New developments on penalty clauses - the Court of Appeal takes a less commercial view

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

Default provisions, good/bad leaver clauses and put and call exit options are commonly included in contracts by parties seeking to provide redress for a breach without having to resort to legal proceedings. However, these provisions run the risk of being held void as penalties. The Court of Appeal has recently overturned a High Court decision and held provisions in a share purchase agreement to be unenforceable. We look at the Court of Appeal's decision and give some practical drafting tips.

What's new?

In our Winter 2012/13 edition we reported on the High Court decision in Cavendish Square Holdings BV, Team Y&R Holdings Hong Kong Ltd v Talal el Makdessi (2012) which set out the modern approach to penalty clauses - placing emphasis on whether the provisions were commercially justifiable, as opposed to whether they represented a genuine pre-estimate of the parties' loss. The case concerned the validity of provisions in a share purchase agreement dealing with the forfeiture by the seller of the final instalments of consideration and the obligation on the seller to sell his remaining shares in the target at an undervalue, both of which were triggered by the seller's breach of restrictive covenant. See here for our previous article which also sets out the facts of the case in more detail. The Court of Appeal has overturned this decision placing greater emphasis on the pre-estimate of loss test. The practical drafting tips arising from this case are as follows.

• Consider drafting the provisions as conditions precedent. In the Cavendish case the relevant provisions (in particular the forfeiture of future consideration) were operative on a breach of the restrictive covenants in the share purchase agreement. The Court of Appeal accepted that if the agreement had been structured differently, so that the payment of future consideration was conditional on compliance with the covenants, the law on penalties may not have been engaged. Although the Court acknowledged that this was an anomalous decision (and a Court is always likely to look to the substance and not the form of a provision) drafting a provision in this way may help make it more enforceable.
• Ensure the provisions do not provide for a remedy that is extravagant or unreasonable when compared with the greatest loss that could flow from the breach. This is not a new test, but the Court of Appeal placed much emphasis on it, considering it before looking at whether there was a commercial justification for the provision. Arguably, once a Court has decided a provision is extravagant or unreasonable then it is likely to be harder to establish commercial justification.
• Consider using a range of remedies depending on which clause is breached and the seriousness of the breach. In Cavendish, there was no attempt to match the covenant breached or the seriousness of that breach, with the remedy provided. The seller forfeited millions of pounds of consideration whether he unsuccessfully attempted to poach one senior employee or whether he breached the non-compete covenant in a serious and sustained way. The fact that such a wide range of potential breaches triggered such a draconian remedy meant that in relation to some potential breaches, the remedy was far from proportionate to the breach and therefore extravagant and unreasonable. When drafting clauses like this it would be sensible to deal with similar breaches and their consequences within categories so as to ensure a proportionate relationship (even a rough and ready one) between the breach and its contractual consequence.
• Consider carefully which entity should be able to recover for the breach in question and draft accordingly. In Cavendish, not only did the seller's conduct give the buyer a right of action, it also gave the target company the right to recover. The Court compared the buyer's loss as against the compensation provided for by the clauses in question. It found that the buyer's loss was zero as it was purely reflective of the company's loss. This is because under the principle of "reflective loss", where a wrong has been done to a company and the company has the right to recover in relation to it, the shareholders' loss (in terms, for example, of a diminution in value of their shares) is classed as reflective of the loss suffered by the company and is irrecoverable. As the buyer had no loss, the Court concluded that the provisions the buyer sought to enforce had to be extravagant and unreasonable. Therefore, when drafting undertakings and covenants of this sort, pay careful attention to which parties are able to enforce them. This might involve excluding the application of the Contracts (Rights of Third Parties Act) 1999 or including specific language clarifying that nothing in the agreement should entitle more than one party to recover for the same loss or make a party liable for the same loss more than once.

The Court of Appeal's reasoning

As mentioned above, the Court of Appeal asked first, whether the provisions were extravagant or unreasonable or a genuine pre-estimate of loss, and second, whether there was any commercial justification for them. In placing its emphasis on the first of these questions, the court seems to be moving towards the classic test of determining whether a provision is a penalty, and away from the more commercial approach taken by the High Court. The fact that the same consequence followed on from a breach of each covenant no matter how trivial or significant the breach; the fact that in law, the buyer had no loss, since it was merely reflective of the company's loss; and the fact that nothing in the agreement prevented the seller from being sued by both the company and the buyer for the same breach, led the Court to conclude that the provisions were extravagant and unreasonable.

The Court did not accept the commercial justification put forward by the buyer (of protecting the goodwill of the company and de-coupling the seller 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 rewrite the parties' agreement by undertaking any scaling down exercise.

Conclusion

Exit provisions allowing an innocent party to buy out a defaulting party at below market value, or provisions allowing one party to withhold or forfeit future payments following a breach, are commonly used in a wide range of corporate and commercial agreements. Contrary to a perceived move by the courts towards upholding contractual provisions negotiated by advised parties at arms' length, this case shows that the Court will step in to prevent reliance on provisions it deems as oppressive - care needs to be taken when drafting to ensure that the correct balance is achieved. We are waiting to hear whether leave to appeal to the Supreme Court will be granted.

Any information contained in this article is intended as a general review of the subjects featured and detailed specialist advice should always be taken before taking or refraining from taking any action. If you would like to discuss any of the issues raised in this article, please get in touch with your usual Olswang contact. This article was included in our Olswang Corporate Quarterly Spring 2014 publication.