Update | Company law: Compulsory transfer provisions

Shareholders' agreements and joint venture agreements almost always contain mandatory transfer provisions such that particular shareholders will have to offer their shares to (usually) the other shareholders on certain events. Those events typically include any one or more of the following: breach of the agreement, breach of other agreements, cessation of directorship or employment and bankruptcy or insolvency. The price at which the shares are offered varies '“ fair market value is common (especially for so-called 'good leavers') but sometimes a shareholder is forced to sell at a lower value. For example, at the nominal value of the shares, at a price per share derived from the net asset value of the company or at a discount to a fair value.

Other times, especially in joint venture agreements, one party has the right to put its shareholding to a party in breach at a premium to fair value. Often the discount on the called shares or the premium on the put shares is triggered by, or calibrated to discourage, perceived poor behaviour (or so-called 'bad leavers').

Increasingly we are seeing concerns as to whether these clauses are actually in the nature of penalties and therefore unenforceable. Can we discourage 'bad leavers' by discounts? How can we avoid the moral hazard inherent in treating good and bad leavers in the same way?

The starting point is that a payment in the event of a breach of contract which is a deterrent and not a genuine pre-estimate of the damage caused by the breach will not be enforceable (Dunlop Pneumatic Tyre Co Limited v New Garage and Motor Car Co Ltd [1915] AC 79).

There are no conclusive tests to assist but Lord Dunedin's judgment in the above case is some guidance:

'(a) It will be held to be a penalty if the sum stipulated for is extravagant and unconscionable in amount in comparison with the greatest loss which could conceivably be proved to have followed from the breach.

(b) It will be held to be a penalty if the breach consists only in not paying a sum of money, and the sum stipulated is a sum greater than the sum which ought to have been paid.

(c) There is a presumption (but no more) that it is a penalty when a single lump sum is made payable by way of compensation, on the occurrence of one or more or all of several events, some of which may occasion serious and others but trifling damage.'

On the other hand, Lord Dunedin gave some latitude by adding 'it is no obstacle to the sum stipulated being a genuine pre-estimate of damage, that the consequences of the breach are such as to make precise pre-estimation almost an impossibility. On the contrary, that is just the situation when it is probable that pre-estimated damage was the true bargain between the parties.'

Penalties are not confined to clauses that demand that the guilty party pays any amount to the innocent party; they also arise by clauses that provide for any benefit to be transferred by the guilty to the innocent party.

Point of compensation

Two things which are important to appreciate in this context are that the effect of a penalty is not that it is unenforceable but that it is only enforceable up to the point that it is compensatory and not enforceable beyond that point, i.e. where the consequence becomes a penalty (Jobson v Johnson [1989] WLR 1026). Further, the rule against penalties does not apply to provisions which require payment on certain events if those events are not events in the nature of a breach of contractual duty owed by the contemplated payer to the contemplated payee (Export Credit Guarantee Department v Universal Oil HL [1983] 1 WLR 399). This is absolutely pertinent to the analysis of whether or not events in shareholders' or joint venture agreements should trigger a compulsory transfer.

It is also important to appreciate that the courts have a strong disposition to uphold contractual terms especially in commercial contracts and especially in circumstances where the parties are of legal bargaining power and are legally represented. For example, in Tullett Prebon v El-Hajjali [2008] IRLR 760: 'Where a bargain has been struck by two parties of equal bargaining power, with each party legally represented, a court should consider long and hard before permitting one of the parties to resile from that agreement.'

Agreements between shareholders

Most of the relevant cases deal with consequences of failure to pay and do not deal specifically with the compulsory transfer events set out in shareholders' agreements. However, the following cases did involve agreements between shareholders and contain the following principles of law:

(a) A company's constitution can compel a member to offer his shares to certain persons at a particular price upon the occurrence of a pre-defined event (Borland's Trustee v Steel Brothers [1901] 1 Ch 279);

(b) it is open to the parties to agree ?a price at less than market value on ?the transfer of shares on the death ?of a shareholder (Jarvis Motors Harrow Limited v Carabott [1964] 3 All ER 89) and;

(c) any obligation to transfer shares at ?a penal price will be unenforceable if the triggering event is the breach of ?a contractual duty of one shareholder to another (Jobson v Johnson [1989] ?WLR 1026).

