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Leaver provisions May 20, 2019
EAT looks at whether bad leaver provisions are penalty clauses

EAT looks at whether bad leaver provisions are penalty clauses

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eaver provisions can be found in a wide range of contractual contexts – the articles of association of a venture-capital-backed company, the articles of association of a private-equity-backed buy-out vehicle, the rules of a share option scheme, in the deferred consideration mechanics of a sale and purchase agreement and elsewhere.  The terminology largely has the same meaning across those contexts, but the way in which the mechanics work are often radically different.

The primary purpose of leaver mechanics, whatever the context, is to incentivise management to remain with a business by putting their equity at risk if they leave the business.  What happens to their equity usually depends on whether they are ‘good’ or ‘bad’ leavers.  And then, further still, typically in leaver mechanics for venture-backed companies and in share option schemes the equity will ‘vest’ over time so as to differentiate between the treatment of ‘vested’ and ‘unvested’ equity.

A recent decision from the Employment Appeal Tribunal (“EAT”) considers whether bad leaver provisions set out in a sale and purchase agreement in the context of a business sale were enforceable.

Background

In Nosworthy v Instinctif Partners Ltd [2019] (“Nosworthy”), the claimant was employed by and a shareholder in Communication Operations Ltd (“COL”). Instinctif Partners Ltd (“Instinctif”) had acquired the entire issued share capital of COL (including the claimant’s shares) under a share purchase agreement in 2013 (“SPA”).

Under the SPA, there were two forms of consideration payable by Instinctif to the selling shareholders of COL:

  • The initial consideration was in the form of Instinctif shares issued on completion.  Those shares were subject to leaver provisions written into the articles of association of Instinctif.  If the claimant resigned as an employee of Instinctif then she was to be treated as a bad leaver and her shares would go up for sale at the lower of their acquisition cost and fair market value.
  • The deferred consideration was in the form of Instinctif shares and loan notes or cash, and was issuable and payable on certain terms post completion.  The SPA also included leaver provisions.  If the claimant resigned as an employee of Instinctif then she would cease to have any right to receive, to the extent not already issued or paid, the deferred consideration.

The claimant also entered into a side deed with Instinctif by which she agreed not to become a bad leaver for the purposes set out in the SPA.

The claimant voluntarily resigned. Instinctif then:

  • Enforced the terms of the articles so that the shares issued at completion to the claimant were transferred for £1 (their acquisition cost) to Instinctif; and
  • Applied the provisions of the SPA so as to be released from its obligation to issue or pay any of the deferred consideration.

The claimant’s claims concerned her right to receive the deferred consideration only, and the buyback of the initial consideration shares does not appear to have been examined by the ET or the EAT.

Heads of claim and decisions

 

Head of claim

 

Basis of claim ET decision EAT decision
Penalty clause

 

The bad leaver mechanic was a penalty clause because the financial consequences for the claimant did not correspond to the financial loss of Instinctif (and the financial consequences for the claimant were not therefore a genuine pre-estimate of loss for Instinctif)

 

Penalty clauses work by reference to a breach of contract – where the consequences of breach are for payment of a sum that is not a genuine pre-estimate of loss or doesn’t protect a legitimate interest of the other party then the clause may be a penalty and unenforceable.

There had been no breach of contract since the leaver provisions worked in the manner prescribed by the SPA.

Note that Instinctif had not relied on the breach of the obligation in the side deed not to be a bad leaver, and so the question as to whether this was a penalty was not examined.

Upheld ET’s decision and examined Cavendish Square Holdings BV v Talal El Makdessi; ParkingEye Ltd v Barry Beavis [2016].

Instinctif’s primary objective when including bad leaver provisions in the articles was not to deter the claimant from breaking their contract but to protect its legitimate interest within the acquired company (of having her as an employee).

Or, to put it another way, the leaver provisions were in the SPA because the value of what Instinctif was buying went down if the claimant decided to leave the business and not because Instinctif wanted to punish the claimant if she left the business; and so per Makdessi the provisions could not have been a penalty even if breach of contract had been claimed by Instinctif.

