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Case law: 'Bad leaver' provisions in company's articles not an unenforceable penalty

Companies seeking to include compulsory transfer provisions in their articles stating that 'bad leavers' are to receive less than full value for their shares, should ensure they are drafted as primary obligations, and not therefore unenforceable as penalties.

September 2018

This update was published in Legal Alert - September 2018

Legal Alert is a monthly checklist from Atom Content Marketing highlighting new and pending laws, regulations, codes of practice and rulings that could have an impact on your business.

A company's articles of association said that a director or employee who left the company had to offer any shares they held to the other shareholders. When determining the price to be received for their shares, the articles stated that if they were a 'bad leaver' they would only receive a very small sum.

A director with shares in a company resigned during a dispute over her expenses. This triggered the clause. The company said that she was a 'bad leaver' and should only receive £2 for her 49% shareholding.

One of her arguments in the dispute was that the fact she would only receive £2, when the shares were worth much more than that, amounted to a penalty and was therefore unenforceable.

The law says that a clause is a penalty if it imposes financial consequences for the breach of a primary obligation in a contract, and this causes a detriment to the party committing the breach that is disproportionate to the other party's interest in the performance of that primary obligation. A clause cannot be a penalty if it is itself a primary obligation – it can only be a penalty if it imposes a secondary obligation.

The Court ruled that she was a bad leaver, and that either:

  • the rule regarding penalties did not apply in this situation or, if it did
  • the clause stopping her from receiving full value for her shares because she was a bad leaver was not a penalty

In either event, the clause was enforceable. The director had become a leaver through her own action in terminating her own contract of employment. The consequences under the articles were that she was deemed to be a bad leaver; had to offer her shares to the other shareholders; and would receive less than full value for them. This was not a consequence of her breach of contract. It was a separate set of primary obligations in the articles and could not be penalties.

Operative date

  • Now

Recommendation

  • Companies wishing to include compulsory transfer provisions in their articles, saying that 'bad leavers' are to receive less than full value for their shares, should draft them in a way that ensures they are primary obligations, and will not therefore be unenforceable as penalties.

Case ref: Signia Wealth Ltd v Vector Trustees Ltd [2018] EWHC 1040 (Ch)

Disclaimer: This article from Atom Content Marketing is for general guidance only, for businesses in the United Kingdom governed by the laws of England. Atom Content Marketing, expert contributors and ICAEW (as distributor) disclaim all liability for any errors or omissions.

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