High Court finds clause imposing harsh consequences for breach of term aimed at protecting IP rights was not an unenforceable penalty

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 [2021] EWHC 467 (Ch).

The court applied the test established by the Supreme Court in Cavendish Square Holding BV v Talal El Makdessi [2015] 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.

Background

Until 2017, the defendant (Mr Makin) and a Mr Yeremeyev together operated a business supplying roofing products to the construction industry, through a group of companies which included the two claimant companies. Mr Makin was managing director of the first claimant (Permavent) and a shareholder of the second claimant (Greenhill, which was the sole shareholder of Permavent).

Mr Makin had invented and developed the "Easy Roof System" which formed a significant part of the claimants' business. In around 2016, a dispute arose between Mr Makin and Mr Yeremeyev as to the running of the business, and as to the beneficial entitlement to the patents relating to the Easy Roof System.

In 2017 Mr Makin resigned as director of Permavent, and purported to terminate Permavent's licence to use the patented Easy Roof System products. He also contacted suppliers of the Easy Roof System, withdrawing permission for them to produce patented products.

Permavent responded by issuing a claim form in July 2017 seeking a declaration that various patents (the "IP Rights") belonged to Permavent and an injunction restraining Mr Makin from transferring or licensing the IP Rights.

In September 2017, the parties agreed a settlement under which (among other things) Greenhill bought back Mr Makin's shares for £620,000 and Mr Makin assigned the IP Rights to Greenhill for £1. The claimants agreed to pay Mr Makin a further payment, the "Easy Roof System Payment" or "ERSP", quarterly in arrears, calculated at 5% of gross turnover and licence fees until the expiry of the IP Rights.

By clause 2.10 of the Settlement Agreement, Mr Makin promised that he would not claim entitlement to, challenge Greenhill's ownership of, or challenge the validity of any of the assigned IP Rights.

Clause 2.11 provided that if Mr Makin breached any of the prohibitions in clause 2.10 then:

• the ERSP would immediately be reduced to zero per cent and no further ERSP would become due;
• the ERSP would be adjusted retrospectively such that any amount of ERSP previously due would no longer be payable and Mr Makin would have to repay any ERSP previously paid to him; and
• Mr Makin would be liable to pay the sum of £616,667 to Greenhill.

In December 2018, Mr Makin sought to register with the UK Intellectual Property Office an equitable interest in five of the patents and patent applications comprising the IP Rights. The claimants then ceased paying the ERSP and sought:

• an injunction requiring Mr Makin to withdraw his notice of equitable interest and restraining him from challenging the IP Rights;
• a declaration that no further ERSP need be paid pursuant to the Settlement Agreement; and
• repayment of all ERSP paid and of £616,667 under the Settlement Agreement.

The claimants obtained summary judgment on the issue of breach, as well as the injunctions sought. The only remaining issue was therefore whether clause 2.11 constitutes an unenforceable penalty.

Decision

The High Court (Mr Justice Zacaroli) held that the provisions in question were not unenforceable penalty clauses.

Zacaroli J noted that the law on penalties is now to be found in the Supreme Court decision in Makdessi (referred to above). This established that the question of whether a clause is unenforceable as a penalty turns on whether: (i) it is a secondary obligation triggered by breach of a primary obligation; and (ii) it imposes a detriment on the contract-breaker which is unconscionable or extravagant as being out of all proportion to the innocent party's legitimate interest in enforcing the primary obligation. The test is not, as previously thought, whether the clause sets out a genuine pre-estimate of loss.

Here it was common ground that clause 2.11 imposed a secondary obligation triggered by a breach of the primary obligations in clause 2.10, and therefore the penalty rule was potentially engaged. The claimants did not seek to argue (as was argued in Makdessi) that clause 2.11 was a price adjustment clause, and therefore a primary obligation which was not caught by the rule. They accepted that it was "arguable" that a majority of the Supreme Court in Makdessi considered that such a clause was caught by the rule.

The claimants argued instead that the detriment imposed by the clause was not out of all proportion to the legitimate business interest which the clause was designed to protect, and therefore did not fall foul of the rule.

In considering whether the detriment was disproportionate to the protected interest, the judge rejected Mr Makin's argument that only the obligation actually breached (ie the obligation not to claim entitlement to the IP rights) should be considered. The obligations in clause 2.10 were to be seen, together, as restricting Mr Makin from interfering in any way with the IP Rights. But even if the obligations were to be viewed separately, the judge did not accept that a breach of the obligation not to claim entitlement to the IP Rights would likely cause less harm than a challenge to their validity, and so that argument would not assist Mr Makin.

Zacaroli J also rejected the submission that the comparison should be between the claimants' interests in Mr Makin not registering the equitable interest at the UKIPO and the consequences imposed by clause 2.11. That would be to focus, wrongly, only on the breach that in fact occurred and the harm that resulted directly from it. The proper comparison was between the detriment imposed and the interests which it sought to protect, as at the date of the agreement.

It was common ground that the interest which clause 2.11 was intended to protect went beyond mere compensation for losses flowing directly from breach of the relevant obligations. Given the importance of the IP Rights to the claimants' business, the judge stated, any breach of clause 2.10 had the potential for very significant harm, including damaging their ability to source, manufacture or sell products, leading to lost sales and longer term damage in their relationships with suppliers. Their ability to raise finance or investment could also be damaged, and the value of the business diminished.

Overall, while the judge described the detriment imposed by clause 2.11 as "undoubtedly extremely harsh", he did not accept that any aspect of the detriment was "extravagant, exorbitant or unconscionable", as being out of all proportion to the interests protected by the clause, given the potential damage to the claimants' business arising from a breach of clause 2.10. While the question was, the judge said, broader than merely comparing the quantum of the detriment with the quantum of the anticipated losses, he noted that the potential damage could reasonably have been anticipated to run to many hundreds of thousands of pounds, commensurate with the quantum of the detriment.

The judge also took into account the fact that Mr Makin had entered into the Settlement Agreement with the benefit of legal advice, and there could be no doubt that he and his solicitors were alive to the full consequences of the clause.