Restrictive covenants and penalty clauses

22nd January 2016

A clause providing for payment of a penalty for breach of contract is unenforceable under the common law. It is therefore very important to be able to recognise when a clause will be a penalty and when it is not. Traditionally, the test applied by the courts was to ask whether the payment was a genuine pre-estimate of damages (in which case it would be enforceable) or not. The courts have also recognised as penalties clauses which disentitle the party in breach from receiving a sum which would otherwise be due to him and a clause which requires a transfer of property – including shares – to the innocent party at an undervalue.

In Cavendish Square Holding BV v El Makdessi and Parking Eye Ltd v Beavis [1], the Supreme Court restated the test for ascertaining whether a clause is a penalty. We have written previously on this case. For those involved in mergers and acquisitions what is particularly interesting about this case is that the Court was considering whether provisions applying on a breach of a post-termination covenant were penalty clauses.

The parties had entered into a sale and purchase agreement by which part of the consideration was payable on completion with the remainder deferred. The deferred consideration was payable by reference to the operating profits of the target group. The seller undertook, as is common, not to compete with the target business for an agreed term following completion. It was agreed that if he breached the non-compete covenant he would not be entitled to the deferred consideration payments and he could also be required to sell to the purchaser the remainder of his shares in the target at a price based solely on asset value and without reference to goodwill (a significantly reduced price).

The seller accepted that he had breached the non-compete clause but argued that it was unenforceable as a penalty. The Court disagreed. Under the test applied by the Supreme Court, a clause will not be a penalty where it is part of a primary obligation. Compliance with the non-compete clause was a “primary obligation” and the clause itself was a “price adjustment clause”. The Court went on to say that, even if the penalty rule had been engaged, the purchaser had a legitimate interest in the observance of the covenants; the goodwill was critical to the success of the business and the loyalty of the seller was essential to preserve that goodwill.

WM comment

An interesting aspect of this case is that the non-compete clause could have endured for up to eight years, which is considerably in excess of current market practice. A restrictive covenant must go no further than is necessary to protect the purchaser’s business interest. The reasonableness or otherwise of the duration of the clause was not in issue before the Supreme Court so this case should not be taken as authority for the proposition that an eight-year restraint will always, or indeed mostly, be acceptable.

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[1] [2015] UKSC 67