Penalty clauses - how to spot them and how to avoid them

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

When entering into corporate and commercial contracts, it is common to structure the deal so that if there is a breach, it can be compensated without having to bring court proceedings. This can be achieved by mechanisms such as forfeiture clauses, put and call arrangements and compulsory buy-back provisions. However, as highlighted by a recent High Court decision, any party hoping to rely on such a provision will need to ensure that it does not constitute an unenforceable penalty. We look at the practical points to consider arising from the case.

It is established law that a provision which constitutes a penalty is unenforceable. The conventional approach to determining whether a provision is a penalty has been to distinguish between a liquidated damages clause, which is enforceable if it is a genuine pre-estimate of loss, and a penalty, which is not (Dunlop Pneumatic Tyre Co v New Garage and Motor Co (1915)). However, a majority of the Court of Appeal in Murray v Leisureplay plc (2005) preferred the broader approach of asking whether the predominant function of the provision was to deter a party from breaching the contract (unenforceable as a penalty) or to compensate the innocent party for breach (enforceable). Most recently, the judge in Cavendish Square Holdings BV, Team Y&R Holdings Hong Kong Ltd v Talal el Makdessi (2012) set out the modern approach to dealing with penalty clauses. The following practical points can be drawn from the case:

• A provision which entitles the innocent party to withhold monies or which requires the transfer of assets from one party to another can constitute a penalty clause: It is well known that a provision which requires the payment of a sum by a defaulting party can constitute a penalty clause. In addition, the court in Jobson v Johnson (1989) held that a clause requiring a defaulting party to transfer property (shares in that case) to an innocent party at an undervalue was also a penalty. In the Cavendish Square Holdings case, a provision in the share purchase agreement entitled the purchaser to withhold a proportion of the purchase price in the event that the seller breached the restrictive covenants. The court made it clear that provisions involving a forfeiture of rights or the withholding of a sum of money are also capable of being penalties (although on the facts, the clause in this case was not).
• A provision may not be a penalty if it can be commercially justified and provided that its predominant purpose is to compensate loss and not to deter breach: In the Cavendish Square Holdings case the judge held that the analysis of whether a provision is a penalty or not depends on the commercial rationale for including the provision in question as opposed to whether it constitutes a liquidated damages clause. This is an important development as it allows the party seeking to enforce the provision a wider set of factors on which to rely, provided always that the predominant purpose of the provision is not to deter the other party from breach.
• A provision which is extravagant or oppressive is likely to be a penalty clause: In the Dunlop case the court held that an innocent party would be entitled to enforce a clause which effectively enabled it to recover "the greatest loss that could conceivably be proved to have followed from the breach", but a clause which provided for compensation over this would be "extravagant or oppressive" and therefore a penalty. This approach was also applied in the Cavendish Square Holdings case, where it was held that in the circumstances of the case the provisions in question were neither extravagant nor oppressive. This test benefits the draftsman by permitting a degree of flexibility in drafting this sort of compensatory provision, particularly where the loss in the event of a breach is difficult to quantify at the outset.

Cavendish Square Holdings - the facts

A dispute arose following the sale of a majority shareholding in an advertising and marketing communications company. The purchaser had placed a significant value on the goodwill in the company, and the ongoing involvement of the seller in the business following completion (as a minority shareholder and director) was critical to the maintenance of that goodwill. The share purchase agreement included provisions designed to protect the goodwill in the company, including restrictive covenants which applied whilst the seller remained involved in the business and for a period afterwards. The following clauses took effect if the restrictive covenants were breached:

• the purchaser was released from its obligation to pay the seller the last two instalments of consideration (clause 5.1); and
• the purchaser became entitled to require the seller to sell his remaining minority stake in the company at net asset value (i.e. disregarding goodwill and therefore at an undervalue) (clause 5.6).

The seller breached the restrictive covenants, resigned as a director of the company and the purchaser sought to enforce both provisions. Amongst other things, the seller argued these provisions were unenforceable as penalties.

The decision

The judge found that the modern approach to the law of penalties requires the following questions to be asked: (1) Is there a commercial justification for the provision? (2) Is the provision extravagant or oppressive? (3) Is the predominant purpose of the provision to deter the breach? (4) Was the provision negotiated on a level playing field?

It was held that whilst a forfeiture clause such as clause 5.1 could constitute a penalty, in the circumstances it was not a penalty because it served the commercial purpose of adjusting the amount of consideration due to the seller. Such adjustment was commercially justified because its purpose was to compensate the purchaser for the loss of goodwill in the company caused by the seller's breach. In that regard, the structure of the SPA, in linking the substantial deferred consideration payment to the goodwill of the company, and in including the restrictive covenants to safeguard and protect that goodwill, was particularly useful to the buyer in proving 'commercial justification'.

Clause 5.6 was held to serve the commercial purpose of 'decoupling' the defaulting seller from the company in the event of breach. Its purpose was not to deter the seller from breach. Further, the purchaser was entitled to assess its loss by reference to the "greatest loss that could conceivably be proved to have followed from the breach." Given the potentially substantial impact of the seller's breach of covenant on the goodwill of the company, the adoption of a net asset valuation of the shares (i.e. disregarding the goodwill) was held not to be disproportionate and was therefore not extravagant nor oppressive.

Conclusion

Termination provisions in corporate and commercial contracts which are designed either to allow a buy-out at a reduced price or to allow an adjustment to be made to the price paid may constitute penalties and may therefore be unenforceable. When drafting these provisions regard should be had to the tests set out in the Cavendish Square Holdings case although, as was also made clear in the case, the courts are generally reluctant to interfere in commercial contracts freely entered into between parties of comparable bargaining power.

Permission to appeal has been given and we will keep you posted if there are any further developments.