Penalty Clauses under Brazilian Law: Is there a common ground with the criteria set forth by Cavendish Square v. Makdessi?

Transcription

1 Penalty Clauses under Brazilian Law: Is there a common ground with the criteria set forth by Cavendish Square v. Makdessi? Thiago Moreira Caio Lucas Gabra 1. Introduction Although extensively debated by scholars and courts, the mechanisms of penalty clauses and liquidated damages do not cease to fuel debates throughout the globe. While in a local scale the topic is treated as a sensitive issue, in an international level, with the constant flow of international businesses across different jurisdictions and legal systems, it represents a sure meeting point for a clash of cultures. In this regard, it is the lawyer s work, specifically of the lawyer engaged in cross-border transactions, to mediate and integrate potential conflicting points and to be prepared and knowledgeable of its own legal system and the one from its counterparty. It is this comparative knowledge that will make him/her able to conduct negotiations, eliminating zones of conflicts between legal systems from contracts and introducing a safe zone of convergence, where a legally feasible solution lies. The core questions related to the application (or not) of penalty clauses and liquidated damages concern more concrete and down-to-fact aspects, such as (i) the nature of the obligation; (ii) the proportionality of the amounts involved; and (iii) the degree of a party s liability for a specific conduct or effect. However, discussions on this topic always involve much more abstract and fundamental concepts, which, at times, trace back all the way to the foundation of a legal system, namely, the integration of principles of good faith, autonomy of the parties and the interference of the State. In view of the foregoing, this paper will outline the concept of penalties and liquidated damages in Brazil, highlighting the distinctions and similarities between Brazilian and English law perspectives after Cavendish Square v. Makdessi. SP v1 1

2 2. Penalty clauses and liquidated damages in Brazil 2.1. Legal background concerning penalty clauses and liquidated damages Following its widely known civil law and legalist approach, the Brazilian legal system has extensively regulated penalty clauses, dedicating a full chapter in the Brazilian Civil Code to this topic (articles 408 to 416). Brazilian law uses the terms penalties and penalty clauses to refer to liquidated damages as a whole, since, as we will further explain, Brazilian law does not repeal, but instead, embraces some deterring/coercive nature of penalty clauses. The Brazilian Civil Code permits the imposition of penalties on a breaching party for: (i) failure to perform the contract as a whole; (ii) failure to comply with specific clauses and obligations on a contract; or (iii) delay in performing an obligation 1. The law distinquishes the types of penalty clauses to which we will further discuss in this paper, especially when comparing them with the criteria established by Cavendish Square v. Makdessi: compensatory and delay penalties. Article 410 of the Brazilian Civil Code 2 contemplates compensatory penalties, which are permitted when a party fails to perform a contract entirely. It also establishes breaches of specific obligations, in which the innocent party may alternatively seek payment of the amount established in the penalty clause (especially when the performance of the relevant obligation is no longer possible and/or worthy) or demand the performance of the breached obligation. 1 Brazilian Civil Code, Art. 409 A penalty clause that is stipulated with an obligation, or in a later act, may refer to the complete non-performance of the obligation, to a specific clause or to a mere delay in performance. 2 Brazilian Civil Code, Art. 410 A penalty clause that is established in case of total default on an obligation will give the non-breaching party an option to claim performance of the obligation or payment of the amount stipulated in the penalty clause. 2

3 Conversely, article establishes non-compensatory penalties, which are claimed in case of delays in the performance of an obligation or breach of a particular provision. Noncompensatory penalties are not an alternative to the obligation, but instead, the innocent party claims them along with the overdue obligation. At this point, it is important to highlight that the term non-compensatory penalty should be understood as compensation for the delay and not to the obligation since the obligation remains due. The delay penalty, although understood as non-compensatory in its nature as the primary obligation remains enforceable and demandable, serves to compensate the damages arising from the delay itself. This concept is key and represents one of the most common issues in contractual claims, when the courts analyze the proportionality of the application of a penalty, as it will be further explained. Another basic concept of penalty clauses and liquidated damages under Brazilian Law lies on article 412 of the Brazilian Civil Code 4, which establishes that the penalty may never exceed the value of the secured obligation. This statutory provision falls within the principle of full compensation for civil liability under Brazilian law, by which a party must be fully recovered for the losses suffered from the other party s breach whenever it is impossible or should have been impossible to revert to the status quo. Similarly, unless otherwise stated in the contract, the contractual penalty represents the maximum indemnification due to the innocent party, even if the actual damages incurred were higher. However, one can typically carve-out the penalty clause by contemplating in the contract the possibility that the innocent party seeks further damages in addition to the penalty amount. In this case, the contractual penalty works as a minimum indemnification amount, pursuant to the sole paragraph of article 416 of the Brazilian Civil Code 5, and if the innocent party manages to demonstrate that it has incurred in higher damages, it will be entitled to indemnification. 3 Brazilian Civil Code, Art. 411 When the penalty clause is established in case of delay, or in special security of another specific clause, the innocent party has the discretion to demand the fulfillment of the penalty imposed, together with the performance of the primary obligation. 4 Brazilian Civil Code, Art. 412 The amount of the penalty imposed in the penalty clause may not exceed the amount of the primary obligation. 5 Brazilian Civil Code, Art. 416, Sole Paragraph Even if the damage exceeds what was provided for in the penalty clause, the innocent party may not claim additional indemnity if it has not been contracted so. If it has been contracted, the penalty remains as minimum indemnity, and the innocent party is responsible for proving further damage. 3

