Another EMI options tax break

Is this the most generous tax relief we have?

Another big boost for EMI share options: the Treasury has relented and will now extend entrepreneurs' relief - the effective 10% rate of CGT - to almost all EMI options. Previously they had said that the employee would have to hold the shares for at least a year - difficult in many schemes.  From April 2013, the relief will be available if the option (rather than the shares) has been held for a year, and the employee has remained employed for that time.

EMI options are almost ludicrously tax-efficient, with an effective negative tax rate. Any company that could be using them probably should be.

Frequently asked questions:

Why was it hard to get the relief previously? Until the 2012 Budget, entrepreneurs' relief was not available unless the employee had held shares amounting to 5% of the company for at least 12 months. Few EMI options amounted to 5%, so most were excluded on that ground alone. But the 2012 budget removed the 5% requirement for EMI options. The 12 month rule remained.

Why was that a problem? Most EMI options are exercised (converted from an option to real shares) only immediately before the shares are sold. There are a number of reasons for this:

• The employee doesn’t have to find or borrow the money to pay the exercise price
• The employee is not at risk of losing money if the value of the shares falls or the company fails
• If there is tax to pay on exercise (usually only if the exercise price was set at below market value at the date of grant) the employee has the money to pay the tax if he has sold the shares – otherwise he may have it deducted from pay under PAYE
• Option exercise can remain subject to conditions being met. Most popular is condition making options exercisable only when the company is sold – which ruled out holding the shares for 12 months
• The company has not issued real shares until shortly before sale, removing all the issues surrounding small employee holdings in private companies – how to buy the shares back if someone leaves, upsetting voting balance, inhibiting owners remunerating themselves by way of dividends…
• Corporation tax relief is maximised: it continues to accrue on the rising value of the shares until the moment before the shares are sold

Until this change, in order to benefit from entrepreneurs’ relief, the employee would have had to exercise his option and get real shares at least a year before sale. If sale was going to be on sale of the company, that meant accurately predicting an exit a year in advance!

Why is there a negative tax rate?

On options granted at market value, there is normally no income tax (or NICs) payable on grant of the option , exercise of the option or sale of the shares. The only tax paid by the employee is CGT on the gain on sale of the shares, to the extent that it exceeds the annual CGT allowance – and the CGT will now usually be at 10%. But the company gets corporation tax relief on the gain[1], even though it has not incurred any cash cost. As the rate of corporation tax is higher than the employee’s effective rate of CGT, the Treasury is paying you!
 

I have been advising companies on employee share incentives for 30 years. If I can help with EMI options or any other kind of share scheme, do get in touch.








Published December 2012
Updated February 2013

 

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[1] Assuming exercise of the option and sale of the shares are at the same value. All tax reliefs mentioned are subject to conditions, and the tax position described is the usual one, but there could be exceptions; always take proper professional advice, ideally from me!

 

 

Giving up limited liability for accounts exemptions

A new concept in UK company law?

I don’t know whether they achieve the record for the most uses of the word “and” in the title of legislation, but the snappily-named Companies and Limited Liability Partnerships (Accounts and Audit Exemptions and Change of Accounting Framework) Regulations 2012 break new ground in other ways.

As well as simplifying audit exemptions for small companies and making it easier to switch between IFRS and UK GAAP, the regulations grant a subsidiary an audit exemption for its individual accounts – but only if the parent company gives a guarantee of all the subsidiary’s liabilities as at the balance sheet date. There are similar exemptions for dormant subsidiaries from preparing and filing accounts at all. In effect, groups are being invited to give up the limited liability of the individual subsidiary entities as the price for avoiding an audit of the subsidiary’s accounts, or to save the cost of preparing accounts for a dormant subsidiary.

If the subsidiary is material it will have to be included in the parent company audit anyway (though possibly at a higher materiality threshold). The parent company audited accounts have to filed against the subsidiary’s record at Companies House, and there are other conditions to fulfil.

Is it worth it? Parent company directors will want to think very carefully before giving the guarantee. It guarantees “all outstanding liabilities to which the subsidiary company is subject at the end of the financial year to which the guarantee relates”. It includes liabilities not shown in the accounts. Those would include, say:

• future contracted liabilities, eg the rent for the whole of the remaining term of a lease, or costs to complete current sales contracts

• mis-selling liabilities or regulatory fines and penalties

• liabilities of the subsidiary under guarantees it has given to third parties

• product recall or warranty costs

• environmental clean-up costs

• personal injury claims unknown at the time.

