Employee Ownership Trusts and the Entrepreneur

Tax exemption and employee participation

Which entrepreneur wouldn’t want to sell his or her company at full value, tax free? And even better, without having to find the buyer and negotiate a deal? That is the tantalising prospect if you consider selling your company to an employee-ownership trust (EOT). I recently completed Excello Law’s latest such deal for CDY Ceiling and Partitions Ltd, based in Hull.

The special tax rules were introduced in 2014 to encourage employee ownership, on the John Lewis model. Previous tax reliefs helped business owners to give their company to employees, but there were not many owners willing and able to be so generous. Now the rules allow a sale to an EOT at a full price, funded from the assets and future cashflow of the company. The seller pays no capital gains tax at all on the sale.

What’s not to like? Some of the advantages of selling to an EOT are:

• The CGT exemption.
• The ability to set the price, so long as it is not more than market value, based on valuation.
• No hard-nosed negotiation with a trade buyer or institutional investor over price or warranties and indemnities, saving time and professional costs.
• Deferred payment to match the company’s free cashflow.
• The sellers can stay as directors and keep management control while they are paid out.
• The sellers can retain shares, so long as the EOT has control.
• Employees do not own shares directly and do not have to be paid out if they leave. They do not have to be given a voice in management.
• Improved engagement and incentives for the workforce.
• Income tax free bonuses can be paid to employees of EOT-owned companies of up to £3,600 per person per tax year.
• An EOT can suit even small companies with modest workforces.

There are some possible downsides, depending on circumstances:

• The need to find trustees for the EOT. If professional trustees are used, they will need to be paid and can be costly. Trustees have heavy legal responsibilities and should usually have liability insurance.
• Trustees have to act in the interests of the employees. They may want to negotiate the terms of the sale, even if it is funded entirely by the company. Trustees should have separate legal advice. There may be tensions between the sellers, the trustees, the management and the workforce. There can be conflicts of interests and each group needs to understand its legal responsibilities.
• If the trust is UK resident, the trustees will pay capital gains tax on any future sale of the company, calculated on the original sellers’ base cost. So the tax on the gain has only been deferred, not avoided. Worse, if the sellers would have qualified for business asset disposal relief (the 10% effective rate of CGT) the trustees will be paying CGT at a much higher rate. If it likely that the trustees will eventually seek an exit, an offshore trust should be used – but that may be much more expensive than UK resident trustees.
• Management succession and long-term strategy may suffer. The sellers may be primarily focussed on paying out the deferred price for their shares, and may then retire, or lose interest. External funding may be harder to obtain through borrowing or equity investment.
• If the price is set high, the trustees may struggle to justify the EOT as benefitting employees, or to deliver any actual benefit to them. At least in the early years, any money available is likely to go to fund the purchase price.
• The sellers depend on the future prosperity of the company to enable it to fund the instalments of the sale price. If it does not perform, they could lose their money or have to extend the payment schedule.
• If the sellers retain a shareholding, or management are given equity, they may not be able to realise its full value if the EOT does not want an exit, and the EOT is the only possible buyer for the minority stake.

My 40 years of legal experience acting both on corporate sales and employee share incentives makes me ideally qualified to advise on EOTs. They provide an attractive alternative to a trade sale, an MBO  or an exchange of equity for debt.

Ethics and new lawyers

How are bad apples getting into the barrel?

A solicitor, qualified in 2017, forged a decree absolute for a client's divorce, and got two clients to pay fees of around £1,600 each into her personal account instead of to her firm. 

What has happened to the intake of my profession? I am disturbed at a case like this one - a very junior solicitor abusing her position in blatant but, in terms of the gain involved, minor ways. Solicitors should have such a thorough grounding in ethics that no-one could be any doubt that doing these things was completely wrong. There may be some malicious individuals who train as lawyers in order to subvert the legal system, but surely they target clients in organised crime or look to pull off some large fraud? Why would you go through all the hard work stress and cost of qualifying only to throw it away? Are there really people passing all those exams who who have no moral commitment to their clients and are also too stupid to realise the inevitability of these petty offences being discovered, or the inevitable penalties?

Do students no longer get the moralistic grounding I got from my chain-smoking ethics lecturer, dismissing any departure from the highest standards as "very shoddy"?

 

Or is it that we are not looking after our young people well enough? Is there more to be done to protect mental health and make sure that those we trust to administer justice can cope with the pressures put on them?

Lawyers, justice and legal funding

Why litigants need lawyers

I didn't write this but I thought it was well put, explaining the impact of populist anti-lawyer attacks, the effect of cutting public funding for the public and why the courts are jammed up: 

"Back in the day, he'd have got free legal advice and that legal advice would have been by respected professionals able to explain to him that his case was not going to win. Now, litigants are told all lawyers are lying scheming toads, and that you don't need them and you can win your case just by virtue of being "right". Of course show me a litigant who doesn't think they're in the right and should win, and I'll show you a flying pig! So people with hopeless cases pursue them and then (unsurprisingly) lose. But what's the reason for losing? It can't be that they didn't have a case. It must be that the judge is corrupt." (Dominic Cooper, comment on Law Society Gazette website)

I would add that the unrepresented and unadvised litigants often don't understand finality in the courts. If they lose a case, perhaps because of procedural mistakes (such as not providing their evidence) they feel that "justice" requires that they should be allowed another go. Resulting in further anger and frustration, like the chap who called the police from the courtroom and asked them to arrest the High Court judge for treason!

