Enforcing bad leaver provisions

Bad leaver provisions are often found in a company’s articles of association or a related shareholders’ agreement. Typically, they set out the price which an individual will receive for their shares when they have to transfer those shares because the individual leaves the company.

So, if an individual leaves in certain circumstances (for example, retirement or ill health), the individual is a ‘good leaver’ and receives the market value of their shares. But in other circumstances (for example, summary dismissal for gross misconduct) the individual will be classed as a ‘bad leaver’ and receive only a nominal amount.

Good and bad leaver provisions can also be used to spell out other consequences that will arise depending on the circumstances of an individual’s departure from a company.

There have been various decisions in the commercial courts which have considered whether bad leaver provisions could be attacked as being an unenforceable penalty. Those cases confirmed that bad leaver provisions are not penalties and are enforceable. Now, the Employment Appeal Tribunal (EAT) has reached a similar conclusion.

Impact of the bad leaver provisions

In Nosworthy v Instinctif Partners Ltd, an employee started working for an employer in 2011. When the employer was sold in 2013, the employee was given a shareholding in the employer which was then included in the sale to the buyer.

Part of the consideration for the sale of the employee’s shares was deferred earn-out shares and loan notes in the buyer. These items were subject to good and bad leaver provisions so a bad leaver would not be entitled to any share or loan notes that became payable following termination of employment, and would also be required to transfer (at cost) any shares they had already received and forfeit the loan notes. As part of the transaction documents, the employee also promised not to be a bad leaver.

The buyer’s articles of association classified an employee who voluntarily resigned as a bad leaver. When the employee resigned in 2016 the buyer sought to rely on the bad leaver provisions meaning the employee had to transfer her shares for cost (£1 per share) and forfeit the loan notes.

Unauthorised deductions from wages

The employee claimed that this was an unauthorised deduction from wages but this claim was rejected. The definition of unauthorised deductions excluded ‘any payment to the worker otherwise than in his/her capacity as a worker’. In this case, the payments relating to the earn-out shares and the loan notes were made to the employee as a seller of shares and not as a worker. So they could not be classed as unauthorised deductions.

Unconscionable bargain

The employee also argued that the bad leaver provisions were ‘unconscionable’. The EAT said this required the employee to have been at a serious disadvantage and to have been ‘exploited in a morally culpable manner’ by the buyer. But the EAT did not agree that this had been the case: the bad leaver provisions were not unconscionable as the employee had not purchased the shares but actually they had been gifted to her as part of the sale process.

There was no evidence that the employee did not have access to legal advice before entering into the sale agreement and she had agreed that the bad leaver provisions were reasonable.

Were the bad leaver provisions penalty clauses?

A typical penalty clause is one which states that if a party breaches an agreement, it must pay the other party B a fixed sum. A clause will be classed as a penalty, and so be unenforceable, if it is a ‘secondary obligation which imposes a detriment on the contract-breaker [the employee in this case] out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation’.

Here, the employee had argued that her resignation had not caused the buyer any loss and that the penalty imposed on her (forfeiture of the loan notes and the repurchase of her shares at minimal value) was out of all proportion to the loss caused by her being a bad leaver. However, the EAT held that, when applying the bad leaver provisions, the buyer did not rely on the employee’s breach of contract, namely breach of the promise not to be a bad leaver. Instead, it had relied on the provisions in its articles requiring share to be transferred and loan notes to be forfeited. So the rule relating to penalty clauses was not applicable as there was no related breach of contract.

Did the company act in bad faith?

The EAT also rejected the claim that the buyer had acted in bad faith by treating the employee as a bad leaver. The buyer had discretion under its articles to reclassify the employee as a good leaver, but the bad leaver provisions in the agreement were drafted clearly and the employee had agreed to them.

It’s good to see the EAT taking a similar approach to the commercial courts on the enforceability of bad leaver provisions. Whilst these provisions are common, their exact requirements will vary from case to case – for instance, in this case voluntary resignation by the employee led to her being classed as a bad leaver. The parties need to be sure they fully understand the provisions they are signing up to and the consequences if they later