Parent companies may not be insured for liabilities they undertake voluntarily by way of a guarantee. Would you want to be the parent company director who exposed the parent company to unknown liabilities to shave a few quid off the audit fee?

 

Trading shares for rights

How will George Osborne’s new share scheme work?

"Workers will be asked to surrender employment rights in return for shares in their company under plans to boost enterprise announced by George Osborne. People who accept the shares will have to waive their rights to redundancy or to sue for unfair dismissal and will not be able to request flexible working hours. The Treasury will not levy capital gains tax when workers sell their shares, which can be worth between £2,000 and £50,000." - Daily Telegraph

 

I don’t wish to enter the political debate on whether employees in small businesses should be able to opt for reduced employment rights, or whether they should have full rights at all. But how would this proposal work on the shares side? I strongly suspect that if it ever sees the light of day, this will be one of those schemes that languishes largely unused – unless it becomes a bonanza for tax avoidance.

 

Of course there are few details available beyond what George Osborne said in his Conference speech. A Government press release adds a couple of points, and promises a consultation, so the promise to “rush through” legislation to be in force by April 2013 looks unlikely to be fulfilled.

So what are the issues that would have to be addressed?

 

·         Under present legislation, the value of the shares (between £2,000 and £50,000 we are told, assuming this means value when they are given) would be immediately charged to income tax, and usually national insurance, when the shares were given. But the new “owner-employee” would have no money to pay the tax, other than his other earnings. Mr Osborne says there will be an exemption from CGT, but doesn’t mention income tax. Will there be an exemption?

 

·         If so, HMRC has been tightening up on employers finding was to confer tax-free benefits on employees, including through employee shares, and this could blow a hole in their strategy. What will stop a senior employee waiving his bonus (and his employment rights) and instead receiving £50,000 in tax-free shares, which he then sells back tax free?

 

·         Further income tax charges can arise if the shares are subject to restrictions or risks of forfeiture. If these rules are waived, further tax planning opportunities open up.

 

·         If the company buys back its own shares within five years of their issue, the gain made by the employee is normally charged to income tax and not CGT, so the promised exemption from CGT looks a bit hollow.

 

·         Most small businesses are very reluctant to part with equity in the company. Minority shareholdings can be a significant brake on the development of the business, especially if they remain after an owner-employee has left and ceases to contribute. But an open-ended commitment to buy shares for cash if an employee leaves would be unaffordable as well as unacceptable. Where is the cash going to come from? Most successful private companies could not easily fund an obligation to buy a significant proportion of their own share value.

 

·         In a start-up micro business the shares are worth very little, so you get an awful lot of shares to make up a minimum market value of £2,000. Entrepreneurs could find they have given away equity that becomes extremely valuable once the business takes off.

 

·         It is an important part of employee share scheme planning to avoid creating incentives for employees to leave. The press release makes it clear that owner-employees must be entitled to full value for their shares and cannot forfeit them as “bad leavers”. This is one of the many attractions of employee management incentive scheme (EMI) options: the employee does not get the shares until their value has been earned.

 

·         Unless a small business is looking for an exit through sale, there will be no visible route for owner-employees to realise their shares except by selling them back to the employer at a valuation. Companies are reluctant to commit to buying shares at someone’s opinion of value. Employee shares can become negative incentives if they fail to grow in value, or if there is no realistic prospect of selling them.

 

 

It's a privilege to talk to your lawyer

Privilege and withholding embarrassing documents

Are you heading for a legal dispute? Or do you deal with sensitive issues that could be pored over in court later? You should be aware of the law on disclosure of documents and the implications of privilege.

The normal rule in any civil dispute, including tax cases, is that both parties must disclose documents which support or adversely affect any party’s case. Failing to disclose documents, or destroying them (including deleting emails) may be punishable as contempt of court, and can result in the court drawing inferences from the absence of documents you would expect to see. As soon as a dispute starts, your lawyer should advise you on preserving and securing evidence – but it may be too late by then. If the authenticity of documents may be questioned, particularly in relation to emails and electronic documents and records, you may need to get specialist help to preserve forensic-quality copies of the records with their original date and time information.

