Agreements between shareholders (often referred to as "shareholders' agreements" or "investment agreements") often provide contractual mechanisms for the protection of investors. One of such mechanisms designed to protect the value of investment (which may factor future cash flows depending on a valuation method used), is a right to request to sell/buy out shares. Such a share option is exercisable in the event of a breach of contract committed either by a company or the other shareholder (for example, a breach of the shareholders' agreement or the articles of association of the company) at a price (typically, at a discount or premium) determined pursuant to a contractual share valuation provision.
In common law jurisdictions, if a term of contract stipulates a sum payable upon a breach of contract (or a property transferrable upon a breach of contract at a price substantially less than its full value) that goes beyond the losses flowing from the breach, such term of contract can be found to be penal. When negotiating a contract, it is advisable to appreciate that in the common law jurisdictions there may exist the doctrine of penalty. Under the common law doctrine of penalty, a penalty is wholly unenforceable and, thus, cannot be used as a measure to protect an investor. For example, in an English case of Jobson v Johnson1 a contractual term for a transfer of shares upon a breach of contract was held to be unenforceable as a penalty.
Accordingly, in order to ensure that a right to call or put shares with a view to protecting the value of investments is enforceable, it is advisable to have regard to the rules on penalty of the law of a country to which the contact is subject. In the context of a corporate transaction in respect of a company formed in the Astana International Financial Centre (the "AIFC"), one should heed the fact that AIFC law differs from the laws of other common law jurisdictions, as this may affect the enforceability of a right to call or put shares when it comes to the doctrine of penalty.
This article outlines the key aspects of the rules on penalties that exist in the AIFC that make them different from those existing in other common law jurisdictions (with the laws of England and Wales being taken as an example) which should be addressed when drafting corporate agreements in respect of an AIFC company. Although AIFC law is modelled on English law, the differences in the penalty rules are explicable by the fact AIFC law is predominantly based on UNIDROIT Principles of International Commercial Contracts 1994, save for some aspects of contract law relating to assignment, third party rights, measure of damages and agency which are broadly consistent with English law.2
English common law
Under the English doctrine of penalty, a penalty is unenforceable. This is a rule of public policy, and its application is not subject to the discretion of the courts.3 A party will not be allowed to sue for a sum found to be penal and will be put to the proof in respect of its unliquidated damages in the usual way.4 On the other hand, the common law rules in England allow the parties to stipulate a pre-agreed sum payable upon a breach of contract by a defendant to liquidate potential damages that may flow from that breach. Such a clause is for liquidated damages and is valid and enforceable. The claimant will be entitled to recover the stipulated sum on breach, without requiring proof of the actual damages and irrespective of the amount, if provable, of the actual damage.5
In England, there co-exist two tests of penalty – the traditional (basic) test and the modern test.
Under the traditional (basic) test derived from the case of Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd,6 the sum payable on a breach of contract is not a penalty if it is a genuine pre-estimate loss which would probably flow from the breach, i.e., the sum does not extravagantly and unconscionably exceed loss which is likely to flow from the breach.
Under the modern rule formulated in the conjoined appeal of Cavendish Square Holding BV v Makdessi and ParkingEye Ltd v Beavis,7 the test is whether the provision is a secondary obligation which imposes a detriment on the contract-breaker out of all proportion to any legitimate interest of a claimant in the enforcement of the primary obligation.
Under English law, the question as to whether an agreed sum is a penalty or liquidated damages is judged by reference to the circumstances subsisting at the time when the contract was made8 (but not at the time of the breach or loss occurred). This ignores the circumstances as they unfold after the time the contract was made. This prevents a perfectly enforceable liquidated damages clause from being turned into a penalty by any subsequent events or development not anticipated by the parties at the time the contract was made.9
AIFC law
The rules in the AIFC around liquidated damages are contained in s. 21 of the AIFC Regulations on Damages and Remedies 2017 and s. 122 of the AIFC Contract Regulations 2017. Section 21 of the AIFC Regulations on Damages and Remedies 2017 provides the following provisions relating to liquidated damages:
"If the contract provides that a party who does not perform is to pay a specified amount to the aggrieved party for non-performance, the aggrieved party is entitled to that amount irrespective of the party’s actual loss."
