Deferred Consideration and Restrictive Covenants: Avoiding Penalties

In negotiating a business sale agreement, a purchaser should consider carefully the legal implications of requiring a seller who breaches a restrictive covenant to forfeit sale proceeds, says a leading corporate lawyer. 

Philip Round, a partner based at the Wolverhampton office of Black Country law firm George Green LLP, said: “Sourcing acquisition finance remains challenging.  The increasingly cautious approach adopted by purchasers and their funders often results in the deferral of a significant proportion of the price payable for a business.  Where much of the target’s value is attributable to the client relationships developed by the seller, a purchaser will understandably require robust non-compete covenants.  Whilst it would seem fair for a seller who breaches such a covenant to forfeit some or all of the deferred sale proceeds, a recent Court of Appeal decision highlighted the risk of such a mechanism being challenged as an unenforceable penalty”.

Mr Round continues: “Where a contract obliges a defaulting party to make a payment the primary purpose of which is to discourage breach rather than to compensate the innocent party, it is likely to be deemed an unenforceable penalty.  This principle applies not only to payment clauses, but also to provisions which entitle the innocent party to withhold funds or to demand that assets be transferred at a price significantly lower than their market value.”

Courts have, according to Mr Round, traditionally been reluctant to set aside such clauses.  “This is particularly the case where the clause has been negotiated by parties of comparable bargaining power.  The decision of the Court of Appeal in the recent case of El Makdessi v Cavendish Square Holdings BV and another demonstrates, however, that courts will step in where they feel that a clause is particularly oppressive.” 

“The case concerned the purchase of a majority shareholding in a large marketing group.  A significant proportion of the price represented the value of goodwill developed by the seller, who retained a stake in the company, remained as a non-executive director, and entered into detailed restrictive covenants. Part of the purchase price was payable in instalments and calculated by reference to the post completion profits of the group.  The share purchase agreement provided that if he breached a restrictive covenant, the seller would lose his entitlement to any future instalments.  The purchaser would, in such circumstances, also have an option to buy the balance of the seller’s shares at a price calculated by reference to the net asset value of the target company, ignoring the significant goodwill element.  When the seller was found to have breached the restrictive covenants, the purchaser sought to enforce this clause.”

Overturning the decision of the High Court, the Court of Appeal held that the relevant clause was an unenforceable penalty.  Mr Round believes that purchasers can learn important lessons from the decision.  “It is essential to understand the Court of Appeal’s reasoning.  Historically, courts focused on the question of whether or not the level of any payment or withholding triggered by a breach of contract constituted a genuine pre-estimate of the innocent party’s recoverable loss.  If not, and the financial impact on the defaulting party was excessive, the clause was likely to be unenforceable.  Courts have, however, more recently held that a payment which is disproportionate to the loss may not be a penalty if there is a strong commercial justification for the clause, and its main purpose is not to deter breach.”

“In the El Makdessi case, the Court of Appeal found that the clause in question was not a genuine pre-estimate of loss, but was “extravagant and unreasonable” for two main reasons.  Firstly, the clause was intended to compensate the purchaser for the reduction in value of the shares in the target company resulting from the seller’s breach.  This was, however, a so-called “reflective loss,” merely reflecting the loss suffered by the target company.  As such, it would not have been recoverable by the purchaser under the general law of contractual damages.  The target itself was entitled to make a claim in respect of such loss under the terms of the share purchase agreement and was considered by the court to be the appropriate claimant.  Any loss of deferred proceeds would therefore automatically be disproportionate to the purchaser’s recoverable loss given that, on the facts, the purchaser had no recoverable loss.”

 “Leaving aside the question of recoverable loss, the clause would still have been disproportionate because it applied regardless of the circumstances of the breach – the seller would have forfeited the balance of the price even for a relatively trivial infringement.  The Court could find no commercial justification for the clause where the likely level of proceeds withheld by the purchaser was potentially out of all proportion to its loss.”

According to Mr Round, purchasers should seek legal advice at an early stage when negotiating a price structure under which a seller forfeits part of the consideration on breaching a restrictive covenant.  “Whilst it would be possible to attempt to link the price adjustment to the level of loss suffered by the purchaser, it is inherently difficult to predict the consequences of infringement when the clause can potentially be breached by any number of competing activities, the financial impact of which could vary significantly.  As the purchaser’s ability to recover is in any event likely to be limited by the principle of reflective loss, any attempt to draft a proportionate clause would appear to be futile, as the price adjustment would in most cases be greater than the purchaser’s recoverable loss.”

“Such a clause may however be upheld if worded in a subtly different way,” concludes Mr Round.  “The Court recognised that a clause which makes payment of the price conditional on compliance with the restrictive covenants, rather than requiring the seller to forfeit the proceeds for breach, might not have constituted a penalty.  Whilst one can never predict with certainty how a court will seek to interpret a particular clause, the Court of Appeal’s decision has emphasised the importance of careful drafting in minimising the risk of challenge.”