But what if you don’t want to disclose embarrassing evidence? You may be able to rely on privilege. You are entitled not to disclose privileged evidence, and no inferences can be drawn from your failure to provide it. The courts are fiercely protective of legal professional privilege, which they see as fundamental to our system of justice. Searches (by regulatory authorities, police or under court orders) must be arranged to protect privilege.

There are two kinds of privilege: legal advice privilege, which protects confidential communications between lawyer and client, and litigation privilege. Legal advice privilege covers communications between lawyer and client for the purpose of taking and giving legal advice. It includes documents created for the purpose, but not the client’s background preparations or reactions which are not to be communicated to the lawyer. It applies whether or not there is a contemplated dispute. It includes communications with in-house lawyers (except in EU competition cases) but does not include general business advice which is not given in a legal context.

Litigation privilege covers confidential communications or documents brought into existence for the dominant purpose of use in actual or contemplated litigation, including criminal proceedings or adversarial regulatory investigations, such as competition inquiries by the OFT or FSA investigations. Unlike legal advice privilege, it includes communications with third parties.

Privilege can be waived, sometimes accidentally: if you waive privilege in a document to advance your case on an issue, all other privileged documents relevant to that issue also lose privilege. If you copy documents for some other purpose, privilege may be lost, and it is lost if the documents cease to be confidential. So care is needed to preserve privilege, including appropriate markings: this lies behind the wording often seen on the bottom of emails about privilege.

If your business is dealing with sensitive issues, the last thing you want is for your deliberations to be used in evidence against you. It may make sense to carry out all your internal discussions with or through a lawyer, so that you attract legal advice privilege. No other profession offers this advantage.

Click to accept

Are website conditions of use binding?

Many websites have conditions of use, supposedly binding the visitor to various conditions. Usually they are of minor importance, but if they are contractually binding, there is no theoretical limit on the obligations that could be imposed. But is there a contract with the visitor?

Probably not, and a recent case[1] strengthens that view, holding there was no consideration even for an online acceptance click. To form a contract there would have to be offer and acceptance, consideration and contractual intention. None of these is likely to be present just in visiting a website.

The case went further. It held that there was no contract even when the consumer set up an account, registered user details and clicked to accept the terms and conditions. The court said there was still no consideration for the obligations of the consumer: the website owner was not obliged to provide him with any service, and could take down the website at any time. A contract only came into being when an actual order was placed.

That is a surprising conclusion, given the minimal requirements to give adequate consideration, so the case may not be reliable as a precedent in other cases. Including some trivial obligation on the part of the website operator could get round the point.

Less surprisingly, the case also says that attempting to make a consumer responsible for all unauthorised use of his account is unfair and unenforceable under the Unfair Terms in Consumer Contracts Regulations 1999 – see my previous post on that subject, On Level Terms.

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[1] Spreadex Ltd v Cochrane [2012] EWHC 1290 (Comm)

The Game is the winner

HMRC takes another kicking over football creditors

Many of my readers will know that I was deeply involved in the rescue of Wimbledon Football Club from administration, as it went on to become the mighty MK Dons.  I was there, in the Court of Appeal, when HMRC’s challenge to the CVA, and indirectly of the Football League’s football creditor rule, took a 3-0 drubbing. [1] Leading Treasury Counsel had his legs taken out from under him by the Lord Chief Justice in the first five minutes.

So I was a bit surprised that HMRC has had another go, this time in proceedings against the Football League itself. HMRC was knocked out in the first round by Mr Justice David Richards. [2]

The football creditors rule has been deeply unpopular with HMRC and other non-football creditors for many years, because it requires football creditors (players, managers, other clubs and the League itself) to be paid in priority when clubs go into administration, leaving less (or nothing) for the unsecured creditors. It offends against the usual principle that unsecured creditors rank equally and get paid proportionately. It works by not allowing the club to play in the League unless the football creditors have been paid. So any buyer will pay off the football creditors and knock the cost off what he would otherwise have paid for the club. Because the money does not go through the administrator’s hands, he cannot distribute it equally. To add insult to injury, the creditors are then asked to agree a CVA (company voluntary arrangement) that prevents them from pursuing their claims; if they don’t agree, the club goes into liquidation and they get nothing.

HMRC tried to use the anti-deprivation rule, which invalidates arrangements that deprive a debtor of assets on bankruptcy. The court held that this can apply to an administration, but its scope is narrow and the funds in question in this case are not assets of the club at the time of administration.