Lawyers have an important role in the justice system. They know what courts are likely to decide, so their advice stops bad cases coming to trial - the vast majority of civil claims are settled. Lawyers understand procedure, so they can gather the necessary evidence and present the client's best case on the day. In criminal cases, they ensure that defendants make informed choices (such as guilty pleas) and are given a fair trial with proper testing of he evidence. Without lawyers, the courts are landed with the impossible task of dealing with chaotic cases, raw unreviewed evidence and bewildered parties. Judges are not investigators. They can only deal with the evidence presented to them.

Practising law is about predicting what courts will decide. A party with no case and no evidence - perhaps a defeated US president - cannot stave off the inevitable by insisting on his day in court, as if the outcome is some random event. Equally, the rights and wrongs of a genuine dispute cannot be decided by one party (often the government) denying the other the right to have the facts established on the evidence.

Legal assistance has to be paid for. Public funding for legal advice is not, as Daily Mail headlines constantly scream, to provide a benefit to criminals or illegal immigrants - it doesn't go to them. It is to make the justice system work, to find out whether there is a genuine dispute, to keep bad cases and bad arguments for overwhelming the courts, and prevent mistakes by the State destroying lives unchallenged.

Populist attacks on lawyers for doing their jobs - allowing people to assert the rights given them by Parliament and keeping the justice system running - are iniquitous attacks on the rule of law.

Solicitors' ethics: the client or the public?

How should lawyers deal with disreputable instructions?

The Solicitors Regulation Authority has published another warning about solicitors becoming involved in dubious investment schemes, after recent cases led to the closure of seven firms and other regulatory action. This rightly highlights the welcome change of attitude we solicitors have had to make. 

It used to be that we represented the client's interests without regard to any wider morality, so long as we were not knowingly participating in criminal conduct or misleading the court. Now, we are required to have broader ethical standards and to have a duty to the public. I'm glad about that. 

Lawyers are now expected to carry out some due diligence and assure themselves that their clients are behaving legally, rather than just accepting the assurances and half-truths clients my give them. The public may assume, rightly or wrongly, that because a solicitor is involved, the investment is legitimate or money is protected.

Professional ethics grew up in the admirable tradition that solicitors represent their clients fearlessly and independently, and that everyone is entitled to legal advice. Solicitors rightly represent people accused of crimes or wrongdoing without allowing personal feelings to cloud judgement, drawing the line at actual knowledge: if you don't know your client is guilty, you can and should represent him in court. But in transactional matters we need a more rigorous approach that avoids actually assisting in schemes that are suspicious or disreputable. The fearless and independent advice is then that the client should not do it. 

Covid-19: suggestions for emergency law reform

Promoting fairness, spreading costs and avoiding a long tail of litigation

In my blog post of yesterday I described the existing law as it applies to business contracts during the coronavirus outbreak. I set out below some of the legal steps I think Government/Parliament should consider taking to stabilise the economy and markets and reduce unfair burden-sharing across the economy. It would normally be profoundly un-Conservative to interfere in private contracts, but in this case the circumstances were entirely unforeseen and the losses will be distributed in a way that is close to random, but with the effect falling particularly heavily on small businesses unable to pass costs back to their suppliers. Government attempts to help business with loans and other support are entirely welcome, but unless Government will contribute the entire cost to the economy, which is unlikely, it is important also to share the remaining burden across the economy as evenly and fairly as possible, and to preserve businesses and jobs so that they can resume after the crisis without a burden of debt or the threat of litigation. That needs to be done with very broad-brush temporary legal measures to complement targeted Government assistance.

English law currently makes no provision for short-term suspension of businesses or the temporary laying-off of workers. Businesses that do not perform contracts may be liable for unlimited claims for losses suffered by the other party.

My suggested steps are intended only to apply during the duration of the Covid-19 crisis. Ministers should take power to remove or suspend them when appropriate, with power to restore them if the virus returns. Inevitably they carry risks of further unfairness, fraud and abuse, but their short-term nature should mitigate that. Considerations of moral hazard (relieving those who did not prepare at the expense of those who did) hardly apply when the present situation was so unforeseeable.

All of my suggestions can be implemented by legislation alone, without of themselves requiring additional public expenditure, though for best effect they would be integrated with the financial measures already announced, or to be announced, by the Chancellor.

1.    For the duration of the crisis, businesses should be given power to “mothball” themselves, or individual sites or business activities within a company, without going to court or any other formality other than public notice. I would call this Suspension.

1.1. Suspension would have the same effect as Administration (Insolvency Act 1986 Part II) but the directors would remain in control and the process could be applied to an identifiable part of a business (such as a retail unit or a product line, with the employees, contracts and assets relating to that unit being deemed to be those of the unit in Suspension as if it were a separate company). Suspension would be permitted only if the directors consider the business to be uneconomic during the crisis and for the sole purpose of preserving the business during the crisis.

1.2. During Suspension, no debts or contracts incurred before 16 March 2020 or accruing under existing obligations could be enforced by legal action or appointment of liquidators/administrators. Employment contracts could not be terminated but employees could be laid off at a specified rate – SSP rate, half pay, 75% or full pay, depending on Government subsidies. Government would undertake to pay all or a proportion of these wages costs, and could provide loans pending later claims. This could be extended to zero-hours workers and contractors engaged direct or through service companies. Alternatively, laid-off workers would be entitled to state benefits during lay-off as if unemployed, but without obligations to seek work.

1.3. Rents and interest payments and accruals could be arbitrarily reduced by 25% or 50% during the peak crisis period, sharing burdens with landlords and lenders, depending on how Government subsidies are to be targeted. Services provided to or by the busienss (other than utilities) could be suspended notwithstanding any long-term contracts, and no payments would be due for services not provided.