4 2.2. Reduction of excessive or disproportional penalties. Now that we have covered the basics and less controversial aspects and applications of penalty clauses under Brazilian law, it is time to go into the most problematic issues, where the debate arises. As previously explained, although the law uses the terms penalty clauses, penalties, under Brazilian law, are mainly established to indemnify the non-breaching party for damages it has incurred or is presumed to have incurred due to acts or omissions of the breaching party. For this reason, the main discussion in enforcement of penalty clauses by Brazilian Courts remain the assessment of the reasonability and proportionality of the penalty in light of: (i) the nature of the transaction and the obligations and rights secured by the penalty; (ii) the extension of a party s conduct in detriment to the obligations and rights secured by the penalty; and (iii) the damages actually incurred, or which a party is likely to have incurred upon the occurrence of the breach. Pursuant to article 413 of the Brazilian Civil Code 6, the court has the duty to equitably reduce a penalty established by the parties in a contract. Furthermore, with the increasing application of the social function of legal relationships and the influence of constitutional rights on private law, since the late 1990 s/early 2000 s, what was initially designed as a mere authority of the courts to calibrate a blatantly disproportional penalty under the former Brazilian Civil Code has gained status of statutory obligation to the court to act and repeal the application of penalties that are (at times subjectively) deemed disproportional and/or unfair 7. Despite recognizing the parties autonomy to pre-estimate damages and establish penalty clauses, thereby preventing excessive burden of proving the extension of damages, which are, at 6 Brazilian Civil Code, Art. 413 The penalty shall be equitably reduced by the court if the primary obligation has been partially fulfilled or if the amount of the penalty is manifestly excessive, in view of the nature and purpose of the transaction. 7 TEPEDINO, Gustavo. BARBOZA, Heloisa Helena. DE MORAES, Maria Celina Bodin. Código Civil Interpretado conforme a Constituição da República. P

5 times, difficult or virtually impossible to accurately quantify, the Brazilian legal system seeks to avoid that the non-breaching party makes a profit from the breach. In sum, to allow otherwise could cause not only the unjust enrichment of one contracting party over the other, but could also, in a larger scale, stimulate market practices grounded on penalty-based gains, which goes against the Brazilian modern principle of contractual good faith, as well as the principle of full compensation, consubstantiated in article 944 of the Brazilian Civil Code 8. Courts are everyday close to unanimity in their understanding of the principles surrounding the application of a penalty. In practice, however, reducing the penalty to a reasonable and proportional level remains a dish with no clear receipt and the application of the statutory command relies mostly on the courts assessment of the particularities of each case. One of the main reasons for the wide range criteria for measuring the excessiveness of a penalty is the fact that article 413 expressly allows the court to reduce penalties in an equitable manner. Although one may find courts who will seek a more accurate solution from a mathematical perspective, many judges may, and in fact do, rely on the discretion granted by the law. Justice Sanseverino in the Brazilian Superior Court of Justice, in 2012, declared disproportional the application of a full termination penalty, which was claimed by a sports gear company that had terminated a sponsorship agreement with an Olympic medalist half way through the contract. The court decreased the penalty to exactly 50% of the penalty amount stipulated in the contract, applying, therefore, a perfect mathematical proportion between the completion of the contract and the application of the contract s termination penalty 9. However, Justice Salomão, also in the Brazilian Superior Court of Justice, in 2014, reasoned, in another case, that the mere time and mathematical proportions may not suffice to: 8 Brazilian Civil Code, Art. 944 The indemnity is measured by the extent of the damage. 9 Brazilian Superior Court of Justice. Special Appeal nº /SP Paulo Tarso Sanseverino. Date of Judgement: December 06,

