Agreeing to differ?

Agreements to agree are unenforceable in England. That includes obligations to negotiate in good faith.

The logic is that (i) an agreement to agree in good faith is too uncertain to enforce, (ii) it is difficult to say whether termination of negotiations is brought about in good faith or not, and (iii) it is impossible to say whether good faith negotiations would have led to an agreement, and if so on what terms, so it is impossible to establish any loss flowing from breach of the obligation to negotiate.[1] To be a binding contract, there has to be an intention to create legal relations and sufficient certainty as to the essential terms.

A recent case [2] has affirmed these principles in relation to heads of terms for a deal: for an agreement to be enforceable, the parties must have reached sufficiently complete and certain agreement on all essential terms. The parties can leave out non-essential terms, but the absence of essential terms means there is no contract, and it cannot be saved by an obligation to negotiate.

A common tourist trap for English companies doing deals abroad is to assume that the same rule applies elsewhere. Our “subject to contract” concept may not be recognised. In many countries the opening of negotiations or the agreement of heads of terms may lead to obligations of good faith, and to possible liability for breaking off negotiations.

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[1] Walford v Miles [1992] 2 AC 128; Petromec v Petroleo Brasileiro [2005] EWCA Civ 891

[2] Barbudev v  Eurocom [2011] EWHC 1560

Salaried partner or employee?

When is a partner not a partner? When he’s an employee. When is a salaried partner an employee?  When he’s not a partner, of course.

Or when the Employment Appeal Tribunal says he’s not. The EAT has decided two recent cases concerning solicitor salaried partners – in opposite ways.

The status of “salaried partner” or “fixed share partner” has been very useful for law firms. Clients like to deal with partners, so salaried partners are given the title as a badge of confidence by the firm, without all the financial consequences of admitting an equity partner.

Firms treat salaried partners in different ways. At one end of the scale, there is the person who is clearly an employee, but who is held out to the public as a partner. He has a contract of employment, he is paid under PAYE and he takes no significant part in the firm’s overall management. He gets no profit share but is indemnified against any losses. At the other end is the fixed-share partner who takes a full part in partnership decisions, gets paid only if there are profits to distribute, perhaps contributes capital to the firm, and often has a small share of profit, which might be linked to individual or team performance. In between are a variety of other arrangements, often poorly thought through, which try to treat the person as an employee whilst making him self-employed for tax purposes. The documentation often looks like an employment contract, with varying degrees of lip-service to the partnership ideal.

In Stekel v Ellice [1]  Megarry J. said that a salaried partner on a fixed salary, not dependent on profits, could still be a true partner, at least if he was entitled to a share in the profits on a winding-up. The relationship is a question of fact, and is not determined by what the parties call it.

Employment protection  Self-employed status can be attractive to the salaried partner who is taken outside the PAYE system. But it is a lot less attractive when the relationship ends, and salaried partners may be tempted to claim employment rights when they are dismissed, as Jeremy Briars did recently in Williamson & Soden v Briars [2]. He won comprehensively. The Employment Appeal Tribunal upheld the Tribunal’s ruling that there was no doubt that Mr Briars was an employee for the purposes of the definition in the Employment Rights Act (ERA) [3]. The question was not whether he was truly a partner within the definition of the Partnership Act 1890 [4], but whether he was an employee within the ERA definition. He had made a seamless transition from employed status with very little change in his role or terms. He received a fixed salary, not dependent on profits, plus a small profit share. He did not share in losses. The documents did not demonstrate acceptance of the heavy burden of partnership. And perhaps most importantly, he was subject to the control and direction the equity partners in a manner appropriate to an employee rather than a true partner.  

It is often said that someone who has been treated as self-employed and has reaped the tax benefits could not easily convince a tribunal that he was in fact an employee when it suited him. But this point was not even mentioned in the judgment in Williamson & Soden, despite Mr Briars having been treated as self-employed for tax purposes for about six years.

Tiffin v Lester Aldridge LLP [5] went the other way. There, the fixed share partner had signed documents and received a benefits package that more clearly pointed to partnership; he received a small profit share, and he was entitled to a small share of surplus on a winding-up; he had limited votes at partners’ meetings, and he contributed a small sum as capital. The Tribunal and EAT both found that Martin Tiffin was a partner, and not an employee, and the Court of Appeal agreed. There was no minimum share of profits, surplus or voting required.

