With a potential recession looming, individuals will naturally be looking to safeguard what they have worked hard to earn, and will earn in the future, even if they are looking to exit their employer or firm. Similarly, where a senior individual is on the way out, either voluntarily or involuntarily, businesses are likely to want to ensure that they are not paying out any more than necessary and will seek to reserve any surplus for the talent they wish to retain.
In sectors where an equity interest comes to fruition at a point in the future subject to certain conditions, and such interest is potentially extremely valuable, the stakes are high for both parties and never more so than in economically unstable times. In short, the value is worth fighting for and thus the likelihood of litigation increases.
Good and bad leaver provisions
Leaver provisions – which deal with the circumstances of an executive ceasing employment or partnership with the private equity firm and the associated impact on their carried interest rights – usually include definitions for “good leavers” and “bad leavers” but also increasingly “intermediate leavers,” “normal leavers,” “early leavers” and “very bad leavers” to try to cater for specific departure situations.
The point in time in the life of a fund that an executive leaves can also be relevant to leaver status. A “good leaver” usually means leaving employment or partnership on grounds of death or disability, and sometimes also includes “not for cause” terminations like redundancy, a no-fault personality conflict or where the firm exercises its discretion in the executive’s favor. A “bad leaver” is usually leaving in circumstances justifying the summary dismissal of the executive, voluntary resignation or where the executive joins a competitor within a prescribed period post-termination.
The good leaver/bad leaver status determination made by the firm will usually determine the level of vesting of the carried interest. For example, good leavers may be able to leave with 100 percent vesting of their carried interest, whereas bad leavers may lose all vested and unvested carried interest. Alternatively, leaver status can result in the price at which the executive sells their shares.
An executive may leave as a good leaver and then become a bad leaver further down the line if they join a competitor within the restricted time period.
Private equity executives will examine these terms when deciding whether to join a firm, and so firms will have to balance business protection and investor concerns on the one hand with still being an attractive proposition on the other.
Challenges to effectiveness and enforceability
Status determination and the mechanics of good and bad leaver provisions are inevitably contentious given the high stakes for all parties. Executives often seek out grounds for challenging status determination where they feel they have been unfairly treated in this regard. Sometimes leaver status is obvious based on the factual matrix at hand, but where the status determination includes a more subjective element, there can be scope for challenge.
The departing executive may question whether the bad leaver provision itself constitutes a penalty and is therefore unlawful under UK law. Where the bad leaver provision imposes a detriment that is out of all proportion to any legitimate business interest the firm could be seeking to protect, it may be held to be unenforceable. Bad leaver provisions should not simply set out to punish, and if the provision is held to be unenforceable for one executive it will be unenforceable for all.
Another aspect which is open to challenge is the decision by the firm in relation to leaver status. Even where there appears to be a clear and absolute express right for the firm to determine leaver status – in the UK, at least – there are constraints on the operation of such decisions, both statutory and equitable. Employees, LLP members and partners are subject to the discrimination legislation – if a decision is tainted by discriminatory factors it will be unlawful under the Equality Act. Employees and LLP members can claim under the whistleblowing legislation where they have suffered detrimental treatment in relation to leaver status because they have made a “protected disclosure” by blowing the whistle. This is particularly relevant in financial services, which is heavily regulated.
On the equitable side, it is generally accepted that good faith will be implied into any exercise of decision-making power. The decision reached must also not be exercised in a way that is objectively irrational, arbitrary or capricious or be so outrageous that no reasonable decision-maker could have reached it. So prudent firms should recognize the importance of recording their decision-making to reduce the risk of a successful challenge.
Bad leaver provisions usually also include reference to joining a competitor within a certain period of time. The law relating to post-termination restrictions means that such provisions may go no further than is reasonably necessary to protect legitimate business interests. Excessively long or wide restrictions may be held to be void, again affecting all carried interest holders.
Departing executives may have other leverage; maybe they are a key person under the investment documentation or a new fundraising is about to be commenced and agreeing to the timing of the departure will be important to the firm in exchange for more favorable leaver status.
Usually there is enough will and leverage on each side to come to a deal, but we are likely to see increased challenge to leaver determination generally as the market becomes more competitive and there is simply less to go around.
Catriona Watt is a partner at Fox & Partners in London