A new kind of deal for 2012?

Buying companies with cash at bank

You only find out who is swimming naked when the tide goes out, as Warren Buffett said. No-one wants to be vulnerable to further economic shocks. Since 2008, companies have been rebuilding their balance sheets. Many successful companies have built up significant cash reserves. They remain reluctant to invest in major expansion or in acquisitions.

Professionals in the M&A market have been waiting for confidence to return so that companies start to spend this cash on acquisitions. But the continuing Eurozone crisis means that no-one is buying, despite the many businesses available at bargain prices. Lack of demand the absence of bank funding for acquisitions keeps values low, even though many businesses are making good profits.

But will we see a new type if deal emerging in 2012: acquisitions funded partly with the target’s own cash?

Cash-rich companies make juicy low-risk acquisition targets for buyers who might be slightly more vulnerable, or for those looking to expand. Selling a company with its cash is highly tax-efficient for vendors. The legal rules banning financial assistance by the target have largely been abolished. If the price is deferred or settled in paper, or at a discount to the cash, the deal can become partly self-financing.

Wishing all bargain-hunters, keen sellers and market professionals a prosperous 2012.

Points for Property Professionals 2

Property transactions with directors.

This is the second in my short series of notes on non-property legal points relevant to property lawyers and others in the property industry. It focuses on sales or leasing of property between directors and their companies.

Shareholders’ approval is needed for property transactions involving company directors, under section 190 Companies Act 2006. The case law (re Duckwari plc (No 2) [1] and Demite v Protec Health [2] highlights the importance of this section, and the immense potential difficulties if it is not complied with. Property professionals should always be alert to section 190 problems when dealing with transactions involving directors and their companies.

Section 190 applies to an arrangement whereby:

·        a director or other relevant person acquires a substantial non-cash asset from the company or

·        the company acquires a substantial non-cash asset from a director or other relevant person.

The grant of a lease involves the acquisition of an asset, so it is included if the value of the leasehold interest is sufficient.

The value of the asset must be at least £5,000 and exceed 10% of the company’s asset value or, if less, £100,000. Multiple assets in the same arrangement, or a series of arrangements, are aggregated. So, for example, shareholder approval is needed where shown by a tick in the table:

Value of transferred asset(s)		Company Asset Value
	(£100,000) or £10,000	£100,000	£2m
£1,500	●	●	●
£7,500	ü	●	●
£15,000	ü	ü	●
£150,000	ü	ü	ü

A company's “asset value” is the value of the company's net assets according to its most recent statutory accounts, or if no statutory accounts have been prepared, the amount of the company's called-up share capital.

The section applies if the person acquiring or transferring the asset is:

·         a director of the company transferring or acquiring the asset

·         a director of its holding company

·         a person connected with a director of the company or of its holding company.

If the director or connected person is a director of the company's holding company or a person connected with a director, the arrangement must also be approved by a resolution of the shareholders of the holding company, or be conditional upon approval. Connected persons include spouse, minor or adult children, associated companies and trusts.

The acquisition can be direct or indirect, eg via a third party, if it forms part of one arrangement.

If the section applies, the arrangement may not be implemented unless it is first approved by a resolution of shareholders of the company and, where applicable, its holding company. The approval can be given before the arrangement is entered into, or the arrangement can be made conditional upon approval. An ordinary resolution is sufficient, and it does not have to be filed at Companies House.

This section does not require approval:

·       by shareholders of a company which is a wholly-owned subsidiary (but it may still require approval by shareholders of a holding company)

·       of transfers of assets within a group of companies (so long as all relevant companies are wholly-owned group members)

·        of arrangements by companies in insolvent liquidation or administration

·         by shareholders of a holding company in insolvent liquidation or administration

·         by shareholders of a holding company which is not a UK company

·         of transactions with members as such (eg dividends in specie)

·         of transactions on a recognised stock exchange through an independent broker.

The section does apply to sales of assets by liquidators of companies in members’ voluntary (solvent) liquidation, and by receivers.

The effect of failure to comply is:

·        the arrangement, and any transaction entered into in pursuance of it, is voidable by the company, unless for various reasons restitution is no longer possible, or the transaction is affirmed by shareholders; resolution within a reasonable period; and

·       the director involved, any connected person involved and any other directors who authorised the arrangement or transaction are each liable to account to the company for any gain which they have personally made, and jointly and severally liable to indemnify the company for any loss or damage resulting from the arrangement or transaction, even if the arrangement is later affirmed by the shareholders.