6 (i) repair the damages suffered by the non-breaching party; and (ii) encourage the performance of contracts 10. In this 2014 case, a known television reporter had given grounds for termination of his contract with Rede Globo, the biggest television broadcaster in Brazil. The reporter had breached its exclusivity obligations by signing with another broadcaster and failing to notify Rede Globo. Considering that his original contract with Rede Globo was close to expiring (approximately 95% of the contract had been performed), the reporter claimed that the contract had been materially fulfilled and that the termination penalty should be proportional to the remaining 5% of the contractual term. However, Justice Salomão highlighted the equitable character of the penalty reduction and that the law does not bind the courts to a mathematical analysis. The Justice then evaluated that, in that particular case, establishing an absolute proportionality between the remaining contract term and the penalty would not compensate Rede Globo for the damages suffered due to the untimely resignation of one of its professionals, who had earned his reputation while working in the company. He also noted that, applying absolute proportions to termination penalties would encourage parties to execute efficient breaches of contract, becoming economically rewarding to one of the parties with gains outweighing losses. The court finally set a penalty in the amount equivalent to 50% of the contractual penalty clause, disregarding the degree of completion of the agreement Punitive damages under Brazilian Law. Ruling like the one issued by Justice Salomão reported above, acknowledging the coercive nature of a penalty clause, also fosters another common debate, i.e., whether or not Brazilian Law recognizes punitive damages. When it comes to penalty clauses, those in favor of the coercive nature of penalties under Brazilian law, and ultimately, in favor of punitive damages, often raise article 416 of the Brazilian Civil Code to support their arguments. Article 416 contemplates mandatory application of penalty 10 Brazilian Superior Court of Justice. Special Appeal /RJ. Reporting Justice Luis Felipe Salomão. Date of Judgement: March 20,

7 clauses regardless of evidence of the losses and damages suffered by the non-breaching party 11. In other words, an argument can be made that, if the law disregards the existence of a damage to uphold a penalty clause, its main concern would be indeed to punish the breaching party and prevent breaches as a whole. However, the wording of article 416 should not be interpreted apart from other legal provisions, but instead it must be systemically interpreted with the Brazilian Civil Code as a whole. In this regard, as we describe throughout this paper, it is clear that the Brazilian Civil Code has dedicated several provisions to connect contractual penalties to the actual damages that a nonbreaching party might suffer, such as: (i) the limitation of the amount of penalties that must correspond to the amount of the obligation; (ii) the possibility of improving the amount of contractual penalty if demonstrated that the damages suffered are higher than such amount (provided that it is established in the contract); and (iii) the court s duty to reduce the amount of the penalty if excessive 12. In truth, the teleological interpretation of the mechanisms described above, as well as applicable court decisions, lead us to the conclusion that Brazilian law has embraced, and indeed seemed to have successfully expressed, that penalty clauses have a hybrid character, i.e., a dual purpose. The first purpose, which is its most relevant, is to pre-estimate damages and compensate the non-breaching party. The second purpose of the penalty, reflected in Justice Salomão s view reported above, is the deterring function, which aims to protect the legitimate and, sometimes-intangible interest of a party, while discouraging the breach by the other. Nonetheless, this deterring purpose should not be confused with punitive will, which is represented by excessive penalties with no nexus to the damage or interest it intends to secure. 3. The English timeline on the doctrine of penalties considering Cavendish v. Makdessi. 11 Brazilian Civil Code, Art. 416 An innocent party is not required to proof any loss to claim a contractual penalty. 12 Superior Court of Justice. Special Appeal nº / SP Reporting Justice. Sidnei Benetti. Date of Judgement

8 As mentioned in the introduction of this paper, as difficult as it might be to deal with several issues regarding the application of penalty clauses in Brazil (or in most jurisdictions), it is a greater challenge to integrate the will of the parties, who, in an international transaction, bring legal dilemmas from their home jurisdiction. In this regard, before emerging in a comparative analysis, it is important to trace a brief overview of the English background on this topic Application criteria set forth in Cavendish Square v. Makdessi For more than a century, due to the doctrine of penalties, English courts have placed a great emphasis on the dichotomy penalty clauses v. liquidated damages. In summary, according to the traditional application of the doctrine, if a contractual amount due by a party upon a breach is considered a genuine pre-estimate of the damages likely to be incurred by the non-breaching party, this provision would be deemed legitimate liquidated damages. In other words, the parties attempt to establish a fair compensation to the nonbreaching party in case of breach. However, if the courts were to find that the remedy was not compatible with the damages effectively suffered, and that the core purpose of the clause was to punish or prevent the breaching of the agreement, the clause would be considered unenforceable. In this case, when a clause is considered a punishment, the breaching party is only liable for the damages that could be proved against him/her. Accordingly, English Courts have typically applied the criteria set forth by Dunlop Pneumatic Tyre Co Ltd v. New Garage & Motor Co Ltd 13 in order to determine if a particular remedy was a penalty, and, therefore, unenforceable, or if it was pre-assessment of the damages likely to be incurred (i.e, liquidated damages). Although the Supreme Court has also established related standards, the main criteria was to assess if the amount due was considered extravagant and unconscionable when compared with the greatest loss that could conceivably be potentially 13 Cavendish Square Holding BV v Talal El Makdessi [2015] UKSC, 22. 8

