Proportionate liability clauses upheld

Need a small slip make you liable for the whole loss?

For many years, businesses have been trying to limit liability according to their fair share of the fault.  Among the first to argue for "proportionate liability" were the big accountants, who are regularly sued over corporate failures because their insurers had deep pockets. The issue frequently arises in the constructions industry, where there are often several firms of contractors and professionals who might share responsibility for a fault or delay.

In most cases, where there are two or more possible defendants, they will be jointly and severally liable for the loss. that means the claimant can sue any or all of them, and recover the whole of his loss from the chosen defendant, leaving the defendants to sort out contributions amongst themselves. that can be very unfair to defendant if the others have gone bust or disappeared. In the very worst cases it can even make claimants careless about the choice of contractors: so long as they have one solid defendant, they need not worry about the competence or financial strength of the others.

"Net contribution clauses" have often been inserted in contracts, but lawyers have doubted whether they worked. Now the Court of Appeal has confirmed that they do - even in consumer contracts.

In West v Ian Finlay & Associates a very simple term was held to work: "Our liability for loss or damage will be limited to the amount that it is reasonable for us to pay in relation to the contractual responsibilities of other consultants, contractors and specialists appointed by you". The clause protected an architect from liability for the part of the claimant's loss fairly attributable to defective work by the (insolvent) building contractor. It survived challenges under the Unfair Terms in Consumer Contracts Regulations and the Unfair Contract Terms Act 1977.

All businesses which could potentially share liability with others should review their contract terms and consider whether they should be using a net contribution clause. That includes most businesses in the construction industry and most professional firms. It remains to be seen whether the same approach can be extended to exclude liability for the defaults of your own sub-contractors.

Consumer credit licences all expire

If you haven't acted, your consumer credit activities are now illegal

All licences granted by the OFT under the Consumer Credit Act 1974 lapse at midnight tonight. That includes the group licence granted to all solicitors.

 

From tomorrow (1 April 2014), consumer credit businesses - including ancillary activities such as credit brokerage and debt collection - require authorisation by the Financial Conduct Authority. If you haven't already applied for interim authorisation, you will need to stop carrying on the regulated activity until you have gone through the application process - likely to take some months.

 

There is no general permission for solicitors, so those engaged in consumer credit activities, including debt collection from consumers, now have to be dual-regulated by the FCA and the SRA (and pay two sets of fees for the privilege). Will consumers be any better off? No, of course not.

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!

Negligence: staying out of the firing line

Shared responsibility in a professional team

Professionals work in teams, formally or informally, on all sorts of projects. Where something goes wrong, it may not be clear that one professional firm is solely responsible.  One professional may have relied entirely on another to do his bit, either by agreement between them or because it naturally fitted in the other's area of expertise; or one may have appointed the other to assist. Successive advisers may have made the same mistake. Two advisers may assume that each other are dealing with an issue. If work or advice has been negligent, the client will be tempted to sue all parties and let them fight it out amongst themselves. It may come down to assessing the contributions to be made by different parties.

In Flanagan v Greenbanks Ltd (t/a Lazenby Insulation) & Cross two successive firms carried out negligent surveys to assess suitability for cavity wall insulation. The Court of Appeal said that both were liable: the negligence of the later survey had not absolved the earlier one of responsibility, nor could the second firm assume that the first had done its work correctly without checking.

Firms can improve their position if sued by including suitable terms in their conditions of engagement - subject always to the usual considerations on limitation and exclusion clauses, especially in consumer contracts. Something like this can help:

"Where other professionals are engaged by you or on your behalf (including any predecessor of ours), we will be entitled to rely on the work and advice of those other professionals and to assume that they have carried out their work with due care and skill and to all relevant standards. We will not be responsible for checking or re-doing their work, or for checking their instructions, assumptions or conclusions, unless specifically instructed to do so, and then only to the extent falling within our area of expertise. We may review or comment upon the work of other professionals where we consider it appropriate but we will not be obliged to so and by doing so we do not assume responsibility for such work. Where we engage or recommend other professionals, our responsibility for their work is limited to selecting professionals whom we believe to be reasonably suitable for the purpose. Where we engage such professionals with ourselves as principals (and not as your agents) our liability for loss or damage arising directly or indirectly from their act or default (including negligence) is limited to the amount we are actually able to recover from them. If we recommend the engagement of other professionals but you decline to do so, we will not be liable for any loss or damage which would have been avoided had such professionals been engaged."

