Introduction

In leveraged buyout transactions, institutional investors that retain the management team in order to continue to run the business often set up put and call options over the managers' shares, which are generally exercisable over any managers exiting the target. These put and call options often include good and bad leaver mechanisms, where the circumstances of the manager's departure dictate the valuation of his or her shares. The share purchase price paid to a person deemed as a 'bad leaver' tends to be discounted or less favourable than when offered to a 'good leaver'.

Bad leaver provisions may, in some cases, raise issues in contradiction with employment law, where the bad leaver is an employee.

On June 7 2016 the Supreme Court affirmed the validity of bad leaver provisions, including price discounting mechanisms in the context of an employee's departure, considering that the protective rules under employment law did not apply.

Facts

The employee, who was also a shareholder of her employer, had entered into a shareholders' agreement under which she granted a call option over all her shares exercisable on termination of her employment. A bad leaver provision was provided which sets out that, in the event of dismissal for reasons other than serious misconduct or gross negligence, the share purchase price was to be determined with a discount of .50% of the actual share value.

When she was dismissed, the former employee brought a claim of wrongful dismissal to the Employment Tribunal which ruled in her favour. The call option was exercised at the discounted purchase price and the former employee claimed payment of the total non-discounted share purchase price. She argued (in substance) before the Commercial Court that there was a lack of consideration, as the disputed price mechanism under the bad leaver provision was founded on an illicit cause (ie, an unlawful dismissal) and that the discounted purchase price applied as a monetary penalty prohibited by Article L1331-2 of the Labour Code.

The Commercial Court and the Versailles Court of Appeal both rejected this claim.

Decision

The Supreme Court ruled that the appeal court had rightfully, and in accordance with its sovereign power of interpretation, inferred that the former employee's obligation under the bad leaver provision was lawful and not founded on an illicit cause. The Supreme Court considered that the bad leaver provision was part of the general balance of the contract and that this provision also contributed to the reward system used to incentivise the former employee to remain involved in the management and growth of the business.

The Supreme Court further held that the price discounting mechanism under the bad leaver provision was not applied as a monetary penalty prohibited by the Labour Code, as the disputed price mechanism did not seek to punish a specific misconduct of the employee, but was intended to apply in the event of different types of dismissal.

Comment

The Supreme Court's decision confirms previous case law regarding the validity of bad leaver provisions applying to exiting managing directors. Notably, such provisions had previously never been submitted to the Supreme Court in relation to employees.

The Supreme Court partially clarified the requirements for valid bad leaver mechanisms by emphasising the general balance of contracts and the contractual freedom that govern put and call options. Thus, when freely and consciously granted by an employee in the context of an investment to a company which is not the employer, such mechanism could, according to the court, be in line with the general balance of the contract and thus valid despite existing protective rules under employment law. However, the risk to have a leaver mechanism invalidated remains under circumstances other than those in relation to a bad leaver.

Even if rendered before the reform of contract law came into effect on October 1 2016, the outcome of this decision should not be challenged by the new legal regime and thus should help to improve legal certainty and the enforceability of put and call options. Undoubtedly, this decision is of practical and technical value.

For further information please contact Alain Levy, Gwenaëlle de Kerviler or Linda Erlandsson at AyacheSalama by telephone (+33 1 58 05 38 05) or email (a.levy@ayachesalama.com, g.dekerviler@ayachesalama.com or l.erlandsson@ayachesalama.com). The AyacheSalama website can be accessed at www.ayachesalama.com.

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