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Cavendish, a WPP, company agreed in April 2008 to buy from Mr Makdessi and another 60% of their shares in a group of companies founded and owned by them (the Company). The negotiations took 6 months; the parties were represented by City solicitors.
The price was to be paid in 4 instalments. The first two instalments were paid on or shortly after completion. The latter two were due to be paid in the years after completion and were to be calculated as a multiple of after tax profits for post-completion periods. There was a maximum payment of $147.5m. All payments included a considerable amount for goodwill - more than 50% of the initial instalments and 77% if the maximum payment was made.
The sellers had a put option under which they could serve notice on Cavendish requiring it to buy their remaining shares in the Company at a price which included the value of goodwill.
The agreement contained post-completion covenants against competition, solicitation of clients, diverting business away from clients and employing senior employees. The High Court found that the covenants were not in unreasonable restraint of trade, a decision that was not appealed.
The agreement stated that, if Mr Makdessi were in breach of the restrictive covenants, he would not receive the third or fourth payments and could be required to sell his remaining shares in the Company to Cavendish for a price based on net asset value, ie excluding goodwill (“the breach remedies”).
With Cavendish’s agreement, Mr Makdessi ceased to be an employee, but continued to be a non-executive chairman until July 2009 and was a non-executive director until he was removed in April 2011.
By December 2010, Mr Makdessi was deemed by Cavendish to have acted in breach of the restrictive covenants and to be in beach of his fiduciary duties to the Company as director. He was doing this by:
Mr Makdessi settled the breach of fiduciary claim with the Company for $500,000. Cavendish then sought an order from the court that Mr Makdessi was not entitled to the remaining payments and was obliged to sell his shares in accordance with the call option which Cavendish had exercised. It also claimed damages for loss of value of shareholding, but abandoned the argument on the grounds that this was “reflective loss” - a principle of public policy which states that, where a shareholder is owed a duty by a third party who also has a duty to the Company, the shareholder cannot recover for his loss in the value of the Company, as per House of Lords case of Johnson v Gore Wood.
Mr Makdessi’s primary defence was that the breach remedies were penal. Two reasons were that any loss suffered was irrecoverable under the reflexive loss principle, so no figure greater than zero could be a genuine pre-estimate of loss: and that there were four separate restrictive covenants, all of which attracted the same draconian remedies, however serious the breach.
Cavendish argued that the breach remedies were not designed to provide compensation on breach, even though they did operate on breach. The appropriate test was whether the clauses had a commercial purpose/justification and lacked a predominant intention to deter. The purpose of the provisions depriving Mr Makdessi of the last two payments was to adjust the price that Cavendish was prepared to pay if Mr Makdessi was unable to keep to the covenants. The call option to buy the shares at net asset value had the commercial purpose of swiftly decoupling Makdessi from the Company in circumstances where he had shown himself unprepared to abide by the covenants.
The High Court found in favour of Cavendish for much the same reasons as were advanced by Cavendish.
The Court of Appeal held unanimously that the remedies available to Cavendish were penal and unenforceable. Its reasoning was as follows:
This case has many things to say about the drafting of prescribed remedies when things go wrong in a contract, and the implications are not easy to work through. When drafting an IT services contract on behalf of multiple group customers, for instance, think carefully about the service credit regime – are they proportionate, who can claim them and for what? And make sure that a service provider cannot end up liable twice for the same loss.
Ideally, all relevant clauses should be reviewed in light of this decision and principles worked out for drafting such clauses in future agreements.
It will be interesting to see whether this case goes to the Supreme Court. In the meantime, it has to some extent clarified the law on penalties, following various recent High Court decisions that have not always set out the law consistently. In particular, the move away from genuine pre-estimate of loss towards commercial justification has been confirmed.
For more information please contact John Sykes, Partner
T: +44 (0)20 7203 5358