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M&A Diligence: Upside fee payable in circumstances other than breach found not to be a penalty

In Edgeworth Capital (Luxembourg) S.A.R.L and another v Ramblas Investments B.V. [2015] EWHC 150 (Comm), Ramblas, together with members of its group (referred to collectively as Ramblas) and two individual investors entered into a series of finance agreements to finance the purchase of commercial real estate.   The agreements included an upside fee agreement, which required Ramblas to pay a large fee (of over €100 million) on the occurrence of any “payment event”.  Ramblas also entered into a senior loan agreement for €1.575 billion, and a junior loan agreement for €200 million.  The two individual investors entered into a personal loan agreement for €75 million. The original lender then assigned its rights under the finance agreements to Edgeworth.

The individual investors breached the personal loan agreement, which resulted in cross-defaults under the junior loan agreement. Edgeworth accelerated the junior loan, and commenced proceedings against Ramblas, seeking payment of outstanding principal and interest, plus payment of the upside fee.  Part of the grounds on which Ramblas opposed the claim was that the amount of the fee far exceeded the amount of recoverable damages for a breach of the junior loan, and therefore could not be a genuine pre-estimate of Edgeworth’s loss.  On this basis, the upside fee was an unenforceable penalty - see Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd [1915] AC 79. Ramblas also argued that default under the personal loan did not constitute a “payment event” for the purposes of the upside fee agreement.

The High Court held that, on a proper construction of the upside fee agreement, a default under the personal loan could constitute a “payment event”.  More interestingly, the Court also found that the upside fee was not a penalty. The obligation to pay the fee was not related to any breach by Ramblas; rather, the triggering event was the default of the individual investors under the personal loan agreement.  The Court emphasised that the doctrine of penalties was only engaged where the clause in question is triggered by a breach of duty owed by the party claiming relief to the party seeking to enforce the clause. The purpose of a penalty clause was to deter the innocent party from breach; a clause's function cannot be deterrence of breach if it does not apply to a breach. The Court also opined that even if the doctrine of penalties had been applicable, given the challenging commercial circumstances in which the finance agreements were concluded, the upside fee would have been commercially justifiable in the circumstances (see, for example, Lordsvale Finance plc v Bank of Zambia [1996] QB 752 and Murray v Leisureplay Plc [2005] EWCA Civ 963).

The decision in Edgeworth is a reminder that the application of the doctrine of penalties in English law is relatively narrow.  Edgeworth is the latest in a line of decisions (for example, see Export Credits Guarantee Department v Universal Oil Products Co [1983] WLR 399, and more recently, the comments of Christopher Clarke LJ in El Makdessi v Cavendish Square Holdings BV and another [2013] EWCA Civ 1539 at 123) that suggest that some simply drafting can ensure that the rules on penalties do not apply. In particular, where a payment obligation arises in circumstances other than a breach of a party to the relevant contract, then the payment will not be a penalty.

Edgeworth also shows that the courts are still reluctant to refuse to enforce provisions which have been freely negotiated and entered into between sophisticated commercial parties.  A party seeking to demonstrate that a clause is penal will need to establish, amongst other things, that the dominant purpose of the clause is to deter breach, and that there is no commercial justification for the clause in the circumstances. The bar to having a provision struck out as an unenforceable penalty clause remains high.

For more information, please contact Adam Kuan, Corporate Associate