The purpose of this note is to highlight the recent Supreme Court decision in Cavendish Square Holding BV v Talal El Makdessi and ParkingEye Ltd v Beavis. The Supreme Court unanimously allowed the buyer's appeal against the Court of Appeal decision and, found that two clauses in a share purchase agreement were not unenforceable penalties.
Mr El Makdessi (seller) agreed to sell to Cavendish Square Holding BV (buyer) a controlling stake in the holding company under a Share Purchase Agreement. The holding company was one of the largest advertising and marketing communications group in the Middle East. The terms of the SPA stipulated that the purchase consideration was partly payable on completion and partly by way of future instalments linked to the group’s operating profits. El Makdessi was also granted a put option for his remaining shareholding.
There was a non-compete restrictive covenant in the SPA which prevented El Makdessi from competing with the group after the sale. The SPA stipulated that if he breached the restrictive covenants he would forfeit the instalments linked to future profits, the put option and, he would be required to sell his remaining shareholding at a discounted price. Following completion, the purchasers pursued El Makdessi for breach of the restrictive covenants, he responded by alleging that the consequences of breaching the restrictive covenants constituted penalty clauses which were unenforceable.
The result was that the High Court initially ruled in favour of Cavendish Square Holding BV on the basis that the consequences of breach were not penalties. However, the Court of Appeal overturned this and ruled that the clause did in fact constitute a penalty. Subsequently, the seller brought the case to the Supreme Court who ruled in favour of the buyer.
Is the clause a penalty clause or liquidated damages clause
If a clause is construed as a penalty clause by the courts it will be unenforceable, since penalty clauses are unenforceable under English law. Courts often use a liquidated damages clause to determine whether a clause is a penalty or not. A liquidated damages clause is described as a genuine pre-estimate of damages/ loss as opposed to a penalty clause which is punitive in nature and punishes the contract breaker rather than compensating the innocent party for the breach. Despite this definition of liquidated damages, the Supreme Court in El Makdessi ruled that a clause which does not represent a genuine pre-estimate of loss may be enforceable provided it has sufficient commercial justification.
In addition, the Court needed to decide if two of the restrictive covenants in question were primary or secondary obligations. If the clauses were primary obligations, they were outside the scope of the penalty rule, whereas secondary obligations are usually considered as penalties.
Nonetheless, in this matter Lord Clarke and Lord Hodge held that one of the restrictive covenants was in fact a secondary obligation which fell within the scope of the penalty rule. However, they both agreed that on the facts, the clauses were not penalties.
Liquidated Damages Test
There are three tests that must be satisfied for a liquidated damages clause to be lawful:
- The harm caused by the breach must be difficult to quantify;
- The amount of the liquidated damages must be reasonable in proportion to the actual or anticipated harm; and
- The damages are structured to function as damages not a penalty.
If these tests are not satisfied, the clause will be construed as a penalty and unenforceable.
It is clear that this is not a straightforward area of law which is evidenced by the varied judgments passed by the Courts. The judgment was passed based on the facts and the Judges’ interpretation and application of case law and contract law. The judges took an open minded view as opposed to an unwavering view in deciding whether the clauses in question were secondary obligations and therefore penalty clauses. With this case in mind, legal practitioners and commercial parties need to consider the commercial rationale when drafting contracts.