Supreme Court re-examines law on penalty clauses in commercial contracts

Facts

The Supreme Court was asked to consider a buyer’s appeal in relation to two disputed penalty clauses contained within a share purchase agreement (SPA). The clauses imposed that if the seller breached the restrictive covenants in the SPA he would:

  • Not be entitled to the remainder of the deferred payments in relation to his sale of shares in the company;
  • Be required to sell his shares in the company to the buyer at a default price based on the net assets of the company not including good will.

Judgment

The judges unanimously found in favour of the buyer, and in doing so re-examined the common law principal in relation to penalty clauses. The law traditionally distinguished between clauses aimed at compensating an innocent party as enforceable and those which are aimed at deterring a breach which are penal and unenforceable. In this case, the Court held that the two clauses in question were not enforceable penalties. The judges stated that the key test in determining whether a penalty clause is enforceable is whether the clause imposes a detriment on the party in breach, out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation. This case is relevant in relation to the negotiating and drafting of commercial contracts. In cases where contracts are negotiated by sophisticated business parties, clauses may now be enforceable even where they are penal.

Cavendish Square Holding BV v Talal El Makdessi