Penalty Rule Overhauled By The Supreme Court After 100 Years

The Supreme Court recently provided welcome clarification on the penalty rule, confirming the circumstances in which it is engaged and setting out "the true test" for penalty clauses.

Cavendish Square Holding BV v Talal El Makdessi [2015] UKSC 67 centred on a series of transactions by which Cavendish acquired 60% of a company owned by Mr. Makdessi and Mr. Ghossoub (the "Sellers"). The agreements included restrictive covenants on the Sellers which were subsequently breached by Mr. Makdessi. Cavendish sought to enforce two clauses which were triggered by that breach and which (i) stopped Mr Makdessi from receiving subsequent instalments of the purchase price; and (ii) gave Cavendish an option to purchase Mr Makdessi's retained shareholding at net asset value (excluding goodwill as reflected in the initial share price).

In order to determine whether the penalty rule was engaged, the Court considered whether the two clauses were secondary obligations or conditional primary obligations.

Secondary obligations arise where a contract requires one party to perform an act and, if he does not perform it, he must pay the other party a specified sum of money. A secondary obligation is capable of being a penalty If the contract does not impose an obligation to perform the act, but simply provides that, if one party does not perform, he will pay the other party a specified sum, the obligation to pay is a conditional primary obligation and cannot be a penalty The Court held that the clauses in question were among the provisions which determined Cavendish's primary obligations, that is those which fi xed...