20 June 2016
If a contractual clause is regarded as penal, it will be unenforceable. The paradigm case in which this arises is where the contract provides that if a party breaches its contract, it is to make a payment to the other party that is regarded as excessive in law.
Recently, the Supreme Court of the United Kingdom recast the test for whether a clause is to be regarded as penal. Cavendish Square Holdings BV v Makdessi  3 WLR 1373 ("Cavendish v Makdessi") concerned an arrangement pursuant to a Sale and Purchase Agreement ("SPA") in which an innocent party was entitled to withhold deferred consideration and to exercise an option to purchase the contract breaker's shares at an undervalue.
The recast test for determining whether a clause will be unenforceable as a penalty is applicable to all contracts. For example, Joint Operating Arrangements ("JOA") are highly analogous to the case under consideration, also being cases in which one often encounters an entitlement to purchase the contract breaker's interest.
The Old Test
The leading authority for penalties for 100 years was Dunlop Pneumatic Tyre Co Ltd v New Garage & Motor Co Ltd  AC 79. There were said to be two significant aspects to determining whether a clause is penal:
(a) Firstly, a clause could only be penal if it was enlivened by a breach of contract.
(b) Secondly, a clause would be penal if it was extravagant and unconscionable in comparison with the greatest loss that could conceivably have been suffered as tested at the time the contract was entered into. On the other hand, a payment that comprised a genuine pre-estimate of loss at the time the contract was entered into would not be penal.
This test was adequate in circumstances where a genuine pre-estimate of loss was relatively straightforward. It was less satisfactory in situations where the clause had to cater to a wide range of potential breaches of varying severity or where the loss to the innocent party could not readily be compensated in damages. Examples of matters not readily compensable in damages include loss of goodwill, the breakdown of trust in a long-term relationship and losses arising from increased competition, all of which are generally significant concerns in the JOA context.
As a consequence, it was in practice often difficult to determine in advance whether a clause was an unenforceable penalty, notwithstanding that in many circumstances it had been negotiated between two sophisticated and professionally advised commercial parties.
The New Position Following Cavendish v Makdessi
The Supreme Court revisited this test for whether a clause is a penalty in Cavendish v Makdessi.
Cavendish v Makdessi concerned a share sale arrangement whereby Makdessi (and another seller) sold 60 percent of the shares in an advertising and media company to Cavendish. As one often sees in the JOA context, the agreement contained a non-compete clause, providing that Makdessi (and the other seller) were not to engage in specified activities in competition with the Cavendish company. Makdessi failed to comply with the clause. Two clauses were enlivened by this conduct that were said to be penal: a clause providing that deferred consideration was not payable and a clause allowing Cavendish to purchase Makdessi's interest in the company without any value being attached to goodwill (and therefore at an undervalue).
The Supreme Court held that the test for whether a clause is penal is:
"… whether the clause is a secondary obligation which imposes a detriment on the contract breaker which is out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation."
There are three aspects to this test:
(a) Whether the clause is a "secondary obligation"
(b) The nature and extent of the innocent party's "legitimate interest"
(c) Whether the detriment caused is "out of all proportion"
Primary and Secondary Obligations
When a party enters into a contract, it has a primary obligation to perform the contract and a secondary obligation to compensate the other party in the event that it fails to perform the contract. Thus, to say that the obligation must be secondary means that the obligation must arise upon a failure by the other party to perform the contract—a breach of contract.
In practice, it can be difficult to determine whether there has in fact been a breach of contract and therefore whether the doctrine of penalties is enlivened. In Cavendish v Makdessi, three of the seven judges considered that the clause allowing Cavendish to withhold consideration was not a secondary obligation. It was instead characterized as a clause adjusting the price payable under the contract in the event that certain circumstances occurred rather than a clause regulating the compensation payable upon breach.
The nature and extent of a party's "legitimate interest" is a question of fact in all the circumstances. As a purely factual inquiry, this is an inherently uncertain issue and other cases may be of limited usefulness.
Importantly, interests need not be strictly economic to be legitimate matters for protection. Thus, in an example relevant to JOAs, a party might have a legitimate interest in ensuring that a long-term relationship can be brought to an end (by exercise of a call option) where trust has been eroded even though this is a matter that might not be readily compensable in damages. Indeed, it is in such circumstances that the sorts of clauses under consideration are most useful.
The Supreme Court also held that a party can have a legitimate interest in simply wishing to deter the other party from breaching the contract.
Out of All Proportion
A clause will not be penal simply because the detriment to the contract breaker is disproportionate to the loss to the innocent party. It is a more generous test than that from the perspective of the innocent party: the detriment must be "out of all proportion." This will again be a matter to be considered on a case-by-case basis.
Other noteworthy aspects to the decision include:
(a) A clause can be penal notwithstanding that it does not provide for the payment of a sum upon breach of contract (the paradigm case). This was a welcome clarification. From a commercial perspective, there is little difference between a clause requiring one to make a payment or a clause allowing the other party to withhold a payment or, indeed, a call option priced at an undervalue.
(b) There is a "strong initial presumption" that a clause negotiated between properly advised parties of comparable bargaining power is not penal.
Impact of the Decision on JOA Default Provisions
Cavendish v Makdessi signals that, in future, the courts will grant greater latitude when considering whether a clause is penal. JOAs between parties of comparable bargaining power will be subject to the strong presumption that default provisions are not penal. Further, it follows from Cavendish v Makdessi that interests can be legitimately the subject of protection notwithstanding that they are not readily compensable in damages. It is legitimate for a clause to allow the innocent party to buy out the contract breaker because the breach would represent a breakdown of trust that undermines the value of the ongoing relationship to the innocent party.
Whether the detriment to the contract breaker is out of all proportion is a question of fact and is consequently highly sensitive to the particular circumstances. Often in the JOA context one will be dealing with a high-risk, capital-intensive undertaking, which means that the potential extent of loss (adjudged at the time the JOA contract was entered into) is very substantial indeed and suggests that the threshold of whether the detriment to the contract breaker is out of all proportion will be a high one. In addition, these factors suggest that a party's legitimate interest in deterring a counterparty from breaching its obligations is likely to be a material consideration.