It is often difficult to predict what will be recoverable as damages for breach of contract. To provide some certainty, parties will often seek to agree the sum that will be payable in the event of specified breaches.
It is well established that such an approach does not present a problem if the sum agreed is a genuine pre-estimate of the probable loss (often referred to as a liquidated damages clause), in which case the claimant will only need to prove that the relevant breach has occurred and not the actual loss. The problem lies where the clause does not represent a genuine estimate of loss but instead is designed to deter a party from breaching the contract, in which case it will be deemed to be a penalty clause and will be unenforceable, leaving the claimant to rely upon normal contractual principles for establishing the damage caused, including the requirement on it to mitigate its losses (see Jobson v Jobson ). It is for this reason that defendants, when faced with contractual claims, will often seek to argue that such clauses are penalties.
THE LAW ON PENALTY CLAUSES
The traditional approach of the courts has been to consider whether the sum in question in the relevant clause is a genuine pre-estimate of the other party’s loss. The case of Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd  provided clear guidance on whether a sum contained in such a clause should be considered liquidated damages or a penalty. Lord Dunedin, in delivering his opinion, noted:
‘… the essence of a penalty is the money stipulated in terrorem of the offending party; the essence of liquidated damages is a genuine pre-estimate of damage’.
The fact that a party has used the term ‘liquidated damages’ or ‘penalty’ will not be conclusive; it is up to the court to judge this based upon the terms and circumstances of each particular case, judged at the time of making the contract, not at the time of breach.
Lord Dunedin also provided some helpful guidance regarding any assessment:
- The sum may be a penalty if it is ‘extravagant and unconscionable in amount in comparison with the greatest loss which could conceivably be proved to have followed from the breach’.
- If the promisor under the contract is under an obligation to pay a certain sum of money, and it is agreed that if they fail to do so a larger sum should be paid, that larger sum will be held to be a penalty.
- There is a presumption that a sum will be a penalty where a single lump sum is payable by way of compensation on the occurrence of one or more or all of several events, ranging in severity.
- In circumstances where the consequences of a breach make a precise estimate of damage almost impossible, this should not be an obstacle to the determination of a sum as being a genuine pre-estimate of damage.
Expanding on the fourth point above, the need for a genuine pre-estimate does not mean that the estimate must be completely accurate. In Murray v Leisureplay plc , the Court of Appeal emphasised that a sum will not be a penalty merely because it is not a precise pre-estimate of the loss; ‘the parties are allowed a generous margin’.
CAVENDISH SQUARE HOLDINGS BV V MAKDESSI: A MORE FLEXIBLE APPROACH?
The case of Cavendish Square Holdings BV v Makdessi  suggests that the courts are moving toward a more flexible approach, going beyond the question of deterrence and considering the commercial justification for the clause in question.
The claimant, Cavendish Square Holdings BV (Cavendish), and Team Y&R Holdings Hong Kong Ltd (Team Y&R) were both companies within the WPP advertising and marketing communications group. Mr Makdessi, the defendant, owned the largest advertising and marketing communications group in the Middle East, the business of which was vested in Team Y&R. Cavendish had a shareholding of 12.6% in Team Y&R.
In February 2008, Mr Makdessi and Cavendish entered into an arrangement whereby Cavendish agreed to purchase the remaining shares in Team Y&R, so as to acquire complete control of the company. An initial purchase was to be made of part of the shareholding, and the remaining shares were to be sold in instalments.
Mr Makdessi contemporaneously entered into a separate agreement to remain as director of Team Y&R on a non-executive basis for an 18-month renewable term. The agreement contained a number of restrictive covenants. Under a restraint of trade clause, Mr Makdessi was prohibited from competing with the WPP Group, from soliciting or diverting away trade, or from employing or enticing any senior employee away from the WPP Group.
The agreement also provided that if Mr Makdessi became a ‘defaulting shareholder’, including through breach the restraint of trade clause, Cavendish could exercise the option to require Mr Makdessi to sell to Cavendish any shares he held at the time of the breach at net asset value on the date of default. The sale on net asset value, rather than on a multiple of profits basis, would result in a much lower payment to Mr Makdessi. This option was known as the ‘put option’.
In December 2010, Cavendish discovered that Mr Makdessi had breached his obligations under the restraint of trade clause through his involvement and interest in a competitor company, making him a defaulting shareholder. Mr Makdessi was deemed to have breached his fiduciary obligations to the company as a director, and following negotiations, a Part 36 settlement offer of $500,000 was agreed by Mr Makdessi. However, the proceedings continued in respect of the restraint of trade clause and ‘put option’. Mr Makdessi argued that the restraint of trade clause was unreasonable, and that the ‘put option’ clauses were penalty clauses, and therefore unenforceable.
The Court held that the restraint of trade clause was not unreasonable and that the ‘put option’ clauses were not penalties. Rather than applying the ‘genuine pre-estimate of loss’ test set out inDunlop, Justice Barton noted that ‘there is no longer any need for the dichotomy between liquidated damages and genuine pre-estimate of loss’ given the modern development of the concept of a penalty beyond damages clauses. He noted that in modern times, penalty clauses have embraced not only the provision for the payment of money, but also an entitlement for the innocent party to withhold money which it would otherwise be required to pay over.
The relevant questions with regard to penalty clauses were therefore:
- Was there a commercial justification?
- Was the provision extravagant or oppressive?