It remains to be seen whether HMRC seeks a return match in the Court of Appeal, but there is not much in the judgment of David Richards J. [3] to give them any hope.

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[1] Inland Revenue v Wimbledon Football Club Ltd & Ors Rev 2 [2004] EWCA Civ 655

[2] I’m getting old. I remember instructing David Richards as (very) junior counsel.

[3] HMRC v The Football League Ltd & Anor [2012] EWHC 1372 (Ch)

Time for a sharp Grexit?

Business implications of Greece leaving the Euro

At last our politicians are admitting the possibility of a Greek exit, and the need to plan for it. But what are the implications for businesses trading with Greece, or with assets there? Here’s one lawyer’s view.

A Greek exit would take one of two forms: a unilateral decision by Greece, or a managed process agreed by the whole EU, or at least the Eurozone. An exit means breaches of the EU treaties, so we are talking about political decisions rather than legal mechanisms. Anything done without formal agreement by all EU member states would be illegal, but that doesn’t mean it can’t and won’t happen – international law doesn’t work like that. Once a Greek exit has been announced, all involved will be under enormous pressure to reach agreements to mitigate the damage, so a unilateral exit could turn into a managed process, perhaps ending with a retrospective treaty. Although a Greek default and exit would be greeted with initial hostility, governments may actually help the Greek government in order to preserve stability in the rest of the Eurozone. Businesses and individuals in other parts of Europe cannot assume that they will be protected by their own legal systems.

Cash

All Euro notes and coins circulating in Greece would (theoretically) be converted into new Drachma at an official exchange rate, making them far less valuable than other Euros. It’s unlikely that the distinction would be made by the country-specific designs of the Euro coins, or the “Y” prefix of the serial number on Euro notes. Notes within Greece would probably be overprinted with a Drachma designation, and banks would close until they could start issuing the Drachma notes. Of course it will be in Greek citizens’ interests to avoid the overprinting and to take their Euro notes abroad, and we can expect border controls and massive currency smuggling. Eurozone governments may want to co-operate in stemming this, as contraband Euros will undermine good German ones, so European governments could introduce bans on possessing or exchanging Euros known to have been smuggled from Greece, and could seize the currency – though not once it was circulating in their own countries.

Bank Deposits

All Euro deposits in Greek banks in Greece will be converted into devalued Drachma, assuming that the banks themselves survive. Even foreign depositors are unlikely to have any legal remedy. Local deposits in foreign banks are likely to be governed by Greek law. Deposits in foreign branches of Greek banks in Euros are probably repayable in Euros. Greek depositors will be rushing to get their deposits abroad, and ideally outside the Eurozone, or to invest them in other currencies such as dollars or sterling. It is possible that the EU, or the Eurozone, would attempt to help Greece by converting Euro deposits in European banks held by Greek citizens or residents into Drachma; that would be controversial and administratively very difficult, especially for small consumer deposits. Greek law may compel its citizens to repatriate their assets, though Greeks may not hurry to comply.

Debts and payment obligations

The whole network of business relationships would be thrown into chaos, with losses falling almost randomly on someone in the supply chain. Euro-designated debts in Greece covered by Greek law would be redenominated into Drachma and could be settled in devalued Drachma. It is likely that Greek citizens or residents would be protected by Greek law against being sued for Euro debts, so even if your contract is governed by English law, you are likely to have difficulty enforcing a Euro judgment in Greece. If the debtor has assets outside Greece, you may be on stronger ground.

All international contracts should include a choice of law and jurisdiction. If you supplied a customer in Greece for a price in Euros under an English law contract, how will you fare? UK jurisdiction is specified, and the court will allow the claim to be served outside the UK – though you might be in difficulty if the customer was a consumer. English courts can give judgments in foreign currency, but will they award Euros or Drachma?

Lex monetae says that where a contract refers to a currency, there is an implied choice of that country’s law to decide what constitutes the currency and payment. It is unlikely that this would apply if Greece seceded and the Euro continued, but it could apply if the Euro broke up, or more likely if the whole Eurozone passed legislation saying which debts were redenominated. That could itself be controversial, as non-Eurozone member states (such as the UK) might block EU legislation that prejudiced UK creditors; the European Court would probably contort itself to protect the Eurozone.

