The recent decision of the Supreme Court in Cavendish Square Holding BV v Talal El Makdessi and ParkingEye Limited v Beavis is one of the most noteworthy for 100 years, providing much needed clarification on the topic of penalty clauses. In its decision, the Supreme Court has demonstrated a flexible commercial approach to enforcing obligations under a contract, as long as they are not penal in nature. Much of the media attention has focussed on the Beavis decision, which considered whether or not an £85 parking fine amounted to a penalty, or broke consumer protection laws (the Supreme Court concluded it did not). However, the El Makdessi decision is very important to businesses, and it is this aspect of the decision that this bulletin is focussed on.

This bulletin looks at the legal reasoning in detail, reflecting the extreme detail in the judgment, and the face that four of the most senior judges in the country have expressed their views. Different practice and sector groups within Bird & Bird will be examining the practical impact of the decision on their fields, and sharing insights with relevant audiences in due course. At this stage, we thought the most helpful contribution was to distil the decision itself.

Bird & Bird will be holding a Dispute Resolution Essentials breakfast seminar series in 2016. The first of these will be on Thursday 11 February with Victoria Hobbs and Jenna Rennie speaking on Penalties and Liquidated Damages and the ramifications of this decision.

Please click here to request an invitation >>

Key messages:

  • If parties are equal and well-advised the court will be reluctant to interfere.
  • A clause will only be capable of being a penalty if the clause provides a remedy for a breach.
  • Judicial recognition of broader legitimate business interests not just actual losses flowing from the breach.
  • A clause will be a penalty if it “is a secondary obligation which "imposes a detriment on the contract-breaker out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation".

Cavendish v El Makdessi - the facts

El akdessi and a fellow shareholder sold a majority shareholding in El akdessi's media and advertising business in the Middle East to Cavendish Square, part of WPP. It was the largest business of its type in the Middle East and was founded by El Makdessi.

Following the sale, El Makdessi breached various covenants contained in the sale agreement which prevented him primarily from competing with the sold business and soliciting customers and employees. Under the sale agreement, that breach of covenant triggered two mechanisms:

  • El Makdessi lost the right to the balance of the purchase price from Cavendish for his shares (the amount of the reduction being up to $44m); and
  • El Makdessi became obliged to sell his remaining, minority shareholding in the business to Cavendish, at a discounted value.

El Makdessi challenged both these provisions as unenforceable penalties. The High Court disagreed with him, but in November 2013 the Court of Appeal, applying its understanding of the law, unanimously upheld his appeal, and held that the mechanisms fell foul of the rule against penalties. Cavendish appealed to the Supreme Court and at the beginning of November seven senior judges unanimously held that the provisions were not penalties but were legally enforceable obligations and therefore valid against El Makdessi.

What is a penalty clause?

Contracting parties will seek to cover all eventualities when negotiating terms. This often extends to providing for the consequences of a breach of a particular term of the contract between them, for example how much should be paid by one to the other as a remedy. This approach may be taken when discussing issues such as delay in delivery; early cancellation by one party; retention of a deposit if there is a failure to perform; remedies for stealing an employee or a client etc. The purpose of such clauses in contracts has been to increase certainty, reduce the prospect of litigation, and preserve relationships even in the face of a dispute over performance or compliance. The long-standing position under English law is that such remedies are enforceable under agreements entered into between businesses unless they are a "penalty", in which case a court will refuse to enforce the payment or payment mechanism. To decide whether a clause is a penalty, courts apply what is often referred to as the "penalty doctrine". The penalty doctrine will only apply to a clause providing a remedy for the breach of a primary obligation rather than the primary obligation itself. Whether or not such a clause is a penalty is a matter of construction.

Supreme Court decision

The decision of the Supreme Court tracks the history of penalty clauses from the beginning of the 16th century until the present day. Counsel for Cavendish argued that the penalty doctrine should be abolished or restricted. The Supreme Court rejected these calls, as well as the submissions by Counsel for El Makdessi that the doctrine be extended as in Australia1. Instead it opted to provide some much needed clarification of the penalty doctrine, seeking to address the fundamental questions of when the penalty doctrine applies and what the appropriate test is. As such it is likely to prove a touchstone in terms of the applicability and scope of the doctrine for years to come.

