Tapestry
Alert: UK - Clawback enforcement
November 2015
Dear Client,
A significant case determined by the
UK’s top court, the Supreme Court, has taken the opportunity (the
‘first in a century’) to review the law relating to contractual
penalty clauses. This case is likely to have an impact on the
enforcement of clawbacks in the UK and in other common law
jurisdictions (such as New Zealand and Bermuda) which have ties to
the UK judicial system. The decision relates to whether a
contract can specify an amount to be paid (repaid) if there is a
breach of contract.
The Court did not abolish or extend the penalty rule but did
significantly change the test as to what would amount to an
unenforceable “penalty
clause”. This ruling was a joint judgment delivered
earlier this month (ParkingEye
v Beavis and Cavendish Square Holding BV v El Makdessi).
This change could impact both employment and incentive related
contracts, particularly clawbacks.
What is a
penalty clause?
It is common for a commercial contract to include a provision
specifying that a particular remedy (such as payment or forfeiture of
an amount of money), will apply if there is a breach of contract. If
the party in breach disputes the application of the provision, and it
is a found to be excessive or imposed merely as a deterrent, then it
could be held to be a penalty and be unenforceable. In the UK the
test applied by the court in the past was whether the provision
represents a ‘genuine pre-estimate of the loss’ caused by the
breach. A similar approach is followed in many other
jurisdictions.
When this is considered in the context of clawbacks, there is a
concern that if a company seeks to enforce a clawback and ask for the
award or its value to be returned the employee could argue that the
clawback was a penalty because it was excessive or was imposed as a
deterrent.
What has
changed?
Previously, to enforce this type of clause you had to show that the
amount to be paid was a ‘genuine pre-estimate of loss’. The
Court has rejected this test and held that the true test for
establishing whether a provision is a penalty is whether the
provision imposes a detriment on the defaulting party which is
out of all
proportion to the innocent party's legitimate interest in
enforcing the defaulting party’s obligations under the
contract.
This more flexible test should mean that parties have greater freedom
in setting out the consequences of a breach of contract without the
need to calculate whether the remedy constitutes a genuine
pre-estimate of loss. The key factors are that the innocent
party must have a legitimate interest in the performance of the
contact and the remedy must not be out of proportion or ‘extravagant,
exorbitant or unconscionable’. The wider commercial context of a
transaction will be of greater relevance. Even if the remedy set out
in the provision bears no relationship to the loss actually
attributable to the breach, it will not necessarily be a penalty if
the employer can show that there is a legitimate reason why
compensation for the actual loss suffered would not be sufficient,
for example where the breach damages the employer’s reputation.
The Cases
In ParkingEye,
the Court held that while the penalty rule was relevant, a charge
imposed for parking in a private car park beyond the free two-hour
period was not a penalty. It found that there were legitimate
interests for the car park manager in charging overstaying motorists,
both to control the use of the car park by shoppers and to make a
profit. The Court also found that the £85 excess parking charge
was commercially justifiable and not out of proportion.
The amount at stake in Cavendish
Square Holding BV v El Makdessi was considerably higher
than the £85 in ParkingEye.
The case concerned a breach of restrictive covenants in a contract
for the sale and purchase of an advertising business. The Court
held that the penalty rule did not apply or, if it did, the terms did
not amount to a penalty. The purchaser had a legitimate interest
in enforcing the restrictive covenants and the terms of the
agreement, although harsh, were not exorbitant or unconscionable. The
Court emphasised that the penalty rule was not intended to make a
better bargain for the defaulting party. It was relevant that the
contract was negotiated in detail by parties of equal bargaining
power and with skilled legal advice.
Tapestry
comment: is this relevant to incentives?
This could be
highly relevant – for example in the context of Clawback and also in the
context of bad leaver provisions. In the past the employee could
argue that these provisions did not amount to a ‘genuine
pre-estimate’ of the loss suffered by the employer - and it may have
been hard for the employer to prove loss, for example where the
employee has breached a restrictive covenant.
Now these provisions
should be enforceable unless the financial cost to the employee is
out of
all proportion to
the employer’s legitimate interest in enforcing the
obligations. Careful drafting remains crucial and it may be
helpful specifically to identify the legitimate interest that the
provision is protecting.
If we can be of any help please let
us know.
Janet Cooper, Bob Grayson and Sharon Thwaites
Janet Cooper Bob Grayson Sharon Thwaites
|