Otherwise, payment obligations will be governed by the chosen law of the contract. English law is likely to say that a Euro obligation must be paid in Euros. The English court’s judgment could then be enforced against the debtor’s assets in the rest of Europe (other than Greece) or (with more difficulty) in many other places

You may need to take care not to acquiesce in the conversion of your debt into Drachma, for instance by accepting the Drachma payment and then attempting to claim the rest of the Euro amount. The actual terms of your contact may be important – if it defines “Euro” as the currency of Greece, you may be in trouble. Any place specified for payment may also be important. If making contracts now, be specific about these things.

Other contractual obligations

Failure to pay in the contractual currency on time will often be an event of default, which may entitle the other party to bring the contract to an end and claim damages – though notice may be needed if time is not “of the essence.”

The imposition of exchange controls could make some contracts legally impossible to perform, in which case they could be frustrated – in which case neither party has a claim against the other, and any loss lies where it falls. Grexit could also trigger “material adverse change” or “force majeure” clauses in some contracts. Otherwise, the contract is likely to continue (in the absence of an insolvency) with the consequences being decided by the courts. If you are about to ship goods, uncertain as to whether you will be paid in Euros or Drachma, you have a difficult decision to make: don’t ship, and risk being sued; or ship the goods, and risk not being paid.

Breaches of exchange control may be criminal offences, in Greece or in other EU states. If it became illegal under English law, or possibly under other laws, to perform your contract, you will not be obliged to carry on. There may be other legal changes in Greece or elsewhere, which could be quite oppressive, such as restrictions on the movement of assets or people. Foreign governments could pass legislation imposing sanctions on Greece, or attempting to protect their citizens and companies from the worst effects of Greek default. They might enforce mutuality, saying that if Greece is only paying its debts in Drachma, debts owed to Greek parties may also be settled in Drachma.

Guarantees and securities for Greek Euro debts have to be interpreted according to the relevant law, but are likely to follow the main payment obligation: so an English law guarantee of a Greek Euro debt would usually guarantee whatever the payment obligation was under the main contract. Contracts or mortgages relating to land in Greece are likely to be governed by Greek law.

Insolvency and State immunity

Many Greek commercial companies are likely to go bust. Europe-wide recognition of insolvency proceedings probably means that their UK assets will be protected from seizure, so that they are distributed to creditors in an orderly fashion. There is no insolvency law for nations, so enforcing government debts and seizing assets will be a free-for-all. UK creditors may have a head start, as many Greek government and bank financial assets are likely to be located in London.

Foreign governments are protected against being sued, but sovereign immunity does not apply to commercial transactions, including State borrowing.[1] When Argentina defaulted on its sovereign debt, there were many examples of bondholders successfully suing in foreign courts and enforcing against foreign assets. Sovereign immunity would protect the Greek government from claims for damages, for instance to recover losses flowing from its breach of the EU treaties.

What if I’m the debtor?

If you owe money in Euros, you may want to try paying in Drachma. If your contract is closely connected with Greece, you may get away with it. The arguments above apply in reverse, but Greek law may make it more difficult for Greek companies to claim settlement of their bills in unreconstructed Euros.

What should I do now?

Many people will be pulling money and assets out of Greece. If trading there, get paid in advance. Remember that any letter of credit or performance bond may only be as good as the underlying obligation, when it comes to currency. If you have a gambler’s mentality and still want to extend credit to Greek parties, make sure your contract is under English law and jurisdiction. If you must make Euros the payment currency, make it clear that you are talking about the European currency and not the Greek one – or perhaps specify the currency of Germany! Include an indemnity by the other party requiring them to compensate you against any loss flowing from their country leaving the Euro, including exchange losses and payment delays. Review what would happen if the other party, or his associates and subcontractors, disappeared in a maelstrom of insolvency and cross-default following Grexit. Make a redesignation of the currency an event of default. And while you’re changing your terms of business, what about Portugal, Ireland, Spain, Italy?

If you’re a bank, launch an advertising campaign in Athens – seeking deposits in nice, safe sterling in an account in London.

