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