Clarity in Corporate Law
Legal musings and helpful hints from Chris Robinson, an independent corporate lawyer in England — for businesses, law firms and their clients.
10 September 2024
21 April 2022
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.
26 February 2021
Ethics and new lawyers
How are bad apples getting into the barrel?
12 November 2020
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:
18 August 2020
Solicitors' ethics: the client or the public?
How should lawyers deal with disreputable instructions?
18 March 2020
Covid-19: suggestions for emergency law reform
Promoting fairness, spreading costs and avoiding a long tail of litigation
Stay safe.
17 March 2020
Covid-19: who bears the loss? Contracts and Coronavirus
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.
20 November 2019
IR35 responsibility for worker status transfers to employers
Employee, consultant, worker, director?
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.
18 November 2019
First disqualified director compensation order
Banned directors can now be made to pay creditors
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.
09 November 2019
Bank liability for fraud
Negligent bank responsible even if payments are authorised per the mandate
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
05 November 2016
Brexit: judicial independence and the Bill of Rights
Attacks on our guarantees of freedom from tyranny
18 October 2016
Forfeiture of partnership and LLP profit shares
Having your slice and eating it
- 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.
26 February 2016
UK company fined at home for failing to prevent bribery overseas
A bung can cost more than a fistful of dollars
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:
16 February 2016
Using directors' powers for their proper purposes
Doing the right thing for all the wrong reasons
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.
04 November 2015
Penalty clauses are unenforceable - aren't they?
It was never 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.