1.4. At the end of Suspension, the business would have to pay its suspended debts (but not cancelled interest, rent or taxes) no later than equal monthly instalments over six months.

1.5. Public service obligations could be imposed as conditions of Suspension, such as contributing to initiatives to provide essential products or services, or making staff available for volunteering, or a general obligation of directors to do everything possible to support public initiatives to fight the virus and keep the economy going.

2.    Alternatively, or as a separate initiative, employers should be given power to lay off employees on short notice for up to three months or the duration of the crisis, continuing to pay them (at reduced rate as above) with the benefit of state subsidies. Existing redundancy processes are too slow (for large businesses consultation and selection for redundancy plus notice period would exceed the likely duration of the crisis) and result in permanent dismissal. Anyone made redundant on or after 16 March 2020 and for the duration of the crisis should be automatically entitled to reinstated within six months unless the employer goes bust or can show that the job was redundant notwithstanding the crisis. This is what Virgin Atlantic is trying to achieve, but without a change in the law, its initiative would not survive challenge in the Employment Tribunal.

3.    All commercial rents and/or trading company interest rates in force between private parties at 16 March 2020 could be reduced by 25% for three months, purely as burden-sharing, on top of any reduction due to the base rate cut. Financial markets would need to be exempted in view of international implications and there might be a size threshold, though it would be a mistake to assume that only small businesses need relief.

4.    Covid-19 should be deemed a “force majeure” event for all contracts (other countries, eg China, have done this); the law would imply a term into every contract governed by UK law that if performance of the contract is rendered impossible, impractical or uneconomic by the coronavirus crisis (including by labour shortage or unavailability of supplies) the obligation is suspended, if capable of being performed later, or cancelled if time-critical, with any advance payments or expenses being refunded (as per section 2 of the Law Reform (Frustrated Contract) Act 1943), plus consumer deposits or prepayments being refundable in full. This would not apply to financial markets or insurance contracts but could apply to bank lending. This is intended to prevent the economy being overwhelmed by a tide of litigation attempting to shift costs to other parties and breach of contract claims for damages, including for loss of profit. Legislation akin to the Protection of Trading Interests Act 1980 could be used to prevent British companies being victims of such claims abroad or under contracts governed by foreign law.

5.    Compliance with Government recommendations on public health should be deemed compliance with a legal obligation for the purposes of all contracts and the law of torts, so that no-one can be sued for doing so and compliance, by the business or third parties, provides a lawful excuse for non-performance of obligations and enables insurance and benefits claims. No-one should be penalised for acting in accordance with Government advice, or because it is advice rather than the law.

6.    Legislation should say that exposure to coronavirus in the course of normal working should not in any circumstances be deemed a breach of health and safety laws by employers or negligence by the operators of business or premises. Otherwise businesses which should be staying open, perhaps in essential sectors such a heath supplies or food distribution, will close down because of the duties they have towards their own staff and the public, and will be reluctant to re-open as the danger reduces. We need to be explicit that businesses and individuals are allowed to take some risk in order to combat the virus and keep the economy going. Employers are reacting as if the call to work from home means that all workplaces must be closed, whether or not home working is possible. We do not want courts examining decisions with the benefit of hindsight, or businesses being burdened with litigation as they try to recover.

7.    Loans made under Government crisis initiatives should be exempted from prohibitions in other contracts and from calculation of financial covenants in bank lending documents. Otherwise acceptance of such emergency loans is likely to amount to a default under existing loans and result in lenders enforcing security, appointing administrators or increasing interest rates and fees to penal levels. There is a danger of lenders seeing receipt of crisis subsidies as an opportunity to recover pre-existing debt. It would be possible to suspend all financial covenants in loan agreements for a period to prevent defaults.

8.    Ministers should take powers to disapply intellectual property rights during the crisis if they restrict business responses to the crisis, eg by inhibiting UK copying and production of ventilators or other essential supplies normally sourced from overseas.

9.    The EU should suspend all State Aid restrictions during the crisis (at least outside the Eurozone) and disapply competition law to the extent that it inhibits businesses co-operating for the efficiency of the economy and the sourcing and distribution of goods during the crisis.

In the absence of steps such as these, businesses will take their own steps to protect themselves and (as they are required by law to do) their creditors and employees by making staff permanently redundant, disposing of assets (eg by not renewing leases) and/or going into insolvency, doing permanent damage to the economy and having knock-on effects for creditors and the wider economy. An overhang of litigation could stifle the economy for years to come. 

Stay safe.

Covid-19: who bears the loss? Contracts and Coronavirus

All the news is about Coronavirus and its dangers to people, society and, in third place, the economy. As well as human tragedies, we are facing unprecedented disruption to work and economic activity. We could be facing an unprecedented wave of bankruptcies. But where will the losses fall?

Supply chains and back-to-back contracts

Supply chains and labour markets are complex and often unstructured, and in many cases the effects of Covid-19 losses will be close to random. Businesses may be fighting for survival, and anxious to pass on costs and losses to other parties. Consumers will want their money back for goods and services they can’t use. Demand has fallen, in many cases to levels at which it is uneconomic to continue. Wages and business costs continue to accrue. Suppliers still want to deliver and be paid.

