In the recent case of Keystone (“Keystone”) and another vs Parr and other (September 2018), the Court found that a director was in breach of his fiduciary duty when he sold his shares to the other shareholders, and then left to set up a competitor company. Furthermore, his actions triggered the bad leaver provisions in the company’s shareholders’ agreement, which meant that the remaining shareholders could claw back and reduce the price they would otherwise had paid for the shares.
Keystone was a healthcare recruitment agency founded by Mr and Mrs Ward (the “claimants”), who then were joined by another shareholder, Mr Parr (the “defendant”). In 2011, the three entered into a shareholders’ agreement containing a “bad leaver” provision, i.e. a clause setting out a compulsory share transfer. Such a clause usually requires a shareholder who is also a director or employee to offer to transfer their shares in circumstances typically relating to gross misconduct or other behaviour justifying summary dismissal. In these circumstances, the transferring shareholder typically receives a discounted price for their shares.
In Keystone’s case, this clause, read in conjunction with the company’s articles of association, provided that in case of a “material breach” of the shareholders’ agreement, either the company or its shareholder were entitled to buy the bad leaver’s shares at a price discounted by 50%.
Keystone enjoyed financial success however, by 2011 it was in financial hardship, and the relationship between the shareholders deteriorated. Mr and Mrs Ward incorporated a new entity, Keystone Holdings, and paid £1.2 million to Mr Parr to acquire his shares. However, in the run up to the sales of his shares, Mr Parr had established a direct competitor company, persuaded one of Keystone’s IT consultants to transfer funds to an account controlled by him, misused confidential information belonging to Keystone, and diverted custom away from Keystone to his new company.
When Mr and Mrs Ward found out about these revelations, they brought proceedings against Mr Parr to claw back part of the price they had paid to him for his shares.
Mr and Mrs Ward’s argument was that what Mr Parr had done and concealed from Keystone, amounted to a breach of his fiduciary duty of acting in the best interest of the company. They also argued that he had a duty to the other shareholders to act to ensure Keystone’s success, to keep accurate accounting records, and to act in good faith towards Keystone and its other shareholders, and failure to do sowould have allowed Keystone to dismiss Mr Parr summarily from his employment. This, in turn, amounted to him being a “bad leaver”, and would have triggered the provisions in the shareholders’ agreement. Mr and Mrs Ward would have been able to claim Mr Parr’s shares at the discounted price of £515,000, and not the £1.2m they had actually paid.
The Court found that Mr Parr was a “bad leaver” on the basis that Mr Parr’s argument that the shareholders’ obligations were owed to Mr and Mrs Ward and not to the company had to be rejected, and that the fiduciary duties were owed to Keystone, and not to Keystone Holdings, the company that allegedly overpaid the shares. Although the latter argument was technically correct, the Court took a more practical approach and refused to accept that there wasn’t a link between Mr Parr’s breach of duties and the price paid to him and decided that there had been a breach of duties, which was enough to impose liability.
In its reasoning, the Court construed an alternative pattern of events in which if Mr Parr had disclosed his actions, he would have been dismissed by Keystone, and would have had his shares bought out. Consequently, the other two shareholders would have decided to acquire his shares with the 50% discount. Although this course of events was just an assumption, it was nonetheless directed by Mr Parr’s wrongdoings. Had in not hidden his action, the Court concluded that this would have been the course events would have taken. In light of this, Mr and Mrs Ward were entitled to claw back the price paid for the shares.
The Court also found that Mr Parr had breached three obligations in the shareholders’ agreement which were: to promote Keystone’s success; to keep accurate accounting records; and to act in good faith towards Keystone and its other shareholders. The Court therefore ordered Mr Parr to pay back to the other two shareholders’ half of the money he had received for his shares.
This case is one of the few regarding bad leaver clauses and its interaction with director’s duties when a director leaves a company. In particular, it reiterates some important points, i.e.:
- A director taking steps in setting up a rival business is in breach of his duties, in particular to avoid conflicts of interests. Although it is not always clear how far a director has to go for this duty to be breached, in a case like this, where the director deliberately hid his action, the breach has occurred;
- The Court will not be held by arguments based on a technicality in imposing liability, as it did in this case, where the argument was that the new company wasn’t owed the fiduciary duties. It is important to think carefully before raising defence arguments based on technicalities;
- Generally, Court will hold bad leaver provisions. However, it is important to ensure that a compulsory transfer is clearly set out as a consequence of a breach of a primary obligation, and not as a contractual penalty.
For more information on or any guidance or advice on directors’ duties and drafting commercial contracts, Cleveland & Co external in-house counsel, your specialist outsourced legal team are here to help.