Forfeiture Clauses In JOAs – New Law, Old Problems

The recent case of Talal El Makdessi v. Cavendish Square Holdings1 considered whether the English common law's antipathy towards penalty clauses would apply where forfeiture of interests against a defaulting party was the prescribed contractual remedy. Although not focused on the oil and gas sector, the principles behind the court's decision will have an impact upon the application of forfeiture clauses in joint operating agreements ("JOAs").

Makdessi v. Cavendish

In the Makdessi case the seller of part of its shareholding in a company gave certain covenants to the buyer which were intended to protect the continuing value of the company. These covenants principally obliged the seller not to compete with the business of the company after completion of the sale. The sale and purchase agreement ("SPA") between the parties provided a form of forfeiture remedy (in that the seller would forego significant future payments due for the shares sold and would also be obliged to sell its remaining shares in the company to the buyer at a significantly discounted value) in the event of a breach of the covenants by the seller.

The seller later admitted to breaching the covenants and the buyer sought to apply the SPA's forfeiture remedy against the seller. The seller issued proceedings in court, seeking a declaration that the forfeiture remedy was a penalty and so unenforceable.

At first instance the court was asked to consider whether the forfeiture remedy was penal in nature and would be unenforceable against the seller. The seller's arguments in favour of the allegation of a penalty related principally to the lack of proportionality between the loss suffered by the buyer because of the seller's breach of covenant and the seller's exposure under the forfeiture remedy.

The court held that the forfeiture remedy was not penal in nature. In arriving at its decision the court focused on whether the remedy was commercially justifiable in all the circumstances, rather than on the more 'traditional' English law approach to the analysis of penalties of whether the alleged penalty clause constituted a genuine attempt to pre-estimate loss.2

The seller then appealed against the decision of the court at first instance. The Court of Appeal concluded (unanimously) that the same legal analysis would be applied but also concluded that in all the circumstances the forfeiture remedy was penal in nature. Two particular aspects of the Court of Appeal's judgment were key:

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