Covid-19: suggestions for emergency law reform

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Stay safe.

IR35 responsibility for worker status transfers to employers

Employee, consultant, worker, director?

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

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

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

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

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

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

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

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

First disqualified director compensation order

Banned directors can now be made to pay creditors

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

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


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

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

Bank liability for fraud

Negligent bank responsible even if payments are authorised per the mandate

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

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

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

Singularis Holdings v Daiwa Capital Markets

UK company fined at home for failing to prevent bribery overseas

A bung can cost more than a fistful of dollars

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

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

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

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

·     Penalties can be swingeing

·     Professional practices are not immune

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

Using directors' powers for their proper purposes

Doing the right thing for all the wrong reasons

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

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

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

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

Dangers for nominee directors - and those appointing them

Directors' responsibilities in sharp relief, and a piercing of the veil of limited liability?

There may be nothing new in the idea that a nominee director must exercise independent judgement and act in the interests of his own particular company, rather than the interests of a parent company or the person appointing him, but Central Bank of Ecuador v Conticorp SA provides an eye-watering illustration to make nominee directors sit up and think!

A Mr Taylor, acting as nominee of a banking group, was the sole director of a Bahamas company. He acted only on the instructions of the banking group, and was paid the princely sum of $2,500 a year for acting as director. On instructions, he signed away a portfolio of assets worth $190m in a transaction at an undervalue. He made no enquiries as to the commercial benefit to his company of the transaction, and did not exercise any independent judgement. Because of that, he was fixed with the knowledge of the nature of the transaction of those instructing him. He was found personally liable for the whole $190m, plus interest that took the claim over $1/2billion.

That can easily happen when someone takes the office of director without taking seriously the attached responsibilities. Perhaps more interesting from  a legal perspective, and more worrying for corporate groups, is that the court also found that other group companies, and individuals in them, were also liable for the full amount due to their "dishonest assistance" of a breach of fiduciary duty. That potentially gives a claimant a much wider range of defendants to aim at, and could effectively avoid the limited liability of the company. It is not only the deluded nominee director who is at risk, but also those who give him instructions and devise the company's transactions. The other people involved could could not honestly have considered the transactions to be in the company’s interests, in the light of what they knew, so they were liable for dishonest assistance.

Turning a blind eye can be enough to establish liability for dishonest assistance: “Dishonest assistance requires a dishonest state of mind on the part of the person who assists in a breach of trust. Such a state of mind may consist in knowledge that the transaction is one in which he cannot honestly participate (for example, a misappropriation of other people’s money), or it may consist in suspicion combined with a conscious decision not to make inquiries which might result in knowledge..." (Barlow Clowes International Ltd v Eurotrust International Ltd).

No-one should ever act as a "nominee" director, in the sense of blindly acting on the instructions of someone else; but nor should anyone assume that they can safely let such arrangements go ahead when it is plain that there is a breach of duty, or  plain enough to require further investigation.

New Companies House search facility

First impression of the new free access to UK company data

The new Companies House search facility, giving free access to information on UK companies and copies of filed documents, has been launched in beta here.

My first impression is that it's excellent - immediate one-click access to documents, a huge improvement on the previous elaborate process of selecting, paying for and downloading documents through the public Webcheck facility and the subscription services used by business customers.

The only downside I can see is that information is now so easily accessible that I'm sure there will be an increase in abuse. There appears to be no attempt to prevent automated services harvesting information, which is now all free of charge, which could be used to assist in identity fraud, to identify targets for spam, or to put together more sophisticated abuses. the information was all there before, but was only available if you knew you wanted it and  were prepared to pay your quid per document.

Address for service

Directors' risk of being served with a claim in the UK

Directors of UK companies have to give an "address for service" to Companies House. This came in in 2009 as a trade-off for the ability to conceal the director's home address (section 1140 Companies Act 2006).

In a surprising decision, a Master of the High Court has ruled that the address for service at Companies House can be used to serve any document on the director, including a claim form starting legal proceedings against him which were unrelated to the company in question (Key Homes Bradford Ltd & Ors v Patel [2014] EWHC B1 (Ch) 10 January 2014). That applies even if the director is not in the UK, and proceedings against him could not otherwise be started in England without the court giving leave to serve proceedings outside the UK (which is not automatic), and an expensive process of serving abroad. The usual rules of court requiring an individual to be served at his usual or last known residence are overridden.

