The courts are frequently asked to determine whether a clause providing for payment of a fixed sum on breach of contract is a penalty (and unenforceable under English law, even if the parties are of equal bargaining power) or a genuine pre-estimate of loss (liquidated damages), in which case the clause will be enforceable. Forfeiture clauses – that is, clauses which entitle the innocent party to withhold monies which it otherwise would be required to pay over, as opposed to demanding compensation in respect of a breach – can also constitute penalty clauses and the question of whether a forfeiture clause was a penalty was at issue before the Court of Appeal recently in El Makdessi v Cavendish Square Holdings BV. 
Facts of the case
The clause in issue was contained in a share purchase agreement. The clause provided that, on the seller’s breach of a restrictive covenant, the purchaser would be released from its obligation to pay certain deferred consideration and would be entitled to compel the seller to transfer the remainder of his shares in the target company at a price based on net asset value (which was less advantageous than the price that would be payable if there were no breach).
The purchaser sought to enforce these provisions when it appeared that the seller had breached the restrictive covenant. The seller, whilst settling the claim, argued that the clause was unenforceable as a penalty. That argument was rejected by the High Court, which noted that:
- the share purchase agreement had been negotiated heavily over a period of time between sophisticated commercial parties, represented by experienced solicitors
- the purchaser was paying a premium over net asset value of the shares, in part as an incentive for the seller to comply with the restrictive covenants
- the restrictive covenants were integral to the agreement as the value of the target business relied to a great extent on the strength of the seller’s personal connections.
In the circumstances, the High Court considered that the forfeiture of the deferred consideration and the variation to the transfer terms were commercially justified and therefore reasonable. Accordingly, the contract was not a penalty and was enforceable.
Court of Appeal decision
The Court of Appeal, however, came to a different view.
The Court noted that the approach of the courts towards an alleged penalty clause was to assess whether the predominant function of the clause was to deter or whether there was a commercial justification for the clause. This required an assessment of whether the figure in the clause was a reasonable estimate of the likely recoverable loss of the innocent party. In the context of a breach of a restrictive covenant, that loss would be whatever loss was suffered as a result of the breach of the covenant. If the sum exceeded the maximum possible loss, that would be an indicator of a penalty; if it fell within a range of possibilities, it might be reasonable, although that was less likely if the range was very wide. If the provision allowed recovery of more than could be recovered by the innocent party by way of damages, that would indicate that the loss was not an estimate of recoverable loss.
Applying that approach to the clause in question, the Court found that the clause lacked any commercial justification and that its predominant purpose was to act as a deterrent. The loss that the seller stood to suffer from the breach of contract was completely disproportionate to the loss attributable to the breach.
Points to consider
Where a contract provides that, in the event of breach, a sum will be paid that is out of all proportion to the loss attributable to the breach, this is likely to be a penalty as its function is to deter a breach. The same principle applies to provisions requiring a right to be forfeited or assets to be transferred at an undervalue, as in the instant case.
The Court’s emphasis upon whether the clause is commercially justified is noteworthy. This appears now to be the position the courts are taking, as opposed to simply applying the “genuine pre-estimate of loss” test to determining whether a clause is a penalty. The Court stated that a finding of a genuine pre-estimate of loss was not necessarily determinative of the issue.
One of the reasons why the Court found that that the clause was a penalty was that any loss that the purchaser would recover for breach would be ‘reflective loss’. ‘Reflective loss’ refers to the diminution in the value of a shareholder’s shares, together with other losses suffered by the shareholder, as a direct result of the loss suffered by the company. Public policy prevents a shareholder recovering for reflective loss. In this case, the purchaser’s loss would be of the value of its shareholding which would be reflective of a loss to the company itself (and the company could recover those losses either for breach of duty or, following the wording of the share purchase agreement, by bringing a contractual claim itself).
This type of provision will not be uncommon in share purchase agreements, where rights are granted to the target company (for example, by giving the target itself enforceable third party rights) as well as to the purchaser. This could, in some circumstances, lead to the target’s claim excluding the purchaser’s. Where this is the case, a disparity could arise between the loss a purchaser could recover (nil) and the amount a seller is required to pay (or have forfeited), increasing the chances of the clause being found to be unreasonable and therefore unenforceable as a penalty.
The Court suggested that this situation could have been avoided by making payment of the deferred consideration conditional upon the seller’s compliance with the restrictive covenants. Accordingly, it will be sensible if payment of deferred consideration is to be dependent upon the seller’s compliance with its restrictive covenants to structure any deferred consideration as a conditional payment, rather than providing that the purchaser’s payment obligation will fall away in the event of a breach of covenant.
Finally, another drafting consideration to bear in mind, is that the Court took a dim view of the ‘one size fits all’ nature of the clause. In practice, the range of loss that could be suffered could be very wide yet the effect of the clause was the same regardless of whether the breach was trifling or short-lived, on the other hand, or of substantial gravity, on the other. Drafting a more nuanced clause will not be easy but it is more likely to be enforceable.
  EWCA Civ 1539