Of course it also helps if the roles of the professional teams are clearly defined, and if each member has a proper definition of its scope of work and terms of engagement. Specifically exclude from your scope of work any high-risk areas you don't regard as part of your role, and adapt your contract terms carefully to each situation.

Valuing partner contributions

Fame at last: published in Solicitors Journal

I have had an article published in Solicitors Journal (25 November 2013) about valuing partner contributions in law firms -http://www.solicitorsjournal.co.uk/management/business-development/finders-minders-and-grinders-working-out-attribution-system-between- (but you have to be a subscriber or to sign up for a trial to read the full article). 

It argues that different partners perceive value very differently, that it's easy to over-estimate the importance of any individual, and that firms have to be careful not to reward more than once for each £1 of profit earned, and to know whether they are recognising achievement only in the current year, or for an entire career.

Retention of title and paying the price

Tangled ROT clauses come unravelled

Retention of title (ROT) clauses have been controversial for over 30 years. When selling goods to a business buyer on credit, you want to keep ownership of your goods until you are paid. If the buyer goes bust, you can hope to retrieve your goods, or claim their value in priority to the unsecured creditors of the buyer. You need an express contract clause to do this: it is not a right given by the general law.

We had thought the law on ROT clauses was becoming fairly settled. The long arguments that used to accompany almost every insolvency are now reduced to a bit of wrangling with the insolvency practitioner. It is fairly settled that the basic form of ROT clause works: you retain title to your goods until they have been paid for. Fancier extensions of the clause are usually not effective. They include:

·         the “all monies” clause which purports to retain title until every debt owed to you has been paid – where there is continuous trading between the parties, this would mean that title would never pass because something was always owing

·         trying to continue ownership of the goods after they have been sold to the buyer’s customers – quite apart from practicalities, section 25 of the Sale of Goods Act says that a buyer in possession of goods with the permission of the seller can pass good title to a buyer from him

·         trust clauses, which purports to give you special rights over the proceeds of sale of the goods when your buyer sells them on. These usually amount to a charge, requiring registration at Companies House and ranking behind other charges on the buyer’s assets

·         agency clauses, which say that the buyer is not in fact buying at all, at least until he pays you, and if he sells the goods you are entitled to the full price from his buyer. If this works at all, this makes you a party to the contract with the sub-buyer and liable if anything goes wrong with the goods. In most cases it is inconsistent with the true commercial relationship and is likely to be ignored.

Two recent cases do not change this position greatly, but they do point to the importance of the drafting of the clause, and also to the fact that a clause which tries to do too much could end up not achieving anything at all. And that the law is still a mess.

Sandhu v Jet Star Retail Limited (in administration) and others is not particularly surprising. An “all monies” clause was held not to work. The surprising aspect was that the ROT clause failed completely, rather than applying just to the price of the actual goods remaining in stock. It is a very short judgment, but the reasoning seems to be that the administrators had already sold the stock before any claim was made, and the terms of the contract expressly allowed the buyer to sell the goods, and did not terminate that right upon insolvency. Therefore, the administrators were entitled to sell the goods, the retention of title ended upon sale and the administrators had done nothing wrong and so were not guilty of the tort of conversion (dealing with goods in a manner inconsistent with the owner’s rights). Had the clause been better drafted, it could have protected the seller so that he received at least the value of the goods remaining in stock at the time of insolvency, or the contract price for those goods, whichever was the lower. It is usually better to be conservative and draft your clause in a way that is likely to be effective under the current understanding of the law, rather than attempting to gain additional rights which put the whole clause at risk.