Directors' addresses for service are often given quite casually, often as the company's registered office, perhaps without consulting the director in question. Now it is clear that directors should take more interest, especially directors resident abroad. Giving an address for service in the UK makes them vulnerable to being sued in England much more easily, even in unrelated matters. They can also be seriously prejudiced if proceedings are served at the company's offices and are not passed on. Disputes with the company are a particular risk: the company may be tempted to serve its claim at its own office, not pass the papers to the defendant, and enter judgment in default.

It is even possible that the address for service can be used for things that would otherwise have to be served personally, such as a statutory demand in bankruptcy or a court order threatening imprisonment for contempt.

Advisers should be much more careful in future about giving an address for service for directors, especially for those resident overseas. The address given does not have to be in the UK, and if it is outside the UK it would still be necessary to get leave from the court to serve a claim form there. Even UK directors might want to give an address abroad!

Directors: personal duty or collective responsibility?

Can a director rely on fellow directors or on majority decisions?

This post is devoted to a quotation from a judgment of Mr Justice Popplewell explaining the degree of personal responsibility of directors for collective decisions, and how far a director can rely on his fellow directors:

"It is legitimate, and often necessary, for there to be division and delegation of responsibility for particular aspects of the management of a company. Nevertheless each individual director owes inescapable personal responsibilities. He owes duties to the company to inform himself of the company's affairs and join with his fellow directors in supervising them. It is therefore a breach of duty for a director to allow himself to be dominated, bamboozled or manipulated by a dominant fellow director where such involves a total abrogation of this responsibility ... In fulfilling this personal fiduciary responsibility, a director is entitled to rely upon the judgement, information and advice of a fellow director whose integrity skill and competence he has no reason to suspect ... Moreover, corporate management often requires the exercise of judgement on which opinions may legitimately differ, and requires some give and take. A board of directors may reach a decision as to the commercial wisdom of a particular transaction by a majority. A minority director is not thereby in breach of his duty, or obliged to resign and to refuse to be party to the implementation of the decision. Part of his duty as a director acting in the interests of the company is to listen to the views of his fellow directors and to take account of them. He may legitimately defer to those views where he is persuaded that his fellow directors' views are advanced in what they perceive to be the best interests of the company, even if he is not himself persuaded. A director is not in breach of his core duty to act in what he considers in good faith to be the interests of a company merely because if left to himself he would do things differently."

I don't think I can usefully add to that.

The quotation is from the (rather lengthy) judgment in Madoff Securities International Ltd v Raven & ors in which the liquidators of Bernard Madoff's UK company attempted, wholly unsuccessfully, to claim against the directors (other than fraudster Bernard Madoff himself) for breach of duty. Among other things, the court affirmed the principle that shareholder approval cures most breaches of duty in an apparently solvent company.

I am indebted to Robert Goddard's excellent Corporate Law and Governance blog for identifying this excerpt and editing it.

Do I need a shareholders’ agreement?

Myths and rumours and minority protection

Whenever a private company has two or more independent shareholders, they will often be told that they should have a shareholders’ agreement. In the broadest sense that’s true: the relationship between the shareholders should always be agreed in some form. But a formal written agreement, in addition to the company’s articles, is not always needed.

The default position is majority rule. A majority of the directors and a majority of the shareholders can do almost anything, especially if they hold 75% of the voting shares. The exception is that they can’t force a shareholder to transfer his shares, except in very limited circumstances. A minority shareholder who does not like the way the company is run has very little comeback. Unless there is misconduct involved, his only hope is the “unfair prejudice” remedy, which is notoriously difficult and expensive to enforce. At best, it gets your shares bought out at a fair market value; it does not stop the unfair conduct, nor is it much good if your shares are worth very little but have excellent prospects for growth.

