Penalty points

It is a well-established legal principle that a clause in a contract whose main purpose is to deter a party from breaching that contract is what is known as a penalty clause, and is unenforceable. However, if a clause sets out a mechanism for determining and paying to an aggrieved party under a contract a sum which represents a genuine pre-estimate of loss suffered as a result of that breach, the courts may hold it to be enforceable.

There is also a line of decisions which set out that even if a clause does not provide for what is akin to such a reasonable assessment, if there is a commercial justification for that clause (it is not simply included to force compliance with the contract), it will be enforceable.

Makedessi v Cavendish Square

Makdessi v Cavendish Square Holdings BV [2013] EWCA Civ 1539 is a decision of the English Court of Appeal, but is also persuasive in Scotland, and many business transactions are cross-border. While it does not set out new law, it tightens the existing law and serves as a reminder to all corporate and commercial solicitors to take great care when drafting contractual provisions which could potentially be construed as penalty clauses.

Cavendish agreed to buy from Makdessi and his co-owner 60% of the shares they held in Team Y&R Holdings Hong Kong Ltd (the “target”). The share purchase agreement regulating the transaction set out that (1) the consideration (a significant portion of which related to the target’s goodwill) would be paid in three instalments: one at completion, and two further instalments (the value of which was based on the target’s goodwill); and (2) if the sellers breached restrictive covenants in the agreement, (a) they would not be entitled to receive any further tranches of consideration due under the agreement; and (b) the buyer would have a call option over the seller’s remaining shares at net asset value.

Makdessi continued in the role of non-executive director in the target after the sale, but was removed by the board as Cavendish felt he had breached his fiduciary duties as a director and the restrictive covenants in the share purchase agreement. The breach of duty claim was ultimately settled, but Cavendish sough to exercise the call option and withhold the two instalments of the price for the shares which remained due.

The Court of Appeal held that withholding the instalments did not amount to a genuine pre-estimate of loss. The real “loss” was in the value of the target and to the target itself, not the shareholders. In addition, the way the clause was framed meant that the severity of the breach was immaterial – the non-payment of future instalments could equally have been activated by a very minor breach as a major one.

The key point to take from the judgment is this: the Court of Appeal stated that had the clause been drafted as a condition to securing the further payments, rather than a penalty for non-compliance, it would have been enforceable – even if in reality the effect had been the same. The crucial drafting error was that the remedy was triggered by a breach of contract.

Regarding the call option, it is fairly typical to see in shareholder agreements and articles of association, provisions under which “bad leavers”, i.e. shareholders who have had their employment terminated for cause etc, have to transfer their shares at net asset value, rather than fair market value. In Makdessi the requirement to transfer at net asset value again amounted to a penalty clause, as the catalyst was a breach of contract. The exercise of the call option would have meant Cavendish received the benefit when it had not actually suffered loss – again it was the target which had, so the inclusion of the call option was not a pre-estimate of loss which Cavendish would suffer due to a breach of the competition provisions. The Court of Appeal was also not persuaded that the clauses were commercially justifiable, despite Cavendish’s assertions that (1) non-adherence to the restrictive covenants had affected the value of the target; and (2) they allowed for the speedy removal of a shareholder damaging the business.

Drafting lessons

The main message from the decision is that solicitors have to be very careful when drafting call options and deferred payment clauses to make sure that they are not triggered by breaches of contract. If conditions have to be met for further payments or obligations under a contract to become “live”, that is one thing, but if they are activated by a breach of contract, that is quite another – even if the ultimate result is the same.