M&A transactions: Court enforces 8 year restrictive covenant and adjustment of price for breach

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The 20 second summary

You should read this update if you negotiate M&A transactions

In Cavendish Square Holdings BV and Team Y&R Holdings Hong Kong Limited v Talal el Makdessi [2012] EWHC 3582 (Comm), the English high court enforced:

  • restrictive covenants that could last for over eight years; and
  • a provision applying on their breach that saw further payments forfeited or adjusted.

These terms might seem aggressive in the abstract. But the courts have signalled that they’ll enforce the terms parties agree - if there’s commercial justification and a level playing field.

The facts of the case are crucial, but it does show that parties can take the driving seat when it comes to determining both the scope of restrictive covenants and the consequences of breach.

About the acquisition

The seller (Mr Makdessi) was the founder of a Middle Eastern marketing and communications agency now vested in the target (Team Y&R Holdings Hong Kong Limited). The covenants were given in a sale agreement with the buyer (Cavendish Square Holdings - a WPP group company).  Under the agreement, the buyer acquired c50% of target (taking its aggregate stake to 60%) and took put and call options over the remaining 40%.

Restrictive covenants that could last over 8 years were enforced

The period of the non-compete and non-solicitation covenants was set by reference to the later of a number of events – one of which was payment for the shares under option. This meant that the covenants could last for over 8 years. The seller argued that the covenants were too long and so not enforceable (even though the breach occurred at the outset). The buyer had to show that the covenants went no further than was necessary to protect the interests it was acquiring.

The court held that the period was not an unreasonable restraint of trade.  It noted that:

  • the period was tied to the buyer’s interest in acquiring the option shares; and
  • the provisions had been extensively negotiated – and the courts should (within limits) look to uphold agreements reached between parties on a level playing field.

The facts – as ever - are crucial:

  • goodwill was key to what was being acquired;
  • the seller was critical to it; and
  • the buyer was paying a substantial price for it.

And it’s worth noting that the restrictive covenants were not tested against the typically more stringent EU competition rules governing seller non-competes (as they were not applied - presumably because there was no business within the EU). But the case does show that long periods may be commercially justifiable.  In fact, there’s no reported English case in which a seller’s restrictive covenant has been held to be unreasonable solely because of its duration.

The price was adjusted because of the breach

The terms of the agreement

The agreement provided that any breach of the restrictive covenants would mean that:

  • any future instalments of the price for the initial shares would no longer be payable; and

    the price payable for the shares under option would be calculated on a net asset value basis as at the date of default, rather than by reference to profits over a four year period straddling the date of the valuation under the option mechanism.

The rule against penalties

Essentially, the “rule against penalties” is that provisions that are to apply on breach must not be set with the predominant purpose of deterring breach. The rule was first applied to amounts set up front as being payable on breach. Over time, it’s been extended to apply to withholding of payments and transfers or forfeiture of property. In determining whether these provisions are enforceable, the focus has shifted from asking “is it a genuine pre-estimate of loss” to:

  • “is there commercial justification?” and
  • “is it extravagant or oppressive?”

Why the provisions were enforced

In this case, justification was found in the fact that the price for the initial shares included a significant amount for goodwill. Also, as regards the option shares, the net asset value price mechanism enabled the exit of the seller to be determined quickly (rather than by reference to profits over future years).

Also, the court held that any breach of the restrictive covenants was a material breach – as it would signify that “the wolf was in the fold”. This would be the case even if an initial solicitation was unsuccessful (and was significant – as the fact that the same consequences can follow any breach – some of which may be minor - has been grounds for finding that a  provision may be a penalty). Overall, the provisions were not extravagant or oppressive.  They had been extensively negotiated on a level playing field.

Again, the facts are key:

  • the price included a substantial premium for goodwill; and
  • a significant amount had already been paid for the initial shares (c$65m – against a maximum, dependent on profit levels, of c$150m).

But the case does show that parties can take the driving seat when it comes to determining both the scope of restrictive covenants and the consequences of breach.

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