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[1] State Immunity Act 1978

EMI share options boost

By far the most tax-efficient incentive

EMI share options (the Enterprise Management Incentive scheme) were given a huge boost in the 2012 Budget, and they are by far the most tax-effective incentive available to unquoted companies to reward and incentivise employees. Most importantly for the majority of participants, Entrepreneur’s Relief – an effective 10% rate of capital gains tax – will now apply to options exercised after 6 April 2012. That restores the attractions of the EMI scheme before the abolition of taper relief a few years back. Participants with no other relevant gains could receive up to £10m of gains at a 10% tax rate. The overall tax rate is actually negative: the corporation tax relief, at (say) 22%, exceeds the tax the employee pays at 10%. So the Treasury is actually subsidising the benefit.

The limit on the value of options that can be granted to any one employee is also to be more than doubled, from £120,000 to £250,000. The limit applies to the value of the shares at the date of grant of the option. This change is not yet in force, because it requires EU approval as “state aid”.

As a reminder, EMI options give an employee a right to acquire shares at a future date at a fixed price, often the current market value. The right can be conditional: it can be exercisable only on sale of the company, so that the owners do not lose and control or suffer dilution until an exit. Or it can depend on meeting performance targets. The usual tax treatment will be:

·         No tax of any kind on grant of the option

·         No income tax or NI (including employer’s NI) on exercise of the option, if the option is granted at market value

·         The company gets corporation tax relief (say 22%) on the notional gain made by the employee at the date of exercise, even though the company has paid nothing out

·         When the employee sells the shares he or she pays 10% CGT on the gain above the annual CGT exemption (with Entrepreneur’s Relief).

In most cases exercise of the option, issue of the shares and sale of the shares are more or less simultaneous.

The Office of Tax Simplification recently published recommendations for simplifying employee share schemes, including merger of the CSOP into EMI and the introduction of self-certification instead of HMRC prior approval of scheme rules (which is already the process in EMI schemes, greatly reducing cost). But merging the two could bring restrictions on the current freedom of EMI, so it may be wise grant EMI options before that happens.

With private company share values still low in a depressed M&A market, there has never been a better time to grant EMI options. Anyone about to exercise an option should consider deferring until after 6 April. If your company has granted unapproved options to key staff because you had used the £120,000 EMI limit, it may be worth considering cancelling the unapproved option and re-granting it within EMI, especially if the share price has not increased much – but only after the new rules come into force.

I have been advising on employee share schemes for 30 years. If I can help with EMI schemes, give me a call.

Out of court

Problems with expert determination clauses

A very common clause used to establish the value of shares or other assets is defective, according to a recent Court of Appeal decision[1].

Contracts and company articles of association often refer share valuation issues to an independent expert accountant. Similar forms of clause are used to settle the accounts of a business, and in property documents to refer valuations or rent reviews to an independent surveyor. The usual form of clause says that an independent expert is to be agreed or, if not agreed, chosen by the President of the Institute.

In this case the court held that both parties have to agree not only to the selection of the expert, but also to all the terms of the appointment, even if he is chosen by the President. So by withholding agreement to the engagement letter, a party could bring the whole process to a halt. The court said the process should be “formal and precise” and, in litigation that had already lasted four years, would only help by declaring that the parties could not unreasonably withhold consent. This case potentially gives the whip hand to the truculent and unreasonable.

I have devised wording to avid the effects of this case and keep disputes out of court. Anyone who might need to rely on an independent expert clause should have it reviewed before a dispute arises.

Non-disclosure agreements (NDAs, also confidentiality agreements or secrecy agreements) are used in a number of commercial contexts, from deal negotiations to technology sharing. But are they worth the paper they are written on? It is sometimes said that the cost of enforcement makes them useless, at least to small businesses.

There are benefits in having an NDA even if you are not likely to sue on it. Foremost is deterrence, and making the other party more aware of the need to respect confidentiality. The biggest downside, in my view, is not cost but evidence, as it's very difficult to prove a breach and even harder to show loss justifying substantial damages. Injunctions aren't much good if the information has already been disclosed (though they can restrain other abuses). I often advise clients not to disclose their "crown jewels" information even if they have an NDA in place.

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[1] Cream Holdings Ltd v Davenport [2011] EWCA Civ 1287

This article in shorter form was originally written for the
Excello Law Limited newsletter and website

Putting the Djinn back in the bottle

Is an NDA worthwhile?

Non-disclosure agreements (NDAs, also confidentiality agreements or secrecy agreements) are used in a number of commercial contexts, from deal negotiations to technology sharing. But are they worth the paper they are written on? It is sometimes said that the cost of enforcement makes them useless, at least to small businesses.

