When reviewing share sale or shareholder agreements, it is not uncommon to find good lever/bad lever provisions that have the effect that a departing shareholder or partner in the business is deprived of the value of his shares or of future profits as if he is regarded as a “bad lever”. As a result of the discussion of clauses of this nature in a recent case, those who are drafting such contracts need to be careful to ensure that such provisions are not drafted too aggressively, otherwise they will be treated as “penalty clauses” and struck out entirely.
The law in relation to penalty clauses will potentially apply to any provisions within an agreement which seek to provide a remedy to the injured party when the other is in breach. A good example of the lawful use of such a clause is a clause which provides that the injured party will have to pay “liquidated damages” (i.e. an agreed sum) in the event of a breach of a particular provision within the contract. So long as that agreed sum is a genuine pre-estimate of the loss that the injured party might be expected to suffer as a result of the breach, then, as a matter of good practice, it may be appropriate for both parties to understand that that will be the consequence of the breach.
The risk for the parties is that whilst seeking to impose a sanction which fixes the financial remedy to the injured party they may find that it goes beyond what a court would find is a reasonable assessment of the likely loss. There can also be a temptation for such a clause to be designed to act as a deterrent. The danger is that if the clause is designed to operate in a punitive manner the court may be entitled to strike it out and treat it as unenforceable on the grounds that it will be considered to be a penalty clause.
In assessing whether or not a clause within a share sale or shareholders agreement might be regarded as imposing a penalty, the court will need to consider
what is the value of the interest which the clause is seeking to forfeit (e.g. a clause might state that if the shareholder is breach of XYZ provisions the shareholder forfeits the market value of the shares and will only be paid the nominal value of the shares; or the purchaser will forfeit their future entitlement to a share of the profits within the earn out arrangements under a share sale agreement).
It must then consider what loss the other parties to the deed might be expected to suffer as a result of that breach. Here lies a potential trap. Often the other parties to the agreement are other shareholders but in many situations it is the company which may have suffered loss and not the individual shareholders. Nevertheless the court must make an assessment as to what loss the injured parties might be expected to have suffered and compare it to the value of the forfeited interest.
Where the loss of the forfeited interest cannot be justified on the basis of the way the loss to the parties has been valued, the forfeiture clause there is a strong argument for saying that the clause should be struck out as an unenforceable penalty.