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Commercial Justification for Penalty Clauses: The Death of the Old Dichotomy?

Document Cited authorities 12 Cited in Related
Vincent
AuthorLorna Richardson
Date01 January 2015
Pages119-124
Published date01 January 2015
DOI10.3366/elr.2015.0255

In Talal El Makdessi v Cavendish Square Holdings BV and Team Y&R Holdings Hong Kong Ltd 1

[2013] EWCA Civ 1539 (henceforth “Makdessi”).

the Court of Appeal provided a useful review of the propositions relating to penalty clauses set out in Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Company Ltd 2

[1915] AC 79 (henceforth “Dunlop”).

 as they have been applied in later cases.3

See the discussion of Dunlop in Makdessi at paras 55–65.

 Perhaps more significantly, the court provided guidelines for considering whether a liquidated damages provision which can be triggered by a number of breaches of differing obligations is penal. Furthermore, the court suggested a shift from the classic test of deciding whether the clause is a genuine pre-estimate of loss or a penalty to a broader approach of considering whether there is a commercial justification for the clause or whether its dominant purpose is deterrence THE FACTS

Mr Makdessi was one of two shareholders who sold part of his shareholding in an advertising and communications group to Cavendish. The price for the shares was to be paid in instalments which included an interim payment and a final payment, both of which were to be paid some time after completion. The agreement between the parties contained a number of restrictive covenants which prohibited Mr Makdessi from undertaking certain activities for a certain period of time.4

He was prohibited from (i) carrying on or being engaged in competition with the group by being involved in the provision of goods or services of a competitive nature to the products and/or services provided by the group within a certain geographic area; (ii) soliciting or knowingly accepting orders or business in relation to the activities in (i) from any client or potential client of the group; (iii) diverting away from the group any orders or business in respect of the activities in (i); and (iv) employing or soliciting or attempting to employ or solicit away from the group any senior employee or consultant (see para 11). The restrictive covenants were held not to be an unreasonable restraint of trade by Burton J at first instance and that finding was not appealed.

The agreement provided two consequences of a breach of any of the restrictive covenants: Mr Makdessi would forfeit the interim and/or final payment due to him in terms of the agreement (clause 5.1);5

Depending on the timing of the breach, both payments might not have been paid and both would be forfeited.

 and Cavendish would have an option to purchase Mr Makdessi's remaining shares in the group at net asset value, which did not take account of the significant goodwill value in the group (clause 5.6). Around two years after the agreement was entered into, Cavendish discovered that Mr Makdessi had breached the restrictive covenants. The issue before the Court of Appeal was whether clauses 5.1 and 5.6 were penalty clauses LAW OF PENALTIES APPLIED

The decision of the court was given by Clarke LJ who noted that the paradigm case in which the law of penalties is engaged is where a party agrees that, on a breach of contract, it will pay the other party a sum of money. However, the law of penalties has been held to be applicable to a clause which (i) disentitles the contract breaker from receiving a sum that would otherwise be due to him;6

But see Agri Energy v Ian Logan McCallion [2014] CSOH 13, although the focus of Lord Woolman's decision appears to be on whether the pursuer could recoup sums already paid over (analysed as a deposit to which the law of penalties does not apply) rather than forfeiture of future sums due under the contract.

or (ii) requires a transfer of property from the guilty to the innocent party for nothing or at an undervalue.7

Para 46. See the comments on this aspect of the decision in E Peel, “Unjustified penalties or an unjustified rule against penalties?” (2014) 130 LQR 365 at 366.

 As such, the law of penalties applied to this case. The case is currently on appeal to the Supreme Court and perhaps this aspect of the case will be a feature of the appeal GUIDELINES FOR CONTRACTUAL PROVISIONS THAT CAN BE TRIGGERED BY A NUMBER OF BREACHES

The court recognised...

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