Consideration Clause: Everything You Need to Know
A consideration clause is a stipulation in an insurance policy that outlines the cost of coverage and when payments should be made.3 min read
2. Deferred Consideration and Penalties
Updated November 4, 2020:
A consideration clause is a stipulation in an insurance policy that outlines the cost of coverage and when payments should be made.
Basics of a Consideration Clause
Consideration clauses are most commonly used in insurance policies and define the amount due for coverage. These clauses also usually define a payment schedule. Other industries also use consideration clauses. When used in industries such as real estate, consideration clauses dictate remuneration based on the terms of the contract.
Generally, consideration clauses dictate that something of value will be exchanged for a bargain. Every party that enters into and benefits from a contract must be given consideration. The best way to understand a consideration is as an exchange. For example, if you provide a service for a business, you can receive a salary in return. In real estate, you would exchange property for regular payments.
In some cases, consideration is used to indicate something of value, such as contractual rights, has been received.
Deferred Consideration and Penalties
In certain circumstances, it is possible to defer consideration. For example, when a company is acquired, the person buying the company might want to spread out their payments instead of making one large payment. When this occurs, consideration will often be based on some sort of performance goal, such as the company reaching a certain level of sales or an important employee staying with the company.
Deferred consideration is used to protect the interests of the buyer and to make sure the value they are receiving is what they were promised. When the person selling the company fails to uphold their promises, the buyer may want to recover their losses. However, in a court case, it will be difficult for the buyer to regain what they have lost, as damages will be restricted.
To make sure the buyer is able to recover their losses, they will usually make sure the acquisition agreement includes provisions for breaches by the seller. In a share purchase agreement, for example, there may be language that reduces or eliminates the deferred consideration to one company shareholder if the contract is breached or company goals are not met.
Share purchase agreements can also contain restrictive covenants, which define what the buyer considers a breach of contract. Some common restrictive covenants include:
- A shareholder leaving the company and directly competing with their former company.
- An undermining of the company's goodwill.
- Failure to meet targets outlined in the acquisition agreement.
Both buyers and sellers should be very cautious when including restrictive covenants or deferred considerations in contracts. For instance, are the provisions enforceable? This means they are liquidated damages, or unenforceable, making them penalties. With a penalty clause, the person damaged receives compensation that is much more valuable than their initial loss. The reason these penalties are so expensive is to help to prevent a breach of contract.
However, parties are also allowed to accurately assess how they would be damaged by a contract breach and request a provision that reflects this assessment. This assessed loss can be more than what the damaged party would be awarded in a court case. Contracts usually require that penalties be an amount of money paid to the damaged party when a breach happens.
However, penalties do not always have to be sums of money. For instance, some penalties may involve the transfer of assets to the injured party. They can also prevent the party that breached the contract from receiving an amount of money that they would have been owed had the contract not been breached. When there is a provision requiring the transfer of assets, this is considered a penalty because it is meant to disincentivize breaches and it likely cannot be enforced.
For this clause to be enforceable, there would need to be an accurate estimate of damages that would result from a breach. This accurate estimate would make the clause a liquidated damages clause. In previous times, clauses were automatically considered penalties if they did not meet the requirements of a liquidated damages clause. Thanks to the decision in one court case, clauses will not be penalties if there is proof that the clause is commercially justifiable.
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