2015 Half-year in review—M&A legal developments
When a contractual provision is
a penalty
The Supreme Court has allowed an appeal from a previous Court of Appeal
decision on whether the loss of a right to future instalments of the price and a separate
discounted price provision in an M&A context amounted to unenforceable penalties
under English law1. It decided that the relevant clauses were not unenforceable
penalties, and articulated a new test based on whether a clause imposes a detriment
on the party in breach out of all proportion to any legitimate interest of the innocent
party. The Supreme Court also confirmed that the rule against penalties is not limited
to clauses which require payment of money on breach but can catch other types
of provision imposing a detriment on a party if it breaches the contract, which can
commonly arise in transaction documents in an M&A context, for example a forced
sale of an asset at an undervalue.
Background
A
buyer (B) entered into a sale and purchase agreement
(SPA) to increase its existing shareholding in a company
by acquiring further shares from the sellers (S). The
price was payable by instalments and linked to a profits
multiple. There were also put and call options over S’s
remaining stake.
However,
if S breached restrictive covenants in the SPA,
B was not obliged to pay future instalments and could
exercise the options at a much lower price than otherwise
based on the company’s net asset value on the date the
breach commenced and excluding the value of the goodwill
of the business. Against this backdrop, S breached the
restrictive covenants.
Decision
Allowing the appeal, the Supreme Court decided that the
relevant clauses were not unenforceable penalties. In giving
its judgment, the Supreme Court clarified and restated the
scope of the English law rule against penalties.
1 Cavendish Square v Talal El Makdessi; ParkingEye Limited v Beavis [2015] UKSC 67.
Traditional tests for applying the rule against
penalties replaced
The
traditional approach to assessing whether a contractual
provision amounts to a penalty has been to consider
whether the primary purpose of the clause was to deter
a breach, focusing for this purpose on whether it was
a genuine pre-estimate of loss. Further, a trend had
developed in recent cases to consider whether a clause
was commercially justifiable in the circumstances of the
transaction when determining whether its primary purpose
was to deter a breach. The Supreme Court now applied a
new and more flexible test, stating that a deterrent is not in
itself inherently penal or contrary to public policy. The real
question is whether the clause is in fact “penal” by virtue
of being disproportionate.
Classification as primary or secondary obligations
Lords
Neuberger and Sumption drew a distinction here
between primary and secondary contractual obligations.
They indicated that a primary performance obligation
cannot be a penalty. To begin with, this would mean that,
if the contract does not impose any express or implied
obligation to perform a particular act, but simply provides
that if one party does not perform it that party will pay the
other party a specified sum, or will lose the entitlement
to be paid a specified sum, the obligation to pay should
be viewed as a primary obligation which is conditional
on aspects of performance based on objective measures
agreed between the parties, and the penalty doctrine
would not be engaged. Potentially, even if, for example, the
obligation on one party to pay a specified sum is conditional
on the other party having complied with an identified
obligation in the contract, that may also be viewed as a
conditional primary obligation, in which case the penalty
doctrine similarly would not be engaged. By contrast to
this, where a contract obliges one party to perform an act
but also, for example, provides separately that if it fails
to do so it must pay the other party a specified sum, the
obligation to pay is secondary and is capable of amounting
to a penalty. However, it will not in practice be a penalty if it
satisfies the proportionality requirement of the new test put
forward by the Supreme Court.
There
is some uncertainty over how exactly this distinction
would be applied and the extent it can be relied on –
see below.
New test based on proportionality of detriment
placed on party in breach
Lords
Neuberger and Sumption said that the true
test for this purpose is whether the provision is a
secondary obligation which imposes a detriment on the
contract‑breaker out of all proportion to any legitimate
interest of the innocent party in enforcing the primary
obligation. “The innocent party can have no proper interest
in simply punishing the defaulter.” The first question is
whether any and, if so, what legitimate business interest is
served and protected by the clause. The second question is
whether the provision made for that interest is extravagant,
exorbitant or unconscionable.
Analysis on loss of future instalments of the
purchase price
Delivering the leading judgment, Lord Neuberger and Lord
Sumption took the view that S’s loss of future instalments
of the purchase price was a price adjustment clause and, as
such, was a primary rather than a secondary obligation.
S
had to earn consideration for the shares by (amongst
other things) observing the restrictive covenants. The
clause was not concerned with measure of compensation
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on breach, even though it was triggered on a breach, and
it was not penal just because damages were recoverable
as well.
The
Supreme Court said that B had a legitimate interest
in ensuring the restrictive covenants were performed in
order to protect the goodwill of the group. That legitimate
interest extended beyond recovering the measure of loss
attributable to the breach. The court could not assess the
precise value of S’s obligation nor determine how much
less B would have paid for the business without the benefit
of the restrictive covenants. The parties were the best
judges of how that should be reflected in their agreement
(these were “matters for negotiation, not forensic
assessment”!) and the court would not interfere with
their freedom to contract on this.
Analysis on application of reduced option price
Lord Neuberger and Lord Sumption also took the view that the
reduced option price was a primary obligation and could not be
treated as invalid without rewriting the contract, which it was
not the court’s role to do. The same legitimate interest applied.
Although
the formula excluded goodwill from the
calculation and, it was argued, did not represent the
estimated loss attributable to the breach, the majority
of the Supreme Court found that it reflected the reduced
consideration which B would have been prepared to pay
for the business on the basis that it could not count on
S’s loyalty.
