Breach of contract — when not paying the price is a penalty

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 that entitle the innocent party to withhold monies that 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.

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, while settling the claim, argued that the clause was unenforceable as a penalty. That argument was rejected by the High Court…

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