Beware of contractual deterrents in share purchase agreements

A recent Court of Appeal decision El Makdessi v Cavendish Square Holdings BV has clarified that certain types of contractual clauses in the context of a share sale could be classed as penalty clauses.

In this case, the court held that certain penalty clauses in a share purchase agreement were unenforceable. They provided that, in the event of a breach of the seller’s restrictive covenants, the buyer’s obligation to pay deferred consideration would cease and he would be entitled to acquire the remainder of the seller’s shares at a price based on net asset value (and excluding goodwill).

This case suggests that a careful approach is needed where a buyer of shares wants to link payment of deferred consideration to the seller’s compliance with non-compete or similar covenants following completion of the transaction. Clauses in a share purchase agreement which provide that deferred consideration will cease to be payable in the event (and as a consequence) of a breach of the seller’s restrictive covenants will be vulnerable to challenge on the grounds that they constitute an unenforceable penalty.

It was acknowledged that it might have been possible to avoid the application of the doctrine of penalties, if the agreement had been drafted so that the buyer’s obligation to pay the deferred consideration was conditional on the seller’s compliance with the restrictive covenants. Bearing this in mind, the buyer should consider structuring the deferred consideration as a conditional payment, rather than providing that its payment obligation will fall away in the event of, and as a response to, the seller’s breach of covenant.

The case highlights that contractual deterrents in share purchase agreements should not be used without careful consideration of their potential legal implications.

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