'Bad Leaver' Provisions: Unenforceable Penalty?
So called ‘bad leaver’ provisions are often found in a company’s Articles of Association, but can they amount to an unenforceable penalty and therefore be ineffective?
The purpose of bad leaver provisions is to require a shareholder/director to offer to sell their shares in specific circumstances, usually where there is gross misconduct or other serious behaviour which justifies summary dismissal. Under a bad leaver provision, the shareholder/director will only receive a discounted price for the shares.
However, following a recent ruling1, companies need to take care to ensure bad leaver provisions are drafted as primary obligations – otherwise they will effectively be penalties and, therefore, unenforceable.
What happened?
A shareholder/director resigned her position following a dispute involving expenses. The bad leaver provisions set out in the company articles stated that bad leavers would only receive a very small sum. She was treated as a bad leaver, and would therefore receive just £2 for her 49% shareholding in the company.
She argued that the clause amounted to an unenforceable penalty. A clause is a penalty if, where there is a breach of contract by one party, that party is contractual required to pay a fixed sum which is penalty – ie. imposes a disproportionate detriment on the party in breach.
However, in this case the compulsory transfer process in the Articles set out a detailed and extensive code for the compulsory transfer of a shareholder’s shares. The High Court found that none of the ‘Transfer Events’ that triggered the process had anything to do with the shareholder’s breach of contract. In fact, the shareholder/director’s reason as a leaver was because she terminated the Service Agreement because of the company’s repudiatory breach.
She terminated her own contract and she was therefore deemed to be a bad leaver under the articles’ provisions. The company was simply enforcing the primary obligations of the shareholders under the company’s articles. It was not, therefore, an unenforceable penalty.
What does this mean?
Bad leaver provisions stating that bad leavers will receive less than full market value for their shares they own will not be unenforceable penalties – so long as they are primary obligations. If they are secondary obligations the doctrine against penalties will apply.
For this reason, companies must take care in drafting their bad leaver provisions to ensure they can rely on them in the case of a bad leaver.
1Signia Wealth Ltd v Vector Trustees Ltd [2018] EWHC 1040 (Ch)
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