Supreme Court Clarifies Contract Penalty Rule

News - 10/12/2015

Last month the Supreme Court fundamentally considered the law relating to contractual penalties.  As a result, rather than considering whether or not a clause imposes a genuine pre-estimate of loss, Courts will focus more generally on whether it provides a detriment that is out of all proportion to any legitimate interest of the innocent party.

The joint ruling considered two very different cases.  One, a $45million dispute relating to the sale of a stake in an international advertising agency based in the Middle East (Cavendish).  The other, a £85 private parking fine levied against a fish and chip shop owner from Billericay.  However, at the heart of both disputes was whether or not these financial consequences were enforceable due to the longstanding prohibition on contractual penalties.

In summary, the Supreme Court found that, whilst there is still a place in English law for the penalty rule, it had “not weathered well” and had lost relevance in the world of modern commerce.  The Supreme Court found that determining whether or not a clause comprises a punishment does not simply involve determining whether or not it involves a genuine pre-estimate of loss.  Instead, this is only one factor and a contractual deterrent can be enforceable so long as the deterrence is not “unconscionable” or “extravagant”.

In addition to the impact on commercial contracts, the Cavendish case is also likely to have an effect on the negotiation and drafting of M&A documents.  In considering the commercial background of the Cavendish deal the Supreme Court held that the penalty doctrine was not, in fact, invoked.  This was because the relevant provision (designed to protect goodwill) was a price adjustment triggered by the breach of a primary obligation rather than a secondary obligation following a breach.

As such, it comprises an inventive way of giving teeth to restrictive covenants designed to protect goodwill.  Such sanctions will require sufficient clarity on the legitimate interest being protected.  This is in order to minimise the risk of it amounting to a secondary obligation (which could be deemed a penalty).  In doing so care must also be given to the consequence that the sale proceeds are earned income for both the transfer of shares and the future observance of the restrictive covenants.  As the market responds to this, we expect careful consideration to be given to the tax consequences of this approach and conventional wisdom relating to earn outs and the capital treatment of sale proceeds.

For more information, please contact Greg Vincent, a Partner in the Corporate and Commercial team at our Wimbledon office on 0208 971 1033.  Further details relating to our Corporate and Commercial team can be found here.

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