Penalty Clauses in the Context of Leaver Provisions

Provisions allowing one party to withhold or forfeit future payments following a breach, or exit provisions allowing an innocent party to buy out a defaulting party at below market value, are common features in a wide range of corporate and commercial agreements. Such clauses provide the parties with redress for a breach without having to resort to legal proceedings.  However, these provisions run the risk of being held void as penalties and therefore, care needs to be taken when drafting to ensure that the correct balance is achieved.

At a minimum, drafting should seek to ensure that any loss suffered by, or payment obligation imposed on, the party in breach as a result of such breach is not "extravagant and unreasonable".

The law of penalties is engaged where the parties have agreed that, upon a particular breach of contract, the party in breach will pay the other party a sum of money. It may also apply to a provision that disentitles the contract breaker from sums otherwise due to him or requires the compulsory transfer of property (for example, shares) to the innocent party at nil or an undervalue. Whether or not the offending clauses are held to constitute a penalty (and therefore unenforceable) will depend on various factors.

On the other hand, liquidated damages clauses, whereby parties agree at the outset pre-determined estimates of losses to be incurred for the failure to meet certain contractual obligations, are valid and enforceable.

Generally speaking, the Courts are reluctant to strike down penalty clauses as this constitutes a "blatant interference with freedom of contract" which is a key principle of the law. Nevertheless, when the courts do intervene and determine a clause to constitute a 'penalty' it is typically unenforceable. Two lines of case law have emerged which provide exceptions to this general rule: (i) where there has been a genuine pre-estimate of loss; and (ii) where there is commercial justification.

Talal El Makdessi v Cavendish Square Holdings BV and another ("Makdessi") currently represents the most authoritative statement of the law, although it should be noted that it has been appealed to the Supreme Court.

In that case, the Court of Appeal overturned a previous High Court decision on whether a discounted price provision in an M&A context amounted to an unenforceable penalty under English law. Whilst acknowledging the trend in recent cases to focus on whether a clause is commercially justifiable in the circumstances of the transaction when determining whether its primary purpose was to deter the other party from breaching the agreement, the Court of Appeal decided that the commercial justification argument did not apply here. Hence the mere fact that provisions are inserted for commercial reasons (in the case of leaver provisions, to effect a "clean break" or to provide suitable incentives to employees) does not guarantee that the provision will escape being struck down as a penalty.

Using the reasoning applied by the Court of Appel in Makdessi:

  • it is settled law that a clause which requires the transfer of property (such as shares) rather than the payment or forfeit of cash can constitute a penalty;
  • it is difficult to argue that a compulsory transfer provision is a genuine pre-estimate of loss. Neither the value of the shares nor the potential effect of the breach can possibly be known at the date on which the manager acquires the shares; and
  • whilst there is almost certainly commercial justification for a provision which requires the transfer of shares from a leaver, the operation of the provision could be 'extravagant' in the sense that the loss that arises as a result of the circumstances leading to the transfer may be wholly disproportionate to the value of the shares transferred (particularly in the case of a bad leaver).

However, a key distinction which must be considered when looking at compulsory transfer provisions is that their application is not effective upon a breach but rather the occurrence of a certain state of affairs, i.e. a manager no longer being employed by the issuing company (for whatever reason). Arguably, the purpose of the provision may not be said to have, as a primary purpose, the deterrence of breach, even where potentially (such as in the case of summary dismissal) there is a breach of other agreements.

Anyone involved in drafting clauses such as:

  • good leaver/bad leaver provisions in shareholder agreements or articles of association;
  • put and call options; or
  • provisions in share purchase agreements, providing for forfeiture of all or part of an earn-out in certain circumstances,

should consider if all or any part of the clause(s) concerned might be regarded as penalty clauses, and so might need to be adjusted so as not to be regarded as penal in nature. The following should be borne in mind:

  • Ensure the provisions do not provide for a remedy that is extravagant or unreasonable when compared with the greatest loss that could conceivably flow from the breach.
  • Consider using a range of remedies appropriate to clause is breached and the seriousness of the breach.
  • Consider drafting the provisions as conditions precedent. In Makdessi the Court of Appeal accepted that if the agreement had been structured differently, so that the payment of future consideration was conditional on compliance with the covenants, the law on penalties may not have been engaged. However, it is important to note that the artificiality of this approach has been criticised in other cases and the courts have previously expressed a willingness to look to the substance of the bargain – Euro London Appointments Ltd v Claessens International Limited [2006] EWCA

Date Published: 27 October 2015