Makdessi v Cavendish Square Holdings BV & Anor

The penalties doctrine can apply to a term triggered by breach even where it withholds an entitlement or requires property to be transferred at an undervalue. The court examines the provision objectively, against the whole contract and its commercial context at the date of agreement. A term is penal where the consequence is extravagant and unconscionable compared with the loss attributable to breach and its predominant function is deterrence. A genuine pre-estimate of loss is relevant but not exhaustive. Commercial justification, difficult assessment of loss, equal bargaining power and legal advice may support enforcement, but are not conclusive. A term that adjusts consideration or separates parties remains subject to the doctrine. The provisions here were penal because they imposed substantial forfeiture or loss of goodwill on a wide range of breaches, including breaches causing no recoverable loss.

Mr Makdessi sold shares in a Middle Eastern advertising group to Cavendish while retaining a minority shareholding. The agreement deferred part of the consideration and included restrictive covenants protecting goodwill. Clause 5.1 withheld interim and final payments if a seller became a defaulting shareholder. Clause 5.6 gave Cavendish a call option over the seller’s remaining shares at net asset value.

Mr Makdessi admitted breaches connected with his involvement in a competing business. Cavendish sought declarations and specific performance. The company separately pursued a fiduciary-duty claim, which was settled for $500,000. Burton J held that the restrictive covenants were not an unreasonable restraint of trade, that clause 5.6 was not penal, and that clause 5.1 was penal because of the possibility of double recovery. The central issue on appeal was whether clauses 5.1 and 5.6 were penalties and whether the subsequent $500,000 recovery affected that question.

1. Disposition. The appeal was allowed. The declarations and directions made below were set aside, save for the declaration that clause 11.2 was not an unreasonable restraint of trade. The cross-appeal was allowed insofar as it concerned the $500,000, which Cavendish was not liable to pay.
2. The penalties doctrine is not confined to provisions requiring payment of money. It can apply to a clause which, on breach, deprives the contract-breaker of an entitlement otherwise due or requires property to be transferred for nothing or at an undervalue. The nature of the breach does not remove such a provision from the doctrine. This followed the principle applied in Jobson v Johnson [1989] 2 WLR 1026 and the authorities concerning withheld entitlements.
3. The question is objective and depends on construction of the whole agreement in its commercial context, judged when it was made. The court asks whether the consequence of breach is extravagant and unconscionable compared with the loss attributable to the breach and whether the predominant function is deterrence. A genuine pre-estimate of loss remains relevant, but the analysis is not confined to a rigid dichotomy between compensation and penalty. Commercial justification, the parties’ bargaining position, legal advice and the difficulty of assessing loss are relevant, but none is decisive.
4. Clause 5.1 was penal. Cavendish’s recoverable damages were likely to be zero because its claimed loss was reflective of loss suffered by the company. Nevertheless, the clause could deprive Mr Makdessi of millions or tens of millions of dollars on the first breach of any of four covenants. The covenants covered breaches of widely varying seriousness and consequences. The forfeiture therefore bore no proportionate relationship to the breach. The possibility of a separate fiduciary-duty claim reinforced the penal character rather than providing sufficient commercial justification.
5. Clause 5.6 was also penal. It required the remaining shares to be sold at net asset value, excluded goodwill and prevented exercise of the put option, which could otherwise produce a goodwill-based price. Adjusting consideration and decoupling the parties were legitimate commercial objectives, but did not justify the extravagant terms selected. The court would not scale down the provisions or rewrite the bargain by substituting a fair-value mechanism not specified by the parties.

1. Court of Appeal (Civil Division) — In [2013] EWCA Civ 1539, the appeal was allowed. The cross-appeal was allowed in part concerning the $500,000 payment.
2. High Court of Justice, Queen’s Bench Division, Commercial Court — Burton J decided the matter under [2012] EWHC 3582 (COMMERCIAL). He upheld the restrictive covenants, held clause 5.6 not to be a penalty, and treated clause 5.1 as penal because of double recovery, subject to repayment of the $500,000.