In Talal El Makdessi v Cavendish Square Holdings BV (2013), the Court of Appeal considered whether certain clauses in a share purchase agreement relating to a breach of restrictive covenants were unenforceable on the basis that they were penalties.

Background

Talal El Makdessi ("Makdessi") was a key figure in the advertising and marketing world in the Middle East.  In 2008, Makdessi sold a significant stake in his advertising group to a WPP Group subsidiary. The purchase consideration was to be paid to Makdessi in instalments and Makdessi was given a put option in respect of his remaining 21% shareholding. The share purchase agreement ("SPA") contained several restrictions on Makdessi competing with the Group after the sale. The clauses in question provided that on Makdessi's breach of a restrictive covenant:

  1. the purchaser would be released from its obligation to pay certain deferred consideration;
  2. Makdessi would lose his put option; and
  3. the purchaser would be entitled to force Makdessi to transfer the remainder of his shares in the target company to the buyer at 20% of net asset value (which was less advantageous than the price that would apply on a sale of the shares where there had been no breach, and ignored goodwill).

After the sale, WPP claimed that Makdessi had breached the restrictive covenants, and sought specific performance of the above clauses. Makdessi argued that the effect of the clauses was to deprive him of up to US$115 million in circumstances where WPP had suffered no losses recoverable at law and that as a result, the clauses were penalties and therefore unenforceable.  WPP argued that the clauses merely adjusted the consideration payable under the SPA and could be 'commercially justified'.

Decisions

At first instance, Burton J found in favour of the purchaser.  He found that the provisions of the SPA had been freely negotiated between sophisticated parties with expert advisers and that the amount claimed by the sellers was not disproportionate, given the considerable amount of consideration paid by the purchaser for goodwill. 

In the Court of Appeal, Christopher Clarke LJ, Patten LJ and Tomlinson LJ unanimously reversed the first instance decision, pointing out that the entire deferred consideration could be withheld for a single breach. The Court held that there was 'no proportionate relationship, even a rough and ready one, between the breach which triggers the operation of the clause and the amount withheld.'  The relevant clauses were found not to be a genuine pre-estimate of the purchaser's loss and were said to be 'extravagant and unreasonable', consequently, and despite Makdessi's breach of the terms of the restrictive covenants, the clauses were held to be penalties and unenforceable.

Comment

The Court of Appeal, in determining that the clauses were penal, did not only focus on the unreasonableness of the clauses but also on the fact that the clauses lacked commercial justification.  The function of the clauses in question was to act as a deterrent to the seller breaching any of the important and heavily negotiated restrictive covenants. However the sum the seller stood to lose under these clauses was out of all proportion to any potential loss attributable to a breach. This lack of proportionality took the clauses beyond the realm of compensation and into the territory of (unenforceable) penalties.

This decision, whilst not new law, serves as a useful reminder of the need to be careful when drafting provisions in contracts regarding remedies for breach, and that due consideration should always be given to the potential for contractual deterrents to be construed as penalties.