An employer seeking to guard against the loss of key employees has a range of tools to achieve that end. A plethora of decisions address the approach to post-termination restrictive covenants. Far less attention has been given to the role of financial disincentives to leaving, such as might typically operate through bad leaver provisions in a long term incentive plan or share ownership scheme. Ordinary restraint of trade principles apply where such a provision is framed by reference to post-termination activity: see Wyatt v Kreglinger and Fernau [1933] 1 KB 793 (CA). But a provision which has the effect of penalising an employee for leaving irrespective of the post-termination destination may be far more difficult to challenge. In a rare instance of a challenge to bad leaver provisions being considered in a tribunal context, the EAT’s decision in Nosworthy v Instinctif Partners Limited UKEAT/0100/18/RN, 28 February 2019 serves to illustrate some of the issues that may arise.
Nosworthy: the facts
Ms Nosworthy (N) was employed by COL as a Business Development Associate. Upon the sale of COL to the respondent, Instinctif, it also purchased a 2% shareholding in COL and she received deferred consideration consisting of earn out shares and loan notes. These were in turn held subject to the terms of an Investment Agreement, pursuant to which she was obliged to comply with Instinctif’s Articles of Association. These provided that a leaver was required to transfer their shares, and that for a bad leaver this would be at the lower of the acquisition cost and fair value, and that loan notes would be forfeited. A bad leaver was defined as including a shareholder who ceased to be employed by COL due to voluntary resignation. She resigned on 3 May 2016, and as a result was required to sell her shares at the acquisition cost of £1 per share (totalling £143) and her loan notes were forfeited. She brought an ET claim raising various challenges to the bad leaver provision. Each of these failed both at first instance and in the EAT, and her deduction of wages claim also failed due to being brought in her capacity as vendor rather than worker (s.27 ERA).
Unconscionable bargain
The first substantive ground of challenge was the somewhat unlikely contention that the bad leaver provisions could be set aside on the basis of the equitable jurisdiction to relieve against an unconscionable bargain. The EAT identified three cumulative requirements before a contract could be set aside on this basis: (a) a party must have been disadvantaged in some relevant way, (b) the other party must have “exploited the disadvantage in some morally culpable manner” and (c) the resulting transaction must be “overreaching and oppressive”. Here N did not get past even the first of these requirements, given that there was no suggestion that she had been unable to take legal advice, and had warranted in the share purchase agreement that she had done so. But as the two further conditions make clear, it would in any event be a very rare case where this line of argument would gain much traction.
Unlawful penalty
Equally the EAT had little difficulty in dismissing the challenge based on being an unlawful penalty. As explained by the Supreme Court in Cavendish Square Holding BV v Makdessi and Beavis v Parking Eye [2015] 3 WLR 1373 (at para 32 per Lord Neuberger and Lord Sumption):
“The true test is whether the impugned provision is a secondary obligation which imposes a detriment on the contract breaker out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation.”
N argued that because the Investment Agreement imposed an obligation not to be a bad leaver, in substance the bad leaver consequences in the Articles were a penalty consequent on breach. That was rejected on the basis that the forfeiture of loan notes and repurchase of shares at minimal value were not a consequence of breach of the term in the Investment Agreement, and the definition of bad leaver did not depend on a breach of contract. Although not cited in Nosworthy, the decision was consistent with a string of recent unsuccessful attempts to rely on the penalty doctrine to challenge bad leaver provisions: See Richards v IP Solutions Group [2016] EWHC 1835, Gray v Braid Group (Holdings) Ltd [2016] CSIH 68 and Signia Wealth Ltd v Vector Trustees Ltd [2018] EWHC 1040 (Ch). As the decisions in Richards and Signia show, even before reaching the issue of whether the detriment is out of proportion to any legitimate interest, a challenge to provisions compelling the transfer of shares below fair value based on being an unlawful penalty may face difficulty in establishing this is a secondary obligation on breach, rather than a primary obligation setting the value for the shares or share options.
Contractual discretion
A different line of challenge concerned the discretion to disapply the bad leaver provisions. It was argued that under the Articles of Association the Remuneration Committee had a discretion to reclassify a bad leaver as a good leaver, and had erred in the exercise of that discretion. That was rejected on the basis that there had been no exceptional circumstances calling into question the exercise of discretion. That was unsurprising on the facts. N argued that it was unfair to treat her as a bad leaver in circumstances where someone dismissed for breach of contract, other than by way of summary dismissal for cause, was still treated as a good leaver. That merely reflected a rational distinction between voluntary and involuntary departures. Realistically N needed at least to establish some failure to take into account all and only relevant considerations. Given the obvious conflict of interest in exercising a bad leaver type discretion, that is a fertile area for challenge applying the approach in Braganza v BP Shipping Ltd [2015] 1 WLR 1661 (SC). That might have been in play if for example N had been able to muster some argument to the effect that there had been known failures of the employer which, though short of constructive dismissal, influenced her decision that she needed to leave, or a practice where others in similar circumstances were known to have been treated as good leave. But no such differentiating circumstance was advanced.
Restraint of trade
The final line of attack was that the bad leaver provisions entailed a financial disincentive to leaving employment which went far beyond anything required for any legitimate business purpose and, it was argued, was therefore void as being in unreasonable restraint of trade. The EAT refused to permit the argument to be advanced, on the basis that it had not been argued below. It was in any event, on the facts, an unpromising argument. But the extent to which such a provision could be open to challenge on a restraint of trade basis remains in something of unsettled state. Ordinary restraint of trade principles apply where bad leaver provisions are framed in terms such as to lead to forfeiture of benefits in the event of taking up employment with a competitor (Wyatt). However, typically an LTIP or similar scheme will provide for forfeiture of benefits on termination of employment which is subject to limited exclusions, such as dismissal on grounds of ill health or redundancy, but is not tied to what happens after termination of employment. Although that might be viewed as imposing a much wider post-termination restraint by deterring the employee from leaving altogether, a line of authority indicates that such payment for loyalty provisions are not to be regarded as in unlawful restraint of trade (see Tullett Prebon Plc v BGC Brokers [2010] IRLR 648). That approach was itself doubted in 20:20 London Ltd v Riley [2012] EWHC 1912 (Ch), albeit only in the context of a decision to refuse summary judgment. It is open to challenge as being inconsistent with authority to the effect that a “broad and flexible” approach is required to the application of the restraint of trade doctrine (see Panayiotou v Sony Music Entertainment (UK) Limited [1994] EMLR 229 at 316-328). Whilst it will take more striking facts than in N’s case to fully test the scope for such a challenge, with the serious consequences that may flow from the application of bad leaver provisions, it may only be a matter of time before this comes to the fore.
Concluding comments
Ultimately a financial incentive provision is always subject to the limitation that the new employer may be willing to make good the departing employee’s loss. Such a provision is therefore typically best applied as part of the employer’s armoury alongside post termination covenants. As illustrated by the failure of the various lines of attack in Nosworthy, it offers significant advantages, notably through avoiding the requirement for limits of time, space and scope applicable to a post-termination covenant (provided it is not conditional upon avoiding post-termination competitive activity). Indeed the mechanisms put in place, such as provision of a shareholding, may also of themselves provide scope for broader covenants, framed on the basis that it is possible to regard these as protecting goodwill upon the deferred sale of the shares upon termination of employment.
JEREMY LEWIS
