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Employment Law Implications for Liquidated Damages and the Penalty Rule following El Makdessi

Paul Gilroy QC looks at the employment law implications for liquidated damages and the penalty rule following El Makdessi in the
Supreme Court

In English law there is a
presumption in favour of freedom of contract. The penalty rule represents an
exception to that principle. A properly drafted liquidated damages clause
entitles the claimant to recover the amount stipulated in the clause even if
the actual loss is less than the amount payable. The inclusion of the clause is
intended to provide certainty, to make the recovery of damages easier and less
costly and, from the opposite perspective, to limit liability.

For
a century, the English Courts have applied the test articulated by Lord Dunedin
in Dunlop
Pneumatic Tyre Company Limited v New Garage and Motor Company Limited [1915] AC
79
when determining whether a contractual provision which purports to
be a liquidated damages clause offends against the rule against penalties. The
Supreme Court has now revisited this area in Cavendish Square Holdings BV v El
Makdessi [2015] UKSC 67; 3 WLR 1373
). Whilst the ripple effect of this
definitive twenty first century reappraisal of the subject has yet to be seen
in the authorities on employment law (currently, the reported cases post-El
Makdessi
have been in the fields of construction, international
arbitration and a family law matter concerning the enforcement of a charge over
property) it is likely that El Makdessi will come to be seen as
a milestone case for those engaged in both contentious and non-contentious
employment work, affecting not only service agreements and termination payment
clauses, but such matters as clawback clauses in settlement agreements,
restrictive covenants, golden parachutes, and provisions concerning the repayment
of training costs.

El Makdessi

By
an agreement, Mr Makdessi agreed to sell to Cavendish a controlling stake in
the holding company of the largest advertising and marketing communications
group in the Middle East. The contract provided that if he was in breach of
certain restrictive covenants against competing activities, Mr Makdessi would
not be entitled to receive the final two instalments of the price paid by
Cavendish and could be required to sell his remaining shares to Cavendish at a
price excluding the value of the goodwill of the business. Mr Makdessi
subsequently breached the covenants. He argued that the relevant clauses were
unenforceable as penalties. The Court of Appeal, overturning Burton J at first
instance, held that the clauses were unenforceable under the penalty rule as
traditionally understood. The Supreme Court upheld the appeal of Cavendish,
thus upholding the validity of the disputed clauses. Lord Neuberger and Lord
Sumption delivered a joint judgment with which Lord Clarke and Lord Carnwath
agreed. Lord Manse and Lord Hodge delivered concurring judgments. Lord Poulson
agreed that the appeal in Makdessi should be allowed.

The new approach

 

  • The
    penalty rule is an
    “ancient, haphazardly
    constructed edifice which has not weathered well”
    . However, it is of longstanding
    and a similar rule exists in all other developed systems of law. It also covers
    types of contract which are not regulated in any other way. It should not
    therefore be abolished, but neither should it be extended.
  • The
    fundamental principle is that the penalty rules regulates only the contractual
    remedy available for the breach of primary contractual obligations, and not the
    fairness of those primary obligations themselves.
  • The
    relevant contractual remedy typically stipulates the payment of money, but it
    equally applies to obligations to transfer assets, or clauses whereby one party
    forfeits a deposit following its’ own breach of contract (such as in the
    Cavendish case).
  • Lord
    Dunedin’s tests in
    Dunlop Pneumatic have too often been treated as a code. The
    speeches of the rest of the Appellate Committee, particularly Lord Atkinson,
    are at least as important.
  • The
    validity of a clause providing for the consequences of a breach of contract
    depends on whether the innocent party can be said to have a legitimate interest
    in the enforcement of the clause. There is a legitimate interest in the
    recovery of a sum constituting a reasonable pre-estimate of damages, but the
    innocent party may have a legitimate interest in performance which is then
    beyond the recovery of pecuniary compensation. The law will not generally
    uphold a contractual remedy where the adverse impact of that remedy
    significantly exceeds the innocent party’s legitimate interest.
  • The
    law relating to penalties has become “the prisoner of artificial
    categorisation” and the concepts of “
    deterrent
    and “
    genuine pre-estimate of loss
    are unhelpful.
  • The
    true test is whether the impugned provision is a secondary obligation which
    imposes a detriment on the contract-breaker out of all proportion to any
    legitimate interest of the innocent party in the enforcement of the primary
    obligation.
  • The
    first step is to consider whether any (and if so what) legitimate business
    interest is served and protected by the clause, and if so and secondly, whether
    the provision made for that interest is extravagant, exorbitant or
    unconscionable.
  • The
    existence of the penalty doctrine is justified by its longstanding invocation
    and endorsement in the United Kingdom and across common law jurisdictions.
  • Damages
    payable on breach will be a penalty if there is an extravagant disproportion
    between the stipulated sum and the highest level of damages that could possibly
    arise from the breach.

