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A recent case has demonstrated the need for clear drafting of complex deal structures, particularly where certain clauses are vulnerable to challenge as unenforceable penalties, according to Philip Round, a corporate partner at George Green LLP.
“It is increasingly rare for the entire purchase price for a target business to be paid on completion,” says Mr Round. “More commonly, a proportion of the price is deferred and adjusted by reference to the post completion performance of the target. Where the continued involvement of a founder is crucial to a successful handover, the entitlement to receive such deferred consideration is also frequently linked to the provision of services under a consultancy agreement or employment contract, or compliance with non-compete restrictions.
The Supreme Court judgement in Cavendish Square Holding BV v Talal el Makdessi considered whether such a clause constitutes an unenforceable penalty.”
Mr Round continues, “it is a longstanding rule of law that clauses which are triggered on a breach of contract, most commonly those which require the offending party to pay a fixed sum to the innocent party, are likely to be unenforceable to the extent that the compensation is out of proportion to the legitimate interests which the parties are seeking to protect. Conversely, if the sum payable is a genuine pre-estimate of the damage suffered, it is likely to be enforceable. In the Cavendish case, the Supreme Court reviewed the tests to be applied in determining whether a clause is an unenforceable penalty.”
“The case concerned the seller of a majority stake in an advertising and communications group. Pursuant to the sale agreement, the seller disposed of a significant proportion of his shares. Part of the price was deferred. The agreement provided that if the seller breached certain non-compete covenants, he would cease to be entitled to the deferred consideration, and would be required to sell the balance of his shareholding at a significant discount.”
Mr Round explains that the seller admitted breach of the restrictive covenants but argued that the clause which sought to prevent him from receiving the balance of the price, and to require him to sell his remaining shares at a discount, were unenforceable penalties. “The Supreme Court, however, upheld the validity of the clauses. It was noted that a clause can only be an unenforceable penalty if it constitutes a secondary obligation, conditional on default. The parties had ensured in this case that the clause in question was integrated into the definitions used in the purchase price structure and was therefore held to be part of a complex price adjustment. As the payment of the purchase price is a primary obligation, the penalty rule was not therefore engaged. Had the penalty rule been relevant, however, the Supreme Court believed it was clear that a significant proportion of the price represented the value of goodwill, and the loyalty of the seller was essential to protect the goodwill and longstanding trading relationships. The clause would not therefore have been out of proportion to the legitimate interests of the purchaser.”
Mr Round continues, “The case illustrates that careful wording of sale agreements can increase the prospect of enforceability. Whilst cases will be determined on the substance of the provisions, clear drafting can ensure that the true nature of a clause is readily apparent to the court. The input of expert corporate lawyers is therefore essential.”
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