"However, despite any agreement to the contrary, the specified amount may be reduced to a reasonable amount if it is manifestly disproportionate to the loss envisaged as capable of resulting from the non-performance and to the other circumstances."
There are some aspects of the AIFC penalty rules that can be underlined. Under the AIFC penalty rules, one potential interpretation is that a purported liquidated damages clause (found to be penal if manifestly disproportionate) should not be stuck out of the contract as being invalid but should still stand. It is only the pre-agreed sum that is reduced to what is "reasonable" and "proportionate" to the loss of the claimant flowing the breach. One may argue that this may imply that the claimant may be entitled to partially enforce the penalty clause to the reasonable extent. A reasonable amount does not necessarily equate the actual loss, and there may be the "other circumstances" which may justify the reasonableness and proportionality of that amount (for example, the difficulty of quantification or proof of loss, profits gained by a contract-breaker from a breach of contract with no loss being visited on the claimant).
However, it should be noted that in any contract between a trader and a consumer, an "an unfair term" (this includes a disproportionately high sum payable by a consumer upon a breach of contract) will not bind the consumer (section 48(1) of the AIFC Implied Terms in Contracts and Unfair Terms Regulations 2017). This statutory provision is derived from the UK Consumer Rights Act 2015.
If an agreed damages clause is found to be penal, the relief is subject to the court's discretion. The court may (but not necessarily) reduce the stipulated amount based on the consideration of reasonableness and proportionality. This follows the civil law doctrine of penalty.10 This should be contrasted with the position under English law where a penal clause is "wholly unenforceable", and the relief is available to the defendant as of right.11
In the context of the law of the Dubai International Financial Centre ("DIFC") (which provides for the similar penalty test), it is submitted that the test of “manifestly disproportionate” provides a higher threshold than the basic test of penalty under English law (a genuine pre-estimate loss or "extravagant and unconscionable" test).12 Further, unlike the modern test of Cavendish under English law, the test in hand does not appear to require a claimant to establish a legitimate interest in securing the primary obligation. It is, however, submitted, at least in the context of DIFC, that when deciding the question whether a particular stipulated sum is "manifestly disproportionate" the English law modern criteria above should be applied.13 The AIFC Court may apply the principles derived from the English case law (see, for example, the recent case of Kozhabay A.A. vs Qosil Limited case no. AIFC-C/SCC/2022/0021 (at para [14]).
Section 122(2) of the AIFC Contract Regulations 2017, however, provides a different test for an agreed damages clause which is not coterminous with the "manifestly disproportionate" test set out in section 21(2) of the AIFC Regulations on Damages and Remedies 2017. Under section 122(2) of the AIFC Contract Regulations 2017, the court may reduce the agreed damages sum if it is "grossly excessive". It is yet to be seen how these both tests will be reconciled.
When the court is called to judge whether a stipulated amount is penal or not (i.e., "manifestly disproportionate"), the proper yardstick against which an agreed damages sum should be judged is the potential loss contemplated by the parties at the time when they entered into the contract. Section 21(1) of the AIFC Regulations on Damages and Remedies 2017 refers to the "loss envisaged as capable of resulting from" the breach. These words point away from an actual loss, and this leaves a scope for an argument that the reasonableness and proportionality of the agreed damages sum must be assessed by reference to what was contemplated by the parties at the time the contract was made, but not at the moment of breach. Therefore, the court should ignore the actual losses of the claimant. If this interpretation is correct, then this follows the legal position under the laws of England and Wales.
However, because section 21(2) of the AIFC Regulations on Damages and Remedies 2017 allows the court to have regard to "the other circumstances", this may give rise to a further enquiry as to whether the court can take an account of the situation at the time the relief is sought.
The test of manifest disproportion under section 21(2) of the AIFC Regulations on Damages and Remedies 2017 should be contrasted with the "grossly excessive" test to be applied under section 122(2) of the AIFC Contract Regulations 2017. The latter applies in relation to "the harm resulting from non-performance", and the word "the harm" in section 122(2) of the AIFC Contract Regulations 2017 appears to refer to the words "actual harm" at the end of section 122(1) of the AIFC Contract Regulations 2017. Under section 122(2) of the AIFC Contract Regulations 2017, the court's assessment of an agreed damages sum must be directed at the actual loss suffered by the claimant, but not at a hypothetical loss envisaged by the parties at time when the contract was made. It remains to be seen whether and how the application of these different tests may differ, if at all.
