In this article, our Private Equity team discusses the importance of leaver valuation and the enforceability of restrictive covenants in shareholders' agreements.

Leaver Valuation

The High Court has recently ruled that a company breached provisions of its articles of association in relation to the compulsory transfer of a leaver's shares. The company failed to instruct an Independent Expert to value the shares as they wrongly treated the former consultant as a Bad Leaver when she was a Good Leaver. As a result of this failure it was claimed that opportunities to sell the shares were lost.

The leaver was a consultant to the company with a fixed term consultancy agreement. This agreement came to an end after nearly 3 years. One of the categories of Bad Leaver in the company's articles was "a consultant of any Group Company who terminates his consultancy on or before the third anniversary of the commencement date of his consultancy agreement", and the company claimed she fell under this category. The court disagreed and said that the "wording naturally refers to some action taken by the consultant to bring the agreement to an end before its natural expiry" and would not cover cases where the consultancy agreement came to an end on its terms. There would have been no logic in granting share options to a consultant whose engagement from the outset was for less than three years.

The company therefore acted in breach of its articles by failing to initiate the correct transfer procedures.

However, it was held that the articles do not guarantee or promise that the shares will be sold and do not impose any duty on the company to find a buyer. On this basis the court found that the former consultant had not suffered any loss as a result of the failure to instigate the transfer process as she still held the shares, and they had actually increased in value (notwithstanding that as shares in a private company they were not readily marketable).

(Ajayi v Ebury Partners Ltd EWHC 166 (Comm))

Restrictive Covenants

The Court of Appeal has recently considered an important case on the enforceability of restrictive covenants in shareholders' agreements.

The defendant was a consultant to the claimant company, and was also a shareholder and a party to the shareholders' agreement.

The shareholders' agreement included various restrictive covenants applying to "Employee Shareholders", defined as "any Shareholder who is also an employee, agent or director of the company…". The relevant restrictive covenants applied whilst the relevant party was a shareholder and for 12 months after they ceased to be a shareholder.

Once the consultant become a leaver, he was deemed to have served a transfer notice in respect of his shares. Despite this deemed obligation, he was still a shareholder at the time of the judgement.

Following the consultant's departure the company brought a claim to the High Court alleging he had breached these restrictive covenants. At trial the leaver claimed that as soon as he ceased being a consultant he ceased to be an Employee Shareholder so the provisions stopped applying to him. He also argued that in any event the restrictions were too wide, and therefore unreasonable, as it would have been possible for him to remain a shareholder, and therefore subject to the restrictions, indefinitely. The High Court agreed with him on both points.

The Court of Appeal dismissed both these arguments.

In interpreting the covenants the court found that it was clear they were there to protect the company for the 12 months after the relevant leaver's departure, and there was no commercial sense in having restrictive covenants that could be avoided by simply terminating one's employment.

In considering whether the covenants were enforceable the judge noted that all restrictions in restraint of trade are unenforceable unless they are reasonable, and also that where such covenants are contained in shareholders' agreements, rather than in an employment contract, the court is "less vigilant" in its scrutiny.

In this case the court found that the restrictions were clearly enforceable. Firstly, it was clear the company had a legitimate interest in seeking the protection; secondly, the shareholders' agreement was made between experienced commercial parties and thirdly, the 12 month period was entirely reasonable to protect the interest, even if it runs from the cessation of the shareholding rather than the termination of employment. In most cases there was likely to be a limited lapse of time between the end of employment and the sale of the shares.

The judge acknowledged the failure in the transfer of the shares in this case, and said he accepted that delay in the transfer process was possible but that the restrictions should not be found unreasonable on the basis of a relatively unlikely possibility that the shareholder will be locked in indefinitely.

(Guest Services Worldwide Limited v. David Shelmerdine [2020] EWCA Civ 85)