The court's decision
In summary, the Supreme Court held that when considering whether a contractual clause is a penalty:
- “The true test is 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. The innocent party can have no proper interest in simply punishing the defaulter. His interest is in performance or in some appropriate alternative to performance.”
- The traditional approach found in the decision in Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd, which distinguishes between a genuine pre-estimate of loss and a penalty, is likely to be adequate to determine the validity of a simple payment of damages clause; the innocent party’s proper interest will rarely extend beyond monetary compensation for the breach.
Primary or secondary obligation
The Supreme Court acknowledged that the application of the penalty rule may depend on how the relevant obligation is framed, although it also said that this will not be conclusive. It should be possible in drafting complex commercial agreements to make it clear what is a primary obligation, which should not engage the penalty rule (Makdessi-type clauses for example), and what is a secondary obligation. Where the sanction is a secondary obligation, the following considerations are important:
- What is the background to, and commercial justification for, the deal?
- What is the overall effect of the breach on the deal, or even other aspects of the innocent party’s overall commercial operation?
- Is the sanction way beyond a “norm” and therefore potentially “unconscionable” or “extravagant”?
Legitimate commercial reason
Whether there is a “legitimate commercial reason” for the clause may become the new battleground in challenges to the validity of clauses imposing sanctions for breach of contract. Theoretically, it would be possible to address this up front in recitals, or in drafting the secondary obligations themselves, with an acknowledgment by the counterparty that there is a legitimate commercial reason for the level of sanction.
However, raising it could complicate negotiations. The counterparty might be inclined to say that the first party must be prepared to stand or fall on the ground he has chosen to occupy and to defend it, should the occasion arise. It may be preferable to ask contracting parties to take a hard-headed view of what is commercially legitimate and defensible, whilst warning them that certain clauses may subsequently be challenged.
I have given below some examples of the types of clauses which have traditionally been danger areas. In each case, those acting for the party which will benefit from the damages/sanctions clause should structure the clause as a primary obligation. If that can’t be done, they should consider the questions set out above, and specifically:
- The commercial background to the clause: who negotiated it and why is it there?
- How was the price adjustment/damages clause quantified?
- Should an acknowledgment that there is a “legitimate commercial interest” for the clause be included in the drafting (if only in the recitals), with an explanation of the background to that interest? The interest could be a business risk relating to matters other than those addressed in the specific transaction.
An M&A deal may contain clauses restricting deferred consideration or an earn-out payable to the sellers (which may have been of concern under the old penalty rule). Such clauses are less likely, post-Makdessi, to cause any issues; they should be structured as primary obligations/price adjustment clauses. Examples are those that provide for:
- The payment of the earn-out monies to be restricted or withheld if the seller is in breach of contract. In the Makdessi scenario, the reduced payment was tied to breach of restrictive covenants; it had nothing to do with punishment and everything to do with achieving Cavendish’s commercial objectives, the Supreme Court said, noting that a “Seller in breach of the restrictive covenants may be actively engaged in undermining the goodwill attributable to his former role in the business”. If, for some reason, the clause constitutes a secondary obligation, it will be worth considering whether it represents a genuine pre-estimate of loss. If it does, it won’t be a penalty. If not, it may be necessary to consider whether it is “unconscionable” or serves the wider commercial interests of the innocent party.
- The seller to stay on in the business as an employee, and where payment is to be withheld if the seller is no longer an employee, either due to resignation or as a result of summary dismissal for gross misconduct, or in circumstances allowing for summary dismissal without pay in lieu of notice (such clauses will usually have a carve out for “good leavers”, such as by reason of death, illness, disability, or retirement at normal retirement age).
- Exit provisions in joint venture agreements or shareholder agreements, where the non-defaulting party has the ability to acquire the shares of the party in default at a reduced price, are close to the Makdessi clause 5.6 scenario, and therefore likely to be a primary obligation, with the result that the penalty rule should not be engaged (Makdessi provided for the acquisition of his remaining shares at a discounted price).
Liquidated damages clauses (LADs) are common in construction contracts. They provide for payments to be made to the employer where there has been contractor delay. In substance, they are secondary obligations and so subject to the rule against penalties as now formulated.
Makdessi confirms the enforceability of LADs. Employers will usually have a legitimate commercial interest in imposing them. Makdessi will make challenges to LADs difficult: the parties to complex construction contracts will normally have freely negotiated them and be of comparable negotiating power, and therefore in the best position to determine what is a legitimate sanction payment. In the construction context, it may not be possible to point to an accepted industry norm for the level of damages under LADs, so demonstrating that the level is “unconscionable” or “extravagant” will depend on an analysis of the particular contract and its commercial background.
