It is common for contractual exit provisions to be triggered by a breach of contract committed by one of the parties, and to provide for the innocent party to obtain a benefit in the form of a call option at a discounted price or a put option with a premium.  In the recent case of Makdessi v Cavendish Square Holdings BV [2013] EWCA Civ 1539, the Court of Appeal examined an exit provision which gave an innocent party a right to call shares at net asset value (which was much lower than fair market value) if the other party breached a non-compete clause and found that it was an unenforceable penalty.  Although the judgment does not create new law, it may represent a stricter approach to applying existing law: it is a stark warning that exit provisions and call options may be unenforceable penalty clauses if they are not based on fair market value.

Traditionally, and following the leading case of Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd [1915] AC 79, the courts had a two-way choice: either a clause was an unenforceable penalty if it was extravagant and unconscionable in relation to the amount of the loss, and the dominant purpose of such a clause was to deter a party from breaching its contractual obligations; or, if it was a genuine pre-estimate of the loss suffered as a result of a breach, it was an enforceable liquidated damages clause.

However, following Lordsvale Finance v Bank of Zambia [1996] QB 752, the courts began to adopt a more forgiving test.  Under this new line of authority, if a clause did not represent a genuine pre-estimate of the loss suffered, it would not necessarily be held to be a penalty if there was a commercial justification for it and the predominant purpose of the clause was not to act as a deterrent against breach. In Bank of Zambia, for example, the Court held that a 1% increase in the interest rate payable on a loan during the period in which the borrower was in default was not a penalty because it was commercially justifiable.  As a result, the courts increasingly tended to uphold clauses as commercially justifiable, rather than finding them to be unenforceable penalties.  In practice, this meant that there was less risk involved in drafting contractual provisions that could have been regarded as penalising a breach of contract.  Following Makdessi, this can no longer be said to be the case.


Mr Makdessi had substantial interests in the advertising and marketing business in the Middle East. Cavendish, a company in the WPP group, agreed to buy from Mr Makdessi and his co-owner 60% of their shares in the Target, Team Y&R Holdings Hong Kong Ltd. Cavendish agreed to pay the consideration in three tranches, one at completion and two further tranches following completion.

The SPA provided that, if the Sellers breached a non-compete clause in the agreement:

  • the Sellers would not be entitled to receive any further tranches of the purchase price; and
  • Cavendish would have a call option over the Sellers' remaining shares at net asset value (which would be much lower than fair market value as it would not include amounts attributable to goodwill).

Mr Makdessi ceased to be an employee of the Target but continued as non-executive chairman until April 2009. He continued to be a non-executive director of the company until 27 April 2011 when he was removed from the board because, in December 2010, he was found by Cavendish to have breached his duties as a director of Target and to have breached the non-compete clause contained in the SPA.

The Target brought a breach of fiduciary duty claim against Mr Makdessi, which was settled for $500,000. Cavendish sought a declaration that Cavendish was entitled to exercise the call option and that Mr Makdessi should be denied further instalments of consideration.

Future Instalments: It Depends on the Drafting

The Court of Appeal found that the provision requiring Mr Makdessi to forfeit outstanding instalments of the price could not be a reasonable pre-estimate of loss. The loss was a diminution in value of the Target and so the proper claimant was the Target.  Because of the operation of the reflective loss principle, the loss recoverable by the shareholders was zero. Furthermore, Mr Makdessi would have forfeited the same amount regardless of whether the breach of the non-compete clause was very minor (such as unsuccessfully soliciting one employee to leave) or very major (setting up a competing business in multiple jurisdictions and soliciting away major clients). Indeed, because the future instalments were based on a valuation of the Target's goodwill, the more severe the breach, the smaller the instalments forfeited by Mr Makdessi (in effect, the compensation received by Cavendish) were likely to become.  If the intention had been to compensate Cavendish for the loss it had suffered, the opposite effect would have been expected.

The Court of Appeal acknowledged that, if the clause had been drafted as a condition precedent to payment, it would have been enforceable.  This was despite the fact that the commercial effect of the clause was the same, whichever way it was drafted: the difference was whether or not the clause operated upon a breach of contract.  If not, it could not be a penalty.

Call Option

The Court of Appeal held that the call option was also an unenforceable penalty as the Sellers were being required to transfer shares at an undervalue, and this was triggered by a breach of contract. The Court of Appeal applied the same reasoning as set out above: the call option, if upheld, would result in Cavendish receiving a benefit that could not be a genuine pre-estimate of the losses that it had suffered (which, at law, were zero).

No Commercial Justification 

In accordance with Bank of Zambia and subsequent authority, the provisions could have been saved if there was a commercial justification for them. Cavendish argued that it was justifiable for the price to be reduced if Mr Makdessi was not prepared to observe the covenants that he had entered into (which would negatively affect the value of the Target's business).  Cavendish also argued that the call option was commercially justifiable, because it enabled an innocent shareholder to swiftly remove a defaulting shareholder who was damaging the Target's business, and that net asset value could be quickly and easily calculated.

The Court rejected this argument.  The Court appears to have been heavily influenced by the fact that the amount that Mr Makdessi stood to forfeit, in tens of millions of dollars, was out of all proportion to the claimants' recoverable loss of zero, indicating that the predominant function of these provisions was to deter a breach.  In addition, the fact that the call option effected a decoupling of the defaulting shareholder was not, in the Court's view, enough to provide commercial justification for the clause. The question of whether the clause was commercially justifiable was to be determined by the terms of the decoupling, which in this case would mean that the Sellers would be transferring millions of dollars of value to Cavendish. In such circumstances, the clause could only ever be a penalty. 

No Alternative Valuation

This left the question of whether Cavendish retained the right to call the shares at a different price.  The Court of Appeal took a strict approach, refusing to re-write the parties' agreement so that the call option would be exercisable at fair market value, as this was not provided for in the SPA (and nor was there any mechanism for determining fair market value).  Accordingly, Cavendish had no right to call the shares.


The Court of Appeal's decision makes clear that - despite the commercial justification line of authority - the courts are prepared to strike down exit provisions where they constitute penalty clauses.  Despite having been in breach of the non-compete clause, Mr Makdessi was entitled to the whole of the purchase price, and Cavendish, the innocent party, had no right to call Mr Makdessi's shares, at any price.  The sole remedy was the settlement sum of $500,000 that the Target had received in respect of the breach of fiduciary duty claim.  This may appear to be a harsh result for Cavendish; however, on the extreme facts of this case, where the amount in dispute amounted to tens of millions of dollars but no loss was legally recoverable at all, there was little scope for the Court of Appeal to find that the provisions were not predominantly intended to deter a breach of contract.  Had there not been such a wide gulf, the Court of Appeal may have been more willing to uphold the provisions on the basis that they were commercially justifiable. Care should therefore be taken with the drafting of any exit provisions that are triggered by breach, particularly if they provide for transfer of shares or other property at anything other than fair market value.

The case is also a good reminder to consider carefully the structure of deferred consideration provisions to ensure that they do not constitute unenforceable penalties.  Where such payments are to be conditional on compliance with certain obligations, those obligations should be structured as conditions precedent to the payment becoming due.  Such provisions should not be structured as providing an entitlement to payment of deferred consideration which is forfeited upon breach of specified obligations.  The former is likely to fall outside the scope of the law of penalties, while the latter is may constitute a penalty (because it is a forfeiture of rights triggered by breach of contract).