The rules on penalties set out in section 21(2) of the AIFC Regulations on Damages and Remedies 2017 and section 122(2) of the AIFC Contract Regulations 2017 are limited in their application to an obligation to pay a sum upon a breach of contract. This follows the civil law doctrine of penalty.14 The doctrine of penalty under English law goes further than that and applies, for example, to a transfer of property at less than its full value,15 a provision disentitling the contract-breaker from receiving a sum of money that would otherwise have been due to him16 and an excessive deposit (which, if paid, is forfeited upon termination of a contract if the payer breaks the contract or, if not paid but payable before the termination, is recoverable as debt).17 Under AIFC law, English law is not the "default" system, although the AIFC Court has the power to have regard to the English caw law, at least, in connection with the interpretation of AIFC law modeled on English law.
Under English law, there exists a parallel jurisdiction of the courts to grant an equitable relief against forfeiture,18 which is a discretionary remedy, and the courts can take the view of the situation at the time when the relief is sought (such as conduct of the parties). Further, under English law, the courts also have statutory powers to grant reliefs in specific circumstances under s. 49(2) of Law of Property Act 1925 and Consumer Credit Act 1974.
In conclusion, when choosing between AIFC law and English law as law governing a contract (for example, a call option exercisable upon a breach of contract), the potential differences in the principles of the law of contract, including penalties, in those legal systems should be borne in mind.
For further information please contact:
Rashid Junusbekov
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Disclaimer
The information in this article does not constitute legal or professional advice. No part of this articles should be relied on or used as a substitute for legal advice. The information in this articles is for general information purposes only. It should also be appreciated that the law may have changed since the date of this article.
[1] [1989] 1 All ER 621.
[2] Laws of the DIFC, Volume 2 (Reissue 2021), DIFC Academy, Lexis Nexis, at page 5.
[3] Chitty on Contracts, 34th edn (London: Sweet & Maxwell), para. 29-210, para. 29-256.
[4] Chitty on Contracts, 334th edn (London: Sweet & Maxwell), para. 29-204; McGregor on Damages 21st edn (London: Sweet & Maxwell), para. 16-028.
[5] McGregor on Damages 21st edn (London: Sweet & Maxwell), para. 16-025.
[6] [1915] A.C. 79, 86–88.
[7] [2015] UKSC 67; [2016] A.C. 1172.
[8] McGregor on Damages 21st edn (London: Sweet & Maxwell), para. 16-032; Liquidated Damages and Penalty Clauses, Roger Halson (London: Oxford Press University), para. 2.44 and 2.45.
[9] McGregor on Damages 21st edn (London: Sweet & Maxwell), para. 16-032.
[10] For example, see article 297 of the Civil Code of the Republic of Kazakhstan.
[11] Contractual Duties: Performance, Breach, Termination and Remedies, 3rd edn (London: Sweet & Maxwell), para. 25-055, 25-061, 25-070.
[12] Laws of the DIFC, Volume 1 (Reissue 2020), DIFC Academy, Lexis Nexis, at page 408.
[13] Laws of the DIFC, Volume 1 (Reissue 2020), DIFC Academy, Lexis Nexis, at page 409.
[14] That is the position under article 293 of the Civil Code of the Republic of Kazakhstan.
[15] Jobson v Johnson [1989] 1 All ER 621 (the case is sited in Contractual Duties: Performance, Breach, Termination and Remedies, 3rd edn (London: Sweet & Maxwell), para. 25-049).
[16] Public Works Commissioner v Hills [1906] A.C. 368 PC and Gilbert Ash (Northern) Ltd v Modern Engineering (Bristol) Ltd [1974] A.C. 689. (the cases are sited in Contractual Duties: Performance, Breach, Termination and Remedies, 3rd edn (London: Sweet & Maxwell), para. 25-050).
[17] Chitty on Contract, 34th edn (London: Sweet & Maxwell), para. 29-259, 29-263.
[18] Contractual Duties: Performance, Breach, Termination and Remedies, 3rd edn (London: Sweet & Maxwell), para. 25-051.
