Compulsory share transfer provisions – are they an unconscionable penalty?
Philip Stephenson, a partner in our corporate team, looks at a Employment Appeal Tribunal decision on bad leaver provisions as they affect compulsory share transfer obligations.
Parties to commercial contracts often agree that, if one party is in breach, that party must pay the innocent party a specified sum or transfer property (e.g. shares) to the innocent party for nothing or at an undervalue.
Courts have drawn a distinction on breach of contract claims between enforcing “liquidated damages clauses” in which the sum is a genuine pre-estimate of loss and a “penalty clause” which is intended as a deterrent against breach by imposing a detriment out of all proportion to an innocent party’s legitimate interest and so is not enforceable. In some of the latter cases, claimants have successfully asked a court to rescind a contract unfavourable to them if it amounts to an “unconscionable bargain”.
The employment tribunal case of Nosworthy v Instinctif Partners Ltd highlights the limits of the penalty clause doctrine and provides a cautionary message for prospective employee shareholders.
Nosworthy, the claimant (“N”), was given 2% of the share capital in her employer just before the employer company was sold to Instinctif Partners, the respondent, (“IP”). N sold her shares to IP on the terms of a share purchase agreement. Consideration for the shares was made up of both initial consideration and deferred consideration. This deferred consideration consisted of IP earn-out shares and loan notes. The investment agreement which both N and IP were party to and the IP articles of association both provided that a ‘bad leaver’ would forfeit their IP loan notes and their IP shares would be transferred at the lower of cost and acquisition value. A ‘bad leaver’ was defined as including an employee who voluntarily resigned.
N voluntarily resigned, was treated as a bad leaver and required to sell her IP shares for £nil. N challenged the bad leaver provisions on numerous grounds including that they were unconscionable bargain and an unenforceable penalty clause.
No unconscionable bargain
In rejecting N’s claim, the Employment Tribunal (the “ET”) found that:
- the bad leaver provisions were not unconscionable. The parties were never in a bargaining position as N was given the shares for nothing as part of the sale of the company;
- the bad leaver provisions were not an unenforceable penalty in this case as N voluntarily resigning was not a breach of contract; and
- the contract was not illegal under the Modern Slavery Act 2015 as the forfeiture provisions did not constitute forced or compulsory labour.
N appealed the decision to the Employment Appeal Tribunal (the “EAT”) which upheld the original decision of the ET.
The EAT set out the following three-part test to determine unconscionability
- One party must have been at a serious disadvantage whether through ignorance, lack of advice or otherwise;
- the other party must have exploited that disadvantage in some morally culpable manner; and
- the resulting transaction must be overreaching and oppressive.
In applying this test, the EAT found that N could not even satisfy the first part of the test. She was not disadvantaged. There was no suggestion that she was denied legal advice before entering into her agreements and, indeed, had warranted to IP both that she had taken legal advice and the bad leaver provisions were reasonable.
No penalty clause
N further argued that forfeiting her IP shares and loan notes at £nil was a double penalty out of all proportion to any loss caused to IP by her breach of contract by being a bad leaver.
The EAT rejected that argument. The forfeiture consequences of being a bad leaver did not depend on N being in breach of contract. Although N had contracted in the investment agreement not to become a bad leaver, IP was not relying on that. Instead it was relying on the IP articles which set out the forfeiture consequences of being a bad leaver.
No bad faith
The EAT also rejected the argument that IP acted in bad faith in treating her as a bad leaver when the Remuneration Committee had discretion to treat her as a good leaver.
This case is a good reminder to employee shareholders that bad leaver provisions are not necessarily either unconscionable or an unenforceable penalty and can be applied against them. When being offered shares that are subject leaver provisions, employee shareholders should obtain legal advice on what amounts to being a bad leaver and the consequences of being one.
For companies offering shares to employees and given that the unenforceable penalty rule only applies to breach of contract claims, it re-emphasises the legal advantages of putting leaver share forfeiture provisions in its articles rather than in an investment, service or other contract with the employer.