The position in an LLP ought to be slightly different. Whether or not two or more people are in partnership is a test of the relationship: as a matter of fact, are the partners carrying on business in common with a view of profit? In an LLP, though, the question of who is a member of the LLP is more defined: a member is a subscriber to the incorporation document or someone admitted by and in accordance with an agreement with the existing members [6]. There should be no room for arguing that a member of an LLP, recorded as such and registered at Companies House, is not in fact a “true” member of the LLP. But it seems you can be both a member and an employee of an LLP: “A member of [an LLP] shall not be regarded for any purpose as employed by the [LLP] unless, if he and the other members were partners in a partnership, he would be regarded for that purpose as employed by the partnership.”[7]

That looks odd, and it is. True partnership and employment are mutually exclusive, it seems; so if he and the other partners were truly partners in a partnership, he could not be an employee; though if they were not truly partners, and he was just called a partner, he could be an employee. What does the section add? Is it not effectively saying that a member of the LLP can never be an employee? Apparently not. In Tiffin v Lester Aldridge and in Kovats v TFO Management LLP [8] the section was assumed to mean the opposite of what it says: that if he and the other partners would not have been partners in a partnership, he could be an employee. In Kovats the EAT specifically recognised the possibility that a person could be both a member of the LLP and an employee.

Tax benefits  But there is one important difference in an LLP. A member of an LLP is always taxed as self-employed, even if he is, in law, an employee. His taxation status does not depend on whether he is an employee within the meaning of the ERA, but on whether he is a member of the LLP. For income tax purposes, in a trading LLP all the activities of the LLP are treated as carried on in partnership by its members.[9] There is no exception for members who are also employees. So we have a potential category of salaried partners (members) in LLPs who are employees for employment protection purposes, but taxed as self-employed. This is very useful, as it allows firms to confer the taxation benefits of LLP membership (and gain exemption from employer NICs) without any real pretence at making the salaried partner a true partner. So long as he is admitted as a member in accordance with the LLP members’ agreement, and perhaps has a small profit share (so that the membership is not a sham or blatant tax avoidance), he can have a contract that resembles an employment contract, and be subject to control and supervision as an employee, without losing the beneficial tax treatment. The potential for tax planning here is considerable, and we could see increasing use of LLP member status intended mainly to save tax.

[IMPORTANT NOTE: With effect from 1 April 2014, major changes have been made to the taxation of LLP members where their status amounts to "disguised employment". It is now very difficult to take salaried and fixed share LLP members out of PAYE. The legislation affects tax (including national insurance) treatment but not employment rights. This article was written before the 2014 legislation and the above paragraph is no longer correct.] 

By the same token, the taxation status of an LLP member ought to be irrelevant to his status for employment rights purposes, though this point does not seem to have been considered in Tiffin or Kovats. In a Partnership Act partnership, unlike an LLP, the tests for employment rights and tax purposes are the same, so a person treated as an employee for employment rights purposes should also be subject to PAYE.

Restrictive covenants  It is said that post-termination restrictions will be harder to enforce against employees than partners, and that restrictions on employees must be narrower in scope if they are to be reasonable. But in fact it is the position and role of the individual that affects the enforceability of the covenant, not his status as employee or partner. Covenants have been enforced against senior employees [10] which might well not have been enforceable against junior partners. In all cases there must be a legitimate interest to protect and the restriction must be no more than is reasonable to protect it, but it is relevant to look at the respective bargaining power of the parties, their mutuality of obligation, and the extent to which the individual would have expected to benefit from the goodwill protected by the covenant.

Having the salaried partner sign new covenants in the same form as the equity partners may well help, both in demonstrating the reasonableness of the mutual obligations and in showing that the partner is a true partner.

What lessons can be learned from the cases? Many salaried partners will be employees, with employment protection rights, if no special effort is made to ensure that they are genuine partners. To make them genuine partners, consider making their remuneration depend on the availability of profits, so they share in risk; having them bear a small share of losses, and/or share in capital profits; having them contribute capital; making them parties to the main partnership or LLP agreement; giving them a benefits package appropriate to a partner; giving them votes at partners’ meetings; and generally treating them as far as possible as partners.