From the perspective of a majority shareholder, there’s not much wrong with democracy. The one key thing all shareholders should want is the ability to buy back the shares of a shareholder who stops being involved in the business, whether because he leaves, dies or gets pushed out. That is usually put in the company’s articles, and obliges a departing shareholder to offer his shares for sale at a fair price, either to the other shareholders or to the company itself. The exact means of valuation is up for discussion, but more often than not it is a straight proportion of the value of the company, without discount for the fact that it’s a minority shareholding, or the fact that there is no prospect of a sale. The majority probably also wants drag-along rights, forcing a minority to join in any sale of the company approved by the majority.

If those two things are in the articles, and the directors have good, strong employment contracts, the majority shareholder probably doesn’t want a shareholders’ agreement: it will only take away rights he has through his majority control.

A minority shareholder, on the other hand, has lots to gain. A shareholders’ agreement will typically give the minority shareholder a veto over a long list of actions, as well as rights to participate in management and to be consulted. It may give him a right to be a director, or to appoint one, and entrench his position so he cannot be sacked. It may impose obligations on the majority to act fairly, and to commit to a particular business plan. The agreement or the articles will give the minority tag-along rights, giving them the right to be offered the same terms as the majority if the company is sold. The majority shareholder may even be obliged to provide funding, or restricted from withdrawing funding he has provided.

What if there are equal shareholdings, or there is no overall control? In my view there is considerable danger in giving minority shareholders a veto, especially over routine business decisions. The company can become deadlocked and the business grinds to a halt, which is in no one’s interests. I generally say that democracy should rule, and the minority should take their chances. What’s sauce for the goose is sauce for the gander: any shareholder could find himself on either side of the argument, and it’s best if the company is allowed to continue to function and make profits while the shareholders argue. How far take this approach depends on the circumstances and the shareholdings: three equal partners putting a lot of money into a joint venture might want more protection than 20 5% shareholders who are passive investors.

What else would you find in a shareholders’ agreement? Restrictive covenants may be important, restricting the ability of a shareholder to compete with the business after he leaves. For a director, those can be in an employment contract, although restrictions relating to a shareholding are less likely to be struck down as unreasonable.

There is often a dispute resolution process. We often see “Texas shootout” or “Russian Roulette” clauses requiring a shareholder to state a price per share at which he will either buy or sell. They rarely work in practice and I advise against them, unless the parties have equal bargaining power, equal ability to run the company and the financial resources to buy out the other shareholders at short notice. There may even be “bad leaver” clauses, obliging shareholders to sell their shares cheap if they do not perform their obligations in the venture.

Do you need a shareholders’ agreement? It’s foolhardy to go into a jointly owned company without thinking through the issues, but I sometimes conclude that a formal written agreement is an unnecessary expense. The company needs appropriate articles with transfer restrictions, obligations to sell shares on leaving the company, and possibly “drag and tag”. Directors should have employment contracts with appropriate restrictive covenants. After that, if you have two or three equal shareholders, or a large majority against small minority holders, I might well dispense with a shareholders’ agreement and let the majority rule.

On the other hand, where an investor is putting in a significant sum of money, or the minority shareholdings are large, an agreement can be essential to protect the value of their investment. Not all shareholders’ agreements are the same, but the wrong approach can lead either to shareholders walking away with much of the value from the business, or the business grinding to a halt under the dead hand management of shareholder vetoes.

I have been drafting shareholders’ agreements for 30 years; if I can help with yours, do give me a call.

The Takeover Code and unquoted companies

A nasty surprise for the vanity PLC

Changes to the Takeover Code take effect in September. The Code regulates merger and takeover activity, largely between quoted companies. But many people (including many lawyers) do not realise that the Code also applies to some unquoted companies. Complying with it can be onerous: it involves a formal process and detailed documents, as well as large fees to the Takeover Panel. For small companies it is sometimes possible to get a waiver from the Panel with shareholder agreement, but that can be time-consuming and expensive. Otherwise, anyone contemplating buying or selling and unquoted PLC should be aware of the Code and the extra costs and delays it will involve.

Many companies think being a PLC gives them extra kudos. It can make the company seem bigger and more substantial than it is – in reality there may be only £12,500 of share capital paid up. A PLC may find it easier to get trade credit or to avoid needing personal guarantees from its shareholders. That status comes at an expense, because a number of Companies Act exemptions and relaxations do not apply to public companies, but it also brings the company within the scope of the Takeover Code. It applies to takeovers of all public companies (PLCs) whether or not their shares have been traded on a public market.