There are benefits in having an NDA even if you are not likely to sue on it. Foremost is deterrence, and making the other party more aware of the need to respect confidentiality. The biggest downside, in my view, is not cost but evidence, as it's very difficult to prove a breach and even harder to show loss justifying substantial damages. Injunctions aren't much good if the information has already been disclosed (though they can restrain other abuses). I often advise clients not to disclose their "crown jewels" information even if they have an NDA in place.

I drafted one for a client only yesterday, though.

 

Charity vaunteth not itself

The new Charitable Incorporated Organisations

Whoever said, “every charitable act is a stepping stone towards heaven” probably didn’t contemplate the Charities Act 2006!

We will shortly have a new form of incorporated body: the Charitable Incorporated Organisation, or CIO, expected to be with us in the spring of 2012. It joins a very select band of forms of incorporation with limited liability. For years we had only the Companies Act company, industrial and provident societies, and companies incorporated by statute or Royal Charter; in recent years they have been joined by the open-ended investment company (OEIC), the LLP, the community interest company (CIC), the European EEIG and SE, and now the CIO.

For many years it has been common for charities to be registered as companies, not least to get limited liability for the trustees. The relationship between charity and company law has always been a little tense, and it started to become necessary for the Companies Act to make special provision for charitable companies. Now it has been realised that it makes more sense to have an entirely separate form of incorporation for charities, overseen by the Charity Commission rather than Companies House and the BIS.

There have been long delays in bringing the new legislation into force, but the latest information is that should be in by the spring – though there is some scepticism about whether this timetable will be kept to. To avoid a logjam of applications, existing charitable companies may not be allowed to apply until later. There will be a procedure for converting existing companies to CIOs, so there will be no need to transfer assets from the old company to the new CIO – though that will still be needed to turn an unincorporated charity into a CIO.

Charities with complicated governance structures or membership schemes would be well advised to start drafting their new constitutions now, if they want to take up the new format as soon as it becomes available. More information is on the Charity Commission’s website. The legislation setting out much of the detail on how CIO’s will work (which is not yet in force) is in Schedule 7 to the Charities Act 2006.

Say Cheese©!

Reproducing the composition of a photograph

I’m an amateur photographer, so I found a recent copyright case interesting: Temple Island Collections v New English Teas – about images of London on tasteful souvenirs in tourist shops. A photograph taken of the same general (but not exact) location and subjected to similar digital manipulation as the original was held to infringe copyright, even though no part of the original was physically copied. The two pictures are reproduced in the judgment or here.

The case stretches copyright towards protecting the creative thought rather than the result. Traditionally it is said that copyright protects the expression of the idea rather than the idea. The problem with protecting the idea, as the judge himself recognised, is where the principle stops. It doesn't stop someone taking a picture from the same vantage point, or converting an image to black and white, or using spot colour on a black and white (which the claimant admitted he has copied from Spielberg’s Schindler's List), or blanking the sky; but at some point doing all these things together, inspired by an earlier work, became copyright infringement.

Would any two, or any three of those factors have been sufficient? If I photograph four of my mates crossing Abbey Road, is that copyright infringement? What if I have one of them take off his shoes? The case contrasts with Creation Records and Noel Gallagher v News Group Newspapers in which The Sun’s photographer did not infringe copyright by snapping an elaborate photo-shoot set from the same position as the official photographer.

I think the new decision is right - after all the reproduction of other forms of work, such as a musical score, does not require mechanical copying, and copying in a different medium can be an infringement. If I made a painting from the photograph (which would be a very poor reproduction!) I would be infringing, so why not if I deliberately re-create a photograph? But it does make it hard to draw the boundary.

Help! The bank has frozen my account!

Collateral damage from money-laundering legislation

I have seen this more than once: a client rings in a panic, having had his business bank account frozen by the bank. His bank won’t tell him why. They are suddenly completely uncooperative, and he is naturally livid. He wants to know how to get the account unfrozen, and if necessary to take immediate legal action. What should you do if it happens to you?

The reason is almost always that the bank has formed a suspicion that the account or the customer is involved in money-laundering (or terrorist financing). Once it forms that suspicion, the bank is obliged by law to block transactions; otherwise it risks committing an offence of converting or transferring criminal property under the Proceeds of Crime Act 2002 or facilitating the retention or control of terrorist property under the Terrorism Act 2000. [1] It also has to make a report to the Serious Organised Crime Agency (SOCA) explaining its suspicions.