In the series of cases of re Duckwari plc it was held that the indemnity for loss and damage is not limited to losses arising from the transaction itself (e.g a sale at undervalue) but also extends to any subsequent loss flowing from the transaction, such as a reduction in value of the asset it acquired. It follows that if the company, without shareholder approval, buys an asset from a director which goes up in value, it keeps the profit, but if the asset value goes down, the company can either avoid the transaction or claim its loss from the directors.

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[1] [1999] Ch 268

[2] [1998] BCC 638 – sale by a receiver is within the section

The lawyer's smoking gun

Insolvency, fraud and privilege

In almost every company insolvency, someone suggests (often quite loudly) that the directors have been guilty of fraud or misconduct. Sometimes the allegation may be serious, and the authorities investigate. One rich source of evidence may be the legal advice given to the company – it may be the smoking gun, proving that the directors knew exactly what they were doing. But can the prosecutors use it?

Legal advice from a lawyer is absolutely privileged from disclosure in most circumstances. That can be the reason why canny directors route sensitive management and compliance discussions through their solicitor – that’s very common in competition law discussions, for instance.

The privilege belongs to the client, not the lawyer, and the client can waive it. That is an important point in connection with insolvency, where the client is often the company. What if the liquidator or administrator waives privilege and provides the advice to the prosecutor or regulator, to be used against the directors who took the advice? I have been there myself, when my advice on financial services compliance was later used by the SFO to help convict the directors, in what turned out to be a fraud – of course I had not been told the half of it.

But the legal distinction between advice to the company and advice to the directors is a fine one, especially when dealing with issues of fraud or regulatory compliance. It’s the directors who may go to jail, even if the company pays the lawyer’s bills. Can the liquidator really pull the rug out from under the directors by turning over the legal advice to the prosecution?

No, the court has said in R. (Stewart Ford) v The Financial Services Authority in October 2011. It held that joint interest legal professional privilege applied to the legal advice. Even where the lawyer’s retainer is in the name of one party – the company – others may be able to rely on the privilege if they had a joint interest in the advice. For joint privilege to arise, the facts must demonstrate that all those sharing the privilege, and the lawyer, knew, or ought to have known, that they enjoyed legal professional privilege with the others. To claim privilege, the director had to show:

i) That he communicated with the lawyer for the purpose of seeking advice in an individual capacity;

ii) That he made clear to the lawyer that he was seeking legal advice in an individual capacity, rather than only as a representative of the company;

iii) That those sharing the joint privilege (the other directors and the company) knew or ought to have appreciated the legal position;

iv) That the lawyer knew or ought to have appreciated that he was communicating in an individual capacity.

v) That the communication with the lawyer was confidential.

The directors succeeded, and the FSA were barred from relying on two crucial emails from the lawyer which had been handed over by the administrators.

The lawyers who gave the advice were my old firm Irwin Mitchell. Interestingly, the authors of the two legal textbooks on the subject were leading counsel on opposite sides in the case!

Points for Property Professionals 1

Undue influence in lease guarantees  

This is the first of a short series of notes on non-property legal points relevant to property lawyers and others in the property industry.

Landlords of commercial premises often require personal guarantees of the tenant’s obligations. But landlords may not be aware that a guarantee procured by “undue influence” by a third party, even without the landlord’s knowledge, may be unenforceable. This applies to guarantees of leases just as it does to bank guarantees, as the landlords found to their cost in the recent case of Trustees of Beardsley Theobalds Retirement Benefit Scheme v Yardley .

For years now, banks have been aware they need to make sure that guarantors get independent advice where there is a manifest disadvantage to the guarantor in giving the guarantee: Royal Bank of Scotland v Etridge. The bank loses out if the guarantee is procured by fraud or undue influence (for instance of a husband or boss), if the bank should have taken steps to ensure that there was no undue influence. Usually it does that by requiring separate legal advice to the guarantor. But landlords have typically not taken the same approach.

In Beardsley Theobalds the guarantor was an employee of the tenant company. A director falsely represented to the landlord that the employee was a director, and the landlord did not check. The director then got the employee to sign the lease without telling him what it was, and only showing him the signature page.

