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M&A Diligence: Enforceability of Agreed Remedy Provisions

Contracting parties will often choose to add a degree of certainty to their corporate or commercial contracts by including provisions that stipulate specific remedies for… Read more

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Contracting parties will often choose to add a degree of certainty to their corporate or commercial contracts by including provisions that stipulate specific remedies for specific contractual events. For example, when a party breaches a contract, it will typically pay damages to the innocent party in accordance with the common law, however, in some instances, the parties will agree that a specific sum be payable upon a specific or general breach (liquidated damages) or that any advance/deferred payments paid/due to the defaulting party be forfeited upon a specific or general breach.

When negotiating and drafting agreed remedy provisions, careful consideration needs to be given to the doctrine of penalties which bars the enforcement of penalty clauses that compensate beyond the actual loss suffered by the claimant.

Liquidated Damages and Penalties

A comprehensive review of the doctrine of penalties was undertaken by the Court of Appeal in Makdessi v Cavendish Square Holdings [2013] EWCA Civ 1539. Mr Makdessi sold part of his holding in a company to Cavendish (ultimately). The sale agreement included various non-compete provisions as regards Makdessi (who remained as a director and continued to hold shares himself) on the basis that the goodwill in the company was considerable and dependent upon Makdessi’s prominence in the market. The sale agreement provided that, in essence, on a breach of any of the various non-compete provisions by Makdessi, he would become a defaulting shareholder: triggering a sale of his remaining shares in the company to Cavendish and forfeiting unpaid portions of the deferred consideration outstanding to him. The deferred consideration was to be paid in stages, calculated by reference to profit.

The issue before the Court of Appeal was whether the forfeit of the deferred consideration and sale of shares (the “agreed remedy”) amounted to an unenforceable penalty. The Court of Appeal concluded that it did based on the following general principles:

the deferred consideration and discount on the shares was “substantial”;
the agreed remedy was “extravagant and unconscionable” in comparison with the greatest loss that could conceivably be proved to have followed from the breach (furthermore, the same consequences applied in respect of a wide range of breaches which fell into different categories of seriousness, many of which could not attract anywhere close to the lost value associated with the forfeit and compulsory sale);
the agreed remedy was “intended to deter and penalise” rather than compensate for actual loss;
the agreed remedy did not represent a “genuine pre-estimate of actual loss” (this should be an objective assessment of what the parties (at the time the contract was made) could reasonably have expected the anticipated loss to be); and
the agreed remedy was not otherwise “commercially justifiable” in the circumstances – if the remedy is particularly harsh, there must be more than merely a commercial reason agreed between parties of equal bargaining power even when competent advice has been provided in respect of the same.

Leaver Provisions

Another example of an agreed remedy is the compulsory acquisition of shareholder-employee shares when their employment terminates (leaver provisions). Good, early and bad leaver provisions in articles of association, shareholder agreements and employee incentive schemes allow a company (or the other shareholders) to compulsorily acquire the shares of a shareholder-employee who leaves the company:

“Good leavers” typically comprise employees who leave due to illness or otherwise on good terms.
“Early leavers” typically comprise employees who voluntarily leave the company prior to the expiry of a fixed commitment period.
“Bad leavers” typically comprise shareholder-employees who are dismissed for gross misconduct, although often “bad leaver” will simply be a catch-all term covering all employees who are not good or early leavers.

Early and bad leaver provisions will generally require a shareholder-employee to give up their shares for a price less than market value. Depending on the discount applied to the market price, such clauses may be considered unenforceable penalty clauses given that the leaver is required to part with its property at less than market value. The following points should be considered in relation to leaver provisions:

The doctrine of penalties only applies to clauses triggered by a breach of contractual duty. Therefore, drafting a leaver provision so that it is triggered by an event other than a breach of contractual duty may avoid the application of the doctrine of penalties altogether. That said, the courts have (in obiter) previously expressed a willingness to look at the substance of a bargain so it is unlikely that such drafting would save a clause that would otherwise be caught by the doctrine of penalties.
To avoid a double jeopardy situation, leaver provisions should be drafted so that any discount on fair value is deducted from any other claims (by the company or other shareholders) against the leaving shareholder in respect of the same conduct. It would also be best practice to provide for a catch-all statement stipulating that there will be no double recovery in any event.
The quantum of the discount applied to leaver shares should be commensurate with the nature, degree and legally-recoverable loss caused by the specific breach of the leaving shareholder. Consideration should be given to whether it is appropriate to provide for different categories of seriousness of breach, each with a proportionate discount rate (a catch-all definition for “bad leaver”, coupled with a single price for all bad leavers may fall foul of the doctrine of penalties).
The mere commercial reasoning that a leaver provision has been inserted to effect a “clean break” or to provide suitable incentives to employees does not guarantee that the leaver provision will be commercially justified and thus enforceable.

Comment

In order to ensure that an agreed remedy is enforceable, it is necessary to give careful consideration to the following factors when negotiating and drafting agreed remedy provisions:

Is the remedy proportionate to the greatest actual loss that could conceivably be suffered as a result of each specific breach that triggers the remedy?