Penalty clause struck down

Makdessi v Cavendish Square Holdings Court of Appeal [2014] Volume 1 246

Mr Makdessi sold his shares in a marketing business which was very successful in the Middle East.  He entered into a restrictive covenant, promising not to compete with the business after the sale.  Clauses in the sale agreement went on to provide that if he breached his restrictive covenant, he lost up to $44m from the purchase price.  Subsequently Cavendish accused him of soliciting clients, acting in competition and soliciting employees. Cavendish invoked the contract to take millions off Makdessi.  Makdessi challenged this on the basis that these clauses were ‘penalty clauses’ and therefore void for public policy reasons.

Court of Appeal Held

1. The consequences of breach of these clauses were “extravagant and unconscionable”.  They were in no sense pre-genuine estimates of loss. The primary function of the clauses was to act as a deterrent rather than to give any sort of compensation.
2. Christopher Clarke LJ remarked “whether or not the figure is a reasonable estimate of that loss it is likely to be affected by the range of possibilities.  The fact that the sum exceeds the maximum possible loss may be an indicator that the provision is penal.  If the sum is within the range it may be reasonable, especially since a broad brush approach may well be justified.  But that may not be the case if the range is very wide, the figure is at one end of it and there are likely to be breaches which will produce trifling loss; or a range of breaches where the losses are likely to be much less than the sum provided for.  The wider the range and the higher the figure within the range or (even more so) beyond the range, the more likely it is to amount to a penalty.”

Commentary

a)     Up to now construction lawyers have regarded Court of Appeal cases such as Alfred McAlpine v Tilebox [2005] as being the leading authorities on when a liquidated damages clause will be struck down as a penalty clause.  Since that case, judges should be hesitated to condemn clauses contained in commercial contracts as ‘penal’ and therefore unforeseeable, especially where the parties are of equal bargaining power and have had high level legal advice.  In recent decisions over the last 20 years the court has recognised the utility of liquidated damages clauses and has been reluctant to intervene in them because this is an interference with freedom of contracts.  There has, in effect, been a presumption in favour of upholding clauses which fix the damages for breach.

b)    The Makdessi decision goes against those principles despite the very high level legal advice which both parties received, and may be an encouragement to Contractors to challenge LD clauses in future.

c)     Certainly in Makdessi the Court of Appeal appeared to be moving back towards the attitude of the House of Lords 100 years ago in Dunlop Pneumatic Tyre Co Ltd v New Garage &Motor Co Ltd [1915] UKHL 1.

d)     In conclusion, expect more successful challenges by Contractors against Liquidated Damages clauses in future.

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