In a partnership, if those things (or many of them) are not done, the firm is at risk of being charged PAYE if HMRC alleges that the individual is not a partner, so it may be safer to operate PAYE from the start. In an LLP you are on safer ground from a tax perspective, so long as the salaried partner has been admitted as a member in accordance with the members’ agreement and the membership is not a sham or an artificial step for the purposes of tax avoidance.

The overall look and feel of the relationship and the documents is important. When reading Williamson & Soden v Briars and Tiffin v Lester Aldridge, it strikes you that the Tribunal’s first impression was important. Jeremy Briars’ engagement looked like employment; Martin Tiffin sounded like a partner. Displacing that initial impression is going to be difficult.

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[1] [1973] 1 WLR 191

[2] [2011] UKEAT 0611_10_2005

[3] ERA 1996 Section 230: an individual who has entered
into or works under a contract of service

[4] PA 1890 sections 1 and 2: carrying on a business in common with a view of profit,
and receipt of a share of the profits is prima facie evidence that he is a partner, but
does not of itself make him a partner; and the remuneration of a servant (employee)
by a share of the profits does not of itself make the servant a partner.

[5] [2010] UKEAT 0255_10_1611 Court of Appeal [2012] EWCA Civ 35

[6] Limited Liability Partnerships Act 2000 section 4

[7] Limited Liability Partnerships Act 2000 Section 4(4)

[8] [2009] UKEAT 0357_08_2104

[9] Income Tax (Trading and Other Income) Act 2005 section 863

[10] eg in Thomas v Farr PLC [2007] EWCA Civ 118

On the Spot

Penalty clauses under attack  

Any law student knows that penalty clauses are unenforceable. If a contract says that you have to make a payment if you breach the contract, that is a penalty – unless it is a genuine pre-estimate of the innocent party’s loss. The rationale is that a penalty clause is simply to intimidate a party and ousts the court’s authority to fix fair compensation. In most cases the law does not stop you breaching a contract, so long as you are prepared to pay damages to compensate the other party. The parties can't agree their own forfeits to punish contract-breakers.

Historically the courts have been reluctant to say that freely-negotiated clauses were unenforceable penalties. Liquidated damages clauses are common in construction contracts and many other contexts, and have often been upheld. In a 2005 case, the judge could only find four reported cases in which penal clauses had been struck down [1]. Only clear and obvious penalties seemed to infringe the rule. There had to be a wide gulf between the amount payable and the loss suffered by the claimant.

Now that seems to be changing. Clauses which have quite subtle penal effects are being successfully challenged as penalties. In particular, requiring one party to perform its obligations whilst the other is released has been found to be objectionable.

In a consumer protection case relating to health club memberships [2], the judge held that it was a penalty to oblige a party to pay the full price for the service over the remainder of the fixed-term contract, after the innocent party had terminated the contract for breach by the client.

There were two groups of contracts under consideration in the case. Some said that the payments for the remainder of the term could be claimed if the club terminated the contract following any breach by the member, however minor. That was a penalty. The court followed an earlier case that said that if a breach was not sufficient to amount to repudiation of the contract by the party in breach, the innocent party could terminate if the contract allowed them to, but they could then only claim payments up to the date of termination, and anything further was a penalty [3]. “Repudiation” means the breach was serious enough to demonstrate that the party no longer intended to be bound by the contract; the contract itself can define, within reason, what breaches will be repudiation. So an elephant trap is created: if the contract allows termination for something that is not repudiation, or fails to define repudiation correctly, the obligation to make payments relating the post-termination period is unenforceable, even if the actual breach is very serious.

Other contracts considered by the court only allowed the club to terminate for a breach of contract that did amount to repudiation. The court said that in those cases the estimate of loss was reasonable: the judge was satisfied that the club would have minimal marginal costs in providing the facilities and could not replace a member with another (clubs are never full), so if the club had sued the member for damages, the damages would been based on the fees for the rest of the fixed term. But the judge still found that absence of a discount for early payment turned it into a penalty. Only when the club added a formula to discount the payment at a high interest rate did the judge hold that it was not a penalty.

