Corporate Law Update

Statements of solvency on a reduction of capital: what must the directors consider?

The High Court has held in BTI 2014 LLC v Sequana SA & others [2016] that payments of dividends were not made in breach of the Companies Act 2006 (the Act).

However, of particular interest is that the court commented on what considerations directors must take into account when deciding whether they can make a solvency statement on a capital reduction.

Facts

Over time, B.A.T. Industries plc (BAT) became liable for certain environmental liabilities in the United States. BAT subsequently sold one of its divisions – Arjo Wiggins Appleton Limited (AWA) – and obtained an indemnity with respect to the liabilities. AWA’s directors included a provision of their best estimate of the liabilities in AWA’s accounts, both at the time and in each subsequent set of accounts.

In 2000 AWA was acquired by Sequana S.A. (Sequana). To meet potential claims under the indemnity, AWA took out insurance and took an assignment of BAT’s historical insurance policies. AWA subsequently ceased to trade and over time lent considerable sums to its parent, creating a substantial inter-company receivable owed to it by Sequana.

In 2008, AWA’s directors decided to remove the receivable by declaring a dividend and setting it off against the receivable. To enable the dividend to be paid, they would first reduce AWA’s share capital.

The directors signed a solvency statement under section 643 of the Act, stating they had formed the opinion that: (i) there was no ground on which AWA could be found to be unable to pay or otherwise discharge its debts; and (ii) AWA would be able to pay or otherwise discharge its debts as they fell due during the year immediately following 15 December 2008. They subsequently paid an interim dividend of €443 million to Sequana, which was set off against part of the inter-company receivable.

AWA’s directors paid a further interim dividend in 2009, this time satisfied by releasing €135 million of the intra-group receivable. Later that same day, Sequana sold AWA.

BAT subsequently claimed that the dividends did not comply with the Act. More interestingly, BAT also claimed that the capital reduction was ineffective because (among other things) it did not comply with the Act and the accounts on which the directors had relied made inadequate provision for the environmental liabilities and failed to give adequate disclosure of contingent liabilities.

Legal background

A private company can reduce its share capital using the solvency statement procedure set out in sections 642-644 of the Act. The directors must give a solvency statement, signed by all of them, and the reduction must be approved by a special resolution of the shareholders.

A solvency statement must say that the directors have formed the opinion, as regards the company's financial position at the date of the statement, that: (i) there is no ground on which the company can then be found to be unable to pay (or otherwise discharge) its debts; and (ii) the company will be able to pay or otherwise discharge its debts as they fall due during the next 12 months.

In forming their opinion, directors must take all of the company's liabilities into account, including contingent and prospective liabilities.

Decision

The court dismissed BAT’s claims and found that AWA’s directors had validly formed the necessary views when they signed the solvency statement. In particular, the court made the following points:

• The directors must actually form the opinions set out in the solvency statement when they give it.
• They do not need to believe the company will be able to pay its debts “no matter what”. If calamity strikes, a company may not be able to pay its debts, but that does not mean that, at the time the solvency statement is made, there are grounds for doubting the company can pay its debts.
• The directors must take into account what assets are available to satisfy contingent and prospective liabilities and, in a non-technical sense, what provision has been made for them.
• It is not necessary when making a solvency statement to apply the solvency tests set out in section 123 of the Insolvency Act 1986. The test for giving the statement is not a technical one, but a straightforward one applying the words of the Act.

Comment

Capital reductions using the solvency statement procedure have become widespread following the regime’s introduction on 1 October 2008. They are often used in corporate restructurings and reorganisations to return surplus assets within subsidiaries, and to return capital to shareholders.

However, questions often arise when carrying out a solvency statement reduction, such as:

• How should directors address contingent and prospective liabilities?
• How confident must the directors be in giving their statement? In particular, do the directors need to hold a cast-iron, rock-solid view that insolvency in the next 12 months is impossible?
• Should directors get external advice, such as an auditors’ report, before making their statement?
• Do the directors need to consider tests in the Insolvency Act 1986?

The BTI 2014 case helps to assuage some of these concerns. It is clear that the directors’ duty when making a statement is to look at the company’s circumstances as they stand at the date of the solvency statement and for the 12 months following that date.

