The Australian High Court recently handed down its decision in Andrews v ANZ – which significantly changed the “penalty doctrine” in Australia. Importantly, the changes have potentially significant and disruptive implications for financial investors’ management incentive arrangements as they have traditionally been structured in Australia.
How has the law changed?
The Andrews decision considerably broadens the circumstances in which a court may find that a contractual provision (say in a shareholders agreement) is unenforceable – either as a “penalty” or “forfeiture”.
Prior to Andrews, the law essentially required that the amount of any payment or forfeiture of property upon a breach of a contract needed to be a genuine pre-estimate of the damage likely to be caused by the breach. If the contract stipulated a payment (or forfeiture of property with a value) clearly in excess of any such estimate, then the payment or amount was treated as void or unenforceable. By way of illustration:
- in an agreement to build a house for $1 million within a year, a clause providing that the builder would have to pay $10 million if the builder failed to complete building within the year would almost certainly be an invalid penalty.
- if a person entered into a purchase agreement to buy a property worth $1 million with a final purchase price instalment post-settlement of $100,000, and on default of paying that final instalment the purchaser was obliged to transfer the property back to the seller for $1, the requirement to transfer the property back for $1 would almost certainly be an invalid forfeiture.
Before Andrews, one of the essential requirements to enlivening the penalty doctrine was that the penalty had to arise out of an actual breach or contravention of the specified terms of the contract. The result of this requirement was that a payment/ forfeiture clause would be valid (that is, it could not be an invalid penalty) if the damages were payable on the occurrence of an event that the payor was not actually contractually obliged to do or avoid – no matter how extravagant the sum provided. The critical distinction was that the event itself was not a “breach” of a contract by any party – it was simply an occurrence that the parties had agreed to treat in a certain way.
A common example in the private equity context of a non-breach payment/forfeiture event is in a shareholders agreement or management equity plan which provides that if a manager with equity securities in a portfolio company ceases to be employed by that portfolio company or its subsidiaries, then the manager can be required to sell or return their securities for an agreed price. In this case, the event that triggers the payment is the cessation of employment, however the cessation is not a breach of the shareholders agreement or management equity plan.
The Andrews decision has now fundamentally altered the penalty doctrine by removing the ‘breach’ requirement. Essentially, the High Court decided that the requirement for breach is no longer appropriate and any pre-agreed payment/forfeiture of property arising from a contractual event (regardless of whether it amounted to a breach) has to be a genuine pre-estimate of the damage likely to be caused by the event. If it is not a genuine pre-estimate, then the pre-agreed payment or forfeiture provision will not be enforced according to its terms and any compensation will simply be determined by general principles of contract damages.
Why is this an issue for private equity sponsors doing deals in Australia?
For many years now, private equity sponsors have incentivised their Australian management teams using fairly customary models. Inherent in these models are a few common themes:
- all of a manager’s equity is usually allocated at the outset of the investment (as opposed to being issued progressively), albeit a manager may have vesting conditions on their equity securities;
- the relative value of the managers’ equity and the returns to management are enhanced by the leverage effects of the capital structure, in the expectation that management will earn that enhancement through their management time and effort; and
- when a manager leaves he or she will generally be contractually required to sell the equity securities he or she holds for a pre-determined price. This price is typically a function of whether the manager is a “good leaver” or a “bad leaver” (or variants on those themes) – a good leaver will generally receive market value whereas a bad leaver will generally receive the lower of market value and original acquisition price (thereby ensuring the manager gets no value uplift).
Until Andrews, comfort around the enforceability of typical leaver buy-back arrangements came from the fact that either the manager was being fairly compensated for the value of their equity (ie. by receiving market value as a good leaver) or, in the case of a bad leaver, the payment arose out of an event that was not a contractual breach and therefore the penalty/forfeiture regime did not apply.
Andrews has now challenged that position – at least as it applies to a bad leaver situation. Where a manager is not being compensated for the true value of their equity securities at the time of their exit from the group, the question is now whether the relevant leaver provisions are a penalty/ forfeiture and can be challenged by a disgruntled manager. In our view, this risk is real and potentially significant.
What are the options for managing the risk?
The effect of Andrews is not just prospective – it can apply to existing contracts.
If you are dealing with an existing equity incentive arrangement, it is unlikely there will be any management appetite (let alone any unilateral right of the portfolio company) to renegotiate its terms.
One argument that can however, still be advanced in defence of an existing leaver provision is that the loss in question (ie. the loss to the portfolio company and its businesses from the relevant manager ceasing to be employed in the business) is not capable of being quantified. The High Court in Andrews continued to accept the principle that the penalty doctrine is generally inapplicable if the loss to the first party caused by the second party’s breach (or failure to perform) cannot be quantified. In short, if the loss cannot be quantified, the penalty doctrine does not apply.
