Why are bad leaver provisions so important?
These important provisions are typically found in shareholders agreements, company constitutions, or employee share schemes (along with “good leaver” provisions) and help to protect companies after employees depart the business.
A “good leaver” will usually mean leaving employment on grounds of death or disability. On the other hand, a “bad leaver” might mean an employee who ceases employment with the company and is not a good leaver. Or a bad leaver might be restricted to leaving employment in circumstances justifying the summary dismissal of the employee. The exact definition of these terms will be negotiated by the parties.
Typically bad leaver clauses will state that departing employees must return their shares at a price that is less than market value – for example at the price they paid for them or for nominal value. Conversely a good leaver might also be required to return or sell their shares, but at a fair value or market value.
Recent court cases
In two cases in 2016, the English and Scottish courts considered whether the relevant bad leaver provisions constituted a “penalty” clause. Penalty clauses usually involve a payment or forfeiture in the event of a breach of contract and are not enforceable.
The leading UK Supreme Court judgment on the law of penalties comes from 2015 and it drew a distinction between a primary performance obligation, which cannot be deemed to be an unenforceable penalty and a secondary payment obligation arising on breach of the primary provision, which can be a penalty. However, a secondary obligation will only be a penalty (and therefor unenforceable) if it imposes a detriment out of all proportion to any legitimate interest of the innocent party in enforcing the primary clause.
In Richards v IP Solutions Group, the UK High Court commented that the bad leaver provisions in the company’s articles were a primary obligation, meaning that the rule against penalties did not apply. The reason for this view was partly because the bad leaver provisions were located in a separate document from the service contracts and partly because the provision had distinct commercial objectives to do with a shareholder leaving the company, and the £1 price was the agreed consideration for the transfer. Even if it had been a secondary obligation, the High Court said that the bad leaver provision would have been enforceable, as there was nothing unconscionable in this arrangement, which had been arrived at between parties dealing at arm’s length with the benefit of expert advice.
The Scottish case, Gray v Braid Group (Holdings) Ltd related to a bad leaver provision in articles of association and a shareholders’ agreement. The case was decided on a different point, but the court did comment that the bad leaver provision was a secondary obligation. They viewed it as a mechanism for determining the consequences when the primary contractual obligations were breached.
Key lessons for companies
The different bases for the courts’ comments demonstrate that the distinction between primary and secondary obligations is not clear-cut, and parties need to be able to justify the proportionality of a provision without relying on its classification as a primary obligation. Both cases emphasised that the parties had expert advice and that the provisions were the result of negotiation.
