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Court of appeal rules on penalty clauses

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Jason Rix

PSL Counsel

London

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30 January 2014

In the case of Cavendish Square Holdings BV & anr v Makdessi [2013] EWCA Civ 1539, 26 November 2013, the Court of Appeal has reviewed the law on penalties and given an important decision on when a clause will be penal.

The test for whether a clause is permitted is twofold: first, there must be a genuine pre-estimate of loss such that the clause is not extravagant and unreasonable; secondly, if there is no such estimate, there must be a commercial justification.

Background

The issue in this appeal was whether two clauses in an agreement for the sale of shares were unenforceable on the grounds that they were penalties.

Mr Makdessi was a key figure in the advertising and marketing world of the Middle East. He had founded a group which became the largest advertising and marketing communications group in that region.

By an agreement dated 28 February 2008 Mr Makdessi and a Mr Ghossoub agreed to sell to Young & Rubicam International Group BV 474 shares in Y&R Holdings Hong Kong Ltd, being 47.4% of its shares then in issue. Young & Rubicam International Group BV transferred its shares in Y&R Holdings Hong Kong Ltd to Cavendish Square Holdings BV and by a novation agreement of 29 February 2008 Cavendish Square Holdings BV was substituted for Young & Rubicam International Group BV as a party to the agreement.

Cavendish is a sub-holding company within the WPP group. The result of the agreement was that Cavendish came to hold 60% of Y&R Holdings Hong Kong Ltd and Mr Makdessi and Mr Ghossoub retained 40%.

The consideration under the agreement included an earn out element, referred to as an “Interim Payment” and a “Final Payment”, in each case to be calculated by reference to future profits.

Clause 5.1 of the agreement provided that:

“If a Seller becomes a Defaulting Shareholder he shall not be entitled to receive the Interim Payment and/or the Final Payment which would other than for his having become a Defaulting Shareholder have been paid to him and the Purchaser’s obligations to make such payment shall cease”.

The definition of Defaulting Shareholder includes “a Seller who is in breach of clause 11.2”. Clause 11.2 contained various restrictive covenants and was prefaced by clause 11.1 which provided that:

“Each Seller recognises the importance of the Group to the Purchaser and the WPP Group which is reflected in the price to be paid by the purchaser for the Sale Shares. Accordingly, each Seller commits as set in this Clause 11 to ensure that the interest of each of the Purchaser and the WPP Group in that goodwill is properly protected.”

Clause 5.6 (the Call Option) further provided that:

“Each Seller hereby grants an option to the Purchaser pursuant to which, in the event that such Seller becomes a Defaulting Shareholder, the Purchaser may require such Seller to sell to the Purchaser (or its nominee) all (and not some only) of the Shares held by that Seller (the Defaulting Shareholder Shares). The Purchaser (or its nominee) shall buy and such Seller shall sell with full title guarantee the Defaulting Shareholder Shares… within 30 days of receipt by such Seller of a notice from the Purchaser exercising such option in consideration for the payment by the Purchaser to such Seller of the Defaulting Shareholder Option Price [defined as “an amount equal to the Net Asset Value [NAV] on the date that the relevant Seller becomes a Defaulting Shareholder multiplied by” the percentage which represents the proportion of the total shares the relevant Seller holds].”

The net effect of clauses 5.1 and 5.6 was that, if he breached his restrictive covenants, Mr Makdessi would lose his entitlement to his share of the Interim Payment and the Final Payment (which could have amounted to anything from zero to over USD 44 million, being the relevant cap, depending on future profits) and be liable to have his retained shares purchased under the Call Option (calculated by reference to net asset value, which would not take account of goodwill).

Mr Makdessi went on to breach the restrictive covenants in clause 11.2, as he later admitted (see the post-script below). The High Court had found the restrictive covenants to be valid and enforceable and there was no appeal from that decision.

Makdessi’s case

Mr Makdessi argued that the doctrine of penalties applied to both clauses 5.1 and 5.6 and that they were penal. Clause 5.1, he argued, operated on breach since it took effect when a Seller became a Defaulting Shareholder which occurred, relevantly, on a breach of clause 11 and, if valid, disentitled him from receiving a sum which would otherwise be due to him. Clause 5.6 also, he said, operated on breach for the same reason.

Cavendish’s case

Cavendish argued that these contentions rested on an erroneous basis. Although clauses 5.1 and 5.6 operated upon a breach of contract, they were not provisions which purported to provide compensation for breach. For provisions such as these, Cavendish submitted, the appropriate test was whether they have a commercial purpose and a commercial justification and lack a predominant intention to deter a breach (see “Commercial justification” below).

High Court (Mr Justice Burton)

Mr Justice Burton found at first instance that clauses 5.1 and 5.6 were not, on their own or together, penalties. There had been a commercial justification (the adjustment of consideration between the parties based on substantial loss of goodwill and the de-coupling of the parties on a speedy and conventional basis), the provisions were not extravagant or oppressive, the predominant purpose had not been to deter breach, and they had been negotiated on a level playing field.

A complicating factor, however, was that Mr Makdessi had previously made an offer to the company in respect of his breach of fiduciary duty as a director by virtue of his conduct which was also in breach of the restrictive covenants, in the sum of USD 500,000, and this had been accepted by the company. Mr Justice Burton considered this to be “double counting” which, he held, did render clause 5.1 a penalty. He therefore gave Cavendish the opportunity to repay this amount, as a term of the court making a declaration that it was not liable to make the Interim or Final Payment and ordering specific performance of the Call Option. In this respect, both sides contended that the judge was in error and the Court of Appeal agreed: the question of whether a clause is a penalty must be judged as at the date of the agreement in which it is contained, and cannot become so as a result of subsequent events.

