Watch out! Your deferred consideration clause may in fact be a penalty

29 / 01 / 2014

When structuring the acquisition of a company the buyer often looks to pay the consideration over a period of time. Such deferred consideration can be dependent on performance targets of the company being met as well as key individuals remaining in the business and protecting the goodwill. This gives the buyer comfort that it is making the right investment and that the company is as valuable as the seller said it would be.

If the seller is in breach of his promises relating to performance, protection of goodwill or otherwise then a buyer will not want to rely on the court’s assessment of damages for breach as these can often be restrictive and do not reflect the true value of the loss suffered by the company or the buyer.  In order to increase the losses that can be recoverable various provisions are negotiated into the acquisition agreement to provide better protection.  In the context of a share purchase agreement (SPA), buyers often include provisions that defer the payment of a part of the consideration to the key seller shareholder which is reduced or falls away entirely in the event of a breach of contract or failure to meet certain targets. Restrictive covenants in the SPA and in the director’s service contract can set out what will be deemed to constitute a breach of contract, for example, if the shareholder/director competes with the target company and undermines the value of the company’s goodwill.

However, great care needs to be taken when drafting and negotiating such deferred consideration provisions and restrictive covenants.  Will they be seen to be a “liquidated damages” clause (enforceable) or a “penalty” (unenforceable)?

Liquidated damages and penalties

Penalty clauses are clauses which have the effect of compensating the innocent party for a loss which is greater than that which it has suffered and are characterised by wording which deters the party from breaching a contract by penalising them with a large financial or other loss.  What is permissible is for a party to make a genuine assessment of the loss that it would suffer should a breach occur and include provisions for recovery of such loss.  This loss can be greater than the loss which a court would award under a usual measure of damages provided that some thought has gone into the assessment and this can be seen as a genuine pre-estimate of the loss that would be suffered.

Penalties are usually drafted in the context of a payment of a sum of money on breach. However penalties are not limited to this. Clauses that require the defaulting party to transfer assets on breach, for example, a transfer of shares (as in Jobson v Johnson (1989)) or that deprive the guilty party of a sum of money can also be deemed penalties.

A provision to transfer a defaulting party’s shares at an undervalue in the event of a breach risks being deemed a penalty, as its aim is to deter breach, and consequently there is a likelihood that the clause will not be enforceable. To be effective, the clause will need to be a genuine pre-estimate of the loss suffered because of the breach, that is, a liquidated damages clause.

In the past, case law has provided that if a clause was not a liquidated damages clause then it must automatically be a penalty. A more modern approach, as adopted in Lordsvale Finance v Bank of Zambia[1] is to further ask whether a clause is “commercially justifiable”. If it is commercially justifiable, it will not be a penalty.

Despite the danger that, on scrutiny of a clause, it may be deemed to be a penalty, it is still worth attempting to negotiate clauses which set out losses that can be recovered. These kinds of clauses provide certainty, and tend to avoid disputes as well as the risk of undercompensating the innocent party.

Recent case law

In the recent Court of Appeal case of El Makdessi v Cavendish Square Holdings BV and another[2], the seller, Mr Makdessi, was amajority shareholder in the largest advertising and marketing communications group in the Middle East (the Group). The buyer wanted to protect the goodwill and therefore placed restrictive covenants on the behaviour of Mr. Makdessi.  The deferred consideration was a considerable sum.

If the seller breached the restrictive covenants, the buyer (Cavendish) could:

  1. withhold interim and final payments of the purchase price; and
  2. exercise a call option requiring the seller to sell the balance of his shares in the Company to Cavendish at net asset value (NAV) (the seller could not exercise a put option (under the SPA) and the NAV would not include goodwill which was an undervalue).

The seller breached the restrictive covenants. He then settled the claim brought by the Company for breach of restrictive covenants for $500,000 (the Settlement Payment) but the buyer sought to enforce (1) and (2) to obtain the remaining shares of the seller at a lower value and withhold payment of the deferred consideration.

The High Court decision[3]

The High Court found that both clauses (1) and (2) were not, on their own, penalties. It noted that experienced lawyers had acted for both parties on negotiations of the SPA and they were wary to intervene and deem the clauses unenforceable.

Firstly, the High Court found that the Settlement Payment rendered clause (1) a penalty clause, as receipt of the Settlement Payment and then an award of damages by the court would lead to double recovery by Cavendish. Secondly, the HC ordered Cavendish to repay the Settlement Payment to Mr Makdessi and ordered the call option at the NAV, enforcing the provisions of clause (2).

The Court of Appeal decision

The Court of Appeal wasted no time in declaring the first finding of the High Court an error. If clause (1) was not a penalty clause at the time the agreement was entered into, it could not be rendered so by the Settlement Payment.

The Court of Appeal further found that clauses (1) and (2) were an “extravagant and unreasonable” penalty because, among others:

  • Cavendish’s loss was zero as it was reflective loss of the Company; and
  • there was no regard to the extent of Mr Makdessi’s breach, that is, if he had unsuccessfully poached the Company’s clients or employees he would face the same consequences as if he had done so successfully.

Key to the judgement was the fact that Mr Makdessi stood to lose millions of pounds while Cavendish’ loss was in fact zero.

The Court found that clauses (1) and (2) were not commercially justifiable and did not accept Cavendish’s argument that the clauses aimed to reduce the consideration owed to Mr Makdessi on breach and were a way of decoupling him from the Company.

Practical implications

This case confirms that there is still uncertainty surrounding the interpretation of penalties.  Importantly, a clause will not be deemed a penalty as long as it is commercially justifiable. Purchasers need to show the commercial rationale for the inclusion of protection clauses, for example evidence of thought processes and calculations. This will be key evidence to help determine that a clause is not a penalty and is enforceable against the defaulting party.

There is some comfort in Clarke LJ’s comments that clauses could avoid being caught by the doctrine of penalties if they were structured so that a deferred payment is seen as a conditional benefit rather than in effect forfeiture in the event of breach.  This could be done by making the deferred consideration payable only if certain conditions were met, including, for example, compliance with restrictive covenants.  The important points to note are that protection for deferred consideration will not automatically be considered as an unenforceable penalty but great care needs to be taken over the drafting of such provisions if loss in excess of the court’s general award of damages is to be covered.