The terms of an M&A deal which reduced the consideration payable to a seller in the event of his breaching the restrictive covenants which applied to him under the share purchase agreement (SPA) was upheld by the Supreme Court today. In a landmark judgment, the Supreme Court overturned the decision of the Court of Appeal, which had previously concluded that the clauses operated as a penalty and were therefore unenforceable. Click here for our blog post on what this judgment means for the law of penalties and the impact on commercial contracts.
The dispute in this case centred around the sale of a large advertising and marketing group based in the Middle East. After completion, Cavendish (a holding company within the WPP group) held 60% of the target and the two sellers, Makdessi and Ghossoub retained 40% and remained as directors of the target.
The SPA set out an element of deferred consideration (an Interim Payment and a Final Payment), included put and call options over the sellers’ retained shareholding at market value and contained the usual restrictive covenants on the sellers. Makdessi went on to breach his restrictive covenants.
The SPA included the following provisions dealing with the consequences of a seller being in breach of any one or more of the restrictive covenants set out in the SPA:
- Clause 5.1 – under which a seller who breached his restrictive covenants would not be entitled to receive the Interim Payment or Final Payment; and
- Clause 5.6 – under which a seller who breached his restrictive covenants would lose his put option and the Purchaser would have a call option over the seller’s retained shareholding at net asset value rather than market value.
Makdessi claimed that clauses 5.1 and 5.6 were unenforceable penalty clauses and was successful before the Court of Appeal. Cavendish appealed to the Supreme Court.
The Supreme Court’s decision
The Supreme Court found that neither clause was a penalty.
Cavendish had a legitimate interest in the observance of the restrictive covenants which extended beyond the recovery of any loss for breach. Once Cavendish could not trust Makdessi to observe his restrictive covenants, once his loyalty was called into question, Cavendish was exposed to a significant business risk whose impact could not be easily measured. The management of that risk was a matter of negotiation between the parties, who were, on both sides, sophisticated, successful and experienced commercial people bargaining on equal terms over a long period with expert legal advice. In that context, Clause 5.1 was a valid price adjustment clause.
In the case of clause 5.6, there was a perfectly respectable commercial case for saying that Cavendish should not be required to pay the value of goodwill in circumstances where the seller’s efforts and connections were no longer available to the target and indeed were being deployed to the benefit of the target’s competitors.
This is a welcome decision which recognises the commercial reality of M&A deals between sophisticated parties. Price adjustment mechanisms linked to contractual performance and bad leaver provisions are a common feature of M&A and private equity and venture capital investments and this decision is extremely helpful in bringing some commercial certainty to the enforceability of such provisions.