The decision makes it very hard to write an agreed damages clause without a lot of technical drafting. Many kinds of clause could potentially be attacked, including:

·         Default interest rates, if they exceed the cost of funds to the innocent party; often the rate is set above the debtor’s cost of borrowing, to deter late payment

·         Clauses that deprive a party of its rights or benefits under the contract without receiving any credit in return for the other party being relieved of its obligations

·         Forfeiture of deposits

·         Contracts for sale of an asset for a price paid in instalments, where ownership does not pass until the last instalment is paid

·         “Golden parachute” clauses in employment contracts, or pay in lieu of notice clauses requiring payment for very long notice periods

·         Timing differences such that a party does not get what it has paid for.

Deposits in property transactions are a special case. A deposit not exceeding 10% of the price has been held to be reasonable, even though it exceeds the likely loss due to the buyer pulling out, because it is in line with the traditional concept of “earnest money”. But a deposit of 25% was held to be fully returnable (less compensation for any actual proven loss) [4]. The court has a statutory power to order repayment of a deposit in property transactions [5], but rarely does so [6]. The court also applied the same principles to a deposit on sale of the shares in a property-owning company, and they would probably be applied to sales of other assets, at least where the effect of a deposit is similar. But the ideal a “non-returnable deposit” is strictly limited, and could well be ineffective in other circumstances. Pre-contract deposits are particularly vulnerable.

One trap for parties and their lawyers could be where one kind of payment is dressed up as another. I have seen agreements, for instance, in which the sale price of a small company is converted into an inflated level of salary for the selling director. The contract might provide that the salary continues to be payable even if the director dies or ceases to be employed, or that a large termination payment is to be made to him. What if the buyer then sacks the director? He can claim that anything in excess of normal employment compensation is a penalty and unenforceable.

A final related point: many lawyers seem unaware of the anti-deprivation rule on insolvency, which says that a provision to deprive a person of his assets on insolvency is void. Contracts often say that they can be terminated on the insolvency of either party, without any thought as to the justice of that for the creditors of the insolvent party. There is some uncertainty about how wide the principle is, and it has been interpreted quite narrowly by the Court of Appeal [7], including a finding that the termination of a licence on insolvency does not infringe the principle. It has been held that company articles requiring share to be sold at full market value on insolvency are valid, but would not be if the price were less than a shareholder would get on other compulsory sales [8]. But it remains the case that a clause that requires the assets of an insolvent person or company to be dealt with otherwise than in accordance with the insolvency legislation will not be effective.

I expect to see more cases on penalties and the anti-deprivation rule, and some may come as a big surprise to the contract parties. Beware of contracts that purport to give any kind of windfall in the event of a breach.

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[1] Alfred McAlpine Capital Projects v Tilebox [2005] EWHC 281

[2] OFT v Ashbourne Management Services {2011] EWHC 1237

[3] Financings Ltd v Baldock [1963] 2 QB 104

[4] Workers Trust & Merchant Bank v Dojap Investments [1993] AC 573

[5] Section 49(2) Law  of Property Act 1925

[6] MIDILL (97PL) v Park Lane Estates

[7] Perpetual Trustee Company v BNY Corporate Trustee Services and Butters v BBC Worldwide

[8] Borland’s Trustee v Steel Bros [1901] 1 Ch 279

Tea and cookies

Should the law demand the impossible?  

Today the law on cookies changes [1].

Cookies are small files downloaded to a user’s computer or phone when they visit a website or use an online service. Most are completely harmless, and many are essential to the operation of the site, or improve the user experience by, for example, recognising you when you return.

The new law, based on a change to the underlying European directive, requires the user’s explicit consent before a cookie can be transferred to his or her computer. But how is that to work? Government advice confirms that relying on the site terms and conditions is not enough; nor can you rely on the user having set the browser to accept cookies, as that is not specific enough. You must actually ask and get informed, explicit consent.

Easy enough, perhaps, if you have a site that requires people to register or log in; you can get their consent as part of that process. But what about a straightforward information website? The ICO guidance offers a few possibilities, but none of them is satisfactory. Use of pop-ups, for instance, is defeated by users with pop-up blockers. Banners are technically difficult to implement and take up precious space on the site. Demanding consents will put people off using your site, and may drive them to competitors who do not comply. A small business with a website hosted on its ISP’s servers often does not have any facility for the necessary technical measures, or for storing users’ consents. It will simply have to stop using cookies (including inspecting cookies provided by other sites). Many small businesses use ready-made website packages or authoring software and will have no idea whether their sites use cookies; they may have to spend money finding out.

