Traditionally, the courts have regarded provisions that require one of the parties to a contract to pay or forfeit a sum of money on breach, which exceeds the loss that the other can reasonably be expected to incur as a result of such breach, as unenforceable penalties. By contrast, provisions for the payment of liquidated damages, representing a genuine pre-estimate of the loss that the innocent party expects to incur as a result of a breach, are accepted as valid and enforceable. Historically, therefore, the courts have distinguished between deterrent and compensatory clauses. However, after reviewing the law, the Supreme Court has provided us with a wider test.
Cavendish Square Holding BV v Talal El Makdessi [2015] UKSC 67; [2015] PLSCS 309 concerned a businessman who agreed to sell a controlling stake in the largest advertising and marketing communications group in the Middle East. The contract stated that the seller would not be entitled to receive the final two instalments of the price if he broke restrictive covenants against competing activities. Furthermore, he could be required to sell his remaining shares at a price that excluded the value of the goodwill of the business. The seller argued that the provisions were unenforceable penalty clauses under the rule against penalties – but the Supreme Court upheld the provisions.
The court noted that the rule does not affect parties’ primary obligations; it controls remedies for breach of contract. On analysis, the clauses in dispute were primary – as opposed to secondary – obligations. They were price adjustment clauses, reflecting the reduced price that the buyer was prepared to pay for the business if it was unable to rely on the businessman’s loyalty (which was vitally important because of the market in which they were operating). The provisions had a function that had nothing to do with punishment. They were not a contractual alternative to damages and the buyer would also have been entitled to recover damages for breach of contract, if any could be proved.
It seems that the provisions would also have passed muster for the purposes of the rule against penalties. It was clear that the buyer believed that the business was worth considerably less if the seller did not comply with the restrictive covenants than if he did – and the court considered that the buyer had a legitimate interest in protecting its investment. Furthermore, viewed in the context of a carefully negotiated agreement between informed and legally advised parties at arm’s length, the court did not consider that the provisions should be regarded as excessive, exorbitant or unconscionable.
Allyson Colby is a property law consultant
