Penalties: the modern approach

If you enter into an agreement that provides that the other party has to pay you a large sum of money if it is in breach, you may find that the court will not enforce that term of the agreement, because it is a penalty. It is the same if the term imposes an obligation that has a similar effect: for example, requiring the party in breach to sell the other party an asset for less than it is worth, or to forego all or part of an expected payment. This is why it is important to remember the law on penalties in many different contexts. It is especially relevant in connection with good leaver/bad leaver provisions in private equity transactions, exit provisions in joint ventures and earn-outs in share and business sales.

In the older cases, when deciding if a term was a penalty the critical question was whether the amount involved was a genuine pre-estimate of the other party’s loss. The trend now, however, is to take a broader approach, focusing on whether the term is commercially justifiable in the circumstances of the transaction or is really just intended to deter the other party from breaching the agreement.

Cavendish Square Holdings BV and another company v Makdessi [2012] EWHC 3582 (Comm), decided in the High Court in December 2012, featured an unsuccessful attempt to invoke the law on penalties in connection with a deferred payment for shares and a call option over further shares. The judgment is a good illustration of the court’s approach and its reluctance to interfere with parties’ freedom to contract in commercial transactions. It also gives us some useful pointers for avoiding the law on penalties.

The facts

The dispute was over various clauses in an agreement for the purchase initially of a 60% holding in the largest advertising and marketing communications group in the Middle-East from its founder and one other person. The buyer attributed much of the value of the target to its goodwill, which was derived almost entirely from the founder’s involvement in the business and his relationships in the region. The consideration was payable in three instalments and included an option for the buyer to acquire the remaining shares at a later date.

The agreement also included restrictive covenants, breach of which resulted in cancellation of any outstanding instalments and triggered the option at a discounted price so that goodwill (which would otherwise have substantially increased the price) was ignored. The founder breached the restrictive covenants, but argued that the buyer could not cancel the deferred payments or buy the remaining shares at the lower value, as these terms were penal.

The modern approach

In line with earlier cases, the judge decided that the law of penalties could apply to terms under which property and money were taken away from the party in breach. It made no difference that the quite separate law of forfeiture, with different rules, might also apply. But were the terms penal? The judge posed four questions and decided they were not:

• Was there a commercial justification for the terms? Yes. The commercial rationale was to provide a complete end to the relationship between the sellers and the buyer and to adjust the consideration for the shares in order to account for a substantial loss in goodwill caused by the breach of the restrictive covenants.
• Were the terms extravagant or oppressive? No. The valuation of the shares included a substantial amount for goodwill. The breach of the restrictive covenants was likely to have a substantial impact on goodwill, and therefore the reduction in the consideration was neither extravagant nor oppressive.
• Was the predominant purpose to deter breach? No. The main purpose of the terms was to decouple the parties and adjust the consideration for the shares.
• Were the provisions negotiated on a level playing field? Yes. The terms were thoroughly negotiated by the parties, who were both represented by experienced solicitors.

The judge also commented that the courts are reluctant to interfere in commercial transactions and should not be too hasty to decide that a term was a penalty (although there might be exceptional circumstances).

What does this mean for you?

Buyers often try to retain key people and protect the acquired business by using structures like those used by the buyer in this case. The case turned very much on its facts and there is no assurance that these structures will work every time. But asking yourself how your proposed transaction stands up to the four questions asked by the judge here will be a good start.