Penalty Clauses In Commercial Agreements Following El Makdessi v Cavendish Square Holdings

It is common for parties to commercial agreements to agree mechanisms for resolving breaches of their agreement without having to resort to legal proceedings. Typically this is done by incorporating provisions, such as forfeiture or compulsory buy-back clauses, into a contract which are activated upon one party's breach of its terms. In such a situation, it is important for the parties to ensure that such provisions could not be characterised as penalties so as to render them unenforceable. This issue was considered in the case of El Makdessi v Cavendish Square Holdings BV and another [2013] EWCA Civ 1539 ("El Makdessi"), where the Court of Appeal was asked to review an earlier decision by the High Court on the question of whether clauses in a Share Purchase Agreement ("SPA"), which were activated in response to the seller's breach of restrictive covenant, constituted unenforceable penalties.

Penalty clauses versus liquidated damages clauses

It is a long-established rule of law that a clause which is deemed to be a penalty will be unenforceable. In determining whether a clause is a penalty, the courts often use liquidated damages clauses (which are enforceable) as a point of comparison. A liquidated damages clause is a "genuine pre-estimate of loss", the main purpose of which is to compensate the innocent party for breach of the terms of an agreement. A penalty clause, on the other hand, functions to punish or deter a party from breaching the terms of an agreement and may bear no relation to the actual loss suffered by the aggrieved party.

Background

Mr Makdessi ("M") was a key figure in the Middle-Eastern advertising and marketing world who sold part of his advertising group to WPP, retaining a 20% holding. According to the SPA, the purchase consideration was payable partly on completion and partly by way of future instalments linked to the group's operating profits. M was also granted a put option in respect of his remaining 20% shareholding.

The SPA contained extensive restrictive covenants preventing M from competing with the group after the sale and provided that if M breached the restrictive covenants he would forgo the instalments linked to future profits and the put option, as well as being required to sell his remaining 20% stake at a discounted value (referred to as the "Consequences of Breach"). After completion, the purchasers pursued M for breach of the restrictive covenants contained in the SPA and, in response, M alleged that...