While that argument has legal merit, it cannot be assured of success. It is well established that a mere difficulty of precise pre-estimation is not necessarily sufficient to render the penalty doctrine inapplicable. In addition, a recent Federal Court decision (Zomojo v Hurd) rather unhelpfully dismissed this sort of analysis as it applied to a departing employee under an executive share option plan.
Looking prospectively, private equity sponsors need to consider whether they remain comfortable adopting the traditional form of management equity incentive model (including leaver buy-back provisions) or whether they prefer to proactively respond to the Andrews decision and consider an alternative model that achieves the same commercial outcome, but does not carry (or reduces) the penalty/forfeiture risk.
Structuring an alternative model
Where a payment is made, such as management equity, in exchange for an additional right, benefit or service, the payment or other benefit will generally not be susceptible to the penalty regime – irrespective of any imbalance between the quantum of the payment and the value of the additional right, benefit or service on the other. This principle opens up alternative structuring possibilities, but it requires an evolution of the traditional leaver model.
A ‘staging’ of the value inherent in equity securities allocated to management could be one such possibility. Rather than having management equity that carries, from day one, an excess value relative to management’s contribution and the private equity investors’ investment outcome as at that time, the terms of management’s equity securities could provide for a potential uplift of value on the occurrence of certain events. In this way, the value attributed to management’s equity securities would better match the actual value of those equity securities from time to time, including at any time at which a manager chose to leave or realise value.
Under such a model, a manager would not be issued equity securities with an inflated value which he or she was liable to lose if certain events occur. Rather he or she would be issued equity securities with a lesser value which could significantly increase if the manager stays with the group through to the time of exit or when he or she becomes a “good leaver”. In the language of the penalty/forfeiture doctrine, there is no payment or forfeiture of value on failure to satisfy certain criteria. Instead, there is the grant of an additional benefit on the provision of additional services by the relevant manager.
Using a form of convertible equity security in the following way may be one value-staging possibility:
- initially, grant the manager convertible “management shares”;
- the economic rights attaching to these management shares would be the right to receive only their issue price on a winding up or other distribution. On a winding up or other distribution, ordinary shareholders (including the private equity sponsors) have the right to receive the balance of any value in the underlying group as a return on their ordinary shares;
- in a good leaver situation or on an exit, the management shares would automatically convert into ordinary shares (ranking equally with the sponsors’ ordinary shares);
- in a bad leaver situation, the management shares would convert into ordinary shares if the market value of ordinary shares was below the issue price of management shares at the time of the manager’s exit; and
- the sale or buy-back of a leaver’s shares would only be permitted once the ability to convert the leaver’s management shares had lapsed (which would occur in a bad leaver scenario if it was determined that the then market value of ordinary shares was greater than the issue price of the management shares) or the management shares had been converted into ordinary shares. Whatever equity securities were sold or bought back (which could be management shares or ordinary shares) would be sold or bought-back at their market value.
In this way the manager and the company should be able to manage the inherent value of management’s equity securities and ensure that an appropriate value has been allocated to them from time to time. In a good leaver situation or on an exit, management shares would always convert into fully participating ordinary shares, thereby ensuring that the relevant management share holder always receives market value. In a bad leaver situation, the management shares would convert or cease to be convertible depending on the market value of ordinary shares relative to the issue price of the management shares, thereby ensuring the bad leaver does not get the benefit of any equity value uplift.
What are the tax implications of the alternative model?
Under an alternative value-staging structure, it should generally be possible for management to achieve tax outcomes that are similar to those under a traditional leaver arrangement, provided the rights attaching to the management shares are structured properly.
For those managers who hold their shares on capital account, it should still be possible to obtain the benefit of the 50% CGT discount. Provided conversion of the management shares to ordinary shares is achieved by a variation of management share rights (rather than the issue of new ordinary shares), which would be the case in the example structure above, the conversion should not ‘reset’ the 12 month CGT discount holding period. That is, management shareholders should generally be treated as having held the relevant ordinary shares from the time they acquired their original management shares. In addition, the conversion of management shares to ordinary shares in this way generally should not, of itself, give rise to a taxing event.
It may also be important in certain circumstances to show that management paid market value for their management shares and/or were dealing at arm’s length with the issuer. In the context of bad leaver provisions, the ATO has previously expressed the view that participating employees should be regarded as dealing at arm’s length where the bad leaver provisions apply in the same way to all participating employees. While each case needs to be considered according to its circumstances, this provides useful guidance in applying the alternative model.
Finally, we do not expect tax deferral to be available under our alternative model (because the management shares are unlikely to be treated as ordinary shares - a pre-condition for tax deferral). However, this is unlikely to be a critical consideration in most cases, given that tax deferral is often not sought in connection with traditional management equity schemes.