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Supreme Court limits ‘negotiating damages’ for restrictive covenant breaches

Out-Law News | 20 Apr 2018 | 3:14 pm | 3 min. read

Damages awarded to the owners of a care business for the breach by their former business partners of a non-compete clause and other restrictive covenants should be calculated based on their actual financial loss, rather than hypothetical 'negotiating damages', the UK's highest court has ruled.

The Supreme Court's judgment overturns that of both lower courts, which had ruled that the case was one in which negotiating damages should be awarded; with the first instance judge describing it as "prime example" of such a case. Negotiating damages, which are also called 'Wrotham Park damages' after a 1974 case, are based on the 'release fee' that one party could have hypothetically received from the other in exchange for lifting the obligation imposed by a restrictive covenant.

Lord Reed, giving the main judgment, found that the lower courts had incorrectly approached the question of how damages should be awarded. The claim, at its heart, was one for "loss of profits and possibly of goodwill", and although the loss was "difficult to quantify" there was no other reason why damages could not be awarded in the conventional way.

"The case is not one where the breach of contract has resulted in the loss of a valuable asset created or protected by the right which was infringed," he said in his judgment.

"Considered in isolation, the first defendant's breach of the confidentiality covenant might have been considered to be of that character, but in reality the claimant's loss is the cumulative result of breaches of a number of obligations, of which the non-compete and non-solicitation covenants have been treated as the most significant," he said.

Lord Reed also used his judgment to set out "a definitive summary of the first principles relating to user damages in tort, damages in equity and damages for breach of contract", meaning that it would be of "considerable practical benefit" in future commercial disputes, according to commercial litigation expert Andrew Herring of Pinsent Masons, the law firm behind Out-Law.com.

"The Supreme Court judgment is very helpful in confirming that the appropriate measure of damages for breach of restrictive covenants is the conventional quantification of financial loss to put the claimant in the same position as he would have been had the restrictive covenants been honoured," Herring said. "The Supreme Court recognised that this quantification may not be easy, but it should be possible, even imprecisely, on the basis of available evidence."

"Claimants in the future will need to be aware that they have the burden of proof and they are very unlikely to be able to fall back on a 'negotiating damages', or 'Wrotham Park damages', alternative quantification of loss, as Lord Reed states negotiating damages is not the correct measure of loss in these types of cases," he said.

The case has been referred back to the High Court, where the judge will be required to assess the actual financial loss suffered by the care business, One Step (Support) Ltd, "as accurately as he can on the available evidence".

Although damages can be awarded on a number of grounds, their purpose is generally compensatory rather than punitive. The idea is to put the wronged party into the same position as they would have been in had they not sustained the wrong. The concept of 'negotiating damages' was introduced following the Wrotham Park case, in which land which had been sold subject to a restrictive covenant was used for housing without the permission of the previous landowners.

The judge in that case awarded damages effectively as an alternative to ordering that the houses be demolished. His reasoning was that a "just substitute" for an injunction requiring demolition would be "such a sum of money as might reasonably have been demanded by the plaintiffs from [the developers] as a quid pro quo for relaxing the covenant".

In the present case, Lord Reed acknowledged the difficulties of calculating the "economic effect" of the breaches of covenant by One-Step's former business partners. However, it did not necessarily follow that it could not be done. The trial judge had been incorrect to rule that One-Step should have the "option of recovering damages in the amount which might reasonably have been demanded ... for releasing the defendants from their covenants". The Court of Appeal also incorrectly ruled that a judge had "broad brush" discretion to award negotiating damages where this was a "just response in the particular case".

Lord Reed said that an award of negotiating damages should only be made with the same "compensatory purpose" in mind as any other award of damages. An award on this basis would be appropriate in "certain circumstances in which the loss for which compensation is due is the economic value of the right which has been breached, considered as an asset". The imaginary negotiation was "merely a tool for arriving at that value", he said.

"Such circumstances can exist in cases where the breach of contract results in the loss of a valuable asset created or protected by the right which was infringed, as for example in cases concerned with the breach of a restrictive covenant over land, an intellectual property agreement or a confidentiality agreement," Lord Reed said. "[In such cases] the defendant has taken something for nothing, for which the claimant was entitled to require payment."

"Applying these conclusions to the present case, it is apparent that neither the judge nor the Court of Appeal applied an approach which can now be regarded as correct," he said.