 

Unconscionable bargains and undue influence as equitable remedies

 

The bad leaver mechanic was not a fair deal and Instinctif had used undue influence over the claimant (at a disadvantage in the employee / employer relationship) to impose inequitable leaver provisions which arose from an inequality of bargaining power. This was not a situation in which the parties were making a bargain – the claimant had not been buying the shares, she had been given them.  (Key on this point is that the SPA said that the shares were issued in consideration for the claimant staying on as an employee and not as consideration for the transfer of the sale shares in COL.)

Further, the remedy for unconscionable bargains was to set aside the contract and so the result would be that she never held the right to be issued with the shares in the first place.

Not unconscionable.

Upheld ET’s decision.

Did not find that the leaver provisions were an unconscionable bargain since the claimant was not at a serious disadvantage when negotiating with Instinctif (whether through lack of knowledge, advice or minimal financial means) – the warranty in the SPA from the claimant that she had taken legal advice was instructive on this point.

The three pronged test in Alec Lobb (Garages) Ltd  v Total Oil (GB) Ltd [1983] was looked at but was not passed by the claimant – had it been passed, the burden would have fallen on Instinctif to show that the bargain was fair, just and reasonable.

Unauthorised deduction from wages (within the meaning of the Employment Rights Act 1996)

 

The leaver provisions automatically stripped the claimant of the economic rights that were the deferred consideration. Did not fall within jurisdiction of ET since the remedy sought by the claimant related to her rights as a shareholder and not as an employee. Rejected since the statutory definition of unauthorised deductions excluded payments which were made to a worker otherwise than in their capacity as an employee.

Stripping the right to receive payments relating to the shares was not an unauthorised deduction since she received those shares in her capacity as a seller.

Forced labour

 

 

The covenant in the side-deed not to become a bad leaver was in contravention of the Modern Slavery Act 2015 since it amounted to forced or compulsory labour.

 

Rejected the argument since the claimant voluntarily took up a position at Instinctif and subsequently resigned when she no longer wanted to continue working there.

The prospect of losing salary and benefits upon resignation is a concern for every employee.

Upheld ET’s decision.
Restraint of trade (citing 20:20 London Ltd v Riley [2012]) Argued at EAT. Not examined at ET. Not accepted as a new ground of appeal and therefore not examined.

 

All grounds of appeal were dismissed.

Conclusion

The judgment doesn’t go this far, but one might assume that the EAT agreed that the value of having the claimant working for the business had been ‘priced in’ to the consideration Instinctif had already paid and was due to pay for the business – following Makdessi, the workings of the leaver provisions were primary obligations to properly align the value paid by the buyer with what it was buying and were not  secondary obligations which imposed a detriment on the contract-breaker out of all proportion to any legitimate interest of an innocent party.

All this is in the context of an M&A transaction, and further still in the context of this particular Nosworthy transaction.  But it is of relevance to leaver provisions in all contexts and:

  • Bad leavers crying penalty and citing unconscionable bargains are unlikely to get far – leaver provisions will generally not work by reference to a breach of contract and leaver provisions are a way of ‘pricing in’ the value in having an employee working for the business; expanding the scope of the rule against penalties will deprive transacting parties of a useful means of adjusting value
  • The importance of separating a) employment rights and obligations from b) the rights and obligations attaching to shares and arising from a sale and purchase is clearly shown by this case
  • As too is the importance of the parties seeking advice on the workings of the mechanics of the leaver provisions (that warranty came in handy for Instinctif)
  • Writing “thou shall never become a bad leaver” into investment and shareholder agreements is seldom if ever a good idea and query whether it would ever be of use to an investor or to the company where leaver provisions had been properly written into the articles of association

If you would like to discuss more about this case, or about leaver provisions in general, then so please contact us at enquiries@humphreys.law.

This piece was researched and prepared by Henry Humphreys and Amir Kursun, with input from the wider Transactional team.

Humphreys Law

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