It can come as a huge shock to a business to find itself bearing the loss of the entire supply chain because it is a man-in-the middle, due to mismatches in contract terms. Purchase orders can’t be cancelled unless the contract terms allow that, even if customers cancel their orders or refuse delivery. Consumers may have rights to cancel, return goods or just fail to pay, but a retailer may not be able to pass the cost back up the chain. The loss will often fall at the retail level, because consumers have legal rights (cancellation, returns, refunds) that retailers must respect; trade contracts up the chain will not usually give the buyer the same rights. International contracts may be worse still, with different laws and legal systems applying to each link in the chain.

Imagine a small travel agent, putting together its own packages for holidaymakers on a modest margin: it may have committed to hotels and airlines, or even paid them in advance, but when the FCO advises against travel, or the destination closes borders, the customers will be entitled to their money back. The agency’s contract with the suppliers may not entitle it to a refund, leaving the agency with the full liability. In an ideal world, supply chains are built with back-to-back contracts and pay-when-paid clauses that allocate the loss appropriately across the supply chain, or to parties who are insured, but that is the exception rather than the rule. Often the loss will fall on the weakest link in the chain, the person who has not been able to negotiate let-outs with either its customers or its suppliers.

Frustration

What remedies does the law allow when a performance of a contract becomes impracticable? Is a party liable for breach of contract if he simply cannot comply?

If the contract terms provide no let-out (such as an express cancellation right, or an implied right to terminate and indefinite contract on reasonable notice), the only legal escape is the legal concept of frustration. A contract is frustrated if something happens after the date of the contract has been formed that is not the fault of either party and is so fundamental that it strikes at the root of the contract and is beyond what was contemplated by the parties when they entered into the contract. It must render further performance impossible or illegal, or make the obligations radically different from those contemplated by the parties at the time of the contract. Frustration brings the contract to an end immediately, and relieves both parties of any unperformed obligations. Under the Law Reform (Frustrated Contracts) Act 1943, money already paid is normally recoverable, less any expenses incurred by the other party. A party who has gained a valuable benefit under the contract must pay a just sum for that, and a party who has incurred expenses may charge them to the other party. 

Circumstances arising from Coronavirus are certainly capable of amounting to frustration. If it became illegal to ship goods across a border, or particular workforce could not travel or was incapacitated, or an asset (such as hotel or ship) was requisitioned or closed down, that could frustrate a contract specifically relating to that, and applying in the short term. Because frustration ends the contract completely, it cannot help if all that is needed is a temporary suspension or delay. The performance of the whole contract must be completely impossible or radically different to what was expected. The contract is not frustrated just because it becomes more expensive or inconvenient to perform, or if there is another way of performing it, or if it cannot be performed due to a risk that should have been contemplated by the parties, such as supplier failure. There is no frustration if the purpose, rather than the performance, of the contract, is impossible: for instance, the European Medicines Agency’s 25-year lease of its London headquarters was not frustrated by Brexit (Canary Wharf (BP4) T1 Ltd v European Medicines Agency [2019] EWHC 335 (Ch)).

A particular issue arises (at the time of writing) from the UK government’s approach to the social distancing measures required to fight Covid-19. The Government is acting by making strong recommendations, rather than imposing legal banks on events or activities. That means compliance is voluntary, so the advice is unlikely to frustrate contracts. A party complying with the advice, or who cannot perform because his employees or suppliers are complying, risks being sued for breach of contract, or forfeiting his advance payments. Not only will that cause losses to consumers (who may not be able to get refunds for holidays, event tickets etc, and may be sued by desperate businesses unable to fill vacancies), but this could be detrimental to the essential public health objectives. Venues will be tempted to stay open and events to go ahead so as to avoid paying refunds or being sued for failing to deliver promised goods or services, and the public will be tempted to go ahead with activities they have already paid for.

Employment contracts are unlikely to be frustrated, except in the sad event of the death of the employee. Employers will still have to pay salaried staff who are ready and willing to work and will continue to have an obligation to provide paid work for other staff. It seems that employees self-isolating will be deemed to be sick, at least for the purposes of statutory sick pay, though it is not clear whether that relieves employers of paying more generous contractual sick pay, or full pay for salaried workers, who are not in fact sick. Emergency legislation has made statutory sick pay payable from day 1.  There is no automatic right to suspend or stop paying staff if workplaces are closed or customers stop buying. Not all contracts provide for short-time and lay-offs. Cuts to the workforce will have to follow usual redundancy procedures, including consultation, selection and payment of notice pay and redundancy compensation.  Employers will be looking for other cost saving measures that can be implemented swiftly. On the day of writing, Virgin Atlantic has invited its staff to take eight weeks of unpaid leave or face mass redundancies; many workforces would not agree to that, but some may feel that they have little option to keep their jobs when others are unlikely to be recruiting. They are unlikely to qualify for most state benefits if still employed but on unpaid leave. The cost of redundancies could well be as great as paying wages through the crisis, depending on how long it lasts. Further emergency legislation is likely in this area.

Force majeure

Many contracts (including standard terms of business) contain “force majeure” clauses. They usually relieve the parties from performing obligations if they cannot be performed for specified reasons beyond the parties’ reasonable control. They may suspend performance for a period, and/or allow the parties to terminate the contract without liability on either side. Labour shortages, transport disruption or supplier default may (or may not) be listed as a force majeure event, though it would still have to be the main cause of the disruption and outside the party’s control. Whether a public health emergency amounts to force majeure depends on the wording of the clause. 

The situation must still be beyond the control of the affected party. Again, the fact that compliance with Government advice is voluntary might not help to bring the situation within the force majeure clause. Inability to pay money due to loss of income will not be force majeure; nor will obligations that are just more expensive or difficult to carry out, but are not impossible.

