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Should you be worried about the enforceability of leaver provisions?

25 March 2014

It is generally accepted by private equity practitioners in the UK that compulsory transfer provisions which provide for members of management to transfer their shares at a nominal value where they become 'bad leavers' do not fall foul of the common law doctrine of penalties.

The recent Court of Appeal judgement in the case of El Makdessi v Cavendish Square Holdings BV [2013] has questioned the validity of this position. In this article, Richard Coleman examines what, if anything, has changed and whether private equity sponsors need to rethink their approach to leavers.

Penalties: the legal position

The ability of the parties to agree the terms of a contract without (in the main) legislative or judicial interference is one of the key principles and attractions of English law. With that in mind, the doctrine of 'penalties' is a peculiarity - hard to rationalise and (as many law students will attest) difficult to explain.

Put simply:

  • the primary remedy for a breach of contract in English law is monetary damages. When determining how much a breaching party is liable for, the intention is to put the innocent party in the position that they would have been had the contract not been breached
  • damages are not (other than in very specific circumstances) intended to go further and punish the breaching party for their breach - indeed an innocent party is obliged to mitigate the loss it suffers
  • as such, provisions primarily designed to deter parties from breaching a contract by penalising them (ie going further than damages would) are, at least in part, unenforceable.

Two lines of case law have emerged which provide exceptions to this general rule:

  • "Genuine pre-estimate of loss" - where a provision was, at the time it was entered into, a 'genuine pre-estimate of loss' likely to be suffered as a result of a particular breach, that provision would not be deemed to be a penalty. An example is a provision in an exclusivity agreement which obliges a breaching party to pay the diligence costs incurred by the innocent party prior to exclusivity being breached.
  • "Commercial justification" - more recently, the courts have suggested that even where a provision is not a genuine pre-estimate of loss, it would be enforceable where is was 'commercially justifiable' and did not have as its primary purpose the deterrence of breach of contract. An example is the imposition of additional interest above standard rates where a payment, for instance under a loan note, is made late.

El Makdessi v Cavendish Square Holdings BV

Makdessi was a case dealing with the consequential effects of a breach of a restrictive covenant by the seller under the terms of a share purchase agreement.

Broadly, under the terms of that agreement, Mr Makdessi was entitled to receive a significant amount of deferred consideration for the sale of a portion of his shares in a company. The agreement also contained put and call options in respect of the remainder of his shares and a number of post-sale restrictive covenants.

The business operated by the target company was highly reliant upon personal relationships and the agreement therefore contained a provision which stated that if Mr Makdessi breached any of the restrictive covenants he was subject to he would both forfeit his right to receive certain elements of the deferred consideration and only be entitled to receive a lesser amount on the acquisition of the remaining shares under the option arrangements.

Following completion of the sale, the buyer alleged that Mr Makdessi had breached a number of the restrictive covenants. The court was asked to confirm that Mr Makdessi was therefore not entitled to receive the remaining deferred consideration and would be forced to sell his remaining shares at a lower value under the option arrangement.

Were the default provisions penalties?

The Court of Appeal agreed unanimously that the default provisions were penalties and therefore unenforceable. Put very simply, the court took the view that as the effect of the breach by Mr Makdessi (the effect could have had a monetary impact of over $44m in respect of the deferred consideration alone) had absolutely no proportionality to the loss attributable to that breach the provision could only be seen as a penalty.

The case is useful in bringing together and restating the modern law of penalties and serves to highlight a number of factors which should be kept in mind when thinking about the application of the law to compulsory transfer provisions:

  • the court's first question in assessing a provision is whether it constitutes a genuine pre-estimate of loss and therefore cannot constitute a penalty
  • if not, the provision may still be enforceable if it is commercially justifiable and is predominant purpose is to compensate loss and not to deter breach
  • commercial justification may not be conclusive where the effect of the provision is so 'extravagant or oppressive', ie out of proportion to the breach itself, that the only sensible conclusion is that its primary function is to deter breach
  • the fact that the provisions were negotiated by parties with even bargaining power is not conclusive.

Application to compulsory transfer provisions?

In a private equity context, compulsory transfer (or 'leaver') provisions require members of management who hold shares to sell those shares at a specified price if they cease to be employed or otherwise engaged by the Company.

The price at which those shares are transferred will depend upon the circumstances in which a member of management becomes a leaver. A leaver who is a 'good leaver' will usually receive the market value of their shares as at the date on which they became a leaver (thus not benefitting from any further upside but crystallising the value they have helped to create) whilst 'bad leavers' will usually receive a nominal sum for the shares, irrespective of all other considerations.

Although it is difficult (but not impossible) for the application of compulsory transfer provisions to constitute a penalty in a 'good leaver' scenario, because the leaver would receive a market value for the shares, some practitioners have suggested that this may not be the case in relation to 'bad leavers' where shares will be transferred at below their market value.

Using the reasoning suggested by Makdessi:

  1. it is settled law that a clause which requires the transfer of property (such as shares) rather than the payment or forfeit of cash can constitute a penalty
  2. it is difficult to argue that a compulsory transfer provision is a genuine pre-estimate of loss. Neither the value of the shares nor the potential effect of the breach can possibly be known at the date on which the manager acquires the shares
  3. whilst there is almost certainly commercial justification for a provision which requires the transfer of shares from a leaver (to incentivise new or existing members of management and to allow for a 'clean break') the operation of the provision could be 'extravagant' in the sense that the loss that arises as a result of the circumstances leading to the transfer may be wholly disproportionate to the value of the shares transferred (particularly in the case of a bad leaver).

However, a key distinction which must be considered when looking at compulsory transfer provision is that their application is not effective upon a breach but rather the occurrence of a certain state of affairs, ie a manager no longer being employed by the issuing company (for whatever reason). As such, the purpose of the provision may not be said to have, as a primary purpose, the deterrence of breach, even where potentially (such as in the case of summary dismissal) there is a breach of other agreements.

It is also interesting to note the approach of the courts since the judgement. Approximately two weeks after the Appeal Court judgment in Makdessi, the High Court handed down its own judgment in the case of Moxon v Litchfield.

Rather than consider the applicable law, Moxon concerned the factual question of whether a director was a 'bad leaver', but it is interesting to note the summary from Mr Justice Hildyard:

"Mr Moxon was…justifiably characterised a "Bad Leaver" and there is no basis of the Court's intervention to modify the consequences provided for…I am conscious that this produces a harsh, even draconian, result for Mr Moxon…but he agreed to those provisions…and he has not demonstrated any sufficient basis for relief from or modification to their effect".

So, if the High Court has anything to do with it, the enforceability of leaver provisions is not something that we will need to concern ourselves with, at least for the time being.

This article was written by Richard Coleman.

For more information contact Malcolm on +44 (0)20 7427 1059 or richard.coleman@crsblaw.com