The judge held that the guarantee was unenforceable. It had been procured by undue influence, and the landlords had not taken precautions against that possibility, such as insisting on independent legal advice. The landlords had “constructive knowledge” of the undue influence, because the landlord was aware of the tenant’s precarious financial position: it was obvious that giving the guarantee was disadvantageous to the guarantor, so the landlord should have been aware of the risk that the guarantor was subject to undue influence. The landlord should also have been aware (though the judge’s reasoning for this is not stated) because the landlord could have checked whether the guarantor was a director. “They should therefore have checked that the proposed guarantor was financially sound, aware of the risks being undertaken and in full agreement with the proposal that he was to guarantee the rent for a fifteen-year period. The guarantor should have been asked to acknowledge in writing that he was fully in agreement to become a guarantor and had been made aware of the risks of signing the guarantee. He should also have provided, through [the tenant], a signed acknowledgement from a solicitor that he had been given appropriate advice before agreeing to sign or a signed waiver of the need to take such advice.”

Unusually, the judge also accepted a defence of “non est factum” (not my deed), available only when the person signing is completely unaware of the nature of the document he is signing. He also allowed a defence to the effect that the guarantor had not authorised the delivery of the deed in escrow, under which it awaited the satisfaction of conditions for two months, which the tenant struggled to fulfil. This last point has wider implications, since parties and their solicitors often fail to consider the authority of parties to deliver deeds and the need for their agreement to any escrow.

The risks to a landlord – or anyone else relying on a personal guarantee – can be reduced by:

·         placing a clear warning just above the signature space about the nature of the guarantee and the need for legal advice

·         putting the guarantee in a separate document (though this could have other implications if it is to benefit the landlord’s successors in title)

·         making sure that the guarantor has a clear financial interest in the tenant company so that the guarantee is not manifestly disadvantageous to the guarantor

·         treating the guarantor as a separate party and not assuming that the tenant or its solicitor has authority on behalf of the guarantor, eg for completion arrangements

·         checking the identity, relationship and financial standing of the guarantor, and his signature

·         insisting that the guarantor gets independent legal advice, providing information about the nature of the liabilities to the legal adviser and getting written confirmation from the legal adviser that he has given the advice.

When the music stops

Common mistakes in LLP agreements  

A limited liability partnership [1] is fairly free-form:  very little in its constitution is prescribed by law. The members of the LLP have to draw up their own agreement, carefully crafted by their lawyer. But with a few years of experience of LLP’s, some fairly basic problems are emerging that could come mean trouble for professional firms established as LLP’s.

At first, lawyers asked to draft an LLP agreement had little to go on. The temptation was just to adapt an existing partnership agreement, perhaps with a few clauses added from a company’s articles. But LLP’s are quite different from traditional partnerships, or from companies. Partnership law does not apply. [2]

Calls, contributions and over-drawing

In a partnership [3], the firm can call on the partners to contribute cash. Even without a power in the partnership agreement, the right is implicit: partners are personally liable for the debts of the firm, and they can recover from each other any outlays they have to make beyond the agreed capital. Losses are shared amongst the partners in an agreed ratio. Many draftsmen, including in some of the commercially-produced precedents, carried this forward into the LLP agreement. They said that members had to share losses of the LLP, and could if necessary be called upon to contribute to them in cash. That may be fine for small sums while the LLP is trading normally, but it potentially drives a coach and horses through the limited liability of the LLP. Say the firm closes and goes into liquidation – it will show a loss equal to the deficiency in its assets. If members are obliged to contribute to losses, the liquidator can ask them for a cheque to cover all the debts.

On the other hand, if there is no requirement to put in cash, other members can lose out. It’s not uncommon for members’ accounts to get out of balance with one another, either for good reasons or due to some manipulation or default by a member, who may have over-drawn or failed to contribute his capital. If the LLP cannot claim the money, the other LLP members may lose out. Members of the LLP do not usually expect the limited liability to be used to avoid sharing the pain equally!

Ideally you need limited obligations to put money into the LLP, which might end if the LLP ceases trading or goes into insolvency, coupled with rights between the members so they can recover any inequality in their receipts and contributions from each other. If the LLP goes into insolvency, the members do not have to make up the deficiency to the LLP, but they make payments between themselves to equalise their losses. But in running the LLP, you also have to be aware of the limited liability of the members. An overdrawn current account or capital account may not be recoverable as a debt, and could represent a loss that will end up being shared amongst the other members.

This is all subject to section 214A insolvency Act 1986 [4] which makes members of an LLP liable to repay all withdrawals form the LLP in the two years before insolvent liquidation, if they knew or had reasonable grounds to believe that the LLP was unable to pay its debts.

Minority oppression and fiduciary duties

Partners in a partnership owe each other fiduciary duties of good faith. Directors of companies owe similar duties to the company, on behalf of its shareholders. What is the equivalent in an LLP, if the LLP agreement says nothing, or excludes fiduciary duties? It was not clear for the first 10 years of the LLP Act, but F&C Alternative Investment (Holdings) Limited v Barthelemy has finally decided that there are no fiduciary duties owed by LLP members to each other, or to the LLP. The members can act purely in their own self-interest, except when they are entering into transactions on behalf of the LLP.