Often there are formalities needed to invoke the force majeure clause, such as giving notice to the other party, or taking steps to mitigate the effect of the event. Unlike frustration, force majeure may apply to the obligations of one party only, and can grant a temporary suspension or delay. On the other hand, the presence of a force majeure clause may mean that the contract is not frustrated: if the agreed terms deal with a situation, that situation will not frustrate the contract.

The cost

The main impact of Coronavirus is the large number of human tragedies. Economic considerations are less important, but the economy also has real effects on keeping people alive and safe. The damage will be spread throughout the economy, but the losses will not be even and will not fall fairly, especially if governments do not intervene. Some individuals and some businesses will suffer disproportionate pain. The English law of frustration and force majeure is not going to help significantly in restoring order or fairness in this crisis. Ultimately, much of the economic cost may be felt through business failures and job losses. Insolvencies result in real and permanent damage, even if new businesses, or phoenix businesses, eventually arise from the ashes to provide the same goods and services. Innocent employees, business owners, shareholders and pension fund members will bear the cost.

Things are changing fast – this article is written on 17 March 2020. Further emergency legislation is very likely – it may include new ways for businesses to suspend or reduce activities.

Stay safe.

IR35 responsibility for worker status transfers to employers

Employee, consultant, worker, director?

Changes to the IR35 tax regime, in force for some time in the public sector, are being extended to private sector employers from 6 April 2020. IR35 Responsibility for deciding tax status is being shifted from the service company to the ultimate employer, under the Off-Payroll Working Rules. 

Many consultants, directors and other workers wanting to have "self-employed" status (or forced by employers to have it) have been engaged through personal service companies. IR35 required personal service companies to operate PAYE in a way that largely eliminated the tax benefits of the structure, but it was left to the individual and service company to decide whether it applied. As there was no risk to the ultimate employer, it did not care if IR35 was ignored, or was interpreted aggressively.

A large or medium-sized company (ie any company not classed as “small”) will have to make its own determination of whether an individual engaged through an intermediary (including his or her own personal service company) would be regarded as an employee (or office holder) for tax purposes, if the services were provided under a contract directly between it and the worker, ignoring the existence of the intermediary. If so, PAYE must be operated on payments to the service company from 6 April 2020. 

Before that date, the company must send the individual and the intermediary a “Status Determination Statement”. 

Note the reference to "office holder" - this includes non-executive directors, who are not normally  employees but are subject to PAYE tax as office holders.

Employers are likely to be far more cautious in making determinations of status than individuals have been, because the risk of failing to operate PAYE falls on the employer. The Check Employment Status Tool (CEST) is the HMRC online tool  to provide guidance, but it has been much criticised in its present form (and found wanting by the courts) and is due to be revised. Employers have to make their own judgements, and may need advice. HMRC is naturally hoping that employers will be conservative and apply PAYE to almost everyone.

The change could well result in many employers ending consultancy company arrangements and bringing consultants fully on board as employees. However, unlike employed/self-employed decisions, deciding to deduct PAYE from payments to service companies does not of itself affect the individual's employment rights status. A person engaged through a service company will not normally have employee's rights against the employer, though they may have rights as a "worker".

I can’t claim any credit for it, but there is a particularly good explanation and Q and A here. All this is subject to any changes resulting from the forthcoming election. 

First disqualified director compensation order

Banned directors can now be made to pay creditors

A director has been ordered to pay over £500,000 in compensation to creditors of a company who suffered from his misconduct, as the first compensation order made under the director disqualification regime. Where a disqualification order has been made, the director can now be ordered to compensate creditors, even if the liquidator is unable or unwilling to pursue the director.

The Secretary of State has to make the application, so the number of cases is likely to be limited by the resources of the Insolvency Service. But in egregious but otherwise hopeless cases, where insolvency practitioners probably have no funding to purse director claims, this provides a new route for creditors to make recoveries. It may become routine for compensation to be considered when disqualification proceedings are brought. Where a director gives a disqualification undertaking to the Secretary of State instead of being taken to court, a compensation undertaking can also be sought.


Published guidance on compensation orders indicates that the Secretary of State will not seek compensation orders if that would compete with claims actually being made by the liquidator or administrator. Distribution of funds can either be via the Secretary of State or by payment to the company for distribution by the liquidator.

In this case, Secretary of State v Eagling [2019] EWHC 2806 (Ch)., relating to wine investments, the director paid all the company's cash to an associate of his and fled to Northern Cyprus. He was disqualified from acting as director or being involved in business management for 15 years and ordered to pay compensation of £559,484. The court and the Secretary of State were able to direct the compensation to benefit the creditors most directly affected by the misconduct, rather than the money going into a general pool. 

Bank liability for fraud

Negligent bank responsible even if payments are authorised per the mandate

The Supreme Court has affirmed a decision that a bank is liable to refund a customer for a fraudulent transaction otherwise properly authorised in accordance with the bank mandate, if the bank was negligent in not recognising and blocking the fraud - the "Quincecare" duty: "the bank should refrain from executing an order if and for so long as it was put on inquiry by having reasonable grounds for believing that the order was an attempt to misappropriate funds."

In this case the company was being defrauded by its own controlling director, and it is hard to see what the bank could actually have done without risking being sued for not carrying out the director's instructions.

This case potentially opens the door to thousands of claims by victims of "push payment" frauds if they can show that the bank was negligent in accepting the customer's instructions.

