Employment Appeal Tribunal finds penalty rule did not apply where no breach relied on

The Employment Appeal Tribunal (EAT) has held that the rule against penalties did not apply where an employer imposed certain contractual provisions (which required the employee to resell shares at acquisition cost and to forfeit loan notes) following an employee's resignation, without alleging any breach of contract on the part of the employee: Nosworthy v Instinctif Partners Ltd [2019] UKEAT 0100_18_2802.

Under the test established by the Supreme Court in Cavendish Square Holding BV v Talal El Makdessi [2015] UKSC 67 (considered here) a clause that takes effect on breach will be unenforceable as a penalty if it is out of all proportion to the innocent party's legitimate interest in enforcing the counterparty's obligations under the contract.

In the present case the clause could potentially take effect in two situations: (i) where the employee voluntarily resigned; and (ii) where the employee was (or could have been) dismissed for cause, ie for the employee's breach. On the facts, the employee resigned and the employer relied on the clause. The EAT held that the rule against penalties did not apply as the employer did not allege a breach.

The EAT did not consider whether the rule against penalties would have applied in this case if the clause had taken effect in circumstances where the employee was dismissed for cause. It was sufficient that, on the facts, the employer was not alleging a breach. The decision is therefore of interest in suggesting that a clause will not be susceptible to the rule on penalties where it takes effect on a non-breach event - even if the same clause could potentially have been caught by the rule where it took effect on breach.

Background

The claimant was given 2% of the shares in her employer as a condition of its sale to the respondent company, and sold the shares to them under a Share Purchase Agreement (SPA). The consideration for the shares included deferred earn-out shares and loan notes.

Under articles 15.6 and 15.7 of the respondent's articles of association, where an employee left the company as a "Bad Leaver", the employee forfeited their loan notes and their shares were re-acquired by the company at the lower of their acquisition cost and their fair value.

Under a separate agreement, at clause 7.23, the claimant covenanted not to become a Bad Leaver. If that provision was breached, the company was entitled to claim from the claimant an amount equal to the aggregate amount payable to her in respect of her loan notes, such claim to be satisfied by a set off.

A "Bad Leaver" was defined for these purposes to include an employee who voluntarily resigned, as well as an employee whose employment was (or could have been) terminated summarily for cause.

The claimant resigned from her employment and was treated as a Bad Leaver. She was required to transfer her shares and was notified that she would receive the acquisition cost of £1 per share (a total of £143), and that she would forfeit her loan notes.

The claimant brought an employment tribunal claim, arguing (inter alia) that the Bad Leaver provisions amount to an unenforceable penalty. The tribunal rejected that argument on the basis that a penalty is a sum to be paid on breach of contract and the claimant was not in breach of contract in resigning from her employment. Although clause 7.23 contained a covenant not to become a Bad Leaver, the respondent did not seek to rely on that covenant and so the question of penalty did not arise. The claimant appealed that finding (and others) to the EAT.

Decision

Mrs Justice Slade gave the judgment of the EAT dismissing the appeal including on the penalty issue.

In Makdessi, the Supreme Court held that the:

"… true test [of a penalty] was whether the impugned provision is a secondary obligation which imposes a detriment on the contract-breaker out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation."

The EAT agreed with the employment tribunal that the respondent was not relying on clause 7.23. It was not asserting any breach of contract on the part of the claimant. The respondent was simply applying the provisions of articles 15.6 and 15.7 as a consequence of the claimant having resigned. Accordingly, there was no question of a penalty.