Talal El Makdessi v Cavendish Square Holdings BV dealt with restrictive covenants in the context of a share sale. The UK Court of Appeal ruling indicates that contractual deterrents should not be used without careful consideration of their construction and potential legal implications.

A recent UK Court of Appeal decision clarifies that certain types of contractual provisions may be classified as penalty clauses. In considering whether the traditional prohibition on penalty clauses would apply in Talal El Makdessi v Cavendish Square Holdings BV [2013] EWCA Civ 1539, the Court took into account circumstances beyond those in which sums not reasonably linked to damage suffered are payable upon a breach. The Makdessi case considered the loss of a right to deferred consideration for assets already contractually sold, and obligations to transfer assets at an undervalue.

This case provides an important reminder that contractual deterrents should not be used without serious consideration of their construction and potential legal implications.

Facts

The Makdessi case dealt with restrictive covenants in the context of a share sale. The seller sold 47.4 per cent of the company’s shares to the buyer and retained 40 per cent of the shares in issue. The agreement expressly stated that goodwill was a key factor in determining the price, and included non-compete restrictions on the seller intended to protect such goodwill. In the event that these restrictions were breached, the seller would become a “defaulting shareholder” and would face the following consequences:

• Forfeiture of two deferred consideration payments from the sale of the shares

• Forfeiture of a put option to sell its remaining shares to the buyer at a price determined by reference to goodwill

• Obligation to sell its remaining shares, by virtue of a call option, at a price determined by net asset value without addition of the value of goodwill, where the difference between a goodwill valuation and a net asset value valuation was likely to be sizeable

The seller admitted to failing in certain director duties and to carrying out activities in competition with the company, including soliciting clients and diverting business away from the company. Because this behaviour breached the non-compete restrictions, the company sought to exercise the “defaulting shareholder” provisions.

Judgment

The Court of Appeal found the defaulting shareholder provisions to be penalties and held that forfeiture of the entire deferred consideration upon default (which could occur by even the most minor or short-lived of breaches) was “extravagant and unreasonable”. Moreover, the Court held that withholding the deferred consideration was a disproportionate remedy to a potential breach, because a wide range of losses, both significant and trivial, could have resulted from a breach of the restrictive covenants.

The Court of Appeal also held that any breach of the restrictive covenants would result directly in a loss to the company; any loss in the value of the buyer’s shareholding would be reflective of the company’s loss. Furthermore, to force the seller to forfeit the put option and lose access to a goodwill valuation was disproportionate. The Court found that the defaulting shareholder provisions’ primary purpose was to deter the seller from breaching the restrictive covenants, and that therefore they were not commercially justifiable.

Penalty Clauses

Over the years, case law has offered the following guidance as to what scenarios might characterise a penalty clause:

• The sum is to be paid on breach of contract and not as a primary obligation under the contract.

• At the time the contract was entered into, the predominant purpose of the relevant clause was to deter a party from breach or to compensate an innocent party for a breach.

• The stipulated sum is extravagant, unreasonable and not a genuine pre-estimate of loss, to be assessed with reference to the greatest loss that could possibly follow from the breach.

• The stipulated sum cannot be commercially justified.

Each of these items is rebuttable, and each case should be considered in the specific context in which the contract was agreed. The onus is on a party to prove that the clause is a penalty clause, bearing in mind that any pre-estimate of loss is not required to be accurate in order to be found reasonable. The courts appear to be primarily interested in striking down penalty clauses which are oppressive and cannot be commercially justified.

Comments

The courts have been reluctant to interfere in commercial bargains, but Makdessi indicates that even withholding monies or calling for a party to transfer property at an undervalue potentially falls into penalty clause territory. Parties should give proper consideration to, and seek legal advice in connection with, the rationale behind certain contractual clauses.

Maintaining board minutes; evidence of negotiations; and any damage quantification analysis, such as accounts or external advice reports, that detail the rationale for such contractual clauses is a matter of good housekeeping. Furthermore, the Makdessi judgment suggests that, had the provision in relation to the deferred consideration payments been drafted such that payment was conditional on compliance, the doctrine of penalties might not have applied at all.

Kavita Mehta, a trainee solicitor in the London office, contributed to this article