Technically, the exchange of cookie information happens as soon as a website has been accessed – before any information has been displayed. How do you get consent without displaying any text? How do you check if a user has consented to inspection of the cookie on his computer without inspecting the cookie?

The ICO has said that it will not rigorously enforce the new law in the first year, allowing businesses time to comply. That in itself is unsatisfactory – either the law is in force or it isn’t. The regulations were only published three weeks ago.

But the main concern is that it is impossible to comply fully with the regulations. It is this sort of legislative mess that brings business regulation into disrepute, and encourages the impression of thoughtless legislation from Brussels.

The other change made by the regulations is to introduce a new power for the ICO to fine businesses up to £500,000 for breach of the rules. No surprise there.

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[1] Privacy and Electronic Communications (EC Directive) (Amendment) Regulations 2011 which amend regulation 6 of the Privacy and Electronic Communications (EC Directive) Regulations 2003

Avoiding the Gotchas

Pitfalls in the execution of documents

I am strongly against the law introducing traps for the unwary by insisting on formalities you couldn’t comply with without detailed knowledge of the law. I’m also against documents being invalidated by minor errors in execution, which leads to injustice for innocent parties.

One such trap is section 44(6) of the Companies Act 2006, which did not exist in the 1985 Act. It says that if a document is executed by several companies, each signatory must sign separately for each company. A completely pointless formality, in my view. If, say, a pension scheme deed has to be executed by all 58 companies in a group, all with the same directors, why shouldn’t it be expressed to be executed by all of them and signed just once by each director?

In Williams v Redcard Ltd the Court of Appeal refused to extend this principle, holding that there was no reason why an individual could not sign both for the company and in a personal capacity, and that it was not necessary for the document to specify that the signatory was acting for the company. Good news so far, though the trap remains when you are dealing with several companies.

But the real worry in the case is the assumption that section 44 was relevant at all. The section 44 formalities (signature by two directors, or one director with a witness) apply to documents executed “by" the company. Usually this applies to deeds; most other forms of contract are simply signed or agreed by a director (or some other authorised person) as an authorised agent “on behalf of” the company, which is permitted by section 43(1)(b). No formalities at all are required to agree most contracts as agent on behalf of a company. The contract in the case was a contract for sale of land, so it had to be in writing and signed by or on behalf of the parties[1], but it did not have to be a deed. Property contracts are often signed just by one signatory on behalf of the company. Yet it was somehow assumed that the contract was not signed "on behalf of" the company by the two directors who signed it, and needed to satisfy the section 44 formalities for execution "by" the comapny.

The reasoning is unclear, but the assumption seems to have been that there must be some clear indication that a person is signing “for and on behalf of” the company before it is accepted that it has been signed by an agent. That creates all sorts of traps for contracts entered into informally. Let’s hope that it is not applied further.

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[1] Section 2 Law of Property (Miscellaneous Provisions) Act 1989

Serving documents via Facebook and email

A County Court has given permission for one of its orders to be served through Facebook [1]. Even the law is trying to keep up with the social media revolution! The courts have a wide discretion to allow service by alternative means likely to come the attention of a defendant. There has been a previous instance of service of a High Court injunction on an anonymous defendant via Twitter.

Many contracts specifically exclude the use of email for service of notices, and I am not convinced it is the right approach. Everyone in business uses email, including for important communications, and the risk of someone being caught out by failing to serve a notice by post exceeds the risk of an email notice not being received.

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[1] http://www.telegraph.co.uk/technology/facebook/8382570/British-lawyer-uses-Facebook-to-serve-court-summons.html

Of course banks want to lend money!

A rare case of a customer successfully suing a bank for failure to advance a loan! It is sometimes claimed that a person who does not get a loan suffers no loss because he avoids liability to repay the loan.

