Consider the following scenario: you are negotiating to buy all of the shares in a company, and the seller – a charismatic individual – is key to the company’s future. You propose to the seller that part of the purchase price be structured as an earn-out, which she will forfeit if she leaves the company before it is paid. Agreed she says, and you sign the deal. Bad news: the seller subsequently leaves the company. Still, you haven’t yet paid her the earn-out. Worse news: a court rules that forfeiting the earn-out is unenforceable, and the seller gets to keep it.

The forfeiture is unenforceable because of the ‘penalties’ doctrine.

Courts recognise that this doctrine is a “blatant interference”1 with freedom of contract, or the principle that consenting adults should be able to reach whatever bargain they want to reach.  (Statutory laws separately interfere with freedom of contract.) Nevertheless, when it is enlivened this doctrine can unravel the commercial terms of corporate transactions.  This article looks at some common commercial terms that, unless properly structured, are at risk of challenge under the penalties doctrine.

What is a penalty?

A term in a contract imposes a penalty if it is secondary to a party’s primary obligation, and upon the failure of that primary obligation subjects that party to an additional and disproportionate detriment.  For example, a loan might state that if a borrower fails to pay interest at 10% per annum on the principal outstanding (the primary obligation), it must pay a late payment fee of an additional 1% per week on that principal amount (the secondary obligation).

Prima facie parties to a contract may stipulate in advance an amount, or ‘liquidated sum’, payable as damages for breach of the contract or failure of a condition. However, if the amount is not a genuine pre-estimate of the loss suffered, and is extravagant and unconscionable, the stipulation could be classified as imposing a penalty and unenforceable.

Earn-outs, escrow accounts and other deferred purchase price mechanisms

In M&A transactions part of the purchase price is often paid on deferred terms. This may be to give the buyer a buffer in case the purchase price is adjusted downwards after finalising the completion accounts (to avoid the need to demand a refund), to enable the buyer to set off warranty claims against the deferred amount, or simply to give the buyer more time to pay. For example:

  • the purchase price could be paid by the buyer in instalments after completion of the transaction;
  • part of the purchase price could be deposited in an escrow account;
  • an earn-out can be used to bridge a gap between the buyer’s and the seller’s respective views about the future performance of the target company, and therefore the purchase price.

Buyers also commonly seek to use deferred payments to ensure the seller performs post-completion conditions, such that the seller will forfeit the deferred payments if the conditions are not met. Such terms were considered by the Court of Appeal of England and Wales in Cavendish Square Holdings BV v Makdessi2. This case arose out of a share purchase agreement (SPA) pursuant to which Cavendish acquired shares in a holding company for an advertising and marketing group from Mr Makdessi and another shareholder.

The terms of the SPA included:

  • earn-out payments to Mr Makdessi, based on a multiple of the profits of the group over a period of years;
  • restrictive covenants preventing Mr Makdessi from, among other things, competing with the group after the sale;
  • forfeiture clauses to the effect that, if Mr Makdessi breached the restrictive covenants, he would (i) forgo the earn-out payments, and (ii) be required to sell his remaining stake in the group at a price that took no account of the substantial value of the group's goodwill (Forfeiture Clauses).

Mr Makdessi subsequently breached the restrictive covenants, but challenged the enforceability of the Forfeiture Clauses.

The Court ruled that:

  • the Forfeiture Clauses amounted to penalties, as the sums to be forfeited by Mr Makdessi were likely to be extravagant and unreasonable when compared with the greatest loss recoverable by Cavendish for Mr Makdessi's breach of the restrictive covenants;
  • there was no proportionate relationship between the different kinds of possible breaches of the restrictive covenants, from trivial to significant, and the sums to be forfeited.

The Court concluded that the main purpose of the Forfeiture Clauses was to deter Mr Makdessi from breaching the restrictive covenants and, if he did so, to penalise him for that breach.

The logic that renders forfeiture of earn-out clauses unenforceable applies equally to forfeiture of other forms of deferred payments. Forfeiture of earn out clauses are particularly vulnerable to be struck down as penalties though, as the value of the earn-out is frequently unascertained at the time of entering into the contract. This means that the value to be surrendered cannot be a genuine pre-estimate of whatever loss is expected to flow from a failure of the condition that triggers the forfeiture.

Indeed the trigger for the forfeiture of the deferred payment need not be confined to a breach of the relevant contract to attract the penalties doctrine.

Moreover, it does not matter whether the deferred payment is to be made in cash, shares or other property.

Joint venture and shareholders agreements

Another common scenario which may attract the penalties doctrine is a joint venture or shareholders agreement that stipulates a compulsory transfer of shares – at an undervalue – following a breach by a party to that agreement.

In Re Pioneer Energy Holdings Pty Ltd3, a shareholders agreement for the construction and operation of a marine fuel facility obliged each of the two joint venture parties to subscribe for equity in the joint venture company, in a number of instalments and funding rounds.  If a party defaulted in doing so, it could be required to transfer to the other party all of the shares that it had previously subscribed for in the joint venture company for $1.  The New South Wales Supreme Court found this compulsory transfer clause to be unenforceable, as it required the defaulting party to transfer its existing interest in the venture for effectively no value. The effect of the clause was a punishment out of all proportion to the default.


The terms of corporate transactions, such as share purchase agreements and shareholders agreements, should be structured with the penalties doctrine in mind if the parties have agreed in principle that a breach of the terms by one of the parties (or even the failure of a condition that falls short of being a breach) will result in that party forfeiting a deferred payment, shares or some other property.  Without an approach that circumvents the penalties doctrine, the 'innocent' party will face the risk that this element of the deal is later undermined, leaving that party with a different bargain to the one the parties reached.