Private Equity: Encouraging decision of Stuttgart Regional Court on leaver provisions

German court decisions on issues relevant to private equity (“PE”) transactions are traditionally rare. A recently published decision of the Stuttgart Regional Court on leaver-clauses used in management participation agreements is noteworthy.

When offering shares to their portfolio companies’ managers, it is usually agreed that the PE investor can demand that managers surrender their shares if they leave their position in the company's management. The courts generally consider such unilateral rights to deprive shares as unethical and thus void, as the right to the discretionary termination of another shareholder’s position forces the concerned shareholder to cooperation and thus restricts the shareholder in the exercise of his/her shareholder rights. The courts’ assessment applies to provisions in a company’s articles of association which place the withdrawal of one shareholder’s shareholding at the discretion of another shareholder as well as to bilateral agreements between shareholders having a corresponding effect, such as the market-standard leaver clauses in shareholder agreements between PE investors and managers.

In 2005, the Federal Court of Justice (Bundesgerichtshof) took the first lance for the recognition of leaver clauses agreed with managers: The contractual right of a majority shareholder to take-over another shareholder’s shares was considered valid if such right is objectively justified due to special circumstances, in particular if the shareholding was offered to the other shareholder only because of his/her management position in the company and this position terminates.

Nevertheless, a residual risk of invalidity remained for leaver clauses used by PE investors even after the decision of the Federal Court in 2005 since the underlying case, which concerned a management participation scheme of Media Markt Group, deviated in essential aspects from the PE-typical management participation.

In the “Media Markt” case, the purpose of granting shares to location managers was to incentivize them by profit distributions and the appreciation of their position associated with the shareholder status. Comparable to PE management participation agreements, the managers had to give up their shareholding when ceasing working for the company. However, they acquired their shares for a consideration corresponding to the shares’ nominal value and received an equal consideration when returning the shares. Thus, the managers did not take any entrepreneurial risk. In contrast to PE management participation models, the managers' incentive was not the achievement of a capital gain. Due to these essential differences to investments offered by PE houses to their portfolio companies’ managers, it could not be conclusively ascertained whether the principles advocated by the Federal Court of Justice in 2005 applied to the market-standard leaver clauses used in PE investments.

The recently published judgment of the Stuttgart Regional Court of 10 October 2018 (Ref. 40 O 26/18 KfH) contributes significantly to certainty for the validity of leaver clauses: The Court confirmed the validity of a majority shareholder’s right to take back a manager’s shares on the basis of a call option which was exercisable upon the termination of the manager’s operative functions in the company. The court went even further and found that leaver clauses are not per se invalid if the majority shareholder was able to trigger the conditions for the call option by his power to dismiss the manager.

In the case decided by the Stuttgart Regional Court the manager had acquired his shareholding at market value and received a consideration corresponding to the shares’ market value at the exercise of the call option. Thus, the manager assumed the full risk of the loss in value of his shares and accordingly held an entrepreneurial interest in the company. The motivation for the manager's participation also corresponded to that of a PE management participation model: The purpose of granting shares to the manager was to bind him to the company and to involve him in decision-making processes at shareholder level, thus – as expressly laid out in the shareholders agreement – achieving the “greatest possible harmony of interests” between the company’s management and the shareholders.

In the recently decided case the majority shareholder was not a financial investor; the decision concerned a family-owned company, which for incentivizing the external managing director adopted an instrument typically used by private equity investors. Although being an interesting aspect of the case, this difference has no impact on assessing the validity of leaver clauses used by PE investors. The decision of the Stuttgart Regional Court is final and – even if it is not a decision of a higher court – in the medium term it is very likely that it will be a reference decision for leaver clauses and underpin their validity.

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