Singularis Holdings v Daiwa Capital Markets

Brexit: judicial independence and the Bill of Rights

Attacks on our guarantees of freedom from tyranny

The vicious attacks on the judges in the papers over the Brexit judgment are disgraceful. We have an independent judiciary and the rule of law for good reasons, and we forget them at our peril. But what did the court actually decide? Contrary to what the tabloids say, it has nothing to do with the referendum and whether it is binding - the Government did not even attempt to argue that the referendum provided legal authority for giving the Article 50 notice. The case turns on whether giving the Article 50 notice effectively changes the law enacted by Parliament. The Government accepted that the notice automatically brings about the end of UK membership and cannot be withdrawn. The court found that this changes the legal rights of UK citizens, and any Brexit agreement with the EU would also have legal effects inside the UK. The power of Government to make (and unmake) treaties is under the Royal Prerogative. It is clear - and very important - that ministers do not have power to change or override the law as enacted by Parliament. A commentator criticised the judges' reliance on "a 17th century statute" - but that is the Bill of Rights, as close as we get to a written protection of freedoms in English law! It says, "the pretended Power of Suspending of Laws or the Execution of Laws by Regall Authority without Consent of Parlyament is illegall ... the pretended Power of Dispensing with Laws or the Execution of Laws by Regall Authoritie ... is illegall." Everyone knows that untangling UK laws from the EU will need an act of Parliament. What the judges have decided - and the point on which an appeal to the Supreme Court could succeed - is that the mere giving of the Article 50 notice has a legal effect that amounts to repealing or suspending the European Communities Act 1972, wholly or partially. That needs an act of Parliament. The central point is whether the Article 50 notice has that effect. Does it, of itself, change domestic laws; or does it, like many treaties, change international obligations in ways that need UK legislation to implement them, which comes later? Can ministers create a legal mess at international level, which then has to be sorted out later by Parliament? Wait for the next thrilling instalment of R (Miller) -v- S of S for Exiting the European Union. 

Forfeiture of partnership and LLP profit shares

Having your slice and eating it

A partner can potentially forfeit all part of his profit share if he breaches his fiduciary duties, according to a recent decision of the High Court. That comes as a surprise to many partnership lawyers, and has some interesting implications for partnerships and LLPs.

Hosking v Marathon Asset Management LLP was an appeal on a point of law from the decision of an arbitrator, so the court was only asked whether forfeiture was possible in principle. The court did not have to decide on the details of how it would work, either generally or in this particular case, so there is a lot of room for interpretation. The judge did quote with approval Snell’s Equity saying “a fiduciary's fees may not be forfeit if the betrayal of trust has not been in respect of the entire subject matter of the fiduciary relationship and where forfeiture would be disproportionate and inequitable.”

A fiduciary is a person in a particular position of trust, such as a trustee, a director or an agent. In other contexts, it has been held that a fiduciary who breaches his fiduciary duties forfeits any right to remuneration for performing them. Most of the cases concerned agents, as in Imageview Management Ltd v Jack, where a footballer’s agent negotiating for a player to join Dundee United made a secret deal with the club for his own benefit, and forfeited his commission. Most of the cases concerned dishonesty.

In Hosking the arbitrator found Mr Hosking guilty of a series of serious breaches of his fiduciary duties to his LLP, largely by making preparations to leave and compete with the LLP. In that particular LLP, full-time working partners got twice the profit share of non-executive partners. Because of this, the arbitrator concluded that 50% of the profit share should be regarded as remuneration for executive services, and ordered it to be forfeited for the entire period in which Mr Hosking was in breach of fiduciary duty. This amounted to over £10 million.

The effect on partnerships and LLPs may be surprising:

• Unlike a straightforward agency, the roles and responsibilities of partners are very complex. Everything a partner does is governed by his fiduciary duties to his partners or his firm. The arbitrator equated the whole of a partner’s share attributable to his work in the LLP with remuneration for performing his fiduciary duties, and said it was "proportionate and equitable" that he should forfeit the whole amount. As well as acting in breach of his fiduciary duties, Mr Hosking must also have performed his duties to a very considerable extent during that period, for the benefit of the LLP and his partners. He got no credit for that work. Was the betrayal of trust really “in respect of the entire subject matter of the fiduciary relationship”? Did it really “go to the whole contract”? 

• The compensation awarded against him for the actual breach seems to have been £1.38 million, so the forfeiture was worth many times the proven financial loss. Can that really be "proportionate and equitable"? 

• The forfeiture period was only four months. What if the breach of fiduciary duties had lasted much longer, perhaps his entire career with the LLP? Would he still have lost all his remuneration for the entire period? 

• Is it fair or realistic to characterise a profit share at a rate of over £30 million a year as remuneration for executive services? Where do you apply for a job like that? 

• A partnership or LLP agreement will not normally attribute a proportion of profit share to remuneration of working partners. It may have a formula which appears to show working partners getting more than others, but the reasons behind that may be varied and complex. Even if the profit share includes a fixed salary, you cannot always conclude that it represents the partner’s remuneration for performing fiduciary duties, or for working for the LLP. Some partners contribute their work, some capital, some contacts or know-how, or in most cases a mixture of all of them; the maths of how their shares are calculated will rarely be a guide to valuing these separate contributions. 

• Does the operation of forfeiture really depend on how partners structure their agreements? If there is a fixed share, often called a “salary”, is that going to be seized upon as remuneration? If partners get interest on their capital, is the rest of their share “remuneration”? If all partners get different shares, can you infer “remuneration”? What if they all get the same, but some do more work than others? What if shares depend on personal contribution, such as personal billings, or on management responsibilities? 

