A key element of any management participation by private equity investors is to secure the re-transfer of shares in the event that the manager terminates his services for the company.
A decision of the District Court (Landgericht) of Stuttgart published in 2019 had confirmed the validity of share transfer obligations in a constellation that corresponded to a management participation typical of private equity, thus - temporarily – made a contribution towards legal certainty. In contrast, in a recently published decision (7 U 1844/19), the Regional Court (Oberlandesgericht) of Munich questions the enforceability of standard share transfer obligations in leaver cases.
The Regional Court of Munich makes reference to the case law of the Federal Court of Justice (Bundesgerichtshof) on the removal of a shareholder by termination. This essentially states that provisions which enable one shareholder to force another shareholder out of the company without an objective reason are unethical and therefore void: they effectively force the concerned shareholder to subordinate himself to the majority shareholder.
In a landmark decision of 2005 the Federal Court had laid down an exception to this in case of the so-called "manager model". However, the manager model reviewed by the Federal Court did not concern private equity and, correspondingly, had little in common with the conditions usually agreed by private equity investors in management participation programs. In its current decision, the Regional Court of Munich measures the management participation of a private equity house against the criteria laid down by the Federal Court and comes to the conclusion that the leaver clauses usually agreed by private equity funds are invalid. Thus, private equity investors can no longer be confident that the typical leaver clauses secure access to a manager’s shares when the manager leaves the company.
One aspect for the result in this case was the – particularly high - participation of the manager with 25%. However, the Munich Court was also substantially guided by the fact that the manager had taken entrepreneurial risk by acquiring his shares at market value and at the conditions also applying to the private equity investor. The incentive by way of a capital gain instead of - as in the "manager model" – regular distributions, makes the manager an investor. Therefore, the Court concludes, that the manager’s shareholding cannot be withdrawn upon termination of his position in the company as there is no connection between the shareholding and the manager’s employment agreement.
In other words: what is desirable as an incentive in management participation models of private equity investors, namely the entrepreneurial participation of the manager and thus the alignment of the private equity investor’s and the manager’s interest, is – according to the Regional Court of Munich – extremely detrimental to the participation model as such. Following the decision, it is no longer assured that private equity funds can enforce their contractual rights under leaver clauses and recover the shares of a manager who quits his position in the company.
For future practice it is advisable to clearly define the motives for granting equity participations to managers in the shareholders’ agreement. It appears more necessary than ever to clearly refer to the incentive concept in the leaver clauses. However, only a decision by the Federal Court will provide legal certainty on the enforceability of leaver provisions.