9 demonstrated by the non-breaching party. In case the disproportion was confirmed, the penalty would be declared unenforceable. For a century, the doctrine of penalties, which was strongly guided by the criteria set forth by Dunlop v. New Garage, was applied, avoiding a number of punishment like clauses, and leading to the interference of the courts in the contractual arrangements of the parties. However, this scenario has been shaken by the outcome in Cavendish Square Holding BV v. Talal El Makdessi. In Cavendish, the Supreme Court had the chance to revisit Dunlop v. New Garage and reevaluate the suitability of its criteria. After several blows to the ambiguity of the criteria and the excessiveness generated by its wide application, the Lords took the time to draw new tests and criteria, which, in their view, would better score the true intent of the parties and determine if the purpose of the clause was to punish/intimidate, or to compensate and protect a legitimate interest. Cavendish Square Holdings BV ( Cavendish ) was a holding company belonging to the WPP group of companies ( WPP Group ), the world s largest advertising and marketing communications group. Mr. Makdessi and Mr. Ghossoub were the owners of what became the largest advertising and marketing communications group in the Middle East ( Company ). In February 2008, the WPP Group agreed to purchase 60% of Mr. Makdessi s and Mr. Ghoussoub s shares in the Company. The WPP Group placed a great deal of importance in the Company s goodwill and the ongoing involvement of Mr. Makdessi, who served as its director and nonexecutive chairman, in the business. Mr. Makdessi was essential to the preservation of the Company s goodwill. Mr. Makdessi and Mr. Ghossoub entered into a Share Purchase Agreement ( SPA ) with a member of the WPP Group that was later replaced by Cavendish. Mr. Makdessi breached certain restrictive covenants of the SPA by resigning as a director of the Company and Cavendish sought to enforce the respective remedies under the SPA, which would: (i) release Cavendish from its obligation to pay the remaining installments of the price of the shares already sold under the SPA; and (ii) permit Cavendish to require Mr. Makdessi and Mr. Ghossoub to sell their remaining minority shares in the Company at a discount based on net asset value, thereby excluding any value placed on goodwill. 9

10 Once the case reached the Supreme Court, the Lords noted that the fate of the case at hand could not be settled by the mere application of the dichotomy between penalties and liquidated damages and the analysis of the proportionality and reasonability of the amounts involved. Moreover, the Court questioned the very segregation itself: this dichotomy [between penalties and pre-estimated damages] may not be exclusive and that there may be clauses which operate on breach and which are commercially justifiable although they fall into neither category. In short, commercial interests may justify the imposition upon a breach of contract of a financial burden which cannot either be related directly to loss caused by the breach or justified by reference to the impossibility of assessing such loss. 14. Accordingly, after deciding for the limitation of the classic rationale, the Court analyzed the commercial justification of the clauses, in which one may assume that there may be interests beyond full compensation that may justify the imposition of an additional financial burden on the party in breach. Consequently, as also highlighted by Lord Mance at the time, it is necessary to focus on the transaction as a whole, the big picture, instead of analyzing solely the suitability of each penalty individually. In Cavendish v. Makdessi for example, it was held that the maintenance of Mr. Makdessi as a director of the Company was essential to the transaction and to its total amount agreed by the parties, therefore, the sanctions applied to Mr. Makdessi had a legitimate purpose and were consistent with Cavendish s main objective. Additionally, it was recognized that all restrictive covenants in the SPA were part of a set of measures against a competitive activity, each of them likely to be difficult to detect, and if detected, difficult to evaluate their extent and impact, thereby justifying the application of the liquidated damages. Therefore, by winding the gaze of English Courts and providing new standards for the application and control of liquidated damages, in our view the Supreme Court restricted the range of the doctrine of penalties and the Courts interference on the autonomy of the parties. 14 Cavendish Square Holding BV v Talal El Makdessi [2015] UKSC 67,

