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Penalty clauses on a breach of contract

The recent Court of Appeal decision in El Makdessi v Cavendish Square Holdings BV [2013] and another serves as a helpful reminder as to the issues arising when inserting a forfeiture clause into a contract.

It is a well-established rule that penalty clauses in contracts are unenforceable. Dunlop Pneumatic Tyre Co Ltd v New Garage & Motor Co Ltd [1915] sets out the classic tests as to whether a particular provision is a penalty:

  • Is the effect of the provision punitive? Even a provision not using the word “penalty” could still be a penalty.
  • A provision that is intended to deter a breach, rather than compensate the innocent party in the case of a breach, is likely to be a penalty (more recently confirmed in Lordsvale Finance plc v Bank of Zambia [1996] and Cine Bes Filmcilik ve Yapimcilik v United International Pictures [2003]). Another particularly useful case is Jobson v Johnson [1998] which confirms that penalties do not have to be for money and in that case concerned the obligatory transfer of shares).
  • Liquidated damages are therefore not necessarily a penalty if the quantum of such damages is a genuine pre-estimate by the parties of the loss that the innocent party would suffer, bearing in mind the specific details of the matter in hand. A level of liquidated damages beyond that which “could be conceivably be proved to have followed from the breach” would be deemed extravagant and a penalty and therefore unenforceable.

However, recent cases such as Azimut-Benetti Spa (Benetti Division) v Healey [2010] and El Makdessi suggest that a fourth principle has been established:

  • Even if a provision is not a genuine pre-estimate of loss or if it is at risk of being seen as unreasonable or extravagant, it may not be a penalty if it can be shown to be “commercially justifiable”.

The facts of the El Makdessi case will be familiar to those who are regularly involved in corporate transactions: the El Makdessi agreement provided for the forfeiture of Mr Makdessi’s right to a deferred payment (the “Forfeiture Clause”) and for a forced transfer of his minority shareholding in the target company at an undervalue (the “Compulsory Transfer Clause”) if Mr Makdessi breached his restrictive covenants. When Mr Makdessi breached his restrictive covenants and Cavendish Holdings tried to enforce the relevant provisions, he argued that they were penal and therefore unenforceable.

The Court of Appeal determined that the relevant provisions were not a reasonable pre-estimate of Cavendish Holdings’ loss and that they were extravagant and unreasonable. The court also noted that they lacked commercial justification because the sum Mr Makdessi stood to lose on the occurrence of his breach was disproportionately high compared to Cavendish Holdings’ loss arising out of such breach and were a deterrent rather than compensation, and therefore an unenforceable penalty. The determination that the arrangement was not commercially justifiable was largely based on the fact there were a very wide range of possible outcomes on the occurrence of a breach by Mr Makdessi and that the level of damages was fixed regardless of how immaterial or minor Mr Makdessi’s breach could have been.

Interestingly, in the previous instance, the High Court’s opinion was that either the Forfeiture Clause or the Compulsory Transfer Clause alone would have been a commercially justifiable reflection of the possible loss of goodwill arising from Mr Makdessi’s breach but, taken together, brought the contract’s forfeiture provisions within the territory of being a deterrent to breach rather than mere damages.

The El Makdessi case and the court’s references to provisions for breach being “commercially justifiable” reminds us that each contract should to be considered on a case by case basis. Whilst it does not provide much certainty as to what is “commercially justifiable” actually means, it does suggest that the most important test is in fact whether the provision in question is intended to be a deterrent rather than a compensatory mechanism.

The three key points to take away from the El Makdessi case are that:

  • In the same way as non-compete/non-solicit restrictions must be tailored in a contract to ensure enforceability, the contractual repercussions of any breach should be measured and commercially justifiable; otherwise, they may be struck out in their entirety and the non-breaching party will (subject to the remaining terms of the contract) be left with only the possibility of making a general damages claim.  
  • In order to assist with the rebuttal of any future challenges as to enforceability, one should retain records of negotiations leading up to the agreement of the forfeiture clause.  
  • As acknowledged by Clarke LJ in the El Makdessi case, it may be possible to draft a contract so that, instead of there being a forfeiture event, there is a contractual upside (for example a further payment) if certain conditions are fulfilled. Whilst the mechanism is quite different the effect could be quite similar.

For further information, please contact James Wilkinson - Corporate associate