Signia v Vector – Bad Leaver Clause not a Penalty
The High Court in Signia Wealth Ltd (“Signia”) v Vector Trustees Ltd et al  EWHC 1040 (Ch) considered whether the “bad leaver” provision in Signia’s articles of association (“Articles”) was to be construed as a penalty clause and was therefore unenforceable.
Compulsory transfer provisions
It is common practice for articles of a company to provide that upon an individual ceasing to be an employee and/or director that individual is required to offer their shares to the other shareholders or to the company at a price fixed in accordance with the circumstances of their departure. If they are deemed to be a “good leaver” then they will receive a higher price for their shares (often market value) but if they are deemed to be a “bad leaver” then they will receive a lower price (sometimes as little as nominal value).
The dispute arose out of an investigation into alleged unlawful expenses of Signia’s managing director, Nathalie Dauriac, during which time Ms Dauriac’s employment terminated.
One of the questions for determination by the Court was whether, following termination of her employment, Ms Dauriac was a “good leaver” or a “bad leaver” under the Articles. If Ms Dauriac was a “good leaver” her shares would be transferred at market price. However, if Ms Dauriac was a “bad leaver” her shares would be transferred for a lower consideration. There was a significant difference between the two values.
Ms Dauriac argued that if she was found to be a “bad leaver” then the differentiation between the two valuations was such that the “bad leaver” provision constituted a penalty and was accordingly unenforceable.
The Court found that Ms Dauriac was in breach of her contract of employment and that the value of her shareholding accordingly fell to be determined on a “bad leaver” basis. The Court went on to consider Ms Dauriac’s argument that the “bad leaver” provisions constituted a penalty.
The penalty doctrine
The penalty doctrine provides that any clause in a contract is unenforceable if it imposes on a party breaching a contract a remedy which is extravagant, exorbitant or unconscionable such that it is out of all proportion to the legitimate interests of the innocent party.
The doctrine only applies to secondary obligations ie. obligations which are trigged by a breach of contract. The doctrine does not apply to primary obligations which are not triggered by a breach.
The Court’s decision
The Court found that, in the instant case, the “bad leaver” provision under the Articles was not a penalty clause for, amongst others, the following reasons:
- the penalty doctrine is an interference with freedom of contract and the court should be careful in applying the doctrine in a commercial case where the contract has been negotiated without suggestion of oppression;
- whilst one of the considerations of the compulsory transfer provisions in the Articles was whether the leaver was in breach of their contract of employment, none of the events that triggered the compulsory transfer process had anything to do with the shareholder’s breach of contract; and
- the compulsory transfer provisions made good sense in the context of a start-up company in that they ensured that the shares would remain with the other shareholders and the current employees of Signia until the anticipated sale of Signia and acted as an incentive for employees to stay.
In view of the above, Ms Dauriac’s shares were valued in accordance with the “bad leaver” provisions and she was awarded just under £500,000 for her shares – significantly less than the market value.
The Signia decision is helpful in clarifying the scope of the penalty doctrine and its application to articles/commercial contracts. The decision also highlights the importance of well drafted articles.