Bad leaver provisions are designed to act as a deterrent and encourage good behaviour among a company’s managers. But how do they work? And, importantly, are they enforceable?
Corporate Solicitor Liz Mills and Corporate partner Sophie Brookes explore the details:
What are bad leaver provisions?
Bad leaver provisions are typically found in shareholders’ agreements or articles of association. They deal with what happens to a person’s shares when that person (usually a director) leaves.
There are many reasons why a shareholder may decide to sell their shares but sometimes compulsory transfer provisions require shares to be sold when a director-shareholder leaves the company. The price which the shareholder receives for their shares may then vary depending on whether they are a good leaver (usually the fair value of the shares) or a bad leaver (usually only the nominal value of the shares).
When might someone be a bad leaver?
The exact categories of bad leaver will vary for each company but typically these could include a shareholder who leaves before an agreed date or one who breaches the terms of his service agreement or a shareholders’ agreement. In this way, shareholders are encouraged to stick to the agreed terms, or face losing the value of their shareholding.
Are bad leaver provisions valid?
The courts are generally reluctant to get involved in agreements reached between parties of equal bargaining strength who have been independently advised. But if a provision which applies following a breach is considered a penalty, rather than a genuine pre-estimate of loss, the courts are more likely to find that it is unenforceable.
So what about bad leaver provisions where, for example, breach of a service agreement means shares must be sold for a heavily discounted price – could these be an invalid penalty?
A recent case
Earlier this year the courts considered a case where two directors were summarily dismissed. The directors were also both shareholders and the company’s articles contained a bad leaver clause, under which the directors were forced to sell their shares for £1.
In fact, the court said the directors had been wrongfully dismissed and so the bad leaver provisions didn’t apply. Helpfully for us, however, the judge went on to consider the validity of the bad leaver provisions, saying that they were not a penalty and would have been enforceable. The judge said that the bad leaver provisions were a primary obligation agreed between the parties for distinct commercial reasons to do with a shareholder leaving the company. The reduction in the value of the shares which applied under the bad leaver provision was not disproportionate with the company’s interest in enforcing the provision.
Lessons to learn
This is a helpful decision in confirming the validity of provisions which can be a key measure by which companies and investors protect the value of their investment in their executive team. But careful thought should still be given to bad leaver provisions as the courts might reach a different decision if the parties are not both independently advised, or are of differing bargaining strengths, or if the discount applied to the share value is completely disproportionate to the interests of the company or investors in enforcing the bad leaver provision.
For more information, please contact:
Corporate partner Sophie Brookes
T: 0161 836 7823