Shareholder agreements will often contain a clause requiring a defaulting party to transfer its shareholding at an agreed price on the occurrence of a specified default event. Where the agreed price is less than the market value of the shareholding, the clause may constitute a penalty and be unenforceable. On one hand, courts have held that the transfer for $1 of a $13 million shareholding was a penalty while on the other, a 5% discount on the ‘fair market value’ of a shareholding was not. An interesting question is, at what point is a default clause at risk of being set aside as a penalty?

Firstly, what is a penalty?

The penalty doctrine is an exception to the common law principle that contracts are to be enforced according to their terms. The court in Dunlop Pneumatic Tyre Co Limited v New Garage and Motor Co Limited [1915] AC 79 (Dunlop) held that a clause constitutes a penalty when the amount payable as a result of a breach of contract exceeds a genuine pre-estimate of the loss that would be caused by such a breach. If the amount payable is ‘extravagant or unconscionable’ and out of all proportion to the maximum loss that might be suffered as a result of the breach or is a single lump sum payable irrespective of whether the breach occurred in respect of just one or several events, the clause may be held to be a penalty and be unenforceable.

Since Dunlop, the courts have focused on reviewing potential penalty clauses in context when determining whether a clause provides for a disproportionate payment or whether the payment is actually compensatory. Relevant factors likely to be considered include the parties relationship at the time of the contract, the origin and discussions relating to the clause, each party’s bargaining position, and the degree of imbalance between the amount payable and the loss likely to be suffered by the non-defaulting party.

But what about freedom of contract?

One of the basic tenets of contract law is freedom of contract. The idea being that individuals are free to enter into whatever lawful agreements they consider will benefit them.

Though the law of penalties acts as a restraint on the principle of freedom of contract and limits the parties' freedom to settle for themselves the rights and liabilities following a breach of contract, courts have considered it necessary to make ‘penalty clauses’ unenforceable to avoid giving effect to contractual provisions which produce unconscionable results. It is however, a balancing act.

This balancing act was demonstrated in the High Court decision in Paciocco v Australia and New Zealand Banking Group Ltd [2016] HCA 28. Here the court, in upholding the validity of the clause, re-confirmed the importance of the values of commercial certainty and freedom of contract and that the idea that the courts will not ‘lightly invalidate a contractual provision for an agreed payment on the ground that it has the character of a punishment.’

Penalty clauses and shareholder agreements

Depending on the requirements of the parties, a shareholders’ agreement may contain a compulsory transfer clause that requires a defaulting party to transfer its shares at a discounted price. This discounted price may be in the form of a fixed dollar amount that happens to be less than the market value, a percentage discount to market value, or some other construction agreed by the parties.

The question of whether a compulsory transfer clause in a shareholders’ agreement amounted to a penalty was examined in In the matter of Pioneer Energy Holdings Pty Ltd [2013] NSWSC 1134 (Pioneer). Here a compulsory transfer clause gave the non-defaulting party the option to acquire all the defaulting party’s shares for $1. The defaulting party paid $13 million for the shares.

In Pioneer, the defaulting party successfully argued that the transfer of its shares for just $1 was ‘extravagant and unconscionable in amount by comparison with the greatest loss that could conceivably be proved to have followed from the breach.’

In deciding whether the clause was a penalty, Bergin CJ considered CRA Limited v NZ Goldfields Investments & Anor [1989] VR 870 (NZ Goldfields) in which a defaulting party was required to transfer its joint venture interest at fair market value less 5%. In this case there was a ‘good commercial reason for the 5% discount’ and the clause stood.

In Pioneer, rather than calculating the default price payable by reference to a discount to the fair market value or taking into consideration when the default occurred, the transfer of all shares was for a ‘lump sum’ of $1. Bergin CJ held that the loss of the whole of the amount invested in the joint venture was out of all proportion to the actual loss and that this amounted to a punishment unenforceable as a penalty.

Drafting considerations

When drafting shareholder agreements, it is important to consider cases such as Pioneer to ensure that the compulsory transfer clauses are not at risk of constituting a penalty.

The point at which a compulsory transfer clause is at risk of being set aside as a penalty will depend on the specific facts and circumstances present at the time the contract is entered into, in addition to the specific contractual terms.

Potentially, in Pioneer, if the clause had been drafted as a small discount to fair market value (as was the case in NZ Goldfields) or the price payable was a lump sum amount that increased to reflect the development stage of the joint venture, the court may have not considered the clause a penalty. What is clear is that nominal transfer prices or aggressive discounts to fair market value that have no bearing to the loss likely to be actually suffered as a result of the breach leading to the compulsory transfer right are at significant risk of constituting a penalty and being determined unenforceable.