Law on penalties

The Court of Appeal undertook an extensive review of the case law on penalties, which it acknowledged as a “blatant interference with freedom of contract”. The older cases approached the issue of penalties on the footing of a dichotomy between a genuine pre-estimate of loss on the one hand and a penalty on the other. The modern authorities indicated that this was too rigid an approach. Recent cases showed the courts adopting a broader test of whether the clause was extravagant and unconscionable with a predominant function of deterrence and robustly declining to find that a clause was a penalty in circumstances where there was a commercial justification for that clause.

Genuine pre-estimate of loss

Against that background the Court of Appeal first considered whether clauses 5.1 and 5.6 were extravagant and unreasonable. It did not do so on the basis that the answer would be determinative as to whether the clauses were penal, but because the issue was undoubtedly a relevant one.

The Court of Appeal found that, when the agreement was entered into, Cavendish’s damages for breach of the restrictive covenants were likely to be zero because they would be damages for loss of the value of its shareholding and thus reflective of a loss to the company itself. The Court of Appeal went on to say that, if the recoverable figure is zero, any estimate other than zero is excessive and a figure in the millions was on its face extravagant in comparison with the greatest loss.

At the time of the agreement, the sums that might be withheld from Mr Makdessi under clause 5.1 were undetermined but they could be anything from zero to over USD 44 million (the relevant cap for his potential share of the earn-out consideration), depending on the future profit calculation. The court was of the view that, whilst it was possible that a breach which caused Mr Makdessi to become a Defaulting Shareholder would so impact the goodwill of the company as to reduce the Interim and Final Payment to nothing, it considered that was a remote contingency against which it was likely, or at least readily foreseeable, that the sums forfeited would be millions or tens of millions of dollars. In the words of the court: “The width of the [restrictive] covenants and the wide range of possible losses that might result from the operative breach are such that the amount likely to be withheld will in respect of part of the range be totally out of proportion.” The Court of Appeal said that similar considerations applied in relation to the Call Option.

The Court of Appeal concluded that the clauses, taken in the context of the agreement as a whole, were not genuine pre-estimates of loss and were extravagant and unreasonable. The Court of Appeal said that was not, however, necessarily conclusive: a commercial justification may mean that a clause which is not a genuine pre-estimate is not penal.

Commercial justification

The Court of Appeal did not accept Cavendish’s submissions that the provisions were commercially justified. In Cavendish’s submission, the clauses were part of a commercial bargain, reached after extensive negotiation, as to the price payable for Mr Makdessi’s shares. If Mr Makdessi did not abide by the restrictive covenants, which were there to protect the goodwill which underpinned a major part of the price, he would not receive the additional payments. In those circumstances, which would also indicate that it was no longer appropriate for him to remain a shareholder, he could also be required to sell his retained shares on a net asset value basis which did not reflect goodwill which he had shown himself unwilling to protect in the manner he had promised.

The Court of Appeal held that the underlying rationale of the doctrine of penalties was that the court will grant relief against the enforcement of provisions for payment (or the loss of rights or the compulsory transfer of property at nil or an undervalue) in the event of breach, where the amount to be paid or lost is out of all proportion to the loss attributable to the breach. If that is so, the provisions were likely to be regarded as penal because their function was to act as a deterrent.

The examples from the cases of fulfilling some justifiable commercial or economic function included, held the court, a modest extra interest in respect of a defaulting loan; a provision for the payment of the costs of earlier litigation; a generous measure of damages for wrongful dismissal; an allocation of credit risk; or the provision of capital which would be needed if a promised guarantee of a loan was not forthcoming. Instead the effect in this case, the court held, was that Mr Makdessi stood likely to forfeit sums in the tens of millions in circumstances where, because of the unacceptability of double recovery, the law, for reasons of public policy, precludes any recovery by Cavendish at all. It was not sufficient, to describe, as Cavendish had, the clauses as having a commercial justification because they adjusted the consideration and effected a de-coupling. The important consideration was the terms on which the clauses provided for the price adjustment and de-coupling to take effect.

The Court of Appeal allowed the appeal, whilst ordering Mr Makdessi to repay the sum of USD 500,000 which had previously been agreed in settlement of the company’s claim for breach of his fiduciary duty as a director.

Comment: Having decided that the relevant provisions should be interpreted as providing compensation for breach, the thing that seemed most to trouble the court was that, in circumstances where there were a range of possible losses, the financial consequences under the agreement were the same. Moreover, the Court of Appeal was of the view that the financial consequences would, in respect of at least part of the range, be excessive and out of all proportion.

It seems from the dicta of the Court of Appeal that making payment conditional upon compliance, as opposed to withholding payment in the event of breach, may side step the law on penalties and that this is just one of the anomalies of the law in this area.

Either way, what is clear is that the court will subject these types of clauses to detailed scrutiny and the Court of Appeal’s decision may signal a greater emphasis on there being a genuine pre-estimate of loss over commercial justification than some of the more recent authorities might be taken to suggest.

Post-script

The High Court had also granted Cavendish permission to apply to commit Mr Makdessi for contempt on the ground that he had made false statements in a document verified by a statement of truth concerning his actions as they related to his compliance with the restrictive covenants. Mr Makdessi also appealed this decision but this appeal was dismissed by the Court of Appeal.

An application for permission to appeal to the Supreme Court was filed by Cavendish on 20 December 2013.

Further information

This case summary is part of the Allen & Overy Litigation Review, a monthly update on interesting new cases and legislation in commercial dispute resolution. For more information please contact Sarah Garvey sarah.garvey@allenovery.com, or tel +44 20 3088 3710.