The more difficult case is Caterpillar (NI) Ltd v John Holt & Company (Liverpool) Ltd, a Court of Appeal case which I hope will be reviewed by the Supreme Court. This case again revolved around sub-sale of the goods by the buyer. The ROT clause was an “agency clause”, which purported to say that the first buyer received the goods not as a buyer, but as the agent of the seller, and sold them to the second buyer as agent of the seller. The Court of Appeal accepted, surprisingly, that this worked, and held that it meant that the first buyer was not liable to pay the sale price to the seller, as it had not bought the goods! Section 49 of the Sale of Goods Act says that a seller can sue for the price either when title to the goods has passed to the buyer, or  “the price is payable on a day certain irrespective of delivery”. As neither of these conditions applied, the seller could not sue for the price. He could probably claim damages for breach of contract, but that was outside the scope of the decision.

If this case remains good law, there are a number of steps sellers can take to improve their ROT clauses and payment clauses, including ensuring that payment is due on a “day certain irrespective of delivery” and removing any reference to agency. Clauses should either not expressly authorise resale of the goods at all, or if they do, should make sure this right does not continue following default and insolvency.

TUPE reform and the small workforce

Reform of TUPE consultation in the small business

Just occasionally, as your lawyer, I find myself having to advise you to do something really absurd, because an absurd law requires it. One of those is where I am helping you with the sale of your business with, say, just one employee. I have to tell you that in order to comply strictly with TUPE, you have to ask that single employee to elect a representative, for you to consult about the transfer of his employment. You are not allowed to consult the workforce directly, even if you can get all of them round a table in the pub. The collectivist approach is compulsory and elections have to be held, potentially delaying the sale transaction. In practice, most small employers have still carried out direct consultation, but it did not comply with the legislation.

Even in a one-man company, the sole director-employee should supposedly elect himself as representative before he informs and consults himself, in a scene reminiscent of Blackadder in the Dunny-on-the-Wold by-election.

Fortunately that particular absurdity is going, when the proposed reforms to TUPE are enacted. Businesses with ten or fewer than employees will be allowed to consult employees direct, without the rigmarole of elections, where there is no union and there are no existing representatives. However, this will apply only to “micro-businesses”, so the absurdity remains when a larger enterprise transfers a business with a small workforce.

The obligation to inform and consult on a TUPE transfer remains important. Employers have to provide the workforce (or their representatives) with information about the proposed transfer and, when “measures” are proposed in respect of the workforce, consult them. There are no fixed time limits, but the consultation must be a sufficient time before the transfer to enable the views of the employee representatives to be taken into account. Failure to comply with these obligations can result in a Tribunal award of up to 13 weeks’ pay to the affected employees.

The intended reforms to TUPE include a number of other (largely pro-employer) technical changes, but the general principles remain unchanged. The Government has abandoned proposals to abolish the “change of service provision” aspects of TUPE which are probably its most controversial aspect, requiring a new contract or to take on the old contractor’s workforce when a contract is re-tendered.

TUPE gets a bad press, but I am old enough – just – to remember how difficult it was to deal with business and assets sales before TUPE came into force in 1982. There was no means of forcing the workforce to transfer, so the transferring employer stood the risk of redundancy or unfair dismissal claims. On the day of completion, the new employer had to write to all staff offering them jobs on the same terms, which could be accepted by turning up for work on Monday morning. The whole thing was complicated and risky, so the legal process for automatic transfer made things a great deal easier for sellers and corporate lawyers, even if not for contractors and employment lawyers.

Reasonable restrictive covenants

The trend in the cases favours the employer 

The courts continue to take a more employer-friendly view of restrictive covenants in employment contracts (and by extension, in other forms of agreement such as business sales and shareholders' agreements). In Coppage v Safety Net Security Ltd the Court of Appeal was forgiving toward features of the covenant once thought fatal: a non-solicitation clause (an agreement not to poach customers) was upheld even though its wording would include former customers, with no retrospective time limit, and could potentially apply to customers with whom the employee had no personal dealings. The court seemed to be prepared to accept what might otherwise be unreasonable restrictions, if the period for which they applied was short - in this case six months. The short period was a "fundamental consideration of reasonableness" and "a powerful factor in assessing the overall reasonableness of the clause".

