Penalty Clauses: Game-Changer

It is common for contracts to contain terms that are intended to prevent the other party from breaching an agreement, or to punish them financially in the event of a breach.  However, it is very important that these provisions are not classed as penalty clauses. The general rule is that penalty clauses in a contract are not enforceable. However, in the case of Cavendish Square Holdings BV v Talal El Makdessi 2016 AC 1172 the Supreme Court revisited the rule, and gave helpful guidance on using penalty clauses in contracts.

Facts
In Cavendish Square Holdings BV v Talal El Makdessi, Mr Makdessi agreed to sell a stake in a holding company to Cavendish Square Holdings. The contract contained a provision that if Mr Makdessi breached restrictive covenants against certain competing activities, he would not receive the final two payments due to him (Clause 5.1). In addition, he could be required to sell the remainder of his shares to Cavendish, at a default price default price based solely on asset value and without reference to goodwill, to which significant value had been attached in the sale price (Clause 5.6). Mr Makdessi breached the restrictive covenants, but argued that Clauses 5.1 and 5.6 were penalty clauses and therefore unenforceable.  

Judgement
The Supreme Court held that the clauses were not penalty clauses. This led to a new test to determine whether a provision in a contract is a penalty and thus unenforceable. Moreover, they could be seen to deter the other party from any breaches, to an extent, however, they do have a “legitimate purpose” as the courts mentioned that these clauses had nothing to do with punishment. The question of a clause’s enforceability should depend on whether the party’s behaviour is “unconscionable or extravagant”, which is beyond the norm.

The New Rule
The new rule differs to the early common law rule. The following principles now apply:
• The party who is relying on the penalty clause does not necessarily have to suffer a loss
• There is more freedom in drafting leases or contracts for the consequence of a breach
• It is not imperative to show that the penalty is a genuine pre estimate of loss
• The purpose of the clause can act a deterrent against a breach of a provision.
• The penalty does not have to be specific financial amount; it can be also for example the transfer of a part of property as a consequence for the breach

By reformulating the penalty rule, this case is very significant towards the flexibility and certainty of the new rule as it shows how important freedom is when drafting a contract. It also displays a sense of security towards cases. Nevertheless, this new penalty clause does raise a few questions, for example, the real definition of “legitimate purpose” that will most likely arise in future cases brought to the Courts in the years to come.

Priya Sejpal is one of the litigation experts at Gelbergs LLP and is happy to help with any queries that you may have. You can contact Priya on 0207 226 0570 or by email at priya@gelbergs.co.uk