of a penalty clause as not amounting to a genuine pre-estimate of loss is “too rigid”.

Whether forfeiture clauses found in JOAs fall foul of the rule against penalties has been a topic of debate amongst oil and gas lawyers for many years, and doubtless will continue to be so for some time.  

Facts

Makdessi sold part of his shareholding in an advertising and marketing company (the “Company”) to Cavendish.  The share sale agreement (the “Contract”) contained clauses requiring Makdessi to protect the valuable good will of the Company.  This required Makdessi to abide by his fiduciary duties to the Company as Chairman as well as restrictive covenants against competition.  If he failed in this regard, he stood to forfeit payments for his shares of c.US$ 44 million (“Clause 5.1”), and be required to sell his remaining shares (valued at c.US$ 75 million) at a substantial undervalue “to effect a decoupling” (“Clause 5.6”). During proceedings, Makdessi acknowledged that he had been in breach of his fiduciary duties to the Company.   The issue was whether the forfeiture clauses in question were unenforceable on the grounds that they were penalties.

Cavendish argued that a commercial justification could permit the reduced price paid. It claimed that, under the Contract, it would pay the full price for the shares provided that Makdessi abided by the restrictive covenants.  If Makdessi failed, he could be required to accept a discount on the sale shares and to sell his remaining shares without the value of the good will he himself was unwilling to protect.  The clauses, Cavendish argued, simply reflected what it was prepared to pay and, in the absence of absurdity, the court should not interfere. 

Decision and Reasoning

Makdessi won and the forfeiture clause was not enforceable.  The parties did not dispute that the law of penalties applied to Clause 5.1.  In respect of Clause 5.6, the Court of Appeal applied Jobson v. Johnson, confirming its application to forfeiture clauses. 

The traditional approach of the courts resulted in a dichotomy. It required an identification of the purpose and effect of the clause: if it was to “frighten” a party into compliance, it was an unenforceable penalty; if it was a “genuine pre-estimate of loss”, it was in principle enforceable.

This traditional dichotomy was too narrow. More recent authorities showed that the courts are: (i) adopting a broader test of whether the clause was extravagant and unconscionable with a predominant function of deterrence; and (ii) robustly declining to do so where there was a commercial justification for the clause.

On the facts, the immediacy and disproportionate nature of the remedies available under the Contract were extravagant, going beyond compensation and into the realms of deterrence.  The Court rejected the commercial justification put forward by Cavendish: the effect of the clauses meant that Makdessi would forfeit sums in the tens of millions of dollars in circumstances where, at law, Cavendish’s loss was nil. The clauses also prescribed a form of double jeopardy because Cavendish had the remedies provided for by the clauses and Makdessi remained liable to the Company.

Comment

The case signals that the issue of whether a forfeiture clause can amount to a penalty is very much alive and well.  The case confirms that the law of penalties applies to forfeiture clauses and, as in this case, it can render such a clause unenforceable.

Within the oil and gas industry, there are different opinions on the strength of the arguments either in favour or against the enforceability of the forfeiture clauses found in JOAs. The arguments regarding the law of penalties in this context are well known. The Court of Appeal in Makdessi v. Cavendish offers the opportunity to review the arguments in a slightly different light.

There are some similarities between the forfeiture clauses in most oil and gas JOAs and the unenforceable forfeiture clause in the Makdessi case:

  • Proportionality: the fact that a single remedy applies to a range of breaches regardless of actual loss.
  • Difficulties of Calculation: as in Makdessi, the value of the forfeited interest in a JOA is unknown at the time of drafting and, potentially, the worse the breach of the defaulting party, the lower the value of the asset to be forfeited – this illogicality was felt by the Court in Makdessi to indicate that the clause might be penal.
  • Double Jeopardy in JOAs(?): if default and forfeiture occurs, depending on the drafting, the defaulting party may still be liable to pay the sums due.
  • Nonetheless, there may also be certain distinctions:
  • Operation of Forfeiture: most oil and gas JOAs include a ‘grace period’, and so the forfeiture does not operate immediately upon a default.
  • Different ‘Phases’ of Field Life: in the oil and gas sector, a court could reach different conclusions based upon the stage of field development.
  • Commercial Justification: there is a potential commercial justification for forfeiture under an oil and gas JOA. Amongst other things, it is often said that the purpose of forfeiture in oil and gas JOAs is to protect an innocent party’s investment by putting in place a mechanism which would enable the joint venture to survive (see General Trading v. Richmond [2008] 2 Lloyd's Rep 475 referred to in Makdessi).

Conclusion

As Christopher Clarke L.J. noted in Makdessi, “the answer” lies not in the fact that forfeiture is used per se, but the terms of its use. 

In the interim, the oil and gas industry continues to await legal developments.  Consideration when drafting JOAs should still be given to whether the courts will uphold the forfeiture clause, as drafted, in all situations where it may be needed.

Makdessi raises further issues in the context of international business joint ventures and our recent article looking at these issues is available here.