"An ancient, haphazardly constructed edifice" - Penalty clauses in commercial contracts

Supreme Court decision upholds the principle but removes requirement for 'genuine pre-estimate of loss'

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Commercial parties contracting under English law will have followed with interest the Supreme Court cases of Cavendish Square Holding BV v Talal El Makdessi the judgment in which has been handed today. The judgment says that the English law rule against penalties has been misconstrued and that LDs don’t have to represent a genuine pre-estimate of loss in order to be enforceable.

This could make life easier in terms of negotiating delay payments for late delivery of implementations (although these are often predicated as price reductions - on which see below). It may also open the way to more significant "pre-determined" liability payment provisions where it might difficult to prove close connection to the loss but where the wider significance of the potential breach for the innocent party is justified and needs to be recognised (e.g. around breach of confidentiality provisions).

In the case, El Makdessi ("M") agreed to sell Cavendish ("C") a controlling stake in a major advertising and marketing company, and also agreed to certain restrictive covenants. If M breached the restrictive covenants, M was to forgo the final two instalments of the acquisition price, and could also be required to sell his remaining shares to C at a pre-determined discounted price. M did breach the restrictive covenants and he sought to argue the clauses were unenforceable as penalties.

While the Supreme Court has stopped short of abolishing the penalty rule, they are clear to limit its application - it regulates only the contractual remedy available for breach of the primary contractual obligations NOT the fairness of those primary obligations.

The historic question of: "does it represent a genuine pre-estimate of loss" is not, held the Supreme Court, always the correct test. Instead it is more important to focus on whether the prescribed remedy would impose on the defaulting party a detriment that is out of all proportion to the legitimate interests of the innocent party (recognising that the legitimate interests might extend beyond the recovery of a pre-estimate of damages).

The Supreme Court acknowledged the realities of commercial negotiations, noting that the best people to judge the fairness or otherwise of the commercial terms were "the parties, who were, on both sides, sophisticated, successful and experienced commercial people bargaining on equal terms over a long period with expert legal advice and were the best judges of the degree to which each of them should recognise the proper commercial interests of the other". For example, businesses can (still) freely negotiate variable payments linked to supplier performance. The court recognised that such a price adjustment structure operates in a different way to a clause which allows the customer to claim liquidated damages for breach of the supplier's performance obligation (which does seem to validate establishing delay payments and service credits as price reductions), but ultimately classification turns upon substance, not form. Any "disguised punishment", said the court, will remain unenforceable.

In Cavendish, the Supreme Court recognised that the relevant provisions were price adjustments and so long as that is not - as a mechanism - out of all proportion to the legitimate interests of the innocent party, the quantum of that price adjustment is not the court's business. In Cavendish, the clauses operated to reflect the price that C would have been prepared to pay for the business if M did not adhere to the restrictive covenants. For the breach of the restrictive covenants to trigger the price reduction provisions was therefore within C's legitimate interests, not disproportionate and accordingly enforceable.

If you'd like to discuss or would like a more in-depth discussion with colleagues on the impact of the judgment and on liability regimes in sourcing contracts more generally, please contact Duncan Pithouse, or your usual DLA Piper contact.