In Essentially Different Ltd v Bank of Scotland PLC [1] the judge dismissed a rather desperate claim by the bank that there was a condition precedent that everyone had forgotten to put in the facility documents. But the interesting part is that he went on to hold that the bank’s breach of contract caused the loss of an opportunity to pursue a project, so that the bank could be liable in damages for that loss. In a Shakespearian turn of phrase, Burton J. held that failure to supply the loan "really knocked the stuffing out of" the project. Whether the project was in fact valuable was left to another day, but clearly banks cannot withhold loans with impunity.

 
 
 
 
 
 
 

[1] http://www.bailii.org/ew/cases/EWHC/Comm/2011/475.html

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Property developers personally liable

Insolvency and the single purpose vehicle

Developers should take note of a recent case in which an SPV’s directors were held personally liable for its debts.

It’s a common scenario (or it was, when developments could be funded…). Entrepreneurial developers identify an opportunity. They form a company to carry out the development – a single-purpose vehicle (SPV). They put in some “equity” – more often subordinated debt, or even a limited guarantee of bank debt – and often from a funding partner rather than the personal wealth of the developers. The rest of the money is non-recourse lending from the bank, secured on the property. All the equity goes on land purchase, so the build costs are funded entirely from bank money, advanced against certificates showing that valuable work has been done. There’s a fixed-price building contract with the contractor – though how fixed may not always be clear to everyone.

If it goes well, the bank gets repaid on sale of the investment, or rolls its loan into investment funding. If sale price is greater than land cost plus development costs, the developers walk away with a profit. If it all goes wrong – cost overruns, long void period before sale or letting, fall in market prices – well, from the developers’ viewpoint, they haven’t lost much – the equity  provider loses out, and the bank may take a bath, the contractor loses his retention and the cost of uncertified work, but the developers just go on to another project.

But what if the SPV liquidator cuts up rough? In Roberts v Frohlich and Another [1] the directors were found to have traded after there was no reasonable prospect of avoiding insolvency. They were made personally liable for the build costs after a certain date, on the grounds that this was a breach of duty to the company and wrongful trading [2].

They had juggled the contractor, the bank and a potential buyer of the development, keeping the balls in the air while trying to resolve some fundamental conflicts. The bank’s conditions included a fixed price build contract and pre-sales, but the contractor was insisting on a cost-plus basis and no sales were likely until construction was under way. Neither bank not contractor knew that the other was not yet committed. In the meantime the directors got the contractor to do groundworks and civils under a letter of intent, and had the contractor order the steel for the construction, with no facility in place to pay for them. They drew down a bank facility for the preparatory works whilst knowing that they could not meet the conditions for the development facility. They continued to allow the contractor to run up large costs They knew that the cashflows they and the bank had relied on could not be met. They were driven, in the words of the judge, by “wilfully blind optimism; the reckless belief that… something might turn up.” When the SPV went into administration and the property was sold, the bank got repaid, leaving the liquidator with a fighting fund of £25,000 to pursue the directors on behalf of the unpaid contractor.

Norris J. found the directors guilty of three breaches of duty: (1) the fiduciary duty to the company to act in the interests of the company, which when the company is insolvent or of doubtful solvency or on the verge of insolvency becomes a duty to protect the interests of its creditors; (2) the fiduciary duty to act with reasonable care and skill and (3) the statutory duty [2] not to trade after there is no reasonable prospect of avoiding insolvent liquidation.

(3) is not surprising: directors can be made liable for debts they continue to run up after the point at which they should have called in an insolvency practitioner [2], and an order to that effect is likely in the next stage of  the case. (1) and (2) are a little more surprising: the duty to the company to act in the interests of creditors has been well known, but it has never been clear what liability might attach to a breach. Unfortunately the reported judgment did not deal with remedies, so we are none the wiser.

What lessons can be learned? Directors cannot speculate wildly with other people’s money, even if was willingly lent into a non-recourse vehicle like an SPV. Expect to see more “non-recourse” lenders to companies trying to recover losses through claims against directors.

Don’t incur debts if you cannot be confident that funding will be in place to meet them. Be honest with bankers and suppliers – it is far too easy to slip from hard bargaining into deception. Or, as in this case, self-deception: make sure that the legal documents say what you wish they did.

Remember the shaving-mirror test: is today the day on which insolvency is inevitable?

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[1] [2011] EWHC 257 (Ch), [2011] All ER (D) 211 (Feb)

[2] Section 214 Insolvency Act 1986