Buyers of businesses will normally try to restrain the sellers from competing against them after sale in order to preserve the goodwill of the business being bought. Whether such restrictive covenants are enforceable depends upon whether they are reasonable overall and is a matter of fact in each case. In addition, however, where there is an earn out, the SPA may provide for forfeiture of that earn out or where the seller retains a minority shareholding, there may be bad leaver provisions requiring such shares to be sold at a low value.

The Court of Appeal has cast some doubt on whether such forfeiture clauses and forced 'call options' are enforceable in Makdessi v Cavendish Square.

If the forfeiture or the undervaluation of shares in a forced sale is considered a 'penalty' at law it is unenforceable and the entire provision will fall away. Hence the buyer will lose its protection and the seller will get full payment despite having breached the restrictions on operation. Penalty clauses have a long legal history. This case develops the test for them and may require buyers and sellers to revisit the terms of their deal.

Any clause which a court may consider to be "extravagant and unconscionable with a predominant function of deterrence" as opposed to compensation or genuine commercial rationale will be struck down. In this respect the historic test for a penalty clause as being a clause which is not a "genuine pre-estimate of loss" has been relaxed.

Clauses in SPAs which provide for substantially more loss of earn out or share value than could reasonably be expected to occur from a breach of the restrictive covenant can be struck down on this basis. Where in reality the loss from a breach of the restrictive covenant is being suffered by the target company (rather than the purchaser), the purchaser will suffer no real loss and consequently any loss of earn out is arguably extravagant and unconscionable. Depending on the facts, it may also be included for the predominant function of deterring such breach of a covenant.

It may be possible to preserve the effect of such arrangements by making payments conditional upon compliance with certain obligations. However, despite the apparent difference being limited to semantics, providing for them to be lost if the covenants are breached is, now, potentially risky.

This change potentially has wider impacts for any clause in a commercial or other contract providing for liquidated damages, the transfer of property or some other right being reduced, undervalued or extinguished. Corporate managers engaged in mergers and acquisitions in particular should take note.