11 3.2. Where does Brazil fit in the English timeline after Cavendish Square v. Makdessi Non-existence of the dichotomy. As it is possible to realize right from the start, the very famous English law dichotomy between liquidated damages and penalty clauses does not exist under Brazilian law. According to Brazilian law, it has been long conceived that, while penalty clauses have a predominant compensatory nature, they also carry, to a reasonable extent, a deterring purpose/coercive character to protect a party s legitimate interest, either by securing the main object of the agreement, its right to a timely completion, or a particular obligation under the contract. Nonetheless, the most important distinction between Brazilian and English laws is the practical consequence of the absence of the dichotomy. While English law has always rejected the enforceability of remedies considered punitive in their essence, assigning to the nonbreaching party the burden of demonstrating its actual loss to receive indemnification, Brazilian law preserves the effectiveness of the penalty clause. Under no circumstance a Brazilian court would be authorized to set a penalty clause aside. Instead, as thoroughly explained in Section 2 above, it would exercise an equitable reduction of the penalty in order to make its application fair to the case at hand and base its decision on the nature of the transaction and the nature and commercial purpose of the breached provisions. For instance, early in 2017, Justice Nancy Andrighy in the Brazilian Superior Court of Justice, declared when examining a case, that the validity and effectiveness of even the most exorbitant of the penalties should not be disregarded 15. In that case, one of the parties delayed the payment of two installments of the contract price by respectively 2 and 3 days, during the course of performance of the contract. Due to the delay, the non-breaching party claimed the 15 Brazilian Superior Court of Justice. Special Appeal nº /SP. Reporting Justice. Nancy Andrighy. Date of Judgement

12 application of the contractual penalty, which was established in the contract as 30% of the full contract price. Justice Nancy Andrighy in her vote reasoned that considering that the payment obligations were substantially completed, the delays claimed were kept to a minimum, and the need to avoid unjust enrichment of the creditor, the penalty should be reduced, pursuant to article 413 of the Brazilian Civil Code. The Justice also followed the principles of good faith and the economic function of the contract and application of the penalty, to substantially decrease the penalty amount from 30% of the full contract price, as claimed, to a minimum of 0.5% of the amount of each overdue installment, without, however, barring or disregarding the validity of the penalty clause Primary v. secondary obligations. When examining Cavendish v. Makdessi, it is interesting to note the relevance given to the difference between primary and secondary obligations when assessing if damages were in defense of a legitimate commercial interest 16. Throughout Brazilian case law and doctrine, this distinction is not found when dealing with the enforceability of a penalty clause. As highlighted in Section 2 above, both types of penalties described in the Brazilian Civil Code, compensatory and non-compensatory penalties are considered to encompass the same objectives, which are (i) to pre-estimate damages; and (ii) to protect the interest of the non-breaching party in the fulfilling of an obligation. The difference between compensatory and non-compensatory penalties, as we have seen, lies on whether the penalty may be claimed in addition or instead of the main obligation, and has no impact in the assessment of whether the penalty is enforceable, neither in full or in part Penalties under the English and Brazilian laws. 16 SMITH, Joanna. Liquidated Damages or Penalty: Cavendish v. Makdessi. Society of Construction Law

13 Despite conflicts between application or exclusion of penalty clauses in English and Brazilian legal systems, Cavendish Square v. Makdessi might represent a significant shortening of the gap between the Brazilian and English laws, in which both weight the commercial justification of the penalty. As previously reported, during the past decades, Brazilian law has considered the macro economical, strategical and social aspects of transactions in which a penalty clause is included, granting its validity when intended as a compensation, but also confirming its deterring function to avoid breaches. However, the previous tests set forth by Dunlop in the early 20 th century, by focusing almost solely on the proportionality of the amounts of penalties, led to substantial odds that a clause drafted in Brazil, for example, would face, not a partial reduction, but its complete exclusion in another jurisdiction since the criteria used would be restricted mostly to mathematical demonstrations. The new test, which is based on the commercial justification rationale adopted by the English Supreme Court in Cavendish, brought the criteria and the concerns from both legal systems closer. In the current scenario, the parties may find significant similarities in the two major admissibility tests in both jurisdictions: the first relates to the assessment of the relevant commercial interest protected by the penalty, and the second relates to the assessment of the proportionality of the penalty at hand. It is in this area of compatibility between the legal systems under analysis that the parties should seek to operate, creating contractual provisions that are reasonable and familiar to all parties to an international transaction. 13