In a recent decision, the High Court has found that a clause in a settlement agreement which was aimed at protecting a business’s IP rights was not penal, despite imposing “undoubtedly extremely harsh” consequences for breach of certain obligations in a settlement agreement. Under the clause, the relevant party would cease to receive any payment under the settlement agreement, and amounts previously received would become repayable, if he breached obligations prohibiting him from claiming entitlement to the IP rights, challenging the claimants’ ownership of the rights, or challenging the validity of the rights: Permavent Ltd v Makin  EWHC 467 (Ch).
The court applied the test established by the Supreme Court in Cavendish Square Holding BV v Talal El Makdessi  UKSC 67 (considered here) for whether a clause is penal, namely whether the detriment imposed by the clause is out of all proportion to the innocent party’s legitimate interest in enforcing the counterparty’s obligations under the contract. If so it will be penal and therefore unenforceable. This replaced the traditional test of whether a clause is a “genuine pre-estimate of loss” and therefore compensatory, or is aimed at deterring a breach and therefore penal. It was therefore accepted, in the present case, that there is nothing impermissible, per se, in a contract term designed to deter breach, rather than merely compensate for losses resulting from a breach.
In Makdessi, the Supreme Court found that the buyer of a business had a legitimate interest in enforcing restrictive covenants, in order to protect the goodwill of the business, and the parties themselves were the best judges of how that interest should be reflected in the agreement (in the form of a clause which, among other things, deprived the buyer of certain deferred consideration that would otherwise fall due). In the present case, the judge held that the claimants had a legitimate interest in protecting IP rights which the court found were fundamental to their business. That interest went beyond mere compensation for losses directly resulting from a breach of obligations relating to those rights and, as in Makdessi, the court was not prepared to find that the detriment the parties had agreed was disproportionate.
The decision emphasises that, in considering proportionality, the court must consider the position as at the date of the agreement, rather than focusing on the breach that in fact occurred and the harm that resulted directly from it. It also illustrates that the court may be less likely to find that a clause is an unenforceable penalty where (as here) it has been entered into with the benefit of legal advice.
It is interesting, too, that in the present case the claimants did not seek to argue that the relevant clause fell outside the rule on penalties as it was a primary obligation in the form of a price adjustment clause, rather than a secondary obligation that took effect on breach. In Makdessi it appeared from the Supreme Court’s judgment as originally published that the majority had found the clause was a primary obligation and therefore outside the rule. However, Lord Clarke made a late amendment to his single paragraph judgment, which cast doubt on whether that finding formed part of the majority reasoning. In the present case, the claimants accepted that it was “arguable” that the majority had found the clause in Makdessi was (in principle) subject to the rule, and they did not seek to argue to the contrary in the present case.