The case was about non-solicitation clauses; the attitude to non-compete clauses (excluding the employee from a business sector completely) might well be less sympathetic.

Covenants must always be carefully crafted for the particular situation, but the court will look at the overall facts as much as the wording of the covenant. The law says that the reasonableness of the covenant must be judged when it is entered into, but the court seemed to stretch that rule where it believed the employee had behaved badly and the claimant was a small business protecting a few customers against blatant poaching.

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.

Consumer credit gets the financial services treatment

The FCA takes over licensing in a whole new style

Any business providing credit to consumers, or introducing sources of credit, needs a consumer credit licence. The requirements and standards have increased gradually since licensing came in back in the 70’s. Back then, almost all applications were granted and hardly any licences were revoked. The OFT has never put much resource into the system and has taken a light-touch approach. That will all change when regulation moves to the financial services regulator, the FCA, in April 2014.[1]

The FCA is a far more demanding regulator. It is used to dealing with large institutions with full-time compliance officers, and the resources to apply detailed, complicated rules. The FCA has the resources to deal effectively with complaints and to make life miserable for those it suspects of transgressions, and it is not known for sympathy with small businesses struggling to comply. Apart from the largest consumer credit businesses, which are already FCA-regulated, consumer credit licence-holders may be in a for a shock.

Until now, the main sanction under consumer credit legislation was the threat that agreements might be unenforceable due to non-compliance. Although a whole industry grew up around this, not many defences based on technicalities were successful. The OFT was unlikely to take action unless the whole business model of the licence-holder was objectionable. The OFT’s expectations were set out in guidance notes, which did not have the force of law.

The FCA has said that it will act very differently. It is used to dealing with individual complaints and sanctioning businesses for isolated non-compliance, as well as looking carefully at the overall suitability of a business. It expects rigid compliance and self-reporting of breaches. Directors and those performing “controlled functions” will be subject to personal sanctions, as they are in other FCA-regulated businesses. The FCA will be translating the OFT’s guidance into enforceable rules. There will also be Principles of Business, High-level Standards and Conduct Standards – in other words, a whole new regulatory environment for businesses to learn and understand.

The FCA does promise some relaxation for lower-risk businesses. Giving deferred payment terms at no cost to buyers of goods and services or introducing them to sources of credit, hiring goods to consumers and not-for-profit debt advice all require licensing at present but are to be the subject of exemptions, and there is to be a new status as authorised representative of an authorised firm, allowing businesses to rely on the compliance of their consumer credit supplier.

All licence-holders have to apply for interim permission from the FCA, with applications stating in September, accompanied by payment of a £350 fee – likely to be the first of many. Full authorisation must be applied for by 2016, and aims to  ensure that regulated firms are well-run, recognise the risks they face and have appropriate strategies, systems and controls in place and the right people in important roles. Individuals who perform key “controlled functions” will be vetted and monitored.

Recommended first steps for licensed businesses are to check that your details are correct on the existing Consumer Credit Register and to sign up to FCA consumer credit emails. Any business contemplated consumer credit activities would do well to apply for an OFT licence before April, as otherwise it will be subject to the full rigours of FCA authorisation.

---

[1] Financial Services Act 2012 (Consumer Credit) Order 2013

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.

 

Another EMI options tax break

Is this the most generous tax relief we have?

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

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

Frequently asked questions:

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

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

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

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

Why is there a negative tax rate?

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

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








Published December 2012
Updated February 2013

 

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

 

 

Giving up limited liability for accounts exemptions

A new concept in UK company law?

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

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

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

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

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

• mis-selling liabilities or regulatory fines and penalties

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

• product recall or warranty costs

• environmental clean-up costs

• personal injury claims unknown at the time.

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