The Code also applies to a private company which has filed a prospectus, had its shares quoted on a market or had a dealing arrangement for its shares within the last 10 years. An unquoted PLC which has never had a share dealing arrangement can always escape the Code by re-registering as a private company, but any company that falls within the 10-year rule is within the Code for the full 10 year period.

What are the consequences if the Code’s application is missed? First and most likely, it will disrupt a transaction if the Code is raised part way through a deal. It gives minority shareholders in the target company extra rights, so they are the most likely to complain. Failing to comply with the Code is a serious disciplinary offence for parties or advisers in the financial services sector, and can also lead to unregulated companies or individuals being publicly reprimanded or banned from activity in the financial markets. A complaint could be made some time after a transaction. The extra rights conferred on minority shareholders may come as a surprise to a controlling majority, and the extra costs of acquisition could have an effect on potential sale price for the company.

Finally, there is that the dreaded Rule 9: anyone acquiring shares in a company subject to the Code which take him (with his associates) over 30% has to make a cash offer for all the remaining shares. That can come as an enormous shock!

Any unquoted company subject to the Code, and its major shareholders, should be aware of their Code obligations, and perhaps consider whether PLC status is worth it. Do not be caught out when a 29% shareholder buys another 2%, or when the quick and easy takeover deal gets bogged down in process and cost.

Vendor funding of business sales

a substitute for bank borrowing?

The market for company sales is slowly picking up after five long years of slow activity. A measure of confidence is back as the Euro crisis fades from the headlines. There is pent-up demand from sellers and buyers. Investors with cash are looking for a return, and equity markets are booming when other investments look unattractive. Companies are looking for a strategy that takes them beyond the defensive mindset of recession.
 

The major obstacle to mergers and acquisition activity remains the lack of funding from the banks. There is no likelihood of that changing, so parties to deals are looking for other ways to finance deals. Top of the list is vendor funding, by deferring payment of the price.
 

Vendor funding can be attractive. It allows deals to be done with little or no dependence on outside parties, and it may allow the seller to maximise the price through an earn-out arrangement, so that the price depends on the results achieved by the new owners. It can have tax attractions, by allowing the seller to spread his gain over several years.
 

Deferred deals do have some serious drawbacks, which are often not appreciated by the parties at the outset. They include:
 

• The seller can end up paying himself out of his own money. He gives away the upside (future growth) but retains all the risk. If the only source of payment is the earnings of the company, why sell? Why not keep the company and the earnings? 

• Credit risk: the deferred price is often unsecured, so that it will not get paid if either the buyer or the company goes bust. Sellers often ask for security, but often there is none of any value to be had: any assets in the company are likely to be charged to the bank, and any seller debt is likely to be postponed to the bank to the point of making the second charge almost valueless. On the other hand, if the company charges its assets to the seller it may find itself unable to borrow. There may be big, expensive arguments between the seller and the bank about priority of security and whether the seller is allowed o enforce his security.
• Sellers sometimes try to get the company or business back if the buyer does not pay, but that rarely works either. By the time the buyer defaults, the company is usually in a worthless state, and the right to recover it might well be unenforceable if an insolvency is involved.

• Buyers usually will not give personal guarantees. If they are not risking enough of their own money, they may have little incentive to make the business succeed and pay out the seller, especially if things star falling behind plan. The seller may find he gets his business back by default.

• The seller may be pressurised into renegotiating of the deal partway through, if there is a risk that he will not recover the full amount he is owed.

• Tax structuring is delicate: the seller does not want to pay tax on money he may not receive, but also wants to protect his entrepreneur’s relief.

• A variable price increases the risk of the deal to both parties. Each will be suspicious of the other’s involvement in the business as they try to manage conflicting priorities. Sellers will want some control to protect what is owed to them, and to keep the business largely unchanged so that its performance can be measured; buyers will want freedom to manage the business, including making major changes such as selling or merging.

 

With the risk increased all round, expert legal advice is essential. I have been handling corporate deals for 30 years with a specialisation in earn-outs and deferred deals. I know the practical realities as well as the legal theory. Call me to discuss your project.

 

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?

 

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
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