The vital importance of a business’s IP rights featured heavily in Mr. Justice Zacaroli’s most recent High Court judgment, where the question for the Court was whether the Claimants could enforce certain terms in a settlement agreement against the Defendant, or whether these were unenforceable penalty clauses. Partner, Mark Snelgrove and trainee solicitor, Brogan Roache summarise.
English courts have historically demonstrated a reluctance to interfere with freely negotiated contracts between two businesses, generally enforcing such contracts in accordance with their terms. An exception to this freedom of contract is the general rule that penalty clauses are not permissible.
Penalty clauses are secondary contractual obligations which impose stringent consequences on a party if that party breaches its primary contractual obligations, those consequences going far beyond merely compensating the other party for the breach.
The leading authority on penalty clauses comes from the Supreme Court’s 2015 decision in Cavendish v El Makdessi, which asked whether:
- the clause in question serves to protect a legitimate business interest of the innocent party?; and
- if it does, whether the detriment imposed on the defaulting party as a consequence of his breach is unconscionable, exorbitant, extravagant or out of all proportion to those interests?
If the answers are no to question 1 and yes to question 2, then the clause will be an unenforceable penalty.
THE FACTS AND ARGUMENTS
The Defendant (“Mr Makin”) and his business partner had, for over a decade, conducted business as directors of the Claimant companies. During this period, Mr Makin invented various roofing products (“Products”) for use by one of the Claimants, Permavent. The patents were however registered to Mr Makin in his personal capacity, with Permavent being licensed to manufacture and sell the Products.
Relations broke down between Mr Makin and his partner, with the parties ultimately signing a settlement agreement in September 2017. This agreement included a £620,000 purchase of Mr Makin’s shares in the Claimant, Greenhill (which owned Permavent), and an assignment to Greenhill of all patents in the Products (“Patents”). In return, Mr Makin was entitled to quarterly royalty payments. Mr Makin’s primary obligation was to not claim any interest in, or otherwise challenge ownership of, the Patents.
In December 2018, Mr Makin applied for registration of equitable interests in five of the Patents at the UK Intellectual Property Office (“UK IPO”). Clause 2.11 of the agreement provided that, in these circumstances, Mr Makin:
- must repay all royalty payments made to him to date (£62,870);
- must repay £616,667 (being the consideration for his shares minus their par value); and
- shall no longer be entitled to any further royalty payments.
Mr Makin argued that these provisions were manifestly excessive and disproportionate, and therefore amounted to an unenforceable penalty.
There was no dispute that the clauses sought to protect an interest that went beyond mere compensation. However, Zacaroli J agreed with the Claimants that the Patents were of fundamental importance to the Claimants’ business and accepted that there was potential for very significant harm to that business if Mr Makin challenged the Patents.
Such a challenge could lead to lost sales during the dispute and in the longer term (as customers turned elsewhere for supplies), cause damage to supplier relationships, harm the Claimants’ ability to raise finance, divert management time, and damage the Claimants’ investment or development opportunities. More broadly, the value of the Claimants’ entire business could be diminished if the validity or ownership of these essential Patents were threatened.
On the other hand, Zacaroli J agreed with the Defendant that the detriment that would be caused to him by enforcement of the relevant clause of the settlement agreement was “undoubtedly extremely harsh”, particularly since his breach of the agreement was at the less serious end of the spectrum. The question to be resolved, therefore, was whether that detriment was “extravagant, exorbitant or unconscionable” or out of all proportion to the Claimants’ interests.
Giving judgment for the Claimants, Zacaroli J held that the detriment imposed on Mr Makin was not so out of proportion to the potential consequences for the Claimants as to make the measures unenforceable penalties. Cumulatively, the measures were designed not only to deter Mr Makin from breaching the agreement but also to protect the Patents on which the Claimants’ business depended, the value of the Claimants’ shares and their wider interests.
Zacaroli J also considered Mr Makin’s conduct in the period leading up to the settlement agreement, which had been particularly hostile and aggressive, as relevant to the question of whether the prescribed consequences of his breach were proportionate to the Claimants’ protected interest. In particular, he considered it was reasonable for the Claimants to be concerned, at the date of the settlement agreement, that, if Mr Makin did interfere with the Patents, he was likely to do so in a way that would make life as difficult as possible for the Claimants. The severity of the measures in the settlement agreement reflected this concern.
Although the Cavendish Square judgment was handed down in 2015, this judgment represents one of the first applications by a court of that authority to a clause closely related to IP. To the extent that Zacaroli J’s judgment recognises the importance of IP to business, it is clearly welcome. It will also be welcomed by those who believe that parties should be free to reach whatever bargain they choose and not have that bargain subsequently interfered with by the courts except in the most exceptional cases.
On the face of it, this decision is a strong one. On the basis of the facts as presented in the judgment, Mr. Makin’s only breach of the settlement agreement to date was seeking to register at the UK IPO an equitable interest in the Patents deriving from the settlement agreement. He had not made any other challenge to the Claimants’ ownership of the Patents and had not (apparently) made any challenge to the Claimants’ ownership of the Patents in the marketplace.
His breach could be, and in fact was, very simply remedied through an application to the court for an order requiring him to cancel his registration at the UK IPO and an injunction preventing from making any other claim to an interest in the Patents. None of the serious damage to the interests of the Claimants discussed in the judgment arose, or had ever been likely to arise, from this particular breach.
That the court in this case considered these matters to be irrelevant to the question of whether the prescribed consequences of the breach were proportionate and hence unenforceable appears to be entirely in line with the authority represented by Cavendish. Mr. Makin’s behaviour prior to the making of the settlement agreement indicated to the court that he was more than capable of making the more serious challenges to the Patents that the clause of the settlement agreement was intended to deter. Furthermore, he had, according to the settlement agreement, entered into the agreement with the benefit of legal advice and hence must be taken to have understood what he was signing up to.
Following this case, companies in a similar situation to that of the Claimants will potentially feel more secure in negotiating contractual clauses which seek to deter the other party from challenging the subject IP or their ownership of that IP. However, a cautious approach will still be advisable, since whether the deterrent is or is not considered proportionate will depend upon the precise factual circumstances. Even greater caution will be required if there is unequal bargaining power between the parties or the other party does not have the benefit of specialist legal advice.
It is also important to bear in mind that, in other types of agreement (notably patent licence agreements) agreements not to challenge the validity of patents may themselves be unlawful and hence unenforceable as a matter of UK and EU competition law.