Legal update on penalty clauses in English law franchise agreements and other IP centric agreements

Clause imposing harsh consequences for breach of a contractual term aimed at protecting intellectual property rights is held not to be an unenforceable penalty.

Summary

A recent High Court case has provided valuable insight into the level of importance that the courts are willing to give to intellectual property rights when determining whether a contractual term aimed at protecting them is an unenforceable penalty.

On 2^nd March 2021, in Permavent Ltd and another v Makin, the High Court held that even though a clause in a settlement agreement was "undoubtedly extremely harsh" it did not constitute an unenforceable penalty due to the importance of the intellectual property rights it sought to protect.

This judgment provides useful guidance on the principles established by the Supreme Court in the landmark joint judgment in the cases of Cavendish Square Holding BV v Talal El Makdessi ("El Makdessi") and ParkingEye Ltd v Beavis ("ParkingEye"). To read our article on the Supreme Court judgment and its relevance for franchise systems, please click here. Whilst this latest judgement does not involve a franchise system, it does relate to the protection of intellectual property rights, which are of course at the heart of every franchise system.

Facts

For many years, Mr Makin was the managing director of Permavent Ltd ("Permavent").  During this time he invented various roofing products under the name ‘Easy Roof System’ ("ERS") for which he applied (and in some cases was granted) patents in his own name.  When Makin’s relationship with Permavent deteriorated and negotiations for the terms of his departure broke down, he purported to terminate Permavent’s licence to use the patented ERS products and to withdraw permission for suppliers of those products to manufacture them.  In response, Permavent issued proceedings against Makin seeking a declaration that various patents and patent applications relating to the products (the "IP Rights") belonged, and so should be transferred, to it and an interim injunction preventing Makin from transferring or licensing them.

The parties entered into a settlement agreement (the "Agreement") to resolve the dispute.  Under the terms of the Agreement, Makin would assign the IP Rights to Greenhill (the second claimant and sole shareholder of Permavent) in exchange for receiving quarterly royalty payments calculated by reference to sales of the ERS patented products.  These payments were to continue until the last of the IP Rights expired.  In addition, the Agreement included a clause in which Makin promised not to claim any entitlement to, or challenge, any of the assigned IP Rights.  It also provided that if Makin broke his promise in breach of this clause he would not only forfeit his right to any future royalty payments under the Agreement, but he would also have to repay any royalty payments he had already received (the "Breach Clause").  

A little over 15 months after the Agreement was entered into, Makin sought to register an equitable interest in five of the patents and patent applications comprising the IP Rights.  In response, Permavent stopped the royalty payments, claimed repayment of all the sums Makin had already received, and sought a declaration that no further royalty payments need be made.  It also sought injunctions requiring Makin to withdraw his notice of equitable interest and restraining him from challenging the IP Rights, claiming that he had acted in breach of the Agreement.  Makin counterclaimed, arguing that the Breach Clause constituted an unenforceable penalty.  

In May 2020, Permavent obtained summary judgment on the issue of breach, as well as the injunctions it had sought.  This just left the issue of whether the Breach Clause constituted an unenforceable penalty.

Judgment

The High Court held in favour of Permavent, finding that the Breach Clause was not an unenforceable penalty.

It confirmed that the law on contractual penalty clauses had been established in 2015 by the Supreme Court in the cases of El Makdessi and Parking Eye.  In the El Makdessi case, the Supreme Court held that the test for determining whether a clause was an unenforceable penalty was whether the detriment imposed by that clause on the party in breach was out of all proportion to the innocent party's legitimate interest in enforcing it.  The Supreme Court also noted that "in a negotiated contract between properly advised parties of comparable bargaining power, the strong initial presumption must be that the parties themselves are the best judges of what is legitimate in a provision dealing with the consequences of breach".

In its judgment, the Supreme Court expressly rejected the then current “genuine pre-estimate of loss” test, namely if the clause was a genuine pre-estimate of loss, designed to compensate the innocent party for losses resulting from a breach, then it was enforceable.  If, on the other hand, the clause was aimed at deterring a breach, then the clause was penal and unenforceable.

Applying the Supreme Court ruling to the case before it, the High Court identified two key questions: 

• what legitimate business interest of Permavent was served and protected by the Breach Clause; and
• whether the detriment imposed on Makin by the Breach Clause as a consequence of his breach was unconscionable, exorbitant, extravagant or out of all proportion to that interest.  This question was to be determined by construction of the Agreement at the date it was entered into, and not by reference to the harm that was caused by the breach.

With regard to the first question, the High Court found that:

• the Breach Clause was designed to protect the Permavent business from the consequences of Makin failing to comply with his obligation not to challenge the IP Rights; and
• Permavent had a legitimate interest in protecting the IP Rights as they were of vital importance to its business:
  • "A dispute over title to the IP Rights could damage Permavent's ability to source, manufacture or sell products. This could lead to lost sales while the dispute lasted and to longer term loss of sales as customers turned elsewhere for supplies. It could lead to longer term damage in the relationship with suppliers. While a dispute was pending, the companies' ability to raise finance or investment could be damaged. More broadly, in the event that a sale of the business was contemplated, its value could be diminished if the validity of, or the companies' claim to, essential IP Rights was threatened by a disgruntled former shareholder, director and employee. Diversion of management time and effort could cause further indirect losses, while other aspects of the business and development opportunities were neglected."

With regard to the second question, the High Court acknowledged that the Breach Clause was "undoubtedly extremely harsh" on Makin but found that it was not "extravagant, exorbitant or unconscionable as being out of all proportion to the protected interest".  This was because of the importance of the IP Rights to Permavent's business and the potential for significant harm to it if Makin were to challenge the IP Rights in the manner identified by (and prohibited in) the Agreement.

Comment

This is a very helpful decision, providing guidance on the principles established by the Supreme Court in the El Makdessi and Parking Eye cases regarding the law on contractual penalty clauses.   It is particularly helpful to those seeking to protect against future challenges to their intellectual property rights, as it provides valuable insight into the factors a court will take into account when considering the proportionality of clauses designed to prevent such challenges.  

In its deliberations, the High Court placed great weight on the importance of the IP Rights to Permavent's business and the extent of the potential harm to that business if those rights were challenged. 

Two further factors were considered relevant by the High Court:

• Makin had entered into the Agreement with the benefit of legal advice, and there could be no doubt that he was fully aware both of the extent of the potential harm to Permavent by his challenge to the IP Rights and also of the consequences of the operation of the Breach Clause; and
• Makin's conduct prior to entering into the Agreement gave rise to the reasonable expectation that if he were to challenge the IP Rights, his behaviour would be such as to maximise the time, costs and management effort required by Permavent to enforce its rights under the Agreement.

This ruling will be welcomed by IP rich businesses as it recognises that their intellectual property rights are a legitimate interest, which they are entitled to protect by means of a contractual deterrent.  The more fundamental intellectual property rights are to a business, and the greater risk of significant harm to it in the event of a challenge to those rights, the more likely it is that a robust contractual deterrent designed to protect them will be enforceable.