The final quarter of 2015 has seen a number of interesting decisions being issued by the Cayman courts, as well as a decision by the Supreme Court in the United Kingdom in Cavendish Square Holding BV v Talal El Makdessi; ParkingEye Ltd v Beavis, regarding enforcement of penalty provisions in contracts, which is highly likely to be followed in the Cayman Islands. On the legislative and regulatory front, the Cayman Islands government has now passed key legislation to implement the OECD’s Common Reporting Standard and the Cape Town Convention.
In the courts
Cavendish Square Holding BV v Talal El Makdessi; ParkingEye Ltd v Beavis  UKSC 67
It is a basic and long-standing common law principle in the law of contract that a provision in a contract which is construed a penalty cannot be enforced. In an eagerly anticipated judgment, a seven-judge Supreme Court re-formulated the applicable test for determining whether a particular contractual provision should be struck down as being a penalty. This decision is almost certain to be followed in the Cayman Islands.
Previously, the law had stood with the well-known decision of the House of Lords in Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd  AC 79 and the classic four-fold test propounded by Lord Dunedin. In the combined appeals in a commercial case Cavendish Square Holding BV v Talal El Makdessi and a consumer case ParkingEye Ltd v Beavis  UKSC 67, the Supreme Court has now re-stated the applicable principle as:
“whether the impugned provision is a secondary obligation which imposes a detriment on the contract-breaker out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation.”
The majority reasoning was provided in a joint judgment of Lords Neuberger and Sumption with which Lord Carnworth agreed, and in separate judgments of Lord Mance and Lord Clarke, who agreed the re-formulation of the test by Lords Neuberger and Sumption.
In order for a contractual provision to be struck down as a penalty, it is necessary to have an affirmative answer to two separate and consecutive questions: First, is the impugned provision a secondary obligation? If not, then it is not a penalty. If it is, one must go on and consider whether the impugned provision imposes a detriment on the contract-breaker out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation? If it does, it will be unenforceable as a penalty.
An interesting question Lords Neuberger and Sumption shied away from is the relationship between penalties and relief from forfeiture, although they acknowledged the possibility that a contractual provision could be both a penalty and a forfeiture. Lords Mance and Hodge, on the other hand, were prepared to grapple with this relationship and concluded that a clause could be considered to be both a penalty and a forfeiture so that the court could consider whether relief against forfeiture should be given:
“in an appropriate case the court should ask first whether, as a matter of construction, the clause is a penalty and, if it answers that question in the negative, it should ask (where relevant) whether relief against forfeiture should be granted in equity having regard to the position of each of the parties after the breach.”
Lord Toulson agreed with them and Lord Clarke was inclined to agree as well.
In reaching their conclusion on the correct formulation of the test, Lords Neuberger and Sumption made a number of pertinent observations:
“the penal character of a clause depends on its purpose, which is ordinarily an inference from its effect. As we have already explained, this is a question of construction, to which evidence of the commercial background is of course relevant in the ordinary way. But, for the same reason, the answer cannot depend on evidence of actual intention.” [Para. 28]
“A damages clause may properly be justified by some other consideration than the desire to recover compensation for a breach. This must depend on whether the innocent party has a legitimate interest in performance extending beyond the prospect of pecuniary compensation flowing directly from the breach in question.” [Para. 28]
“The real question when a contractual provision is challenged as a penalty is whether it is penal, not whether it is a pre-estimate of loss. These are not natural opposites or mutually exclusive categories. A damages clause may be neither or both. The fact that the clause is not a pre-estimate of loss does not therefore, at any rate without more, mean that it is penal. To describe it as a deterrent (or, to use the Latin equivalent, in terrorem) does not add anything. A deterrent provision in a contract is simply one species of provision designed to influence the conduct of the party potentially affected. It is no different in this respect from a contractual inducement. Neither is it inherently penal or contrary to the policy of the law. The question whether it is enforceable should depend on whether the means by which the contracting party’s conduct is to be influenced are “unconscionable” or (which will usually amount to the same thing) “extravagant” by reference to some norm.” [Para. 31]
This led up to their conclusion at paragraph 32:
“The true test is whether the impugned provision is a secondary obligation which imposes a detriment on the contract-breaker out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation. The innocent party can have no proper interest in simply punishing the defaulter. His interest is in performance or in some appropriate alternative to performance. In the case of a straightforward damages clause, that interest will rarely extend beyond compensation for the breach, and we therefore expect that Lord Dunedin’s four tests would usually be perfectly adequate to determine its validity. But compensation is not necessarily the only legitimate interest that the innocent party may have in the performance of the defaulter’s primary obligations.”
