Punitive Provisions in Business Sale and Purchase Agreements are Unenforceable

Business buyers need to make sure that they protect themselves in sale and purchase agreements (SPA) while not making clauses so draconian they are unenforceable.

There are plenty of risks that buyers of businesses take on when they complete a sale and purchase agreement but many can be mitigated to some extent with contractual provisions such as warranties, restrictive covenants and liquidated damages clauses.

In protecting themselves, buyers need to be aware of a fundamental principle of contract law; that contractual damages seek to put the injured party in a position they would have been in if the contract was properly performed. The emphasis is on compensation not punishment.

Contractual provisions should not seek to be disproportionate or punitive for the seller or they will not be enforceable.

Punitive clauses: Makdessi v Cavendish Square Holdings [2013]

The Court of Appeal recently drew attention to the issue of punitive contractual clauses in Makdessi v Cavendish Square Holdings [2013] when it held that restrictive covenants in an SPA were unenforceable.

The transaction related to the purchase by Cavendish Square Holdings of a large Middle Eastern advertising and marketing business owned by a Mr Talal El Makdessi. The SPA provided that a majority of the shares would be sold to Cavendish (60%) with an amount payable upon completion and deferred compensation payable in two instalments based on formulas tied to future earnings.

The SPA also contained extensive restrictive covenants that prevented the seller from competing with the business after the sale or soliciting its clients. In the event of the breach of those covenants, the buyers would not have to pay the deferred consideration and the seller would be obliged to sell their remaining holdings (40%) at book value. Book value amounted to only around 23 per cent of the entire value of the business with goodwill making up around 77 per cent based on the valuation figures in the agreement.

Following completion Mr Makdessi was subsequently accused by Cavendish of breaching the restrictive covenants and it sought to enforce them. Although Cavendish succeeded in the High Court, the Court of Appeal overturned that decision.

Basis of the Court of Appeal Decision

The Court of Appeal held that the clauses relied upon by Cavendish in pursuing its case were punitive and unenforceable. It stated that the clauses were extravagant and unreasonable as they were not genuine pre-estimates of loss in the context of the agreement as a whole.

It also rejected the claim that the clauses were commercially justifiable; it found that they were included as a form of deterrence rather than to compensate for loss. The provisions were also disproportionate as the seriousness of the breach was not taken into consideration in triggering the clauses, so minor breaches would result in significant losses for the seller.

Comment

The case shows the importance of careful drafting when it comes to SPAs; protecting buyers from loss is reasonable but only if the aim is to compensate them and not to punish sellers. For specialist advice contact Peter Gourri today by email PGourri@rollingsons.co.uk or telephone 0207 611 4848.