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Supreme Court makes it easier to claw-back bonuses

Supreme Court makes it easier to claw-back bonuses

It is a general principle of English contract law that the parties should be held to the bargains that they enter into. Of course, in the employment law context, this is modified by the various statutory employment rights that employees enjoy – such as the right not to be unfairly dismissed. However, when it comes to recovering bonuses, the law that applies is ordinary contract law.

Whilst claw-back provisions have become ever more common since the financial crisis as a result of regulation in the financial services sector and investor pressure in listed companies, there are (as yet) relatively few cases where such provisions have been successfully enforced.

One of the arguments to be deployed by individuals faced with a demand to repay a bonus will be that the claw-back obligation is void as an unlawful penalty.

The restriction on so called penalty clauses goes back to the 17th century and similar rules apply in most other legal systems. It is based upon an unease that someone who breaches a contact should be required to pay a sum much greater than the usual damages available for breach of contract.

The leading cases on penalty clauses were previously over a century old and the test has now been recast by the Supreme Court in Cavendish Square Holdings BV v El Makdessi [2015].

The Facts - Cavendish Square

Whilst the facts of Cavendish Square do not concern claw-back clauses in an employment law setting they are of interest to employers who purchase other businesses and so are worthy of consideration.

The case involved the sale of a controlling interest in a global advertising agency by its two founders to global agency WPP. As part of that agreement, Mr El Makdessi received a fixed sum of £35m payable by two instalments together with an earn-out up to £44m depending upon the profit in the following three years (the “Earn Out”). As part of the deal the two founders retained 40% of their shares in the agency and Mr El Makdessi agreed to stay on as a non-executive Chairman. Mr El Makdessi also entered into a number of restrictive covenants by which he agreed not to compete with the agency for at least two years after he ceased to be a shareholder.

The share purchase agreement contained two clauses intended to police the deal.  The following applied if the founders breached their non compete obligations:

  • Firstly, they would no longer be entitled to the Earn Out payments.
  • Secondly, they would have to sell their remaining 40% of the agency to WPP for a greatly reduced price, equivalent to its net asset value upon the date of default.

Mr El Makdessi competed with the agency. In response, WPP sought exercise their right to withhold the Earn Out and purchase Mr El Makdessi’s remaining shares. Mr El Makdessi argued that the non-compete was void as a restraint of trade and that the provisions were unlawful penalties.

Cavendish Square – The decision

The High Court rejected his arguments regarding restraint of trade. The tests for judging the legality of non-competes entered into in the context of a commercial business sale are very different to those which apply to employees. Here, WPP were paying a very considerable sum for the business, Mr El Makdessi had very close relationships with the clients of the agency and the provision was negotiated with Mr El Makdessi on a level playing field. This decision was not appealed.

The High Court also rejected Mr El Makdessi’s arguments that the provisions were penalties. Mr El Makdessi successfully appealed to the Court of Appeal but WPP appealed to the Supreme Court. The Supreme Court decided in favour of WPP. They held:

  • The earlier caselaw, which focused on whether or not penalty clause was a “genuine pre-estimate of loss” remains relevant to simple liquidated damages clauses (such as golden handshake clauses); but
  • In cases such as this, the question is whether: (a) the innocent party has a legitimate interest in the clause; and (b) the clause is unconscionable or extravagant in the circumstances.

The new test is significant to cases such as this where the employer (here WPP) would have great difficulty proving very substantial loss.

How does this apply to bonus claw-back provisions?

Firstly, it is important to distinguish “claw-back” clauses from the concept of “malus”. Malus is the ability of an employer to adjust a bonus or other award before it is paid (or vested). Claw-back is often more controversial because it gives an employer a right to recover the bonus after it has been paid.

Typically claw-back provisions are not drafted on the basis that they apply on a breach of contract (i.e. as the provisions in Cavendish above) but rather in specified circumstances (i.e. if the profits upon which the bonus are based are restated). This is a very fine but important legal distinction. It is also one that, with clever drafting, can be circumvented. For example, in Cavendish, the share purchase agreement was drafted so that Earn Out was not payable if Mr. El Makdessi breached the contact. But it could have been drafted in the reverse – i.e. so that is was a condition of receiving the Earn Out that he had complied with his non-compete. The non-lawyers among you will think that distinction silly (and we agree) but that is what the law is. Whilst the Supreme Court did not decide the point they appear to have left open the ability of individuals to argue the claw-back provisions (however drafted) are disguised penalties.

Previously claw-back provisions were vulnerable to challenge on the basis that they were out of proportion to any loss suffered by the employer and so were void as penalties.

As a result of Cavendish employers do not now need to justify these provisions on the basis of loss. Rather they can argue that they have a wider legitimate interest in enforcing them which is often likely to be the case and especially if they are imposed as a result of a regulatory or investor requirement. Cases will then turn on whether the obligation to repay is extravagant or excessive which is likely to include consideration of factor including:

  • seniority of individuals
  • extent to which clause is negotiated
  • whether clause imposed by regulatory requirement or in line with institutional voting guidance
  • circumstances in which repayable
  • amount repayable

Therefore, whilst claw-back clauses may still subject to review by the courts, following Cavendish they are much more likely to be enforced.

There will undoubtedly be further litigation around claw-backs over the coming years.