New Rules for Liquidated Damages and Penalty Clauses

Facts

Mr Makdessi had built up a substantial group of companies in the advertising business in the Middle East.  Cavendish Square was the holding company for a major western marketing business (part of WPP) which agreed to buy Makdessi's shares.  It was important to the maintenance of the value of the business being sold that Mr Makdessi would not compete.  The contract provided that if he defaulted on his obligations, Cavendish could acquire the shares at a reduced value which disregarded goodwill.  Mr Makdessi nevertheless set up in competition, and so Cavendish exercised their right to reduce the purchase price very considerably.  Makdessi challenged this; he argued that the shares sale provisions were forfeiture clauses, and furthermore they were penalty clauses within the meaning of Dunlop Pneumatic Tyre Company v New Garage & Motor co [1915] AC 79 House of Lords.

Held

The High Court held the clauses were not penalties.

Court of Appeal

The Court of Appeal held that the provisions constituted a penalty because their primary function was to deter Makdessi from competing.  The sums involved were not a genuine pre-estimate of the damage that either party thought likely to ensue from such default.

Supreme Court

The Supreme Court Held:

(a) the law will not generally uphold a contractual remedy where the adverse impact of that remedy significantly exceeds the innocent party's legitimate interest;

(b) the proper definition of a penalty clause is that it 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";

(c) the practical implications are that one should first consider whether there is a legitimate business interest which is served and promoted by the clause;

(d) if there is, then one must further ask whether the provision made to protect that interest is extravagant or exorbitant or unconscionable;

(e) Accordingly, applying this new statement of the law, the clauses in Cavendish and Makdessi's contract were NOT unenforceable penalty clauses.  Cavendish had a legitimate interest in preserving the goodwill of the business by preventing Mr Makdessi from reviving all his old contacts and setting up in competition with the purchasers.  Although the reduction in the value of his shares was a matter of many millions of pounds, so too was the value of the business which could be undermined by his activities, and therefore it would be wrong to say that the reduction in share value was either extravagant or unconscionable etc.

Comment

This is a historic case in which dozens of precedents were examined and the whole roots of the law of penalty clauses re-analysed.  Cavendish's solicitors appointed 3 barristers and a QC; Makdessi's solicitors replied with 2 QC's.  The most important outcome is that seeking to deter or to penalise contract-breaking behaviour is no longer forbidden, and is no longer punished by invalidating the clause.  The businessman's legitimate interest in deterring contract breaking has been recognised, provided that the outcome is not exorbitant or unconscionable.

It is therefore still quite possible that a liquidated damages clause, or a clause for the forfeiture of property, will be struck down as being a penalty clause.  The Supreme Court's achievement has been to maintain the fundamental concept, to rationalise it, bring it up to date and make it fundamentally more useful for the business community.

For more information, help or advice please contact Rob Langley on 0191 211 7975 or email [email protected].