30 September 2009

Does the Conventional Penalties Act affect the enforceability of Involuntary Transfer Provisions?

It is often provided in a shareholders agreement that on the occurrence of certain "Trigger Events" (for example, the death, disability, or insolvency of a particular shareholder, or on the breach of the particular shareholders' agreement by a shareholder), that a shareholder will be compelled to forfeit a certain portion of the fair market value of his shares in the company, depending on the nature of the particular Trigger Event. Such provisions are popularly referred to as "haircut" provisions. The question arises as to whether or not such haircut clauses fall within the ambit of the Conventional Penalties Act, 15 of 1962 (the Act).

Prior to the promulgation of the Act, the common law regarded a penalty clause as prima facie unenforceable. The law as it was has been replaced by the provisions of the Act with the consequence that, subject to the provisions of the Act, any stipulation for a penalty or for liquidated damages flowing from breach of a contractual obligation may be enforced in any competent court. The Act states that if it appears to a court that such penalty is out of proportion to the prejudice suffered by the creditor by reason of the act or omission in respect of which the penalty was stipulated, the court may reduce the penalty to such extent as it may consider equitable in the circumstances.

The first question to be answered is whether or not the haircut provisions fall within the definition of a "penalty stipulation" as contemplated within the Act. Based on the wording of section 1(1) of the Act and as confirmed by several court decisions (for example,. Parekh v Shah Jehan Cinemas (Pty) Ltd and Others 1982 (3) SA 618 (D), De Klerk v Old Mutual Insurance Company Limited 1990 (3) SA 34 (E) and Sun Packaging (Pty) Ltd v Vreulink 1996 (4) SA 176 (A)), it is a requirement that the liability of the debtor to pay, to deliver or to perform derives from breach of contract. Therefore, in order for the Act to apply, a party cannot simply be exercising its rights under a contract - there must be a breach of contract as a result of which a certain penalty may be enforced.

A further requirement of what constitutes a penalty, is that it must be intended "to operate in terrorem, i.e. as a penalty in the common law sense". The effect hereof is that a particular consequence (such as a forced offer of shares for sale) in the event of a breach of contract is not automatically a penalty. The court needs to look at all the circumstances in order to determine whether the provision was imposed with the intention of it being a penalty. In addition, the intention must be to operate "in terrorem".

It is questionable whether standard haircut provisions will be seen as a penalty and fall under the provisions of the Act. These provisions are usually not included in order to strike terror into the shareholder to ensure that he will comply with contractual provisions in respect of various other contracts.

In many instances, haircut provisions are introduced to ensure efficient working of the shareholders' relationship - other shareholders normally agree to become shareholders with particular parties because those parties will bring something of value to the relationship. If such shareholders do something or fail to do something that goes to the very heart of expectations that were created and those expectations are disappointed, it is questionable whether a Trigger Event in such circumstances is a penalty provision.

This does not mean that there is no risk of a successful challenge and all concerned should be alive to that risk. However, even if such haircut provisions are found to constitute a penalty, that is not the end of the matter. To get any relief, the shareholder will have to show that the extent of the haircut is disproportionate to the prejudice suffered by the company and other shareholders. Prejudice in this context is not confined to financial prejudice.

Peter Prinsloo,
Director, Corporate and Commercial

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