• In a partnership or LLP, the profit shares must go somewhere. They must still add up to 100%. If the profit share is forfeited, what happens to it? In this case the arbitrator said that it would fall into the general pool and be shared, including by Mr Hosking, according to the partners’ remaining entitlements. That result is a bit random: if there had been only one other partner, Mr Hosking would have received back half the amount he forfeited, under his remaining profit share. But if the arbitrator had held that he forfeited only half his remuneration, or that the “remuneration” element was less, he would then have got back a larger proportion of the forfeited amount. 

• What if the partnership or LLP agreement makes no provision for the sharing of the amount forfeited? What if all other partners were on fixed shares? 

• Partnership disputes typically involve a wide range of allegations and counter-allegations. What if all the partners had been in breach of fiduciary duties, perhaps in different ways and different degrees of seriousness? Would they all forfeit their profit shares, and where would they go? The potential for forfeiture is likely to create enormous arguments in partnership disputes as each partner claims that the others should forfeit all or part of their profit shares.

• What if some partners are complicit in the breach of duty? Do partners forfeit their shares as against some partners but not others? Do they forfeit shares to each other? If all but one of the partners are guilty, does the innocent partner get 100%?

• We seem to have slipped from forfeiture for “dishonesty” in the early cases to forfeiture for any breach of fiduciary duty in Hosking. In a commercial context, such as partnerships and LLPs, there really has to be more allowance for the realities of business life. Forfeiture is a punitive measure, not a compensatory one, and gives a windfall to the injured party even if all his losses have been made good. Bad behaviour, short of criminal fraud, does not normally have this effect.

At least the judge accepted that the partnership deed or LLP agreement can exclude forfeiture. I have already modified my standard forms (I immodestly think my LLP agreement is the best there is!) with a clause you can have for free: “Without prejudice to any other remedy for any breach of fiduciary duty or of this agreement, no part of the profit share of any Member is liable to be forfeited under the principle of equity that a fiduciary may forfeit remuneration due to his breach of fiduciary duty.”

Partnerships and LLPs are a business arrangement founded on contract. In my view there should be limits on how far equitable principles should intrude into partnership law. Enforcing fair dealing and openness between partners is essential, but this decision seems to go too far. 

UK company fined at home for failing to prevent bribery overseas

A bung can cost more than a fistful of dollars

Last week Sweett Group PLC became the first company to be sentenced for the crime of failing to prevent bribery by an associated person (s7 Bribery Act 2010). One of its overseas subsidiaries paid bribes to secure a contract concerning an hotel in Abu Dhabi: Sweett Group is an AIM-listed construction consultant.

An English court imposed a fine of £1.4 million and a confiscation order of £851,000, plus costs. A number of lessons can be learned:

·     The Bribery Act has not gone away: the noise made by law firms when it came in has abated, but the Serious Fraud Office will prosecute British companies for failing to stop corruption overseas

·     Co-operating with the authorities will not always avoid prosecution – Sweett Group reported itself after it got media attention, but the SFO did not even offer a “plea bargain” deferred prosecution agreement

·     Penalties can be swingeing

·     Professional practices are not immune

·     UK companies must take precautions: demonstrable adequate procedures to avoid bribery, and an anti-bribery culture must exist before the problem arises.

Using directors' powers for their proper purposes

Doing the right thing for all the wrong reasons

One of the more subtle aspects of a director's duties is the obligation to use his powers  only for the purpose for which they were granted. this duty was often known only to company law experts until it was codified in s171(b) Companies Act 2006.

The Supreme Court has just given a reminder of this duty in Eclairs Group v JKX Oil & Gas Plc. The company's board served information disclosure notices on two major shareholders, holding 39% of the voting rights. they then decided that the responses were inadequate and exercised powers to remove the shareholders' voting rights. The court concluded that the directors were motivated by the desire to stop these shareholders voting against the board's proposals at a forthcoming meeting, and not by a wish to achieve disclosure the information they had requested - so the decisions were invalid.

How do you disentangle all the complicated motives that lead a single director, still less a whole board, to come to a decision? Lord Sumption said, "Directors of companies cannot be expected to maintain an unworldly ignorance of the consequences of their acts or a lofty indifference to their implications. A director may be perfectly conscious of the collateral advantages of the course of action that he proposes, while appreciating that they are not legitimate reasons for adopting it. He may even enthusiastically welcome them. It does not follow without more that the pursuit of those advantages was his purpose in supporting the decision. All of these problems are aggravated where there are several directors, each with his own point of view." But he approved the formulations from earlier cases, "if, except for some ulterior and illegitimate object, the power would not have been exercised, that which has been attempted as an ostensible exercise of the power will be void, notwithstanding that the directors may incidentally bring about a result which is within the purpose of the power and which they consider desirable," and "regardless of whether the impermissible purpose was the dominant one or but one of a number of significantly contributing causes, the [decision] will be invalidated if the impermissible purpose was causative in the sense that, but for its presence, the power would not have been exercised."

The most common abuse of powers for an improper purpose seems to be in the issue of shares, where the power to allot shares is used to dilute minority shareholdings or distort the voting control of the company. The power to issue shares is primarily for the purpose of raising capital for the company, and its use as a weapon in shareholder disputes will usually be illegitimate. Dressing it up as a rights issue, perhaps where you know the minority have no money to invest, will not help if the rights issue would not have happened but for the intention to bring about the change of control.

Penalty clauses are unenforceable - aren't they?

It was never a penalty!