But LLP members who manage the LLP, effectively as directors, can and will have fiduciary duties to the LLP. That is because, as with partners and directors, the fiduciary duty comes from the agency arrangement: a person with control over the affairs or property of someone else, such as a director managing a company on behalf of its shareholders, owes a fiduciary duty.

That still leaves individual members of the LLP exposed, because the fiduciary duties are owed to the LLP, not the members. What if a minority of members is bullied by the majority? Part of the gap should be filled by section 994 of the Companies Act, the “unfair prejudice” remedy, as modified for LLP’s. But unlike a company, an LLP can exclude its members’ section 994 rights in the LLP agreement [5]. Lawyers acting for the LLP may have done that without thinking about it. That potentially leaves individual members with very few rights to combat oppression.

Not having an LLP agreement

Always have an LLP agreement! The issues above are insignificant compared to the problems arising when there is no written LLP agreement. Every active LLP should have one. It is the basic constitution of the LLP: unlike a company, there is no default set of articles that will fill most of the gaps. The default provisions for LLP’s are totally inadequate. The recent case of Eaton v Caulfield [6] provides a good illustration: full-blown litigation over what the agreed terms of the LLP were, with the judge deciding that in most cases the parties had not managed to exclude the default provisions.

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[1] Formed under the UK Limited Liability Partnerships Act 2000

[2] Section 1(5) Limited Liability Partnerships Act 2000

[3] Governed by the Partnership Act 1890

[4] Inserted by the Limited Liability Partnerships Regulations 2001

[5] Regulation 48 of The Limited Liability Partnerships (Application of Companies Act 2006) Regulations 2009

[6] [2011] EWHC 173, see this article

Another blow to ESC C16

Informal winding-up made more difficult

(revised 7 February 2012)

When solvent companies have ceased trading, they often want to distribute their assets without the expense of a formal members’ voluntary winding-up. HRMC’s concession C16 [1] allows companies to be struck off the register under the Companies Act [2] without a formal winding-up, whilst treating the distribution of assets as a distribution in a winding-up (taxed as a capital gain) rather than a taxable dividend.

But when the concession is put on a statutory footing it is to be limited to distributions not exceeding £25,000. The policy justification for this is not clear (vague references to "abuse"), but it means far more solvent liquidations and more fees for insolvency practitioners. And previously (when this article was published in its origianl form) the Treasury Solicitor’s office announced that it has withdrawn its BVC17 guidelines. The guidelines said that the Crown would not seek to recover share capital distributed to shareholders before a company's dissolution if the company has been struck off, the shareholders had taken advantage of HMRC's extra-statutory concession C16, and the amount of the distribution was £4,000 or less.

Returning the share capital, share premium account or capital redemption reserve to shareholders is an unlawful reduction of capital for company law purposes, and the company has the right to recover it. When the company is struck off, its property, including the right of recovery, vests in the Crown (or the Duchy of Cornwall or Duchy of Lancaster) as bona vacantia [3]. The Crown does not routinely pursue all these cases, but the risk is there, and it makes it difficult for professionals to recommend this route.

Under the BVC17 guidelines, it was safe to proceed if the amount involved was less than £4,000. The fact that the guidelines are being withdrawn suggests that some cases involving less than that amount may be pursued in future.

The justification given given was that the Companies Act 2006 procedure for reduction of capital out of court can be used instead. That is true: the new reduction procedure is extremely flexible and useful, but it does involve some documents and professional costs. It needs both a special resolution and a declaration of solvency by the directors. I have done many reductions of capital under the old and new procedures, and the new ones are far easier and cheaper, but there is still a cost involved. This is more cost and formality for small businesses, at a time when the Government is supposed to be reducing it.

There had already been some speculation that the usefulness of ESC C16 was ending [4], and this two changes are further nails in the coffin. Perhaps IP’s and accountants advising on striking off businesses under C16 should equip themselves with a set of legal documents to carry out reductions of capital without a large increase in costs; but those exceeding £25,000 of distributable assets will need to be done by way of formal winding-up, once the current draft Order comes into force.

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[1] http://www.hmrc.gov.uk/specialist/esc.pdf at page 62, likely to be replaced by legislation following a recent consultation

[2] Companies Act 2006 sections 1000 et seq

[3] Section 1012 Companies Act 2006

[4] See this AccountingWeb article