Tue 29 Dec 2015

Penalty clauses - New approach by Supreme Court

It is common for parties to agree that specified sums be paid upon breach of a contractual provision.  Traditionally where that sum is found to be a genuine pre-estimate of damages it will be enforceable, but where it is not a genuine pre-estimate it will be considered a penalty and unenforceable.

The facts in Cavendish related to the sale by Mr Makdessi of his advertising and marketing group to Cavendish, making Cavendish the majority shareholders in the holding company of the group.  The Share Purchase Agreement ("SPA") contained stage payment provisions.  The SPA also prohibited Mr Makdessi from carrying out certain activities which had the potential to compete with the interests of the group.  If he breached this prohibition then clauses 5.1 and 5.6 of the SPA provided that he would not be entitled to the two final staged payments and he could be required to sell Cavendish the remainder of his shares at a default price. 

Mr Makdessi breached the prohibition but argued that 5.1 and 5.6 were unenforceable penalty clauses.  Cavendish was successful at first instance, but that decision was overturned by the Court of Appeal.  Thereafter, the Supreme Court upheld the validity of both clauses 5.1 and 5.6. 

The Court's judgement abandons the old distinction between penalties and genuine pre-estimates of loss. It held that clauses of this type can be considered enforceable even if they bear no relation to the company's loss. Such clauses will not be held to be penalties if the company has a legitimate interest to protect. In this case, the legitimate interest it was protecting was the goodwill in the business. The goodwill was critical to Cavendish and the loyalty of the defender was critical to the goodwill. As far as the court was concerned these clauses were a perfectly legitimate way of conducting commercial business regardless of the fact that they were by no means a genuine pre-estimate of the pursuer's loss.

Where you are dealing with two parties who are on an unequal footing, such as is often the case in an employer/employee relationship, clauses of this type may be more difficult to enforce but that possibility cannot be ruled out in light of this decision particularly where the contract in question is with a senior executive who knows what he is signing and whose departure is costly to the business either for reasons of goodwill or because he is demonstrably taking business/contracts with him.

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