In recent years, the courts have expanded the basis on which they will uphold as non-penal a contractual term providing for a sum to be payable, or other sanction to apply, on breach. As well as the traditional test of whether the amount due is a genuine estimate of loss, a clause may also be enforceable if there is a commercial justification for it. However, in Cavendish Square Holdings BV v. Makdessi  EWCA Civ 1539 the Court of Appeal explained the limits to this principle. The safest answer is always, where feasible, to draft your term so the rules on penalties do not apply.
Mr Makdessi was the founder of a group of companies which became the largest advertising and marketing enterprise in the Middle East. He and his fellow shareholder agreed to sell a 60% holding in the relevant holding company (target) to Cavendish Square Holdings.
Cavendish paid the initial consideration and later instalments, amounting to some US$75.5 million, to Mr Makdessi and his associate. Further payments were due at later dates, calculated in part by reference to the audited consolidated profit after tax for named periods. Both the paid and deferred consideration reflected significant sums for goodwill. Each seller also got a put option to elect to later sell their residual shareholding in the target to Cavendish at a price also reflecting consolidated profit after tax over a specified period.
Mr Makdessi remained a director of the target after the transaction. The agreement subjected him to various restrictive covenants. These included not carrying on any competing business and non-solicitation of business or staff.
Clause 5 dealt with default. It provided a seller who became a "Defaulting Shareholder":
- would no longer have a right to the deferred consideration payments (Clause 5.1); and
- would trigger Cavendish's right to exercise options to buy that seller's remaining shareholding in the target at a price calculated by reference to net asset value. In other words this was likely to be significantly less than the price the seller would have expected to receive if exercising his put options (Clause 5.6).
A seller became a Defaulting Shareholder on breaching any restrictive covenant.
Cavendish later alleged Mr Makdessi had breached his duty to the target by his involvement with a competing business and by soliciting clients away from it. Mr Makdessi admitted his breach of fiduciary duty and settled the target's claim by paying US$500,000. But his activities also amounted to a breach of the restrictive covenants under the share sale agreement. Cavendish exercised its right under clause 5.1 to withhold further payment and its call option under clause 5.6. Mr Makdessi argued that Cavendish could not enforce those terms because they were penal.
The first instance decision
The judge held the clauses were not in principle penal, either alone or in combination. The purpose of each clause was, principally, to adjust the consideration if Mr Makdessi breached the non-compete covenants. Clause 5.6 additionally enabled the parties to speedily decouple their dealings in that event. Both terms were commercially justifiable to protect goodwill in the target.
However, the target had already recovered compensation from Mr Makdessi for his breaches of duty. This resulted in double-counting and, taken with clause 5.1, gave Cavendish an extravagant return. The court refused to enforce clause 5.1 unless the target agreed to repay the US$500,000.
Both sides appealed.
The Court of Appeal's review of the law
The Court of Appeal took the opportunity to review in detail the key case law on penalties. From this it summarised various propositions.
- The rules against penalties apply not only to terms calling for a party that is in breach to pay his counterparty a sum of money. They also apply to clauses disentitling the contract-breaker from receiving a sum otherwise due or calling for them to transfer property to the innocent party for nothing or at an undervalue.
The traditional approach is that the distinction between an unenforceable penalty and enforceable liquidated damages is a matter of interpretation, dependent on the terms of the agreement and admissible circumstances of each case. The label applied is not determinative; the hallmarks of a penalty include a payment in terrorem of the contract-breaker, as opposed to a genuine pre-estimate of loss. In assessing whether there is a genuine pre-estimate of loss:
- the clause is penal if the sum in question is extravagant or unconscionable in amount when compared with the maximum loss that could result from the breach. (It is not automatically fatal that the clause might allow recovery higher than the actual loss);
- the clause is a penalty if the breach consists only of non-payment of a sum due and the sanction exceeds the figure that should have been paid;
- there is a presumption the clause is penal if it specifies payment of a single lump sum but the loss suffered from a breach could vary from the serious to the trifling;
- the fact that the loss flowing from the breach is difficult or impossible to calculate in advance does not prevent the sum specified from being a genuine pre-estimate.
- The modern approach is that, even if the sum due on breach may not be a pre-estimate of loss, this does not automatically make it penal. But you have to show there was a good commercial reason for the clause, so that deterring breach was not the dominant purpose.
Applying the principles to the facts
The Court of Appeal said neither clause was a genuine pre-estimate of loss.
- Each clause was likely to come into play when Mr Makdessi was not only a Defaulting Shareholder but also a director. The target would thus have a claim against him for breach of duty. Cavendish's claim for breach of the restrictive covenants was then likely to be zero. This was because it would derive from the decrease in value of its shareholding and the target's own loss fully reflected that decrease.
- The sums that Mr Makdessi might forego if clauses 5.1 and 5.6 were valid were uncertain (because they depended in part on the target's performance). However, those sums were likely to run into many millions of pounds. That sanction was extravagant when the actual loss was zero.
- Moreover, those significant sums would be withheld on any breach of the covenants by Mr Makdessi, even though the impact might have been trifling. An example would be an unsuccessful effort to solicit business. The same sanction would apply to the most seriously damaging of breaches.
The next question therefore was whether there was a commercial justification for the clauses.
Cavendish argued the terms were part of the parties' commercial bargain. The restrictive covenants were necessary to protect the target's goodwill, which formed a major plank of the acquisition valuation. If Mr Makdessi breached the covenants, he would not receive the full price. Also, in those circumstances, it would no longer be appropriate for him to remain a shareholder. It would then be justifiable to force him to sell his shares at a price that did not include value for the goodwill he had failed to protect. The court should not interfere on matters of price and price adjustment, which were for the parties to agree.
The Court of Appeal disagreed. The court should intervene where the amount to be paid or lost on breach is out of all proportion to the damage the breach results in. The effect of the clauses − price adjustment and severing the parties' relationship − might well be justifiable. But the court had to consider the terms on which those results were achieved.
The modern approach to deciding whether a sum payable on breach is a penalty provides a useful additional argument for a party trying to enforce such a clause. The commercial justification test may come to the rescue if you cannot meet the traditional genuine pre-estimate of loss test. It will often be worth spelling out any justification in the drafting (perhaps in a preamble to the clause). An example might be a supplier seeking damages for breach of a "take or pay" commitment. The clause could then point to any capital or other outlay incurred to meet the supply commitment which will be wasted if the customer fails to buy.
However, Makdessi shows the modern approach may not be as liberal as it first appears. It is clear the court will still closely consider any major difference between the amount payable and the loss that might be suffered. The Court of Appeal suggested the significance of any inconsistency may depend on how closely the (alleged) commercial justification relates to the nature or extent of the loss. Again, specifically explaining that link in the drafting could help.
But the best safeguard is to draft agreements so that liability to pay compensation is not triggered by breach. Parties can often readily achieve this by making the obligation in question a condition. So, inMakdessi, the agreement could have provided the deferred consideration and Mr Makdessi's right to exercise his put option were conditional on complying with the restrictive covenants. Then, as the Court of Appeal confirmed, no question of penalties would have arisen.