Drafting

The
penalty rule may be avoided by drafting the relevant clause as a primary
obligation. The Supreme Court stated that the issue “can still turn on questions of drafting, even where a realistic
approach is taken to the substance of the transaction and not just its form”
.
Taking the facts of El Makdessi for example, drafting the relevant provision in
that case as a condition precedent, making payment of the final instalment
conditional on compliance with the restrictive covenants, could have had the
result of avoiding the law on penalties. However, the Judges of the Supreme
Court had different views on what amounted to primary and secondary
obligations. Accordingly, careful drafting will not always guarantee that the
penalty rule can be avoided by framing what amounts to a penalty as a primary
obligation. It would nevertheless seem sensible to at least use the label of
primary obligation as a means of bolstering the prospect of the clause being
upheld.

Prospects
of enforcement are also improved if the clause identifies the interest which is
to be protected and which is acknowledged by the parties to be a legitimate
interest.

El Makdessi underscores the need to tailor a
repayment clause in a settlement agreement according to the different
circumstances in which the agreement might be breached (see also CMC
Group plc and others v Michael Zhang [2006] EWCA Civ 408
). The same
principle applies to early termination of a service agreement.

Application
to Sport

The managers of elite football
clubs in England will frequently have clauses in their service agreements which
purport to be liquidated damages clauses, specifying fixed sums which will be
payable either way in the event of early termination (ie termination prior to
the expiration of a specified fixed term) but there is often a disparity as
between the sum payable by the manager for early termination and the sum
payable by the club in such circumstances. Unusually, in Berg v Blackburn Rovers Football
Club & Athletic plc [2013] EWHC 1070 (Ch)
, it was the club seeking to argue that such a
provision (in a service agreement drafted by its own solicitors) amounted to a
penalty, having dismissed its manager a matter of weeks into his tenure, giving
rise to a liability under the relevant clause to pay him a sum in excess of £2
million. The High Court held that the payment did not constitute a penalty on
the basis that it was a sum of money payable under a contract on the occurrence
of an event other than a breach of a contractual duty owed by the paying party
to the receiving party. It is known that the Premier League Manager’s
Arbitration Tribunal considered El Makdessi in the recent case of Pulis
v Crystal Palace
but the Tribunal’s full award in that case has not
been released. It remains to be seen
whether the more extravagant provisions described as “liquidated damages”
clauses contained within the contracts of the managers of the highest profile
will survive scrutiny in the wake of El Makdessi.

The
Future

El Makdessi replaces the “genuine
pre-estimate of loss” test with a broader test of the “wider commercial
context”, but even prior to El Makdessi the Courts were willing,
when assessing whether a clause was penal, to give weight to the commercial
context of contractual arrangements. It
may be that there is now scope for expert evidence on this issue (see also Azimut-Benettia
SpA v Healey [2010] EWHC 2234 (Comm)
).

The Supreme Court has, in effect,
endorsed the presumption of freedom of contract. The bar seems to have been
raised for those seeking to challenge the enforceability of liquidated damages
clauses. The clear emphasis now is on whether the detriment imposed on the
contract breaker is “out of all
proportion to any legitimate interests of the innocent party”
. Post-El
Makdessi
it seems likely that the courts will proceed on the basis that
properly advised parties with comparable bargaining power will be the best
judges of agreeing, in advance, the price of a breach of contract.

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