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Joshua_Mirwis_phParties to a contract may agree in advance on the level of damages payable to compensate the innocent party in the event of breach without having to bring court proceedings. However, agreed damages clauses will be struck down by the court if they are deemed to be penalty clauses. A clause will be treated as a penalty clause if the sum fixed is not a genuine pre-estimate of loss (Dunlop Pneumatic Tyre Co Ltd v New Garage & Motor Co Ltd [1914] UKHL 1). In the case of Murray v Leisureplay plc [2005] EWCA Civ 963, the Court of Appeal adopted the wider approach of ascertaining what the predominant function of the clause was. If the main function was to deter a party from breaching the contract it would be unenforceable as a penalty but if it was to compensate the innocent party for the breach it would be enforceable.

This case considers the effect of agreed damages clauses in the context of a sale and purchase agreement (“SPA”) that adjusted the price payable for the shares in the event that the seller breached certain restrictive covenants. 

Facts

Cavendish Square Holdings BV and Team Y&R Holdings Hong Kong Ltd (the “Company”) were part of the WPP group of companies, the world’s largest advertising and marketing communications group. Mr Makdessi and Mr Ghossoub were the owners of what became the largest advertising and marketing communications group in the Middle East (the “Group”). The business of the Group was vested in the Company by 2008 and the WPP group had acquired 12.6% of the Company. In February 2008 the WPP group agreed to purchase from Mr Makdessi and Mr Ghossoub the majority of the shares in the Company (Mr Makdessi and Mr Ghoussoub would collectively retain 40%). The WPP group placed a great deal of significance on the goodwill in the Company and the ongoing involvement of Mr Makdessi in the business following completion as a director and non-executive chairman was essential to the preservation of that goodwill.

Mr Makdessi and Mr Ghossoub entered into a SPA with a member of the WPP group, and by a later novation agreement Cavendish (also within the WPP group) was substituted. Under the SPA the consideration was to be payable partly on completion and partly by future installments. Mr Makdessi and Mr Ghossoub gave certain restrictive covenants which, if breached, would (a) release Cavendish from its obligation to pay any future installments for the shares already sold (clause 5.1) and (b) entitle Cavendish to require Mr Makdessi and Mr Ghossoub to sell their remaining minority shares in the Company at a discount based on net asset value, thereby excluding any value placed on goodwill (clause 5.6).

Mr Makdessi breached the restrictive covenants by resigning as a director of the Company and Cavendish sought to enforce both clause 5.1 and clause 5.6. The issue brought before the court was whether the price adjustment provisions amounted to penalty clauses.

Decision at First Instance

Mr Justice Burton in the High Court applied the commercially justifiable test (similar to the principles advanced in Murray) and held that the provisions in question were enforceable agreed damages clauses. The court found that there was a commercial justification for the provisions due to the substantial loss of goodwill caused by Mr Makdessi’s resignation (in breach of the restrictive covenants) and therefore a net asset valuation of the shares was appropriate. Furthermore, the SPA had been negotiated between commercial parties of equal bargaining power and the predominant purpose of the clause was not to deter breach.

Court of Appeal

The Court of Appeal overturned the decision of the High Court and held that the price adjustment provisions were in fact unenforceable penalties.

The court posed two questions when determining if the provisions were penalties: 1) were the provisions a genuine pre-estimate of loss; and 2) if the provisions were not a genuine pre-estimate of loss, were they commercially justifiable?

The court held that the provisions were “extravagant and unreasonable” because the same consequences followed on the occurrence of a number of different breaches regardless of how minor or substantial the breach. The court noted that Cavendish’s loss otherwise recoverable for breach of the restrictive covenants was zero because the loss of the value in Cavendish’s shareholding was reflective of a loss to the company itself. As the loss recoverable by Cavendish was zero, the price adjustment that would allow Cavendish to withhold millions of dollars for breach of any of the restrictive covenants was unconscionable.

The Court also refused to accept the commercial justifications put forward by Cavendish that the clauses were part of a commercial agreement reached after negotiations between sophisticated parties with equal bargaining power. The clauses went too far to be commercially justifiable and the Court refused to carry out any scaling down exercise.

Although the court did explore the case law as to what amounts to a penalty clause, the Court of Appeal judgment specifically notes that any guidelines established are of limited use as they are rebuttable and each agreement must be analysed in its context to determine its enforceability.

Supreme Court

The appeal was heard by Lord Neuberger, Lord Mance, Lord Clarke, Lord Sumption, Lord Carnwath, Lord Toulson and Lord Hodge between 21 and 23 July 2015.

The issues for the court to consider were:

  1. if the rule does apply to such contracts, whether clauses 5.1 and 5.6 are within the scope of the rule; and
  2. whether the rule against penalties applies to commercial contracts between sophisticated parties;
  3. if the clauses are within the scope of the rule against penalties, whether the Court of Appeal was wrong to conclude that they were penal and therefore unenforceable.

This is the first time that the Supreme Court has had the opportunity to consider the law of penalty clauses and their application in a commercial context. The judgment will seek to provide clarification on the tests to be applied when determining whether a provision is a penalty and will potentially have wide-ranging impacts on many areas of the law.