However,
Lords Hodge and Clarke construed this provision
as a secondary obligation, although they were of the view
that it was not penal on the facts. This was because it was
a legitimate means of protecting B’s investment, given that
a large proportion of the purchase price had been attributed
to goodwill. Lord Hodge said that the reduced option price
on breach of the restrictive covenants had nothing to do
with punishment and everything to do with achieving B’s
commercial objective of acquiring the business.
Uncertainty over distinction between primary and
secondary obligations
It is perhaps surprising that Lords Neuberger and Sumption
concluded that the clauses in question were primary
obligations. Both clauses prescribed the consequences of
breach of the restrictive covenants. The classification as a
primary obligation is particularly surprising in relation to the
reduced option price, given that this was an entirely separate
provision which was clearly triggered on a contractual breach.
As above, two members of the Supreme Court disagreed
with this categorisation on the reduced option price and
they also kept an open mind on it for the purposes of the
loss of future instalments of the purchase price. However,
all members of the Supreme Court were in agreement
that the clauses were not in any event penalties, because
the detriment was proportionate to the innocent party’s
legitimate interests. Following the judgment of Lords
Neuberger and Sumption the penalty doctrine was not strictly
engaged, due to their classification of the clauses as primary
obligations. However, they went on to comment more
broadly and it is helpful that their comments have advocated
a flexible test for determining what amounts to a penalty.
There nonetheless remains some uncertainty over whether
or how the courts may apply the categorisation between
primary and secondary obligations in practice. Often the
distinction between a primary and secondary obligation will
not be clearcut. It will always be important that parties are
able to justify the proportionality of the provision concerned
in any event, without relying on classification as a primary
obligation. Even if a clause is found to be a secondary
obligation, there should nonetheless not be a penalty where
both a legitimate business interest is served by the secondary
obligation and the obligation is not extravagant, exorbitant or
unconscionable.
Penalty doctrine wider than payment triggers
on breach
The
Supreme Court also confirmed that the rule against
penalties is not limited to clauses which require payment
of money on breach but can catch other types of provision
imposing a detriment on a party if it breaches the
contract. Examples it gave include clauses: withholding
payments on breach; requiring the party in breach to
transfer assets either for nothing or at an undervalue; or
resulting in loss of an exorbitant non-refundable deposit
(particularly where such a clause exceeds the percentage
set by long established practice). Whilst to date this has
been the better view, it is helpful to have this clarified,
not least because such provisions can easily arise in an
M&A context. For example, provisions in shareholders’
agreements which are triggered on a shareholder’s default
may involve forced sales by the defaulter at a discount
or purchases by the defaulter at a premium to fair value.
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Further, you sometimes see non-refundable deposit
arrangements either at pre-contract stage or payable at
signing of an SPA.
The
judgment makes it clear that the rule against penalties
is engaged in these situations and the same test applies.
The test is whether the sum or remedy stipulated as
a consequence of a breach of contract is exorbitant or
unconscionable when regard is had to the innocent party’s
interest in the performance of the contract.
Freedom of contract upheld
More
generally, the Supreme Court emphasized that in the
case of a negotiated contract between properly advised
parties of comparable bargaining power there is a strong
initial presumption towards freedom of contract and that
the parties are best-placed to judge what is legitimate for
protecting someone’s investment.
Joined case was subject to rule against penalties,
but no penalty on the facts
A joined case heard by the Supreme Court at the same
time involved a claim by the operator of a car park against
a motorist who had stayed beyond a two-hour free parking
limit, where the car park prominently displayed signs that this
would result in an £85 charge. The Supreme Court decided
that the rule against penalties was engaged in this instance,
because the fine was triggered when the motorist stayed
beyond the two-hour limit. However, applying the same test
the fine was not a penalty on the facts, because the operator
had a legitimate interest in levying it to meet the running
costs of the car park, generate a profit margin and provide
landowners a reasonable turnover of available parking for
potential customers of their commercial tenants. The amount
of the fine was also not extravagant or unconscionable
when compared to other car parks. It did not matter that the
purpose of the fine was to deter a breach.
Key lessons
It
is helpful that the Supreme Court has replaced both the
historic “genuine pre‑estimate of loss” and the more recent
“commercial justification” tests with a more flexible one
based on whether the clause imposes a detriment on a
party out of all proportion to the innocent party’s legitimate
interests. This arguably sets the bar for what amounts to
a penalty higher than before, including under the previous
commercial justification test.
Although
the circumstances of this particular case were
fact-specific, regarding breaches of restrictive covenants
where a large proportion of the price had been attributed to
goodwill and the covenants were critical to B’s investment,
the new test appears to be of more general application.
It
is also helpful that the Supreme Court has confirmed
that the rule against penalties is not limited to payment of
money on breach but can catch other types of provision
imposing a detriment on a party if it breaches the contract.
As discussed above, it is not uncommon to see such
provisions in transaction documents in an M&A context.
It
is also welcome that the Supreme Court has confirmed
that a conditional primary obligation cannot be a penalty.
This clarifies that it may be possible to avoid the penalty
doctrine by making the trigger for imposing a “detriment”
on one party conditional on aspects of performance rather
than a contractual breach.
However,
the distinction that Lords Neuberger and
Sumption drew between primary and secondary
obligations may seem artificial. It will not always be
clearcut. Further, often it will not be feasible to avoid
the combination of a primary and secondary obligation
structure. An example is where a self-standing primary
obligation is required as a basis for, say, injunction
rights. It will be important that parties can justify the
proportionality of the provision concerned without
relying on classification as a primary obligation.
It
is helpful that the judgment reinforces the court’s
reluctance to interfere with parties’ freedom of contract
and the contractual certainty which they favour, albeit that
the Supreme Court emphasized that it is substance, not
form, that counts.
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