Penalty Clause Unenforceable, Rules Court of Appeal

A recent Court of Appeal case has reaffirmed the principle that the English courts will uphold a clause that allows commercial restitution, but not one that constitutes a penalty.

When an advertising business bought a Middle Eastern company that had been built up using the extensive contacts of its managing director, it understandably insisted on a strong non-competition clause being included in the sale agreement.

The clause lasted for two years and provided for very stringent financial penalties in the event that the vendor breached a number of obligations.

The managing director of the company sold breached the agreement, even during the 'handover' period in which he was an employee of the purchasing company. The purchasers then sued him for breach of duty (for which they received a settlement) and also for the breach of the non-competition clause.

One of the stipulations of the agreement was that any breach meant that the balance of the purchase consideration for the company was no longer payable.

The maximum loss which the vendor could suffer by the breach was more than $80 million. The Court ruled that this was totally disproportionate to any loss which the purchaser might suffer as a result of the breach. As such, this provision constituted a penalty clause and could not be enforced.