Financial & Legal News

INSIGHT: So called ‘penalty’ clauses in commercial contracts

  • Posted on

In the recent case of Cavendish Square Holding BV v El Makdessi, the Supreme Court reset and clarified the rule on penalties, unanimously allowing the appeal from the Court of Appeal.

Background

Mr Makdessi founded a group of companies (the “Group”) that became the largest advertising and marketing communications group in the Middle East. Mr Makdessi and his business partner Mr Ghossoub (together, the “Sellers” and individually a “Seller”) were the majority shareholders in the Group’s holding company. In 2008, the Sellers entered into a share purchase agreement (the “SPA”) pursuant to which they sold a significant proportion of their shares to Cavendish. The payment terms in the SPA provided for staged payments. The SPA provided that, following completion, two further payments could be made to the Sellers: an "Interim Payment" and a "Final Payment". Both payments were linked to the Group’s operating profit. Clause 11.2 of the SPA prohibited Mr Makdessi from carrying out certain activities which had the potential to compete with the Group’s interests. Clauses 5.1 and 5.6 provided respectively that, if a Seller breached clause 11.2:

  • he would not be entitled to the Interim and Final Payments; and
  • he could be forced to sell to Cavendish his remaining shares in the Group at a default price, based solely on asset value and without reference to goodwill.

Mr Makdessi admitted that he had breached clause 11.2, but argued that clauses 5.1 and 5.6 were unenforceable on the basis that they amounted to penalties. Cavendish's claim was for declarations that clauses 5.1 and 5.6 were valid and enforceable.

The Court’s decision and reasoning

Cavendish was successful at first instance, but that decision was overturned by the Court of Appeal in favour of Mr Makdessi. On 4 November 2015 the Supreme Court overturned the Court of Appeal’s decision.

The Supreme Court decided that the rule against penalties was not engaged by the above-mentioned clauses in the SPA. This was because they concerned primary obligations. One clause provided that, if Mr Makdessi (the seller) breached certain restrictive covenants, the buyer did not have to pay any future instalments of the price. In the Court’s view, that clause was a price adjustment clause. As such, Mr Makdessi was under a primary obligation to observe the covenants in order to receive payment. Furthermore, the buyer had a legitimate interest in the observance of the restrictive covenants, as the goodwill of the business was critical to its value to Cavendish.

The other relevant clause in the contract stated that Mr Makdessi could be required to sell his remaining shares to the buyer at a price excluding the goodwill of the business. The clause reflected the reduced consideration which Cavendish would have been prepared to pay on the assumption that it could not count on the loyalty of Mr Makdessi. Furthermore, Cavendish had a legitimate interest in matching the price of the retained shares to the value that Mr Makdessi was contributing to the business.

Effect of the judgment

The judgment provides helpful guidance as to how the penalty rule should be applied to modern commercial contracts. In effect, it restores the ability of parties to make their own bargains, and confirms the Court's role in enforcing those bargains. Businesses and their lawyers will, naturally, want to understand what amounts to "legitimate interest" in order to be able to justify a particular charge or sanction in the relevant commercial contract. In short, expert legal advice is needed when negotiating clauses which impose a sanction for breach.

Should you have, or need any assistance in connection with drafting, enforcement or defence of provisions in an SPA or Asset Purchase Agreement similar to those outlined above, or require any assistance in connection with transactions generally, please contact Keith Kennedy (partner in the Corporate and Commercial Department) at keith.kennedy@pearsonlegal.co.uk or by telephoning 0161 684 6942. 

Also in this issue of Insight

Please note that the information and opinions contained in this article are not intended to be comprehensive, nor to provide legal advice. No responsibility for its accuracy or correctness is assumed by Pearson Solicitors and Financial Advisers Ltd or any of its members or employees. Professional legal advice should be obtained before taking, or refraining from taking, any action as a result of this article.

This blog was posted some time ago and its contents may now be out of date. For the latest legal position relating to these issues, get in touch with the author - or make an enquiry now.

Written by Keith Kennedy

Author

    How can we help?

    Please fill in the form and we’ll get back to you as soon as we can.