Money talks: contractual penalties and other remedies in Brazilian M&A disputes

Monetary remedies are widely used in M&A transactions worldwide to protect interests of parties from contract breach. Brazil is no exception, and local transactional attorneys are used to negotiating both (a) general compensation for damages and (b) penalties for breach of specific obligations. Yet, no matter how experienced parties and counsels may be, when an M&A deal governed by Brazilian law is at stake, they should take heed of peculiar legal aspects in respect of these monetary remedies and of the risk of courts interfering with the amounts agreed upon by the parties.

Seeking compensation for contractual breach is the general rule in Brazil: absent specific monetary consequences for failure to comply with a given provision, its violation will entitle the innocent party to claim damages in litigation or arbitration. In M&A transactions, this is what generally applies to the indemnification sections in respect of breaches of representations and warranties and of certain covenants, crucial in most deals.

Things get more interesting when it comes to the latter category – fines and other penalties for breach of relevant obligations, typically adopted when damages may be difficult to prove or quantify, or where a party intends to create an additional disincentive against breach. Breach of confidentiality and break-up fees are recognizable cases, but far from being the only ones: for example, in order to protect the future earnings prospects of the target company, buyer may seek that seller abides by non-compete and non-solicitation obligations.

This is not as easy as it seems at first glance, because penalty clauses in Brazil can be structured either as pre-quantified compensation (exempting the innocent party from the requirement of proving the occurrence and amount of damages) or as non-compensatory remedies (encouraging performance of contractual obligations rather than indemnifying the innocent party). This distinction has practical consequences.

Pre-quantified damages are a substitute for performance, and therefore exclude the creditor’s right to specific performance. Furthermore, they only enable a claim for damages that exceed the contractually provided amount if such claim is specifically authorized in the contract. On the other hand, non-compensatory damages are not an anticipation of damages and can be enforced concurrently with specific performance of the breached obligation.

Another crucial aspect is that, regardless of their type, such remedies cannot exceed the value of the obligations to which they pertain. For obligations that do not have a value explicitly associated with them (e.g., a non-compete obligation), the cap of the penalty clause corresponds to the damages that would be incurred by the innocent party. It follows that (a) the Brazilian legal system does not accommodate “penalty clauses” as such term is used in other jurisdictions, where these remedies may exceed compensatory damages, and (b) the amount of a given non-compensatory remedy must be lower than the amount that would be applied as liquidated damages for breach of the same obligation.

In disputes involving penalty clauses in Brazilian deals, parties should not be surprised if local courts end up tampering with the nature (compensatory versus non-compensatory) and amount of the penalty or fine that the parties negotiated.

Even when parties specify which type of penalty clause is at stake, a Brazilian court may still determine if it is compensatory or non-compensatory based solely on the court’s own view on whether or not the sought amount can be deemed a pre-estimation of actual damages. Any such interference will affect underlying rights of each party in an M&A transaction. For example, if a penalty for breach of a non-compete obligation is deemed in court to correspond to liquidated damages, enforcement would imply seller being able to compete with the sold business.

Likewise, under Brazilian law, courts shall equitably reduce the amount of any penalty clause (regardless of its type), if its amount is considered manifestly excessive vis-à-vis the nature and purpose of the transaction, as a matter of public policy. Courts of law and arbitral tribunals alike have trimmed down liquidated damages amounts to conform them to an amount they deem “reasonable”.

The good news is that risks of court intervention can be mitigated. When negotiating M&A transactions in Brazil, parties should focus on each particular issue with respect to which they want to set out a penalty clause and: (a) determine whether or not the penalty is to be a substitute for performance; (b) expressly set forth which type of penalty clause is sought; (c) if they elect pre-quantified damages, keep record of how the applicable quantum was determined; (d) ensure that amounts of non-compensatory remedies do not correspond to liquidated damages; and (e) as applicable, set forth that if actual damages exceed the amount agreed, the aggrieved party may claim the balance in court.

After all, if court and arbitral precedents have taught us anything, is that it is much better to spend time and money crafting a well-rounded penalty clause than spending considerably more time and money fighting over a poor provision later on.