Penalty clauses

A common problem in contract drafting is avoiding writing a liquidated damages clause that manages not to be a penalty. I thought the touchstone was whether it was a genuine pre-estimate of loss - an honest attempt to put a value on the damages that would be suffered if there were a breach. Not so. In Cavendish Square Holdings Ltd v El Makdessi [2012] EWHC 3582, a case on a restrictive covenant in a share sale agreement (a breach of which meant that future instalments need not be paid and the seller would have to sell the rest of the shares at a lower valuation) the High Court decided the matter on the alternative "commercial justification" test. The court held that the adjustment of consideration would reflect the loss of goodwill. The provisions were not extravagant or oppressive and the purpose was not to deter breach. The provisions had been negotiated on a level playing field (and yes, those words do appear in the judgment).

So, the commercial justification test is more flexible than the old genuine pre-estimate one, although I have a feeling that the one will often include the other - that the commercial justification for a dodgy clause is that it does represent the loss that might be suffered. But there will be cases that go the other way too: and the key element in deciding what is a penalty and what isn't must be whether it is designed to deter breach or not.

There's another point to watch out for: in the case, the consideration adjustment clause was held to be a penalty because it covered a loss which had already been compensated, by damages for breach of fiduciary duty. So make sure you don't include anything that looks like double counting!