Written by Thédoor Melchers.

In M&A acquisition agreements, buyers often propose to include a penalty clause in their first draft. The penalty is connected to non-compliance of provisions in the agreement aimed at protecting the value of the company (being transferred). Examples include provisions on confidentiality, competition, non-poaching of customers, suppliers or employees and similar provisions.

The wording of penalty clauses commonly used in acquisition agreements has evolve to a standard provision over the past 25 years. Generally speaking, the provision usually resembles the following:

"In the event of any failure by Seller to comply with Articles [X], [Y], [Z], Seller shall, without any further action or formality being required, immediately pay an amount equal to EUR [●] per failure, to be increased by EUR [●] for each day such failure continues, as a penalty (and not in lieu of damages) to the Buyer or at the Buyer's request to the Company, without prejudice to any other rights or remedies available to the Buyer and/or the Company, including a claim for damages to the extent that the amount of damages exceeds the total amount of the penalty."

In the early stages of negotiations, the seller often simply deletes the penalty clause in its entirety in its mark-up of the agreement. The buyer then reinserts the penalty clause in its entirety into the agreement in its original form. This often creates a stalemate fairly early in the process, which remains in place until the final stage of negotiations.

The penalty clause then (along with provisions on the duration of the guarantees and the amount of the cap and basket of the guarantees) often ends up on the list of 'last outstanding issues' to be agreed at the eleventh hour of the negotiation process. This effectively means that the remaining open issues of both parties are exchanged against each other in order to get to agreed documentation. Thus, negotiations are at that stage no longer based on substantive arguments or textual adjustments that do justice to the interests of buyer and seller. At that point, the (understandable) desire of both parties to be able to sign the acquisition agreement after an intensive negotiation process often wins from diligence and content.

The question is whether this is wise. After all, the (financial) stakes involved in an acquisition are substantial in most business takeovers. It seems a misused opportunity during the negotiation process, given that parties could easily consider alternative solutions instead of just integrally deleting or maintaining the penalty provision.

A number of alternative solutions that could be considered are set out below.

1. The first thing that could be negotiated is the notice of default which is usually required for the penalty to become due. Not in all circumstances is it necessary the delete the requirement of a notice of default in its entirety. Perhaps it could be worded in a way that removes all or part of the incentive not to report a default (in the hope that the buyer will not find out). Why not take a similar approach as the regulations on GDPR. Such regulations sets out an obligation to report a data breach within 72 hours after the data breach has been detected. Only after the lapse of 72 hours, a penalty will start to accrue.
2. Furthermore, the penalty clause could distinguish more clearly between the amount and purpose of the penalty. Does the penalty aim to fix the amount of the damage because it is otherwise difficult to determine such amount, or is the purpose of the penalty to encourage the seller to do or refrain from doing something? A one-off high penalty amount seems reasonable if the obligation relates to preventing disclosure of essential trade secrets, while a lower penalty amount, increased with an amount per day that the infringement continues, seems more appropriate for an obligation to take action (e.g. transfer an IP registration after the transfer of the business has taken place). Furthermore, the amount that adds up per day need not be fixed, but can increase or decrease over time.
3. One might also wonder why the parties do not consider an alternative burden of proof, for example in a contractual arrangement regarding mitigation of the amount of the penalty. For example, the parties could agree that the amount of the penalty will be reduced by [Y]% if the seller proves that the actual damage caused differs from the amount of the penalty by more than [X]%.

The disadvantage is that the text of a penalty clause becomes longer due to the above elements. However, in an industry where provisions in acquisition agreements are already highly standardized and where models and/or AI are increasingly used, this should not be a problem. One would expect the first draft of the standard penalty provision to work as a menu of choices in which the various alternative solutions are presented to the parties. Buyer and seller can thus make a considered choice early in the negotiations as to which alternative elements are appropriate in the given circumstances of their case.

Upon request, we will gladly send you an example of a more comprehensive penalty clause, in which various alternatives are further elaborated! Please direct your request to Thédoor.Melchers@Wintertaling.com.