Restrictive covenants and penalty clauses: the view from the Supreme Court

9 minute read
10 November 2015


The Supreme Court has restored a 2012 High Court ruling related to competition after the sale of a business, which had been reversed by the Court of Appeal in 2013.

There is a long line of cases covering the extent to which buyers can legitimately keep sellers out of the same market following a sale. This is usually done by contractual covenants, whereby the seller agrees not to take certain actions for a defined period. These restrictions may be backed up by provisions entitling the buyer to payment of specified amounts if the seller later breaches the covenants.

Sellers who have entered into these kinds of restrictive covenant have traditionally attacked their validity on two separate grounds:

  • that the restriction is an unlawful restraint of trade, going further than is required to protect the legitimate interests of the buyer; and
  • that any payment required for alleged breach of the restrictions is a penalty (i.e. the amount payable grossly exceeds the loss that could actually flow from the breach of contract); or in other words, the payment clause is there purely to "scare off" the seller.

Our earlier alert issued in December 2013 reported on the reversal of the first instance judgment by the Court of Appeal.

The Supreme Court has now restored the first instance decision in favour of the buyer.

Background to the case

TYR was prominent in advertising and marketing activities in more than 20 countries in the Middle East. A company in the WPP advertising and marketing communications group held a 12.6% shareholding in TYR.

In 2008, the WPP group company (WPP) acquired a further 47.4% of TYR's shares, taking the total WPP group holding in TYR to 60%. The price for the 47.4% holding was a maximum of around $150 million, payable partly on completion and partly by way of future instalments. This was against a net asset value for the whole of TYR's business of around $70 million.

TYR's business had been built up mainly on the back of personal contacts established by its proprietors, one of whom (the defendant, Mr Makdessi) was prominent in Lebanese business and society. It was not surprising that WPP insisted that the sale and purchase agreement (SPA) contained extensive non-competition covenants from the sellers. It also contained put options under which the sellers could force WPP to buy the remaining 40% of TYR at a price based on a profit multiple.

The SPA also provided that if there was any breach of the non-competition covenants:

  • WPP no longer had to pay a penny of the future instalments of the price for the 47.4% holding; and
  • the sellers entirely lost their put options referred to above; instead WPP had an option to acquire the remaining 40% of the shares at a lower price (based on net asset value).

The non-competition covenants were expressed to continue in force until the expiry of a period of two years after WPP acquired all of TYR's issued shares under the above options (or after earlier termination of the sellers' employment/directorships); this could have been as late as 2016, or around eight and a half years after completion of the SPA.

In spite of the very large amounts paid to Mr Makdessi, and the even larger amounts due in the future, he carried on competing businesses after completion of the SPA. He did so at a time when he was a director of TYR. This meant that, leaving the SPA aside, Mr Makdessi was in breach of his fiduciary and other duties to TYR as its director. TYR sued for those breaches and the action was settled with a payment of $500,000 to TYR.

WPP pursued Mr Makdessi separately for breach of the restrictive covenants in the SPA. Mr Makdessi responded that the covenants and price adjustment clauses were unlawful and unenforceable because:

  • their duration was excessive and in restraint of trade; and
  • the forfeiture of future instalments of the sale price was a penalty.

It was held that the provisions were, in general, reasonable in the circumstances. Relevant factors included:

  • the overall terms of the deal had been heavily negotiated over a period of over six months between sophisticated parties who were acting freely in their own best interests, not under any form of oppression, and who were represented by experienced solicitors; there was accordingly a "level playing field".
  • the buyer had agreed to pay a very substantial premium over net asset value, provided the restrictions in the SPA were complied with; it was prepared to pay handsomely for the protection of TYR's goodwill.
  • the fact (expressly acknowledged in the SPA) that the value of TYR's business depended heavily on the sellers' personal connections in the Middle East region.

The duration of the covenants was also acceptable. The judge commented that "as has frequently been stated, at any rate in vendor-purchaser covenants [as contrasted with contracts of employment], there is no reported case in which a restriction otherwise reasonable has been held to be unreasonable on grounds of duration".

The court also held that the parties were free to agree a recalculation of the price by reference to potential loss of goodwill through breach of the restrictive covenants. Loss of rights to future payments could, in principle, amount to a penalty, just as much as a payment obligation falling on the sellers. However, the forfeiture of the future instalments and the variation of the option terms were justified in the circumstances. They were thus not penalties and these provisions were enforceable, save as mentioned below.

The only problematic element was that, as mentioned above, WPP had already procured TYR to sue the sellers for breach of their duties to TYR by acting in competition with it. This had led to a settlement sum of $500,000 being paid to TYR. To the extent that the price adjustment allowed WPP to recover reflective loss (i.e. loss based on the diminution in the value of TYR's shares), this amount had to be offset in order to avoid double counting. To the extent that the SPA permitted any such double counting, that was an invalid penalty.

Cavendish Square Holdings BV v Talal El Makdessi [2015] UKSC 67

Action points

This case should certainly not be taken as authority that eight year restrictive covenants and loss of over $100 million in sale price instalments on breach will be valid in every case. Any restrictive covenant must still pass the test of going no further than required for the protection of the buyer's legitimate interests.

However, the decision does demonstrate that courts will be slow to find invalidity where terms are freely negotiated between parties on a "level playing field". Where it appears that the price agreed takes account of any rights given up by the seller, this will also be a highly relevant factor. On the other hand, excessive restrictions are never justifiable purely by the amount allegedly paid for them.

It should be noted that neither UK nor European Union competition rules applied in this case. Where those rules apply, any agreement restricting competition must clear additional hurdles. Published guidance states that a non-competition agreement is justified for a period of up to three years where both goodwill and know-how are transferred, but only up to two years where goodwill alone is transferred. But these are only the broadest starting points and each transaction must be considered on its own specific facts. The geographic scope and subject matter of any restrictions must also be appropriately limited by reference to the specific business involved.

Accordingly, in framing non-competition clauses, it is essential to analyse the respective bargaining strengths of the parties and the extent to which value is being given for any restrictions accepted by the sellers. The nature and location of the target business should also be carefully considered before deciding what restrictions are reasonable and justifiable in each case.

The case has no relevance to the validity or otherwise of restrictive covenants in contracts of employment. Courts approach these on the assumption that there is rarely, if ever, a "level playing field" as between employer and employee. It is therefore much more difficult to show that a lengthy restriction is reasonable and necessary and has been entered into of the employee's free will.

NOT LEGAL ADVICE. Information made available on this website in any form is for information purposes only. It is not, and should not be taken as, legal advice. You should not rely on, or take or fail to take any action based upon this information. Never disregard professional legal advice or delay in seeking legal advice because of something you have read on this website. Gowling WLG professionals will be pleased to discuss resolutions to specific legal concerns you may have.