UK: Bad Leaver Clauses And The New Rule Against Contractual Penalties

Two recent decisions touch on the interaction between bad leaver clauses and the new rule against contractual penalties set out by the Supreme Court in November 2015.

Background

In Cavendish Square Holdings BV v. Makdessi [2015] UKSC 67 the Supreme Court distinguished between primary obligations, to which the rules on penalties do not apply, and secondary obligations, to which the rules on penalties do apply. The Supreme Court also stressed that a secondary obligation will be penal if it does not protect a legitimate interest of the innocent party or does so in a way which is not proportionate. (For a more detailed analysis of the Cavendish decision, see The new rule against contractual penalties.)

A bad leaver clause is a compulsory share transfer provision in a company's articles of association or shareholders' agreement. It requires a shareholder who is also a director or employee to offer to transfer his shares in certain circumstances. Typically these relate to gross misconduct or other behaviour justifying summary dismissal. In these circumstances, the transferring shareholder typically receives a discounted price for his shares.

Facts

In Richards and another v. IP Solutions Group Ltd, the English High Court had to consider if the defendant, on the facts, could summarily terminate the claimants' service contracts. If it could, the court had to consider whether the bad leaver clause in the company's articles which the defendant had triggered amounted to an unenforceable penalty.

In Re Braid Group (Holdings) Ltd [2016] ScotCS CSIH 68, the Inner House of the Court of Session in Scotland was dealing with an unfair prejudice claim under section 996 of the Companies Act 2006. The primary issue was whether a court order could in an order made under that section require the transfer price to be determined by reference to the bad leaver clause in the articles.

In both cases the court's comments on penalty clauses were obiter. They are therefore only of persuasive authority. Nonetheless they offer useful guidance on the judicial approach to bad leaver clauses after Cavendish.

In Richards the bad leaver clause in the articles stipulated that a bad leaver would get £1 for all the shares that he was required to transfer.

In Braid the bad leaver clause stipulated that a bad leaver would get the lower of 75% of the fair value of his shares and the subscription price (including any premium) paid by him.

Decisions

In both cases the courts found that the bad leaver clauses did not fall foul of the rule against penalties, but for different reasons.

In Richards the court recognised that the issue was complex and deserved fuller argument. However, it decided that the leaver provisions in the articles, including the bad leaver clause, were more akin to primary obligations. These were agreed between parties for commercial reasons to do with a shareholder leaving the company, rather than secondary obligations consequent on breach of the employment contract. But even if the clause had been a secondary obligation, there was nothing unconscionable in an arrangement arrived at between parties dealing at arm's length with the benefit of extensive expert advice. Had it been necessary, therefore, the court would have found that transfer provisions in the bad leaver clause were enforceable.

In Braid, in contrast, the court agreed unanimously that the transfer provisions in the bad leaver clause were secondary obligations. They backed up a primary obligation to comply with a service contract and provided a mechanism for dealing with the effects of a breach of that primary obligation. On whether the secondary obligations were an unenforceable penalty, two of the three judges considered that they were not. They did not consider it unfair that a shareholder who was guilty of gross misconduct should have to give up his holding and, in return, get back his original financial stake. However, one judge disagreed with this analysis and found the clause to be penal.

Comment

Both courts found that provisions which set a transfer price at a significant discount to market price were, in the context of gross misconduct, enforceable. However, the different conclusions on whether these were primary or secondary obligations show that the boundaries between the two are far from clear. Given that bad leaver clauses are typically triggered on a breach of employment obligations, those wishing to rely on them would be wise to treat them as secondary obligations. Therefore, any compulsory transfer provisions which take effect on a breach should be proportionate to the interest which they are protecting. For example, if there is only a single transfer price for all bad leavers, defining a bad leaver as anyone who is not a good leaver may be more open to challenge than a definition that links being a bad leaver to serious misconduct.

Richards and another v. IP Solutions Group Ltd [2016] EWHC 1835

Re Braid Group (Holdings) Ltd [2016] ScotCS CSIH 68

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