Corporate-penalty clauses

Settlement agreements are often negotiated in respect of restrictive covenants.

There was much comment in the legal press last year on a High Court decision which upheld a restrictive covenant in a share sale agreement, drafted to have effect for a minimum of eight and a half years. Courts have consistently distinguished between what may be a reasonable restriction in an employer/employee situation and a buyer/seller situation, but even so, eight and a half years is hardly typical.

Further, breach of this particular restrictive covenant had dire consequences for the seller in that the buyer ceased to have to pay future instalments of the consideration and a put option was triggered requiring the seller to sell the balance of his shares in the company; draconian stuff, but not a penalty, in fact, commercially justifiable, according to the court.

Are there practical implications for buyers and sellers of businesses? The significance of Cavendish Square Holdings BV and another v El Makdessi is likely to be what it signals about the courts’ reluctance to interfere with parties’ freedom in commercial transactions and how so called “penalty clauses” are likely to be regarded.

What is a penalty clause and what’s the issue?


When negotiating the terms of an acquisition or investment it makes sense for a company to consider carefully the circumstances in which a breach of contract might occur, and the potential consequences of that breach. This is particularly true in the context of restrictive covenants, which seek to restrict the ability of a seller to compete with the business of the target company for a specified period after completion of the transaction. In investment transactions, similar consideration must be given to the consequences of implementing good leaver/bad leaver provisions. Buyers in particular may well be keen to include a specific formula for how damages for any breach might be calculated.

However, the danger in including such a formula is that if such a contractual term is determined to be a penalty for breach, rather than a genuine pre-estimate of loss, the court may refuse to enforce the term. In negotiating this kind of provision, buyers and sellers must be mindful of the rules against penalties in contracts. A recent case in the High Court highlights the modern approach of the courts with regard to penalty clauses.

Cavendish Square Holdings BV and another v Makdessi – the facts


The dispute revolved around a suite of agreements to purchase shares in a large advertising and marketing communications group in the Middle East, under which Cavendish Square purchased up to 60% of the target and took an option for the purchase of the balance. The purchase price for the original acquisition was payable in various instalments, and the price for the option shares was based on an agreed formula, including a substantial premium for the goodwill in the target.

The agreement contained a number of provisions restricting the sellers from taking direct or indirect interests in competing enterprises and clauses which addressed the issue of the buyer’s loss in the event the restrictive covenants were breached. The parties agreed that breach of the restrictions would result in the cancellation of any outstanding instalments for the original 60% and would substantially reduce the price for the option shares (largely by eliminating the premium for goodwill).

In the event, one seller admitted various breaches of the restrictions, but argued that the agreed terms to deal with the breaches were so extreme that they amounted to a penalty, and, accordingly, were unenforceable. The High Court disagreed, and while cases such as these will generally turn on their own facts, the court indicated some useful criteria for judging whether clauses contemplating particular measures of loss were penalties or not.

Criteria


The judge in the Cavendish Square case asked himself four questions:-

 
  • Was there a commercial justification for the terms? In this case there was, as the terms dealing with the breach effectively adjusted the purchase price to deal with the damage to the goodwill being acquired.

  • Were the terms oppressive? Although the sellers disagreed, the judge decided the terms were not, largely on the basis that the breach and damage were clearly connected, and the valuation fully justified.

  • Was the predominant purpose to deter breach? There will in any such terms be at least an ancillary deterrent to breach, as a seller will naturally not wish to have to pay out any damages at all. In this case, it was decided that the main purpose was to allow the parties to go their separate ways while adequately compensating the buyer for any loss of goodwill.

  • Were the provisions negotiated on a level playing field? The substantial commercial experience of both parties, coupled with the use of experienced and reputable solicitors, led the judge to conclude that they were.

What are the implications?


It is not always possible to pre-estimate loss adequately in relation to given provisions in a share purchase or other agreement. Even if it is possible, doing so may be a double-edged sword for a buyer, who may suffer considerably more loss than was estimated and the agreed terms could leave him unable to recover his full loss. On the other hand, including such a pre-estimate may well cut out costly arguments in litigation over the loss, and, (as in the Cavendish Square agreement), in the event that an appropriate mechanism in the agreement can adjust the purchase price or otherwise setoff the loss, the buyer may be able to take some control over recovery.

In the event that a buyer wants to include such principles at the heads of terms stage, he must bear in mind the need to connect the measure of loss and the damages adequately and to avoid the allegation of oppressiveness. Conversely, a seller should be aware that it is not easy to strike down terms as penalties, as courts will generally be respectful of parties' freedom of contract.

In order to address these issues, and to conclude an appropriate bargain at heads of terms stage which is enforceable once it makes its way into a legally binding agreement, it may well be beneficial to involve solicitors at any early stage in negotiations.

For more information about this case or advice about negotiating heads of terms, possible penalty clauses or corporate settlement agreements please contact us for a free initial discussion.

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