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Sonio Singh – a Partner in the Corporate/Commercial department at Davis Blank Furniss – discusses Shareholder Agreements…

I was recently approached by a client who is the majority shareholder/director of a company. She works alongside three other minority shareholders/directors, but it came to her attention that at least two of them had breached various terms of their service agreements and Shareholders’ Agreement. The Shareholders’ Agreement and related Articles of Association provided that if they leave employment in such circumstances then they will be classed as ‘bad leavers’ and the remaining shareholders could buy their shares at the par value of £1 per share.

This can be a common problem so below, I address the likely issues that arise when seeking to enforce these ‘bad leaver’ provisions…

‘Bad leaver’ provisions are a complex area legally and are notoriously difficult to enforce in practice. In many cases, they generate numerous claims and counterclaims between shareholder directors who have fallen out; sometimes leading to literally years of litigation. Often, in cases involving small companies, it’s preferable for the Shareholders’ Agreement to contain simple no fault/ fair value exit provisions instead.

The first question you have to ask is whether you have sufficient control of the board to dismiss the offending directors? The second is whether the dismissal is lawful under the relevant employment law? If the answers are ‘no’ then they will potentially have unfair and/or wrongful dismissal claims.

Unless your Shareholder Agreement successfully excludes the same, such claims may include the loss of the value of the shares triggered by the dismissal and subsequent par value buy out. In the related field of share options, it has recently been held that you can contractually exclude such share value losses from wrongful dismissal claims but not from unfair dismissal ones.

Also, if the dismissal wasn’t lawful, you will need to read the ‘bad leaver’ provisions carefully. It’s quite common for them not to trigger on an unlawful dismissal, so trying to enforce them only to find that hadn’t triggered could be a costly mistake.

Finally, ‘bad leaver provisions’ have been the subject of challenges on the grounds that they are penalty clauses and therefore unenforceable. They may be at risk as they are designed to deter a breach as opposed to being a reasonable pre-estimate of the loss should such breach occur.

One way of sidestepping this issue is if the ‘bad leaver’ provisions are simply triggered by an employee leaving irrespective of whether there is a breach of his or her employment contract. The principle behind the drafting of such provisions is that only those employees that are there for the “long haul” – or are employed at the time of exit – get to benefit from an increase in the value of their shareholding.

Another straightforward way of avoiding this problem is if ‘good leavers’ (who obtain market value on exit) are simply those who leave by way of death/incapacity or who are declared to be ‘good leavers’ at the discretion of the majority shareholder(s). However, this usually won’t be appropriate where the co-shareholders are founders/quasi-partners as opposed to employees who are ‘made up’ and hold a relatively small shareholding.

Drafting Shareholder Agreements/Articles of Association where ‘bad leaver’ provisions may be required continues to remain an extremely specialist area and detailed advice is required to avoid the traps detailed above. Ensuring that all minority shareholders have the opportunity to take independent legal advice is also prudent practice in avoiding these pitfalls.

To learn more about Sonio and his work, please visit:
http://www.dbf-law.co.uk/our-people/sonio-singh/

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