One of the leading textbooks (Cadman) suggests therefore that in those circumstances not involving insolvency or a breach of an obligation owed by one shareholder to the other, the shareholders are free to agree compulsory transfers of shares which might otherwise be regarded as penal. In other words, if the event triggering the sale of the shares is not a breach of the contract between the shareholders, it cannot be a penalty.

Enforceable discounts

Following the logic of the above, triggering events which are not, as a matter of fact, breaches of the contract which are the symptom of or the consequence of the event which is a breach of the contract may well be enforceable. The shareholders could therefore craft such events to allow an offer of the shares at a discount but with a lower risk of unenforceability.

There is also an argument, bearing in mind, as expressed in the Tullett Prebon case, that only extravagant or unconscionable penalties which are above the greatest possible loss arising from the breach should be unlawful, that a discount of, say, 25 per cent is not a penalty if the triggering event could cause a range of losses up to the lost 25 per cent in value of the shares. This looks a difficult argument to make '“ the losses arising from the breach should affect the value of the shares of the guilty party to the same extent; to impose a further discount may be extravagant or unconscionable. This suspicion is compounded by the presumption in Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd [1915] AC 79 that if one sum is payable on all of a number of varying breaches, it will be a penalty.

Commercial justification?

The other possible argument is that the courts have allowed payments which are not a genuine pre-estimate of the innocent party's loss on the grounds of commercial justification (Lordsvale Finance v Bank of Zambia [1996] QB 752). However, this case related only to a one per cent increase in an interest rate on a breach and the judge warned that 'exceptionally large increases' in interest rates could be a penalty.

The Supreme Court of Victoria (in CRA Ltd v Goldfields Investments [1989] VR 873), held that a compulsory transfer of shares by a party in breach at a five per cent ?discount to fair market value was not a penalty. The reasoning was that the essential purpose of the clause was not to penalise but was principally to further the aims of the relevant joint venture by legislating for the consequences of a breach. The point made above '“ that the fair market value of the shares should already price in the cost of the breach '“ does not appear to have ?been discussed.

Nathan Searle and Kate Wilford of Hogan Lovells International LLP on uk.practicallaw.com have argued that it is likely that the English courts would be sympathetic to an argument that exit clauses providing for the interest of a defaulting party to be transferred at a discount to an innocent party are commercially justifiable '“ but that it is a matter of degree. One can see that the five per cent discount is more likely to be justifiable than the 25 per cent discount. As the discount gets larger, the greater the chances are that the court will feel that the discount is a deterrent or a punishment rather than a sophisticated mechanism to deal with a need for the parties to part company on agreed terms.

While we do not know for sure how ?or when the law will react to cases on ?these points, we can conclude that it is perfectly permissible to trigger compulsory sales of shares on events which do not involve a breach of a contractual duty (e.g. death, bankruptcy, cessation of directorship or employment).
The risk of a challenge in this way to a compulsory transfer obligation is hugely minimised (almost to zero) if there is no discount to the actual market value or other element which is punitive or a deterrent, and the lower any discount, the lower the risk of a challenge from an aggrieved party and the lower the risk of that challenge being upheld by the courts.
Drafting so that triggering events are not breaches of the contract may assist and may render the event immune to challenge '“ but this has not been tested in the courts. And finally, where discounts to actual value are possible, it would make sense for the agreement to record the reasons for the discount and the parties acknowledge (and have been advised on) the consequences and they accept the possible outcomes and believe that the scheme and the possible outcomes are commercially justified.
Clearly, there is scope for further debate and comment on this issue.