When does the penalty doctrine apply?

The decision emphasises that the purpose of the penalty doctrine is not to enable the courts to review the primary bargain that parties have entered into. Instead, it is confined to the review of the "remedies available for breach of a party's primary obligations, not the primary obligations themselves"2. Therefore, the extent to which a provision in an agreement is a 'primary obligation' (i.e. part of the underlying bargain) or a secondary obligation needs to be assessed before the penalty doctrine can be considered to apply.

The judgments include some practical examples of when the penalty doctrine may apply, beyond simple liquidated damages clauses. So, for example, the Court accepts that the penalty doctrine could apply to a provision requiring the transfer of goods rather than money3. Some members of the Court also support the penalty doctrine's application to the withholding of a sum of money4, a forfeiture provision5 or a deposit as a form of surety6.

A "price adjustment clause" on the other hand, will often be better viewed as a primary obligation, and as such outside the scope of the penalty doctrine. However, a note of caution is necessary here - the Court had differing views on whether the clauses in question were primary obligations, and therefore outside the scope of the penalty doctrine, or secondary obligations, but not penalties on the facts of the case7. The Court also signalled it was very aware that price adjustment clauses could be open to abuse, and if such a clause was, in reality, a disguised punishment then the mere fact that something was expressed as a price adjustment clause would not prevent it from being a penalty8.

What is the test of whether something is a penalty clause?

The key test of whether something is a penalty clause is formulated slightly differently by the different judges. Thus Lords Neuberger and Sumption phrased the true test as being"whether the impugned provision is a secondary obligation which imposes a detriment on the contract-breaker out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation" 9, whereas Lord Hodge referred to the question of "whether the sum or remedy stipulated as a consequence of a breach of contract is exorbitant or unconscionable when regard is had to the innocent party's interest in the performance of the contract" 10. Lord Mance considered that "what is necessary in each case is to consider, first, whether any (and if so what) legitimate business interest is served and protected by the clause, and, second, whether, assuming such an interest to exist, the provision made for the interest is nevertheless in the circumstances extravagant, exorbitant or unconscionable" 11.

What these tests have in common is a focus on the legitimate interests of the innocent party, beyond their likely remedy in damages for a particular breach. This can be seen as a continuation of the recent trend towards recognising broader commercial interests when assessing whether something is, or is not, a penalty clause.  In formulating these tests, the Supreme Court re-evaluated some long-standing assumptions about liquidated damages and penalty clauses, and provided some useful clarifications. Key among these clarifications were:

  • the question of whether a provision is intended to act as a deterrent is not helpful, with Lords Neuberger and Sumption noting that "to describe it as a deterrent…does not add anything" 12;
  • similarly, the choice was not between a clause being a 'genuine pre-estimate of loss' or a penalty. Lords Neuberger and Sumption noted: "A damages clause may be neither or both. The fact that the clause is not a pre-estimate of loss does not therefore, at any rate without more, mean that it is penal" 13;    
  • the circumstances surrounding the entry into the contract are relevant when assessing whether or not a clause amounts to a penalty. Where a contract is negotiated between"properly advised parties" of "comparable bargaining power" there is a strong presumption that they are the best judges of what is a legitimate provision dealing with the consequences of breach14. In other words, the courts should be reluctant to get involved;
  • The four tests set out by Lord Dunedin in the decision of Dunlop15, which had previously been seen by many as a definitive guide to assessing whether a provision is penal or not, were not discarded. While Lords Neuberger and Sumption noted it was"unfortunate" that the four tests had been applied in this manner, given they had only ever been proposed as considerations rather than rules, they also noted their expectation that these questions would usually be "perfectly adequate" for assessing the validity of a straightforward damages clause, where the legitimate interest of a party would "rarely extend beyond compensation for the breach" 16.