The law has been clear: a clause in a contract imposing a penalty for breach of contract was unenforceable. What was completely unclear was  (1) what amounted to penalty and (2) whether the rule applied beyond the payment of money following a breach of contract. For many years the accepted formulation was that if contract term provided for a payment which was "more than a genuine pre-estimate of loss" it would be an unenforceable penalty; otherwise it was a legitimate "liquidated damages" clause and not a penalty. In more recent years more complex cases have tested the rule, involving more than a straightforward payment for non-performance. the trend seemed to suggest that any clause whose effect was intended to be deterrence rather than compensation was potentially vulnerable to attack as a penalty.

In a judgment today (4 November 2015) these developments of the law on invalid penalty clauses has been rolled back by the Supreme Court. It gave a combined judgment on two cases that could hardly be more different. Cavendish Square Holding v El Makdessi concerned "bad leaver" type clauses  under which Mr El Makdessi, who had sold shares in a company, stood to lose the remaining instalments of the price and to be forced to sell his remaining shares cheap — the last limb alone would cost him $44m — because he had breached non-compete covenants. ParkingEye v Beavis was about an £85 penalty charge for overstaying in a retail car park.

In both cases the Supreme Court said the clauses were not penalties and were valid. The test for a penalty is now "whether the sum or remedy stipulated as a consequence of a breach of contract is exorbitant or unconscionable when regard is had to the innocent party’s interest in the performance of the contract", which will allow far more aggressive terms than some of the cases suggested. Deterrents are allowed, so long as they are not exorbitant or unconscionable, and there is no longer any necessary relationship with the damages that might be awarded by the courts for the breach. Contract writers are likely to become bolder in specifying remedies for breach.

Most “bad leaver” clauses are now probably safe, though still subject to possible equitable relief from forfeiture if the party in breach can provide recompense by other means. 

The £85 parking overstay charge was also held not to be an unreasonable term under the Unfair Terms in Consumer Contracts Regulations 1999 (now Part 2 of the Consumer Rights Act 2015).

The Supreme Court did close one loophole: in deciding whether the clause is a remedy for a breach of contract, the courts will look at the substance of the obligations and not just at how they are expressed. Writing the contract so that there is no breach, but just a conditional obligation, will not get round the rule on penalties if the substance is that one is the primary obligation and the payment is a secondary compensation: so if instead of saying "you must supply the goods; if you do not supply the goods you will pay me £1m" you say "you can either supply the goods or pay me £1m", the court can still decide that the supply of the goods is the primary obligation and the payment is a penalty for breach of it.

The case is a victory for traditional freedom of contract and for certainty, at the expense of the introduction of concepts of fairness, proportionality and the protection of the weaker party into contract law.

US stock option plans subject to English law?

Courts clash on jurisdiction over employees 

It will come as a great surprise to many international employers that their US stock option plans are subject to the exclusive jurisdiction of European courts, as the plans apply to employees in Europe.

Many American companies offer stock option plans or other share incentives on a global basis, with employees having conditional rights to receive stock in the US holding company, or stock issued by a vehicle created for the purpose in the USA. The stock option plan will be established in a state of the USA and subject to its laws, and may or may not be tailored through sub-plans to meet tax requirements in other countries, such as the Enterprise Management Incentive Scheme in the UK.
Rights are granted under a contract direct between the American entity and the employee. 

The Brussels Regulation (recast) governs the jurisdiction of all courts in the EU to hear cases, and says that an employer may bring proceedings only in the courts of the Member State in which the employee is domiciled. At first glance, the stock plan is not an "individual contract of employment" and the US entity is not the employer, so the special rules for contracts of employment in would not apply. As an English lawyer I have no difficulty with the concept of a separate contract with a third party dealing with stock options or incentives, and I would not consider it to be a contract of employment, or the incentive provider to be an employer. Indeed, in English law it has been held that a share option is not a term of the contract of employment: Micklefield v SAC Technology Ltd [1990] 1 W.L.R. 1002. 

But Samengo-Turner v J & H Marsh & McLennan (Services) Ltd held that words used in EU legislation must be given an autonomous (European) meaning so that each Member State will apply it consistently and not interpret it in accordance with its own national law. The terms of the Brussels Regulation are essentially an employment protection measure, to stop employees being sued anywhere other than than their own home jurisdiction, and the English courts would give effect to that: not only by including any contract relating to employment as an "individual contract of employment" and the benefits provider as an employer, but also by granting an anti-suit injunction preventing the foreign company from taking proceedings in its own country.

In the recent case Petter v EMC Europe Ltd the English Court of Appeal became engaged in an unseemly scramble to establish jurisdiction either in England or in Massachusetts, with both courts being asked to grant injunctions preventing a party from continuing proceedings in the other place. Courts of different countries usually try to respect each other and not fight over jurisdiction, but in this case the Court of Appeal decided it had to grant an injunction effectively overturning the decision of the Massachusetts court, in order to protect the employment rights of UK employees.

A fight over the choice of court is not the end of the matter: an English court will still apply foreign law if that is the law chosen in the contract: the Rome I Regulation on the law applicable to contractual obligations allows the parties to choose the applicable law, even for a contract of employment, and an English court can apply foreign law if presented with evidence of what the foreign law is. However, this is subject to the application of mandatory rules of local law. Whilst the courts of England and Massachusetts should theoretically apply the same laws in reaching their decision, a court in England is likely to give far greater weight to English employment rules such as the duty of trust and confidence between employer and employee, principles of English law banning contractual penalties and granting relief from forfeiture of assets, restrictions on deductions from pay and the requirements for non-compete restrictions not to be unreasonable restrains of trade. The legal environment in the UK is far more friendly to the employee than in the USA, so employees may be very keen indeed to have any litigation heard here.