Don’t Get Stuck in The Penalty Box - The World Post-Makdessi
Richard Boynton and Noah Stewart-Ornstein
Long viewed sceptically by commercial lawyers as an unpredictable interference with freedom of contract, the penalty rule has grown over the past half millennia from its humble equitable beginnings into a broad common law principle. As contractual arrangements grew increasingly complex, judges struggled to articulate a clear, principled approach, leading to the rule growing into a "haphazardly constructed edifice" in need of reform (to quote Lords Neuberger and Sumption). This rationalisation came in 2015 with the UK Supreme Court's (UKSC) decisions in Cavendish Square Holding BV v Talal El Makdessi and ParkingEye Limited v Beavis. This article considers Makdessi, some of the cases that have followed it and the lessons for contractual drafters.
Makdessi and the UKSC Mr Makdessi and a business partner sold 60 percent of the shares in a company to Cavendish in exchange for four staged payments. The initial two were for significant amounts, reflecting the goodwill in the business. The latter two were payable if the company's profits exceeded a threshold. The agreement contained standard non-compete provisions and required Makdessi to dispose of his interest in a competitor. The parties agreed that if Mr Makdessi or his partner breached the covenants, Cavendish: (i) would not be required to make any additional payments (the 'forfeiture clause'); and (ii) would be entitled to buy the defaulting party's remaining shares at their net asset value, which excluded the value of the goodwill (the 'call clause'). The agreement was negotiated over six months, with both sides represented. Mr Makdessi did not honour the non-compete provisions. When confronted, he admitted wrongdoing and paid the company $500,000 for his breaches of fiduciary duty (he had remained a director). Cavendish considered that Mr Makdessi was therefore: (i) not entitled to the final two payments under the forfeiture clause; and (ii) obliged to sell his shares to Cavendish for their net asset value pursuant to the call clause. Mr Makdessi argued that both clauses were unenforceable penalties. In five opinions spanning more than 300 paragraphs, the UKSC unanimously upheld both clauses. The revised tests Lords Neuberger and Sumption (with whom Lord Carnwarth agreed) cast aside the traditional focus on the binary characterisation of an impugned clause as either a genuine pre-estimate of loss or a penalty intended solely to deter breach. While accepting that the prominent four-part test set out by Lord Dunedin in Dunlop Pneumatic Tyre Co Ltd might still apply in "straightforward" situations, the Lords rendered it largely irrelevant instead concluding that "[t]he true test is whether the impugned provision is a secondary obligation which imposes a detriment on the contract-breaker out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation".