Corporate Law Update: 14 - 20 May 2022

20 May 2022

In this week’s update: The court interprets an earn-out procedure in a share sale agreement, The LSE consults on amendments to its admission standards and a new Voluntary Carbon market, ESMA publishes a statement on half-yearly reporting in the context of the ongoing conflict in Ukraine, Government comments on the impact of the UK’s national security regime on taking security over shares and the UK Endorsement Board adopts its first post-Brexit financial reporting standard.

Court interprets earn-out procedure where expert accountant declined to act

The High Court has found that the buyer of shares in a company did not comply with an earn-out procedure in a share sale and purchase agreement (SPA).

In particular, the court found that the buyer was not entitled to prepare an earn-out statement itself when the SPA required the target company’s auditors to prepare it.

What happened?

Asher and others v Jaywing plc [2022] EWHC 893 (Ch) concerned the sale by a number of individuals of the shares in a company that carried on a digital marketing business.

Under an earn-out mechanism in the SPA, the sellers were entitled to:

  • additional payments if the company achieved a specified revenue target in each of the first two financial periods following completion of the sale; and
  • a further payment if aggregate revenue across both of those periods exceeded a specified target.

The SPA also set out a procedure for determining whether the earn-out payments had been triggered. Following the end of each financial year, the buyer was required to provide the sellers with:

  • a balance sheet and profit and loss account for the company; and
  • a statement prepared by the company’s auditors, setting out a calculation of the company’s revenue and any corresponding earn-out payment.

The sellers would then have ten business days to dispute the calculations, failing which they would be deemed to have accepted it. The sale agreement contained a mechanism for deciding any disputes if the parties were unable to agree between themselves.

The first earn-out payment was paid.

When the time came to calculate the second earn-out period, the company’s auditors declined to prepare the relevant calculations, citing concerns around their independence. As a result, the buyer prepared the earn-out statement itself and appointed an accounting firm to review its calculations.

The accountants marked the statement up, following which the buyer sent the statement to the sellers. However, the version the buyer sent did not include all the comments provided by the accountants and included some additional adjustments made by the buyer itself.

The statement sent to the sellers asserted that the revenue target had not been met and so no earn-out payment was payable.

The sellers brought legal proceedings against the buyer. They claimed that the earn-out statement was not valid because it had been prepared not by the company’s auditors (as stated in the SPA), but by the buyer itself with assistance from a different accountant.

As a result, they argued, the ten-business day period for them to raise any complaint had not begun and the buyer was in breach of the SPA. They claimed damages from the buyer equal to the amount of the earn-out payment they believed was payable.

The buyer responded by arguing that it was not able to comply with the express terms of the SPA, as the company’s auditors had declined to prepare the earn-out statement. As a result, it said, the court should imply a term into the SPA that the buyer was entitled to appoint its own accountant to prepare the earn-out statement.

What did the court say?

The court agreed in part with both the buyer and the sellers.

The judge said it was an implied term of the SPA that, if the company’s auditors were not willing to prepare the earn-out statement, the buyer could appoint an appropriately qualified third-party firm of accountants of its choice to prepare it. This term was required, as a matter of business necessity or efficacy, to allow the earn-out mechanism in the SPA work in those circumstances.

The sellers had argued that the SPA had specified the company’s auditors as the firm responsible for the earn-out statement to ensure a degree of independence in its preparation. They said the buyer should not be able to choose an alternative accountant unilaterally without consulting them, as that would undermine that concept of independence.

The judge disagreed. He noted that the sellers were free to lodge an objection if they disagreed with a statement prepared by an alternative accountant chosen by the buyer. Moreover, the buyer had the power in any event to replace the company’s auditor, so the sellers never in reality had any degree of control or influence over the identity of the person preparing the statement.

However, the court nonetheless found that the earn-out statement did not comply with the requirements in the SPA. That was because, although the alternative accountant had reviewed the statement, the buyer had prepared it, had not accepted all the accountant’s comments and had included other amendments not suggested by the accountant.

In essence, therefore, the buyer had prepared the earn-out statement, rather than the company’s auditors (as contemplated by the SPA) or an alternative accountant (as permitted by the implied term).

The buyer was therefore in breach of the SPA and the period of time for the sellers to object to the earn-out statement had never begun.

However, in the end, the court concluded that the relevant earn-out targets had not been met, and so the sellers were not entitled to damages.

What does this mean for me?

The judge’s decision to imply a term into the SPA allowing an alternative accountant to prepare the earn-out statement is pragmatic and logical.

Where parties invest time and thought into negotiating and structuring a detailed earn-out procedure, it would be unfortunate (particularly for a seller) if the procedure and, ultimately, the commercial agreement were to be rendered moot merely because the chosen expert declines to act.

The decision gives comfort to buyers and sellers that the courts will strive to ensure commercial contracts can be carried out and will accept sensible solutions to plug any gaps.

However, a court will imply terms into a contract only if certain conditions are met (broadly, that the implied term is so obvious as to go without saying or is needed to make the contract work), and that a court will look at this on a case-by-case basis. Contract parties cannot assume that the court would reach the same decision in other circumstances.

The judge’s decision that the statement did not satisfy the terms of the SPA highlights another point, namely that, where a contract sets out a specific procedure (whether expressly or in an implied term) for serving documents or determining a payment, the courts will hold the parties to that procedure.

In this case, by selecting which of the accountants’ comments to include and by interposing its own, the buyer had effectively departed from the agreed procedure.

When negotiating and implementing an earn-out procedure, parties should bear certain points in mind.

  • Consider who is best placed to perform any calculations. There is logic to appointing the target’s own auditors, as they will be familiar with its business. However, a seller should bear in mind that, after completion, the buyer will have control over who to appoint as the target’s auditors.
  • Appointing an independent firm of accountants can avoid this problem. However, that firm will need to read into the target’s business, which may in turn require more time and increase costs.
  • In either case, the parties should consider what should happen if the chosen expert declines to act. Leaving this silent in the SPA is likely to lead to uncertainty and, ultimately, disputes. There may be value in including one or more back-up procedures to cater for this.
  • This could include asking a third party to appoint an accountant if the parties ultimately reach a stalemate. If adopting this approach, parties should ensure they chose an appropriate body to make that nomination and that they will be able to comply with that body’s application procedure.
  • When working through the earn-out mechanism, follow the procedure to the letter where at all possible. Any deviations from that procedure risk putting the integrity of any calculations or notice into doubt and generating legal proceedings.

LSE consults on amendments to admission standards and on new Voluntary Carbon Market

The London Stock Exchange has published Market Notice N12/22, in which it is consulting on changes to its Admission and Disclosure Standards and on the creation of a new Voluntary Carbon Market.

The Exchange has asked for comments on both elements of the consultation by 11 July 2022. It expects to confirm the new rules in or around September 2022.

The Admission and Disclosure Standards

The Standards apply to an entity that is looking to admit securities to any of the Exchange’s markets, other than AIM and certain other specific instances.

The Exchange has set the amendments out in an attachment to the notice. The main proposed amendments are set out below.

  • The early notification process (under which an issuer must notify the Exchange no later than when it submits its eligibility letter to the Financial Conduct Authority’s Listing Transactions team) would be extended to cover all new securities (rather than just equity and depositary receipt securities, as at present).
  • The early notification date for Specialist Fund Segment (SFS), High Growth Segment (HGS) and ATT only issuers would be increased to 30 business days prior to admission.
  • In line with the proposed extension of the early notification process, there would be a new early notification date for debt issuers of five business days prior to admission.
  • All communications between the Exchange and an issuer (either directly or via its advisers) would be confidential. An issuer would be prohibited from disclosing them without the Exchange’s prior written consent.
  • Where an issuer ceases to have any securities admitted to trading, the Exchange would retain the ability to investigate and take disciplinary action in relation to breaches of the Standards that occurred when the issuer had a class of securities admitted.

The Exchange is also proposing a number of “administrative or corrective changes”.

The Voluntary Carbon Market

This consultation follows the Exchange’s announcement at COP26 in November 2021 that it intends to develop a market offering to support publicly-traded carbon funds.

The VCM would not be a separate market per se, but rather a “designation” for publicly-traded carbon funds, the purpose of which would be to inform investors of specific information relating to the fund’s investment in carbon reduction or removal projects.

The idea is that this will, in turn, encourage corporates that are looking to access long-term carbon credits to complement their net-zero strategies to direct capital towards climate change mitigation projects (and so scale funding for these projects).

To qualify for the VCM designation, a fund would need to satisfy certain criteria.

  • It would need to be a closed-ended investment fund. (The Exchange has said it will consider extending it to other asset classes in the future.)
  • It would need to be admitted to the Exchange’s Main Market or AIM.
  • It would need to have an investing policy focused on carbon reduction and/or removal projects that are expected to yield carbon credits.
  • It would need to be possible to map revenues from its other investments to the FTSE Russell Green Revenues Classification System so as to ensure the rest of the fund’s portfolio is in keeping with low-carbon transition principles.
  • It would need, within three years of receipt of the VCM designation, to invest in at least one project whose carbon credits meet specific criteria. (These refer to specific recognised carbon standards (including the UK Woodland Carbon Code, Gold Standard and Verra) that would verify the carbon credits generated by the project.)
  • Its portfolio would need to be managed by a person authorised by the Financial Conduct Authority or the equivalent regulatory body in Jersey, Guernsey or the Isle of Man.

The VCM rules would not provide for how carbon credits are delivered to investors. The fund would need to decide this and explain this to its shareholders.

VCM status would attract additional obligations on top of those with which the fund is already required to comply. This is in line with the expectation that the existing UK legal and regulatory obligations for companies admitted to public markets will provide a robust framework to maintain integrity.

These obligations would include additional disclosures in the fund’s prospectus or AIM admission document, as well as disclosures in its annual report on matters relevant to achieving carbon credits.

ESMA publishes guidance on half-yearly reporting in context of Ukraine conflict

The European Securities and Markets Authority (ESMA) has published a statement on the preparation of half-year financial statements and management reports in light of the ongoing conflict in Ukraine.

ESMA recognises that sanctions imposed on Russia and Belarus pose significant challenges to business activities and introduce a high degree of uncertainty.

However, it emphasises the need for issuers to provide information that is useful to users and adequately reflects the impact of events on the issuer’s financial position, performance, cash-flows and principal risks and uncertainties.

ESMA also notes that its comments in the statement apply to reporting in other interim periods in accordance with IAS 34 (Interim Financial Reporting) and to annual financial statements prepared in accordance with IAS 1 (Presentation of Financial Statements).

Although the statement applies primarily to issuers within the EU, it may be of interest to UK issuers seeking to understand how to frame their financial statements during the ongoing conflict.

Government comments on impact of national security regime on taking security over shares

The City of London Law Society (CLLS) has published a response from the UK Government concerning the potential impact of the UK’s national security and investment (NSI) regime on taking security over shares.


Under the NSI regime (which is set out in the National Security and Investment Act 2021), the Government has the power to “call in” an acquisition for review if one of certain “trigger events” applies and the acquisition may give rise to a risk to national security.

One of those trigger events is where a person comes to “hold” more than 25% of the shares in a company or other legal entity. Moreover, where the entity operates in one of the 17 so-called “sensitive” sectors, the acquirer will be required to notify the Government of the proposed acquisition before completing it.

When providing debt finance to a group of companies, a lender or (through its security trustee or agent) a lending syndicate will usually wish to take security over the shares issued by the various group companies as collateral for the loan.

Although this security is usually described as a “share pledge”, as a matter of English law, it usually takes the form of an “equitable charge” or “equitable mortgage”. Under this mechanism, the lender (or security trustee) gains an “equitable interest” (a form of economic interest) in the shares but does not take legal title to them.

The CLLS asked the Government whether, in its view, taking a share pledge of this kind over more than 25% of the shares in a company is likely to amount to a trigger event under the NSI regime.

The Government’s response

In response, the Government has stated that “holding shares” in this context refers to having shares in a company. Although granting security over shares could create an equitable interest in them, it would not appear to grant any control over the shares.

The Government has said that it does not regard the grant of security of this kind as “[falling] within the scope of mandatory notification” until an event occurs that gives control. This might be the transfer of control of voting rights if the security becomes enforceable. The Government is considering whether to issue any further clarification on the point.

Although the Government’s response specifically addresses only mandatory notifications, the logic of its response should apply also to transactions where notification is not mandatory. We therefore assume that, in those cases too, the Government considers that a trigger event has not arisen and so is not capable of being called in on the basis of holding shares in the entity.

What does this mean for me?

The Government’s announcement is useful for anyone (whether or not an institutional lender) looking to take security over shares in an English company as part of a transaction or financing.

However, a person taking security over shares in a company should bear a few things in mind.

  • In rare cases, taking security may involve the lender or security trustee taking legal title to the shares. In this case, the lender or security trustee will most likely “hold” the shares for the purpose of the NSI regime and a trigger event may well occur.
  • Even if the lender or trustee does not take legal title to the shares, it may need to do so when it comes to enforce its security, which, again, may give rise to a trigger event.
  • If the lender or trustee will not take legal title on enforcement, it may look to sell the shares to a third party using its power of sale. Once again, this may give rise to a trigger event.
  • Even before the security is enforced, from the point at which it becomes enforceable, voting rights may transfer to the lender or trustee, in turn triggering one of the other trigger events under the NSI regime.

UK Endorsement Board adopts first post-Brexit reporting standards

The UK Endorsement Board (UKEB) has announced the adoption of the first International Financial Reporting Standard (IFRS) for use by UK entities following the UK’s withdrawal from the European Union.

Since 31 December 2020, UK-adopted international accounting standards (IASs) have consisted of all IASs already adopted in the EU. The purpose of the UKEB is to endorse and adopt new and amended standards issued by the IASB. On endorsement, these standards will be added to the set of UK-adopted IASs.