Lords Neuberger and Sumption then went on to stress that the rule is an interference with the principle of freedom of contract and undermines certainty in the law which is of particular significance in commercial contracts. They made a welcome observation in paragraph 35:
“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 the commercial context the judgment provides strong support for leaving the parties to their bargain, and the re-formulated test should make it more difficult in future to challenge a contractual provision in a commercial contract as a penalty. Although in one sense the new formulation could be seen as introducing additional uncertainty into the law, in practice it is likely to lead to more certainty in commercial contracts.
RMF Market Neutral Strategies (Master) Limited v. DD Growth Premium 2X Fund (In Official Liquidation)
In this case, the liquidators of DD Growth Premium 2X Fund (In Official Liquidation) (“DD Growth”), a Cayman Islands investment fund, sought to clawback redemption payments made to RMF Market Neutral Strategies (Master) Limited (“RMF”), as a redeeming investor, at a time when it was subsequently shown that DD Growth was insolvent when the payments were made. The liquidators’ argument was based on section 37(6)(a) of the Cayman Islands Companies Law (2007 Revision) (the “Law”), which provided that:
“A payment out of capital by a company for the redemption or purchase out of its own shares is not lawful unless immediately following the date on which the payment out of capital is proposed to be made the company shall be able to pay its debts as they fall due in the ordinary course of business.”
The liquidators sought to argue that the payments made to RMF were payments made out of capital at a time that DD Growth was insolvent and that, in effect, payments out of either share capital or share premium were impermissible.
At first instance, the chief justice of the Grand Court of the Cayman Islands dismissed that argument, instead finding that the provisions of section 37(6)(a) of the Law were not breached as only a de minimus amount of $1/1000 per share represented share capital, with the remainder representing share premium, the use of which was permissible pursuant to the Law. This is the position that is found in the current version of the Companies Law (the 2013 Revision).
In a landmark decision, the Cayman Islands Court of Appeal held that section 37 of the law must be read in conjunction with section 34 of the law, which provided that payments by a company out of share premium for the redemption or purchase of its own shares are not payments out of capital and, as such, are not subject to any solvency requirement. The Court of Appeal attached particular importance to section 34(2)(f), which refers to the use of share premium “for providing for” the premium payable on redemption which is held to cover payment for the premium due.
Further, the Court of Appeal failed to be persuaded by the liquidators’ argument that the convoluted wording of section 37(5) supported the contention that the payments made to RMF were made out of capital, considering this argument to be “circular.”
It is now therefore clear that for the purposes of section 37(6), share capital is given its natural meaning and represents only the par value of shares. This clarity will be helpful for the directors and managers of other Cayman Islands investment funds and investors seeking to redeem from them.
Key legislative changes
Common Reporting Standards (CRS)
We discussed the OECD’s CRS in some detail in the last edition of Law Talk and the fact that they were soon to be implemented in the Cayman Islands.
The Tax Information Authority (International Tax Compliance) (Common Reporting Standard) Regulations, 2015 have now come into effect, and Cayman Islands reporting financial institutions that are affected by the CRS should be actively preparing for CRS compliance, noting that the new account opening procedures should be in place for Jan. 1, 2016.
Further parts of the regulations (e.g. in respect of the specific requirements for compliance) are still expected. In addition, it is anticipated that additional guidance and self-certification forms will be forthcoming shortly.
Cape Town convention extended to the Cayman Islands
The Convention on International Interests in Mobile Equipment and the associated Protocol to the Convention on International Interests in Mobile Equipment on matters specific to aircraft equipment (collectively, the “Cape Town Convention”) (which we discussed in some detail in the June 2015 edition of Law Talk) came into effect in the Cayman Islands on Nov. 1, 2015 in line with its entry into force in the United Kingdom on the same date.
The Cape Town Convention, as extended to the Cayman Islands, will meet the requirements for the Cayman Islands to have made the requisite qualifying declarations under the Organization for Economic Development Aircraft Sector Understanding.
This significant and long-awaited development will no doubt be welcomed by the global aircraft finance community and Cayman Islands’ practitioners alike.