In Cavendish Square Holdings BV and Another v El Makdessi [2012] EWHC 3582, the High Court of England and Wales held that a restrictive covenant that would last for a minimum of eight years in the absence of a breach was reasonable and enforceable. The Court also held that an option for the seller to sell his shares to the buyer in the event of a breach of contract was not, on its own, a penalty clause.

BACKGROUND

Cavendish Square Holdings BV (Cavendish) was a company in the WPP advertising and marketing communications group. Mr Talal El Makdessi owned the largest advertising and marketing communications group in the Middle East. The business of Mr Makdessi’s company was vested in a third company (the Company) of which Cavendish owned 12.6 per cent. In February 2008, Mr Makdessi and Cavendish entered into an agreement whereby Cavendish agreed to purchase the remaining shares in the Company in instalments, so as to acquire complete control. Mr Makdessi simultaneously entered into a separate agreement to remain as director and chairman of the Company on a non-executive basis for an initial 18 month, renewable term.

The terms of the agreement included a restraint of trade clause (Clause 11.2), which prohibited Mr Makdessi from entering into competition with the Company, from soliciting or diverting away any trade, or from employing or enticing any senior employee away from the Company. In the absence of any breach, Clause 11.2 would last for a minimum of eight and a half years, owing to the structure of the call option written into the agreement, which was not exercisable until 2011 and would not be completed until 2016.

The agreement also provided that where Mr Makdessi acted in any way that made him a defaulting shareholder—including any breach of Clause 11.2—Cavendish could exercise the option to require Mr Makdessi to sell to Cavendish any shares he held at the time of the breach at net asset value on the date of default (the put option).

In December 2010, Cavendish discovered that Mr Makdessi had breached his fiduciary obligations to the Company as director and his obligations under Clause 11.2, by remaining involved and interested in a competitor company. This made him a defaulting shareholder. The parties entered into negotiations regarding Mr Makdessi’s breach of fiduciary duty and agreed a Part 36 settlement offer of US$500,000. Proceedings continued in respect of Mr Makdessi’s breach of Clause 11.2. Before the court, Mr Makdessi submitted that Clause 11.2 amounted to an unreasonable restraint of trade and that the clauses containing the put option amounted to unenforceable penalty clauses.

DECISION

Mr Justice Burton held that the restraint of trade clause was not unreasonable. His decision took into account several factors, particularly the circumstances in which the clause was negotiated. The parties were experienced, of equal bargaining power and were acting in a commercial context. Burton J also cited the substantial goodwill in the Company, for which Cavendish had paid a large sum. As Mr Makdessi not only retained an interest in the Company, in acting as the non-executive director/chairman, he was also a very influential seller who would be a “formidable competitor”. Under the terms of the agreement, Mr Makdessi specifically agreed to terminate his contract with a competitor and, in breach of the agreement, did not. In the circumstances, it was held that any competition breach would be, and was, material.

Restraint

Specifically, regarding the practicalities of the restraint, the covenant could not have been said to have been uncertain, and therefore unreasonable, simply because its commencement date or duration was uncertain. As long as Mr Makdessi remained involved in the Company, he would owe fiduciary duties to it and, in the absence of the breach, the effect of the restraint under the covenant would be deferred. Burton J found, however, that such deferral did not result in the clause being unclear, or uncertain. In particular, the duration of the restraint, albeit for a minimum of eight and a half years, was tied to the relevant interest of Cavendish as minority shareholder. Notably in relation to restrictive covenants for restraint of trade, case law does not hold that restrictions that are found to be otherwise reasonable should be deemed unreasonable on the basis of duration alone.

The Put Option

The court held that the put option clauses were not penalty clauses. Burton J followed the ruling in Lordsvale Finance plc v Bank of Zambia [1996] QB 752, in which it was established that clauses that neither function to deter one party from breaking the contract (unlawful penalty clauses), nor to compensate the innocent party for breach (enforceable liquidated damages clauses) will not breach the rule against penalties where they are otherwise commercially justifiable. In particular, Burton J highlighted the importance of the put option clauses as a means of serving to adjust the consideration paid by Cavendish for the business. The inclusion of the clauses in the agreement was rendered a very real commercial justification, given the amount Cavendish had offered for the substantial goodwill in the business.

Notably, Burton J held that acceptance of the Part 36 settlement offer did serve to render clause 5.1 of the put option a penalty. This was because Cavendish’s loss had already been compensated by the consideration paid under the terms of the settlement. Any further compensation payable by Mr Makdessi under the put option would amount to “double counting”, with the effect that Cavendish would receive more than any conceivable loss of value in the shareholding and the adjustment to the consideration would be more than appropriate. Whilst the Court felt it would be inappropriate to strike out the clause in its entirety, Cavendish was invited to give credit for the money received under the terms of the Part 36 offer and, in return, to enforce the put option to its full extent. The settlement money would then be added to the price given for payment of the shares, on transfer.

COMMENT

This case highlights an increasing tendency of the courts to consider the commercial justification test when determining whether or not a clause amounts to a restrictive (and therefore, unenforceable) penalty clause. This may be of use to parties seeking to establish a more flexible and commercial approach to compensation for breach, and for whom other commercial grounds may provide an effective way of quantifying potential loss.