- Was the predominant purpose of the provision to deter the breach?
- If relevant, was the provision negotiated on a level playing field?
In this instance, the Court found that there was a commercial justification to the clause; that being to ‘decouple the parties on a speedy and conventional basis’ and adjust the consideration payable. Given that there was to be a substantial delayed payment for goodwill, the imposition of covenants to protect that goodwill had a clear commercial purpose which served to deter any finding of extravagance or oppression in the clauses.
Considering Lord Dunedin’s statement of the need to assess the ‘greatest loss that could conceivably be proved to have followed from the breach’, Justice Barton noted that breach of the agreed covenants could have a substantial impact on the goodwill of Team Y&R – goodwill for which Cavendish had agreed to pay a very substantial sum. The impact of this was to such an extent that the adoption of a net asset valuation was not disproportionate. Further, thorough negotiation had taken place between the parties. As a result the ‘put option’ clauses could not be labelled oppressive or extravagant.
The Court did however consider that part of Cavendish’s loss had already been compensated by consideration paid under the terms of the settlement; any further compensation payable by Mr Makdessi under the ‘put option’ would amount to double recovery. Cavendish would receive more than any conceivable loss of value in the shareholding, and the adjustment to the consideration made by the ‘put option’ would be penal. Accordingly, while the Court did not strike out the ‘put option’ clauses as a penalty, it did rule that in order to enforce the ‘put option’ to its full extent, Cavendish would need to give credit for the $500,000 received under the settlement agreement.
ACTUAL BREACH OF CONTRACT
It is important to remember that, contrary to a popular misconception, the rule against penalty clauses only applies where there has been an actual breach of contract and will not be relevant if the trigger event is not a breach; a rule that is well illustrated by the recent cases of Henning Berg v Blackburn Rovers Football Club & Athletic Plc  and Cadogan Petroleum Holdings Ltd v Global Process Systems LLC .
Henning Berg v Blackburn Rovers
In Henning Berg v Blackburn Rovers, the High Court determined that a contractual payment due as compensation on early termination of a fixed-term employment contract was enforceable. Berg was appointed by Blackburn Rovers Football Club as manager on a fixed-term contract, running from November 2012 until June 2015, which contained the following clause:
‘In the event that the club shall at any time wish to terminate this agreement with immediate effect it shall be entitled to do so upon written notice to the manager and provided that it shall pay to the manager a compensation payment by way of liquidated damages in a sum equal to the manager’s gross basic salary for the unexpired balance of the fixed period assuming an annual salary of £900,000…’
After just 57 days in the job, Blackburn Rovers terminated the contract. Mr Berg claimed that he was due £2.25m under the contract, the figure he would have been paid for the remaining duration of the contract. Blackburn Rovers initially admitted liability and agreed to pay Mr Berg the remainder of the contract, but later sought to withdraw this admission, arguing that the clause in question was a penalty.
The Court held that, even though the clause used the language of breach of contract, making reference to ‘liquidated damages’, the construction of the clause actually gave the club the right to terminate the contract early and so there was no breach and the rule on penalty clauses was not applicable.
Cadogan Petroleum Holdings Ltd v Global Process Systems LLC
Similarly in Cadogan v Global Process Systems the Court refused to apply the law on penalties. Here, as part of a settlement, the parties had agreed to enter into a sale agreement whereby Global Process Systems (GPS) would buy back two gas plants for $37.5m, payable in a series of instalments, although ownership was not to pass until full payment was complete. GPS paid instalments totalling $7.5m, but did not pay any further sums due.
Under the agreement, any failure to pay an instalment by GPS would allow Cadogan to terminate the contract without prejudice to any accrued rights under the agreement or its right to claim damages for breach. As a matter of construction, the Court held that the agreement made it clear that Cadogan was entitled to keep the instalment payments made by GPS and rejected the argument that those payments amounted to penalties since the obligation to pay the instalments was not triggered by breach; it preceded and was independent of any breach.
While it would seem sensible for parties, in appropriate circumstances, to utilise clauses that provide certainty regarding the damages that will be paid on account of a breach, when those parties later become defendants faced with a clause that they then consider will cause them financial hardship, they will inevitably seek to challenge the validity of those clauses. Therefore to have greater certainty about what they are agreeing to, parties must understand the potential significance of the clauses in question.
As both Blackburn Rovers and GPS discovered, a sum payable under a contract for reasons other than breach of contract will not be considered a penalty irrespective of the language used to describe the clause within the contract.
Where the rule of penalties is applicable, it is clear that the courts are looking to adopt a more flexible and commercially focused approach where the circumstances of the case require a departure from the usual ‘pre-estimate of loss’ approach and prefer not to interfere in a bargain struck between contracting parties of equal bargaining power.
Cavendish highlights the tendency of the courts to consider commercial justifications in determining whether a clause amounts to an unenforceable penalty. It has been suggested that the judgment is particularly relevant to companies seeking a more flexible approach to compensation for breach of restrictive covenants, companies considering good/bad leaver provisions in private equity transactions or earn out provisions in acquisition agreements. Utmost care must be taken that any payment or variation of consideration is commercially justifiable and not oppressive.
It should be noted that both Cadogan and Cavendish are under appeal to the Court of Appeal and so further clarification of the courts’ position on penalty clauses should follow in due course.
By Henry Stewart, associate, and Annie Clarke, trainee, Edwards Wildman Palmer (UK) LLP.