Although the Supreme Court has held that it is not essential for an LAD to reflect a genuine pre-estimate of loss, it continues to be advisable to base delay damages clauses in construction situations on a realistic estimate of the loss the employer stands to incur if completion is delayed. On the other hand, there is now less reason to be concerned that the LADs provisions could be struck down on account of a theoretical possibility that they could materially over-compensate the employer. The decision therefore makes it somewhat easier to draft effective LADs to cover complex phasing and handover situations, without having to legislate scrupulously for every permutation.
For the reasons given above, it may not be sensible to embark on a discussion about legitimate commercial interests in the course of drafting negotiations, but contracting parties should be encouraged to think about what they would say about this if the clause is challenged.
Although in Makdessi the Supreme Court was concerned with the particular facts of a corporate transaction, their Lordships took the opportunity to make certain obiter comments as to how the penalty rule might apply to different types of commercial arrangements between businesses. Most helpfully:
“Modern contracts contain a very great variety of contingent obligations. Many of them are contingent on the way that the parties choose to perform the contracts. There are […] provisions for variable payments dependent on the standard or speed of performance and “take or pay” provisions in long-term oil and gas purchase contracts, to take only some of the more familiar types of clause. The potential assimilation of all of these to clauses imposing penal remedies for breach of contract would represent the expansion of the courts’ supervisory jurisdiction in to a new territory of uncertain boundaries, which has hitherto been treated as wholly governed by mutual agreement.”
This should give some comfort that certain types of arrangement fall outside of the rule altogether.
In a typical outsourcing agreement, the supplier will be obliged to comply with a set of service levels, with service credits for the customer accruing when service falls short of the agreed levels. Drafters obviously need to be mindful of the law of penalties. The related commercial issue is whether the amount of service credits that may apply in any given breach scenario are sufficient to reimburse the customer for its losses and, if not, whether it has the right also to seek damages. The outcome often falls somewhere between:
- Treating the credit as a price adjustment so that the customer merely pays charges commensurate with the actual level of service received.
- Treating the service credit as liquidated damages and the sole financial remedy available to the customer (though the customer may also have the right to terminate for serious breaches).
Following negotiation, parties often end up with a compromise position. For example, the customer must choose whether to seek damages or accept the credit. Alternatively, the service credit applies for breaches to a certain threshold level of seriousness, but if the standard falls below that threshold then damages may be sought.
The provision of a service to the specified service level must surely be considered the primary obligation. Makdessi strengthens the argument for ensuring that service credits are clearly framed as a price adjustment (particularly in light of the comments made by the court on contracts specifying variable payment referred to above). As to how a (non-penal) price adjustment relates to the concept of liquidated damages, on the facts of Makdessi, Lords Neuberger and Sumption commented as follows:
“[clause 5.1] is plainly not a liquidated damages clause. It is not concerned with regulating the measure of compensation for breach of the restrictive covenants. It is not a contractual alternative to damages at law. Indeed in principle a claim for common law damages remains open in addition, if any could be proved.”
Long-term supply agreements
Commercial agreements can generally be distinguished from the arrangement between Mr El Makdessi and Cavendish, in that they tend to embody ongoing (often long-term) arrangements, and require terms which are capable of weathering the storm of changing circumstance. For example, a supplier of goods under a long-term supply agreement may have an interest in ensuring that the customer commits to a certain minimum level of purchase. As was the case prior to Makdessi, it is open to contracting parties not to characterise this commitment as an obligation, so that the need to pay for any shortfall is not triggered by a breach or, in the language of Makdessi, the obligation to pay for the shortfall is not a secondary one.
That said, in respect of a fully negotiated contract, for which both parties had legal representation, and in which the supplier has a credible legitimate interest in securing the customer’s commitment, Makdessi provides comfort that the court is less likely to interfere with the bargain that has been struck. See also the comments on “take or pay” clauses in the oil and gas industry as referred to above.
A further category of commercial agreement identified by the Supreme Court as being relevant to a discussion on the law of penalties, is one which requires a purchaser to pay “an extravagant non-refundable deposit”. For example, this could be the case where a customer contracts for services which are due to be performed at a specific time, such as the hire of a venue, and for which the customer must pay a proportion of the purchase price in advance of performance (to be lost in whole or in part on cancellation).
In Makdessi, Lord Hodge considered whether deposit provisions should be analysed under the law on forfeiture or the penalty rule, concluding that non-refundable deposits could potentially be challenged under the penalty rule. A supplier in this situation could be advised to ensure that the amount of deposit lost bears some relation to the costs that the supplier has incurred in preparing to perform the service, and that it can defend its legitimate interest in that context.
This article was originally posted on practiallaw.com