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By James Pressley
Let's say you are selling a company, or buying shares in a company. You may have concerns about the trustworthiness or ability of the other side to live up to their obligations. So you push your solicitor to insert clauses into the share purchase agreement to cover your risk.
One problem with doing this is that in any subsequent court action, the court may decide that a draconian measure is a penalty and therefore unenforceable. Defining what is and is not a penalty is also not a simple matter. We do have some court decisions which relate to particular cases, but not a definitive list.
Take the following case. C BV, the buyer, owned 12.6% of the Company's share capital and agreed to buy a further 47.4% from M and his fellow shareholder G, the sellers. Clause 11 of the share purchase agreement set out restrictive covenants which applied to M and G, such as a covenant not to compete with the Company and similar covenants intended to prevent M and G from diverting customers, business and employees away from the Company.
M breached the restrictive covenant. M was due further instalment payments at later dates, but the share purchase agreement with C BV also provided that if M breached the restrictive covenant clause, M would not be entitled to receive those further instalment payments. This was the situation in El Makdessi v Cavendish Square Holdings BV and another  EWCA Civ 1539.
The Court of Appeal held that the clause in the share purchase agreement stating that M would not be entitled to receive the further instalment payments because of breach of the restrictive covenant was a penalty, and was therefore unenforceable. Clarke LJ, who gave the principal judgment, suggested that the share purchase agreement might have been enforceable had it stated that payment of the further instalments to M was conditional on M's compliance with the restrictive covenants. Clearly, this is drawing a pretty fine line.
Various judgments seek to define what is a penalty. Perhaps a modern definition is: "whether a provision is to be treated as a penalty is a matter of construction, to be resolved by asking whether at the time the contract was entered into the predominant contractual function of the provision was to deter a party from breaking the contract or to compensate the innocent party for breach". In practice, this is not always going to be easy.
Turning to Jobson v Johnson (1988) 4 BCC 488. In this case, the seller was again owed instalments payable at later dates. The share purchase agreement contained a term which stated that if the buyer failed to make payment of any instalment, the buyer had to transfer the shares it had purchased back to the seller at a fixed price, which was lower than the amount the buyer had paid. The court held that the offending clause was unenforceable as a penalty.
It can be seen that the preparation of share purchase agreements might be a minefield for penalties. A judge might argue that the particular point about a penalty is that it requires deterrence against the breach of a contract. But, turning to Clarke LJ's suggestion in El Makdessi, it is difficult to see how making payment of instalments conditional on not breaching restrictive covenants cures the problem. M will still be aware that breaching the restrictive covenant will result in loss of payment, which surely is effectively the same punishment.
You as the client may consider that the clauses in El Makdessi and Jobson were perfectly reasonable methods of ensuring that the other side lives up to their side of the bargain. However, the courts have clearly set out that these are penalty clauses and they are of no use to you if they are unenforceable.
So what is to be done? First, you should consider exercising restraint when, after a long day negotiating, you ask your solicitor to insert a clause into a share purchase agreement with the aim of eliminating risk of breach by the other side. Second, you must ensure that you pick a solicitor with the knowledge and experience to draft your share purchase agreement without including infringing penalty clauses.
This post was written by James Pressley a lawyer at Excello law. Should you wish to contact him, then you can do so by either sending him an email on firstname.lastname@example.org or you can find out further information by looking at his profile page on the Excello Law Website.
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