The appellants had agreed for the sale of his company by way of a share sale agreement. The price to be paid was to vary accoriding to the operating profits. A large part of the price reflected goodwill. The agreement contained a clause providing that if a seller became a defaulting shareholder he would not be entitled to receive any further payment in respect of the price. Clause 11.2 of the sale agreement contained various restrictive covenants and a shareholder who acted in breach of those covenants became a defaulting shareholder. Moreover, by clause 5.6 each seller granted the purchaser a right to buy his remaining shareholding at a price calculated by reference to the net asset value of the group if he became a defaulting shareholder. A question arose whether clause 11.2 or 5.6 was unenforceable as a penalty.
Held: The principles under which penalties are unenforceable apply to clauses which disentitle a party in breach of contract from receiving a sum of money otherwise due to him or which require a transfer of property for nothing or at an undervalue and so were potentially applicable. However, a clause might not be a penalty, even though it did not contain a genuine pre-estimate of loss, if its dominant purpose was not to deter breach and the fact that there was a good commercial justification for it might lead to the conclusion that that was not the case. The clause would be a penalty only if the sum stipulated was extravagant and unconscionable.
Christopher Clarke LJ explained: ‘The underlying rationale of the doctrine of penalties is that the Court will grant relief against the enforcement of provisions for payment (or the loss of rights or the compulsory transfer of property at nil or an undervalue) in the event of breach, where the amount to be paid or lost is out of all proportion to the loss attributable to the breach. If that is so, the provisions are likely to be regarded as penal because their function is to act as a deterrent.’
Applying that approach, he concluded that the clauses were penal in nature and said: ‘I am conscious that the approach I have adopted may be viewed as similar to that of Arden LJ in Murray, with which Buxton LJ disagreed and which Clarke LJ did not prefer. It is however difficult to address any question of penalty without considering whether the provision is extravagant, and, if it is, whether there is a commercial justification. I venture to think that the difference in approach may not be as marked as it might appear provided that (a) undue significance is not given to the discrepancy between the amount payable under the clause and the loss that might be sustained on breach – the significance of the discrepancy may depend on how closely the justification relates to the nature or extent of the loss; (b) no presumptions are treated as irrebuttable; (c) proper account is taken of the desirability of upholding bargains freely entered into and of any commercial justification for allegedly penal clauses, before deciding that the predominant function of the clause is deterrent and that it is penal. That seems to me to be the case here, not least because the relevant clauses fall foul of Lord Dunedin’s Proposition 4 (a) as well as having several other indicia of their penal nature.
I am also conscious that there is a degree of ambiguity as to what is meant by the terms ‘extravagant’ and ‘unconscionable’ and how such descriptions fit with the concept of deterrence. ‘Extravagant’ and ‘unconscionable’ were terms originally used to characterise a provision which required far too high a payment in the event of breach. That it did so offended the conscience of equity, which treated it as penal – because its function was not to compensate but to deter breaches of obligations – and unenforceable (save as to the amount of the proved damage). Nowadays, when a term which provides for excessive payment on breach may be valid if it has a proper commercial justification, the term ‘unconscionable’ would, perhaps more appropriately be used for a clause which provides for extravagant payment without sufficient commercial justification. Such a clause is likely to be regarded as penal and deterrence its predominate function, on the basis that if it requires excessive payment and lacks commercial justification for doing so, there is little room for any conclusion other than its function is to deter breach or, to put it positively, to secure performance.’
Patten, Tomlinson, Christopher Clarke LJJ
[2013] 2 CLC 968, [2013] EWCA Civ 1539
Bailii
England and Wales
Citing:
Cited – Dunlop Pneumatic Tyre Company Ltd v New Garage and Motor Company Ltd HL 1-Jul-1914
The appellants contracted through an agent to supply tyres. The respondents contracted not to do certain things, and in case of breach concluded: ‘We agree to pay to the Dunlop Pneumatic Tyre Company, Ltd. the sum of 5 l. for each and every tyre, . .
Cited – Cavendish Square Holdings Bv and Another v El Makdessi ComC 14-Dec-2012
The parties disputed whether clauses in a share sale agreement between them amounted to a penalty and as such were rendered unenforeable.
Held: Burton J felt able to escape those constraints, and concluded that the two provisions were valid . .
Cited – Lordsvale Finance Plc v Bank of Zambia QBD 20-Mar-1996
The court looked at a facility agreement opened by a bank in favour of the defendant which provided that in the event of default the defendant should pay interest during the period of default at an aggregate rate equal to the cost to the bank of . .
See Also – Cavendish Square Holdings Bv and Another v El Makdessi ComC 14-Dec-2012
The parties disputed whether clauses in a share sale agreement between them amounted to a penalty and as such were rendered unenforeable.
Held: Burton J felt able to escape those constraints, and concluded that the two provisions were valid . .
See Also – Makdessi v Cavendish Square Holdings Bv and Another (Commital) CA 26-Nov-2013
Appeal against permission to apply to commit the applicant for alleged contempt. . .
Cited by:
Cited – Parkingeye Ltd v Beavis CA 23-Apr-2015
The appellant had overstayed the permitted period of free parking in a retail park by nearly an hour. The parking was managed by the respondent who had imposed a charge of 85.00 pounds. The judge had found that the appellant was in breach of a . .
Appeal from – Cavendish Square Holding Bv v Talal El Makdessi; ParkingEye Ltd v Beavis SC 4-Nov-2015
The court reconsidered the law relating to penalty clauses in contracts. The first appeal, Cavendish Square Holding BV v Talal El Makdessi, raised the issue in relation to two clauses in a substantial commercial contract. The second appeal, . .
Lists of cited by and citing cases may be incomplete.
Contract
Updated: 26 November 2021; Ref: scu.518421