You may be an entirely innocent party. The suspicion could relate to an investor, employee, customer or supplier. The concept of “proceeds of crime” is extremely wide, and can include, for instance, the benefit of tax evasion, or business cost savings arising from minor offences.

Suspicions can be triggered by the bank’s internal systems, far away from your relationship manager. All banks now operate back-office systems for flagging up and reporting unusual transactions. Your manager might know why something has happened, but it may still look suspicious to someone – or a computer – in head office.

What is more, the bank is prevented from telling you why it has done what it has done: it is an offence to “tip off” a person if that could prejudice an investigation following the report. The only way to avoid lying to you is for the bank to say nothing at all, so it just clams up. Of course this can be a nonsense: any criminal or terrorist, and most well-informed people, will know that if a bank or professional adviser suddenly refuses to act on instructions and won’t tell you why, it is probably because they have a made a money-laundering report.

SOCA can give consent to allow transactions to proceed, or if it doesn’t respond within seven working days, the freeze ends. But if SOCA refuses consent, the freeze is extended until 31 days from the date of refusal of consent. In that case, SOCA will usually have notified the police or other enforcement agencies. If they want further time to investigate, they will have to make an application to court.

The courts have consistently supported banks when they have relied on their duties under the money-laundering legislation, even if the customer is entirely innocent. [2] So the customer usually has no remedy, even if his business is left in ruins. A Mr Shah has been claiming losses of $330 million from HSBC which he alleges flowed from their blocking of transfers from his account.

To be protected, the bank just has to satisfy the court that it had a suspicion. The suspicion does not even have to be reasonable: if the bank has a suspicion, it must report and it must stop the transaction. The court has said that the bank must “think that there is a possibility, which is more than fanciful, that the relevant facts exist. A vague feeling of unease would not suffice. But the statute does not require the suspicion to be 'clear' or 'firmly grounded and targeted on specific facts' or even based on 'reasonable grounds'." [3]

Mr Shah tried a variety of different attacks on the bank’s position. He said that the bank’s suspicion was irrational; negligently self-induced; mistaken; and/or automatically generated by computer. He said that the bank was negligent, or breached its duty to give him relevant information about his affairs. The Court of Appeal dismissed all these claims apart from the last. It allowed the claim to go forward only in case Mr Shah could prove that the bank did not in fact have a suspicion at all; or he could prove loss from the bank’s failure to tell him what was going on, at a time when it was not protected by the “tipping off” requirement – perhaps because the investigation had ended. In a second visit to the Court of Appeal, the court even refused to order the bank to tell Mr Shah which employees had the suspicions and made the reports, on grounds that it was not relevant; public interest immunity could also apply.[4] Mr Shah’s lawyers made a third unsuccessful visit to the Court of Appeal [5] before the remains of his case came on for trial in December 2011. The trial is still going on, with a decision not expected for several months, but the legal principles are clear.

So what advice do I have for the innocent bank customer, without the resources of Mr Shah, to fund costs? Each case depends on its facts, but early litigation is not likely to be successful. In the short term, the best answer is usually to work with the bank to allay the suspicion and get the freezing lifted. If the client thinks he knows what has caused the suspicion, give the bank the evidence. Ask them to seek the permission of SOCA to proceed with the transaction, as a matter of urgency. Whilst pointing out the possibility of a claim may focus their minds and make them review their decisions, it is unlikely that there will be a successful claim if there is a genuine suspicion. Bank customers should perhaps be alive to these issues beforehand and try to head them off, for example by giving the bank an explanation in advance of transactions that may look suspicious. As Mr Shah is finding out, the cards are heavily stacked against the customer.

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[1] It could also be that t has not completed its client due diligence under the Money Laundering Regulations 2007 or its ongoing monitoring has noticed a problem with it, which can oblige it to block bank account transactions under Regulation 11.

[2] K v National Westminster Bank; R (UMBS Online Limited) v SOCA; Shah v HSBC Private Bank [2010]

[3] R v Da Silva

[4] Shah v HSBC Private Bank [Oct 2011]

[5] Shah v HSBC Private Bank [Nov 2011]