The High Court has recently considered whether the compulsory transfer provisions in a company's articles, under which "bad leaver" shareholders were entitled only to a reduced value for their shares, amounted to an unenforceable penalty.

Background

A bad leaver provision in a company's articles requires a shareholder who is also an employee to transfer their shares for less than their market value when they cease to hold office or employment with the company.

A penalty is a secondary obligation which, in the event of a breach of a primary obligation under the contract, imposes on the contract-breaker a detriment that is out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation (Cavendish Square Holding B.V. v. El Makdessi [2015] UKSC 67). A penalty is unenforceable under English law.

Facts

D was the managing director of Signia, a wealth management company. The relationship between D and the founder of Signia deteriorated over time and, during disciplinary proceedings brought by Signia against D in relation to expenses claims, D resigned from the company with immediate effect.

Signia took steps to enforce the compulsory transfer leaver provisions in the company's articles. It asserted that D was a bad leaver under these provisions and therefore obliged to sell her shares in the company for a value significantly below market value.

A bad leaver was defined in the articles as "any Leaver who is not a Good Leaver or an Incapacitated Leaver". In effect this meant that an employee shareholder who was leaving employment other than as a result of resigning at a time when they were not in breach of their employment contract or as a result of death or disability was a bad leaver.

While D maintained that she was not a bad leaver, she contended that, if indeed she was, the differentiation between the price to be received on a sale of shares by a good leaver and bad leaver constituted a penalty and that the court should, for this reason, not enforce the bad leaver provisions, but treat her as a good leaver.

Decision

The court held that the penalty doctrine did not apply to this situation and that, even if it did, the leaver provisions were not a penalty and were therefore enforceable in accordance with their terms.

It found that, on the facts, D fell within the definition of a bad leaver under the articles. However, the enforcement of the bad leaver provisions was not a remedy available to Signia due to D's breach of the articles. Signia was simply enforcing the primary obligations of the shareholders pursuant to its articles, which set out a detailed and extensive code for the compulsory transfer of a shareholder's shares. The fact that the valuation of D's shares would be affected by whether she was a bad leaver or not did not operate to change the nature of those provisions.

The court noted that if it were wrong on this and the penalty doctrine did apply, the leaver provisions would only be unenforceable if they were "out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation". The purpose of the leaver provisions was to ensure that the shares in Signia remained with the founder and the current employees of Signia – which made good sense in a start-up venture – and to incentivise employees to stay. A whole range of factors was relevant to the value attributed to shares pursuant to the compulsory transfer process. There was nothing in these out of proportion with the legitimate interests of all of the parties to the articles.

Comment

The case is a useful example of the courts applying the rules on penalties post-Makdessi to bad leaver provisions. The decision of the court that the bad leaver provisions were primary rather than secondary obligations and, therefore, not subject to the rules on penalties is helpful from the point of view of a party wishing to enforce a bad leaver provision. The decision accords with the earlier case of Richards and another v. IP Solutions Group Ltd [2016] EWHC 1835 (covered here), though, as we noted in our commentary on that case, the court came to the opposite conclusion in Re Braid Group (Holdings) Ltd [2016] ScotCS CSIH 68. In any event, all three cases suggest that, provided bad leaver compulsory transfer provisions are drafted in a proportionate manner, they should be enforceable even if they are classified as secondary obligations.

Signia Wealth Ltd v. Vector Trustees Ltd [2018] EWHC 1040 (Ch)

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