Avoiding penalty clauses: new guidance from the Court of Appeal

This article was produced by Olswang LLP, which joined with CMS on 1 May 2017.

A solution to dealing with a potential breach of contract in commercial contracts is to include a liquidated damages clause, for example service credits. Similarly, in corporate deals, other mechanisms, such as put and call options and compulsory buy-back provisions, can be used to achieve redress without having to resort to litigation. However such provisions run the risk of being held void as penalties. We look at the latest guidance given by the Court of Appeal and highlight some practical drafting tips.

What's new?

Last year we reported on the decision in Cavendish Square Holdings BV, Team Y&R Holdings Hong Kong Ltd v Talal el Makdessi (2012) where the High Court set out the modern approach to dealing with penalty clauses. The Court placed emphasis on whether there was a commercial justification for the provision in question. This broader approach signalled a shift away from the previous preoccupation with whether or not the provision was a genuine pre-estimate of loss. In December 2013 the Court of Appeal reversed the High Court's decision on the facts, placing greater emphasis on the pre-estimate of loss test. The Cavendish case concerned a share purchase deal and in particular the validity of provisions dealing with: the forfeiture by the seller of the final instalments of the purchase price and an obligation to sell remaining shares at an undervalue triggered by breach of the seller's restrictive covenants.

Practical drafting tips

We set out the facts in more detail below, but the wider practical lessons for drafting are:

• Consider drafting the provision as a condition precedent: In the Cavendish case the relevant provisions (in particular the withholding of the final instalments of the consideration otherwise payable to the selling shareholder) were operative on breach of various restrictive covenants. The Court accepted that if the contract had been structured differently so that payment of the final instalments was conditional on compliance with the restrictive covenants, the law on penalties might not have been engaged (an anomalous result, as admitted by the Court). This is because the law of penalties only comes into play when the provision in question is operative on a breach of contract. This is not an opportunity to simply restructure an extravagant and unfair provision as a condition precedent. Rather, where there is concern, this solution may be considered as a belt and braces approach to saving the provision.
• Ensure that the provision is not extravagant or unreasonable in amount by comparison to the greatest loss that can conceivably flow from the breach: This is not a new test. However the Court of Appeal placed much emphasis on this point, considering it first before looking at whether there was any commercial justification for the provisions. It also concluded that as the provisions were "out of all proportion to the loss a attributable to breach" their predominant function was a deterrent (and accordingly the provisions were penal) Arguably once the Court has concluded that the provision is extravagant or unreasonable, it will be harder to establish a sufficient commercial justification. Therefore it is important to get this right, whatever commercial justification there may be. This is particularly the case given that the Court of Appeal (overturning the decision of the High Court) refused to entertain any kind of "scaling down" exercise (i.e. holding the provision valid except to the extent that is constitutes a penalty) to save the provisions.
• Exercise caution where there are multiple breaches and/or multiple consequences: In the Cavendish case, the consequences of breach were operative on any one of four stipulations, no matter how serious or trivial the consequences of breach. For example the same consequences followed an attempted but unsuccessful poaching of employees, or a sustained and successful poaching of a majority of the target company's clients. The Court held that there was no proportionate relationship between the various breaches and the contractual consequences. It cited with approval the test in Dunlop Pneumatic Tyre Co v New Garage and Motor Co (1915) that "the strength of the chain must be taken at its weakest link. If you can clearly see that the loss on one particular breach could never amount to the stipulated sum, then you may come to the conclusion that the sum is a penalty". Whilst it would be impracticable to hypothesise about every single possible breach and eventuality (and indeed that is not required: in the Cavendish case the Court held that if the likely loss is within a range, an average figure or a figure somewhere within the range is likely to be acceptable), it would be sensible to deal with similar breaches and consequences within categories so as to ensure a proportionate relationship (even a rough and ready one) between the breach and the contractual consequences.
• Consider carefully which entity should benefit from the mechanism or provisions in question: In the Cavendish case the share sale agreement in question was entered into between the selling and buying shareholders in the company and the provisions in questions sought redress for the buying shareholder on breach. The Court compared the loss suffered by the buying shareholder, as against the compensation provided for. As the buying shareholder's loss was reflective of the company's loss, it was irrecoverable and hence zero. This is because, where a wrong has been done to a company, the loss suffered by the shareholders in that company is "reflective" of the loss suffered by the company, and accordingly irrecoverable. This lead to the conclusion that the provisions were extravagant and unreasonable in amount, particularly as there was nothing to prevent the company from also bringing proceedings against the selling shareholder for breach of the restrictive covenants. It is important therefore to consider carefully which party should be the beneficiary of the provision in question and ensure that the agreement does not allow for such "double jeopardy".

The facts of the Cavendish case

The selling shareholder sold a large proportion of his shares in an advertising and marketing communications company which he had founded. The share price placed a large value on the goodwill in the company, and the buying shareholder sought to protect that goodwill by the inclusion of restrictive covenants. The share sale agreement made provision for the following consequences on breach:

• the two final instalments of the consideration for the purchase would be withheld;
• the selling shareholder was required to sell his remaining shares in the company at net asset value (i.e. disregarding goodwill, and therefore potentially at an undervalue). As a consequence the selling shareholder was prevented from exercising a put option pursuant to which he could sell his remaining shares in the company at a much higher price taking into account goodwill.

On breach of the restrictive covenants the buying shareholder sought to enforce the above provisions and the selling shareholder argued that the provisions in question were invalid as penalties.

The High Court held that the provisions were not penalties as they could be commercially justified. See our analysis of that decision here. The selling shareholder appealed.

The Court of Appeal decision

The Court of Appeal asked the following questions: (1) were the provisions extravagant and unreasonable or a genuine pre-estimate of loss; (2) was there a commercial justification for the provisions?

Much emphasis was placed on the first of these questions. The factors pointing towards the provisions being extravagant and unreasonable were:

• the same consequences followed on the occurrence of any one of four stipulations, no matter how trivial or significant the breach;
• the loss otherwise recoverable by the buying shareholder was zero because its loss was "reflective" of that of the company;
• there was nothing to prevent the selling shareholder from being sued by both the company and the buying shareholder for the same breach, a kind of double jeopardy.

The Court did not accept the commercial justifications put forward by the buying shareholder (of protecting the goodwill of the company and de-coupling the selling shareholder from the company in the event of breach). The suggestion was that the clauses went too far to be commercially justifiable, and the Court refused to undertake any scaling down exercise.

Does the decision impact your drafting?

Provisions such as those discussed in this article are subject to the law on penalties. Whilst the decision of the High Court in Cavendish signalled a modern approach with an emphasis on the commercial justification of such mechanisms, the Court of Appeal appears to have placed the emphasis once again on whether or not the provision is a genuine pre-estimate of loss. When drafting these types of provisions regard should be had to the factors highlighted above by the Court of Appeal.