The updated doctrine applied

In terms of deciding whether or not the penalty doctrine should be applied at all, the members of the Court approached each clause separately. The clause disentitling El Makdessi to future payments otherwise owed under the contract for shares already transferred was viewed by Lords Neuberger and Sumption as a price-adjustment clause, and as such a primary obligation, such that the penalty doctrine did not apply, with Lord Hodge noting the strong arguments in support of this position, but not determining the point17. Differing positions were adopted in relation to the clause requiring El Makdessi to sell his remaining shares at a price that discounted any value attributed for goodwill. Lord Hodge, despite noting the strong arguments in support of Lords Neuberger and Sumption's position that this was a primary obligation, concluded that it was a secondary obligation, such that the penalty doctrine applied18.

However, despite differing approaches to whether or not the penalty doctrine applied, and the precise question that should be asked, the outcome was unanimous, with the court finding neither clause was a penalty, even if examined through the prism of the penalty doctrine. Key findings in reaching this conclusion included:

  • The goodwill of the business being purchased by Cavendish was crucial, and made up the large part of the business's value. El Makdessi had built the business before selling the shares to Cavendish using his extensive personal connections and relationships. Cavendish therefore had a legitimate interest in protecting the goodwill of the business it was purchasing and ensuring that El Makdessi would not act in a "disloyal" way by breaching the post-sale restrictions - that legitimate interest could not be quantified in simple financial terms alone.
  • In rejecting arguments that the clause disentitling El Makdessi to future payments otherwise owed for shares already transferred was 'exorbitant', Lord Hodge noted that this clause was not addressing the loss which Cavendish may suffer from breach of a restrictive covenant, but instead the "disloyalty of a seller who was prepared in any way to attack the company's goodwill" 19
  • The same interests were considered to justify the clause requiring El Makdessi to sell his shares for an amount that excluded any goodwill value, with Lord Mance noting that"complete severance of relationships was a natural provision to include as a consequence of any such breach" 20. 
  • Overall the agreement was carefully negotiated between informed parties who had the benefit of legal advice at arm's length.

What this means for you

The full ramifications of this decision will no doubt take some time to be fully digested. However certain preliminary observations can be made. Key among these is that the Supreme Court has reformulated the essential question to be asked when considering whether something is a penalty. In so doing, the court rationalises some of the existing decisions, and as a result provides a more flexible, modern test that reflects the reality of many modern-day commercial practices. Encouragingly, where two equal, well-advised parties have reached an agreement, this decision emphasises that the courts should be reluctant to interfere.

It is very helpful that the Court has recognised that some payment clauses are actually price adjustment mechanisms and part of the "primary" deal, rather than being remedies for breach. That is similar to the argument which for many years has been used to uphold the legal enforceability of service level agreements (SLAs) which are very commonplace indeed in commercial agreements - i.e. that they simply adjust price to incentivise good performance, and sanction inferior performance.

The acknowledgment by the Court that some provisions in contracts seek to protect highly legitimate interests which are non-monetary, but which nonetheless are a core part of the transaction (e.g. protection of goodwill, or reputation or, in the words of one cited case, protection of the "integrity" of the innocent party's trading system) is another significant feature of this decision. There had already been a clear shift away from the concept of a 'genuine pre-estimate of loss' being determinative, towards consideration of other 'genuine commercial interests'. However this case cements that shift and takes a more realistic view of the varied interests that parties to an agreement may have.

It remains important to retain evidence of the thinking behind these mechanisms, created at the time of the contract to help cement the parties' interests.  But now, such evidence is not just to show that the figures are not exorbitant, but also to summarise the legitimate interest which the clause is seeking to protect.

Incidentally, the rejection by the Supreme Court of an extension of the penalty doctrine to situations of non-breach means that the UK and Australia now have distinct approaches to the issue of what constitutes a penalty, with it remaining to be seen whether other common law jurisdictions such as Hong Kong and Canada will embrace the modern approach endorsed by the Supreme Court in this decision.