The penalty clause in a company’s by-laws and the impact on M&A transactions – the opinion of the Notary Council of Milan

Thursday 31 March 2022

Paolo Consales

Pirola Pennuto Zei e Associati, Rome


To clarify certain approaches common in M&A practices – particularly in those cases when there is an acquisition of only a majority shareholding – a recent opinion from the Notary Council of Milan confirmed the legitimacy of those clauses of a company’s by-laws providing a penalty for breaches by the shareholders of certain obligations under the by-laws. This opinion should be considered when:

  • negotiating the acquisition of the (majority or minority) stake in an Italian company;
  • the management or the existing shareholder is to retain a shareholding in the target company; and
  • negotiating way-out clauses or deadlock clauses.

The by-law penalty clause

The Notary Council of Milan (the Council) is the public entity charged with governing the activities of all notaries in the Milan region. It is particularly active in providing guidelines to notaries in all areas of corporate law; its opinions are widely respected and applied. Several of its opinions impact M&A transactions and should be borne in mind while negotiating M&A deals. In November 2020, the Council issued an opinion clarifying the legitimacy of clauses of a company’s by-laws that limit the circulation of shares by recalling a shareholders’ agreement so that the effects of the shareholders’ agreement impact not only the parties, but may also have effects vis-à-vis the company.

Opinion No 198, issued on 23 November 2021, confirmed that it is legitimate to insert in a company’s by-laws a clause providing for the application of penalties on shareholders, should the obligations provided in those by-laws be breached. The penalties can:

  • be in the form of the payment of an amount indicated in the by-laws;
  • effect material changes of the corporate rights in the company for the breaching shareholder; or
  • lead to a conversion of the category of the shareholder’s shares with consequent changes in the shareholder’s rights.

In the opinion, the Council made reference to the following provisions of the Italian Civil Code:

  • the exclusion of a quota holder: pursuant to Article 2473-bis of the Italian Civil Code, the quotaholder of a limited liability company (Società a responsabilità limitata) may be excluded ‘for just cause’ in the event the quota holder fails to comply with an obligation provided by law or by the by-laws. The excluded quotaholder is entitled to obtain reimbursement for their quotas; and
  • consequences for shareholders who do not fulfil their contributory obligations or breach the obligation to provide services as contributions in exchange for shares.

On the basis of these provisions, the Council clarified that the penalty may provide:

  • pecuniary obligations vis-à-vis the defaulting shareholder. By including this type of clause, it is possible to predetermine the amount of damages arising from the breach of specific obligations imposed by the by-laws. In other words, in this case the penalty clause has a compensatory and/or punitive function; and
  • material change of the corporate rights of the shares owned by the breaching shareholder, including, by way of example:
    • the automatic conversion of the shares into another share class. This different share category can (and most probably will) provide limited rights for the shareholder, such as a limitation on voting rights or reduced rights in relation to the distributions of profits;
    • the suspension or limitation of voting rights.

The Council also resolved the issue relative to the vote required to insert such clauses into a company’s by-laws. The Council stated that the introduction of these clauses would not require the consent of 100 per cent of the corporate capital, but only the approval of the majority required by law – provided that the clauses refer to circumstances which do not already apply to any of the shareholders when the relevant clause is approved.[1]​​​​​​​

The Council also clarified that it is possible to combine the penalties with other remedies, such as the exclusion of the breaching quotaholder (in limited liability companies) or the redemption of the shares of the breaching shareholder (in joint stock companies).

Given that the breaching shareholder would be entitled to receive a certain sum should they be excluded by the company or if their shares are redeemed, this would be an additional advantage for the non-breaching shareholders or for the company. It would be possible to offset the amount due to the breaching shareholder for the redemption of the shares against the amount due by the breaching shareholder as a penalty.

Lastly, it must be borne in mind that the general rules governing penalties set out in Italian law must be applied to the penalties provided in a company’s by-laws. Therefore, the penalties may be reduced on an equitable basis by the court if:

  • the obligations from which they arise have been partially fulfilled by the shareholder; or
  • the amount of the penalty is clearly excessive, taking into consideration the interests of the company in the fulfilment, by the shareholder, of their relevant obligations.

Main applications of the by-law penalty clause in M&A transactions

As already mentioned, the Council’s opinion may have wide applications in M&A transactions, particularly in those situations when the acquisition is for less than 100 per cent of the corporate capital and a minority shareholder is to keep its shareholding in the target company or the acquisition is for just a minority stake. For example, the Council’s opinion could have an interesting effect when a private equity fund decides upon a management buy-out transaction agreeing on certain way-out clauses or mutual put and calls, or when a venture capital fund invests in a startup company.

From a practical point of view, it is possible to see the benefit of by-laws penalty clauses in the following cases: 

Tag-along clause

The penalty may be provided for violation of a tag-along obligation by the purchaser, which can be requested to compensate the minority shareholders, or by limiting its shareholders’ rights. Hence, prior to going to court, such a clause could be a strong incentive not to breach the tag-along clause and protect minority shareholders.

Drag-along clause

The same approach could be considered for the violation of a drag-along clause by the minority shareholder. Knowing that, in the case of breach of a drag-along obligation, the minority shareholder would be subject to the obligation to pay compensation for damages or  lose (part of) its shareholder’s rights, is a good reason to comply with the drag-along clause and sell to a third-party purchaser interested in purchasing 100 per cent of the company.

Non-compete obligation

A penalty for the violation of a non-compete obligation would be very helpful when managers of the target company are also shareholders/investors, along with a financial partner. The possibility that the violation of such an obligation may have an impact on the shareholders’ rights of the managers, thus jeopardising their positions as shareholders of the company, would be a strong disincentive for certain actions, also making it easier to negotiate the governance clauses.

Deadlock resolution clauses – the ‘Russian roulette’ clause

If a Russian roulette clause is inserted in the by-laws, it would also be possible to provide that, in the event of breach of the relevant obligation to sell or to purchase, the breaching shareholder would pay a penalty or lose part of its voting rights. The non-breaching shareholder would consequently be able to overcome the deadlock situation and approve the relevant resolution by itself, with the penalty being an important incentive to comply with the clause.

It is clear that this result would not be possible if the penalty is included only in a shareholders’ agreement that is effective between the parties but not involving the target company.


[1] For joint stock companies, Article 2385 of the Italian Civil Code provides that the resolution regarding the amendment of the by-laws must be passed at an extraordinary shareholders’ meeting and requires the approval of shareholders representing more than half of the share capital, unless a greater majority is required by the by-laws.  For limited liability companies, Article 2479-bis of the Italian Civil Code provides that, for amending the by-laws, the favourable vote of shareholders representing at least half of the share capital is required.