The Court of Appeal recently ruled on the enforceability of certain clauses in the event that sellers breach restrictive covenants – buyers need to be careful that non-payment clauses are not penalties.

Clauses held to be unenforceable

• In short, the clauses in question in the Court of Appeal’s case said that if the Seller breached a restrictive covenant, the Buyer was entitled to (a) not pay some deferred consideration; and (b) force the Seller to transfer the remainder of his shares in the Company at a price based on net asset value (being at an undervalue compared to the true value of the business).

• The Court found that the above clauses were penalties; the Buyer could not enforce them.

Summary of the case

• The Company which was acquired is in advertising and marketing; the Company’s success was due in large part to the Sellers’ personal relationships with their clients.

• The Share Purchase Agreement (“the SPA”) for the purchase of the shares in the Company imposed restrictive covenants on the Sellers, including the non-solicitation of clients.

• The Buyer had agreed to pay the purchase consideration in seven tranches, the last two of which were dependent on the financial results of the Company. After completion, the Buyer would have 60% of the shares of the Company and the Sellers would have a remainder of 40% of the shares.

• In the event of breach of the restrictive covenants by one of the Sellers, the SPA said that the Buyer’s obligation to pay the last two tranches of the consideration to that Seller would cease (ie the Buyer would not need to pay the breaching Seller his share of the last two tranches). The SPA also said that the Buyer was entitled to buy that Seller’s remaining shares in the Company, valued at net asset value (which was at a substantial discount to the actual value of the business).

• One of the Sellers breached his restrictive covenants and the Buyer asked the Court to declare that the Buyer was entitled to not pay that Seller the last two tranches of the consideration and that the Buyer was entitled to buy the Seller’s remaining shares. The Court held that the clauses were not enforceable as the effect would be an unlawful penalty.

Comments

• There are complex arguments as to why the Court ruled that the above clauses were penalties. A number of legal factors were taken into account by the Court in arriving at that decision, including (among others) whether the predominant function of the clauses was to act as a deterrent to breach, whether they were extravagant and unconscionable, whether they represented a genuine pre-estimate of loss and whether or not there was a commercial justification for them.

• Restrictive covenants are likely to be important in deals where the target depends on client relationships. Following the ruling, consequences of breaches of the restrictive covenants need to be carefully drafted bearing in mind the factors above, otherwise they may be unenforceable. Alternatively a different consideration structure can be considered, such as making the deferred consideration conditional on the seller complying with the restrictive covenants.

If you are interested in acquiring or disposing of a company or business, please feel free to get in touch with Jean Bevan, corporate partner at Bevan Kidwell LLP at jean@bevankidwell.com or 0207 843 1820.

Please note that the above does not constitute legal advice.