Whist directors cannot be gung-ho and need reasonable grounds for making the statement, they are not required to contemplate every unlikely eventuality. They can interpret the wording of the Act in a straightforward manner and use their common sense and reasoned judgment to form their view.

In particular, it will be a relief to directors undertaking a straightforward capital reduction, perhaps on an intra-group reorganisation or pre-sale restructuring, that they are not automatically obliged to consider the solvency tests in the Insolvency Act 1986 when making their statement.

That said, it would still be wise for directors to consider their potential liability carefully and decide on a case-by-case basis what investigations they should carry out before making their statement. For example, a simple reduction by a dormant subsidiary to return surplus assets may require very little in the way of consideration. By contrast, a reduction by a substantial trading entity with numerous trade creditors will be more complex and is likely to warrant taking detailed legal and accounting advice.

Is a “bad leaver” provision a penalty?

Background

In November 2015, the Supreme Court delivered its landmark judgment in the combined case of Cavendish Square Holding BV v El Makdessi and ParkingEye Ltd v Beavis [2015], in which the Court was asked to (in legal terms) clarify the law relating to contractual penalties.

Under English law, a contractual clause which amounts to a penalty is unenforceable. Normally, a penalty clause consists of a requirement to pay a sum of money on a breach of contract, but it can also extend to an obligation to transfer property, such as shares in a company.

The Lords clarified that a clause will amount to a penalty if two conditions are met:

• It must be a secondary obligation, activated by breach of another obligation, and not a primary obligation that kicks in only in specified circumstances. A primary obligation cannot be a penalty.
• It does not protect a legitimate interest, or it protects a legitimate interest but its effect is exorbitant or unconscionable (i.e. not proportionate).

In the end, the Supreme Court held in Cavendish that a reduction in the price payable for shares in a company when a seller breached non-compete covenants was a primary obligation, in the form of a price adjustment, and so could not be a penalty. By contrast, in Beavis, it held that an obligation to pay a charge for staying beyond a stipulated time in a private car park was a secondary obligation, but that it was proportionate and protected a legitimate interest.

Since Cavendish case, the focus has been on whether “bad leaver” provisions might amount to penalties under this new formulation.

A “bad leaver” provision requires a shareholder of a company who is also a director or employee to offer his shares to the other shareholders or the company in certain circumstances. The triggers for this vary, but they commonly include gross misconduct or other behaviour justifying summary dismissal.

The price payable for the shares is normally docked to reflect the potential damage caused by the shareholder’s behaviour. It might be set at a discount to the market value of the shares, or alternatively at the nominal value of the shares (usually much lower than market value) or a nominal amount (such as £1). The purpose is to disincentivise behaviour that adversely affects the company.

Practitioners have been awaiting a case that sheds light on the potential for “bad leaver” provisions to constitute penalties. Like proverbial buses, two have now come along at once.

Richards v IP Solutions

In Richards and another v IP Solutions Group Ltd [2016], the High Court had to decide whether “bad leaver” provisions in a company’s constitution were an unenforceable contractual penalty.

The case concerned two directors of IP Solutions Limited (IPS), each of whom held 30% of IPS’ shares. Each director also had a service contract with IPS entitling him to a base salary and a quarterly bonus. However, the bonus was payable only if IPS hit certain cash levels in the relevant quarter.

A dispute arose over whether IPS hit the required level of cash in the first quarter. The two directors alleged that it had. One of them instructed the payroll department to pay the bonus to them, grossed up to take account of PAYE deductions. The remaining directors took a contrary view, based on cash-flow extracts produced by IPS’ finance director.

This culminated in a board meeting at which the remaining directors resolved to terminate the two directors’ service contracts for misconduct. Five months later, they were sent notices under the “bad leaver” provision, requiring them to transfer their shares back to IPS. The purchase price was set at £1. The two directors subsequently claimed the “bad leaver” provision was an unenforceable penalty.

In the event, the court found that IPS had not been entitled to dismiss the directors. Whilst the court considered the penalty point, its comments are not binding, but they do provide some guidance.

Perhaps surprisingly, the court felt that the “bad leaver” provision was a primary obligation that embodied distinct commercial reasons to do with shareholders leaving IPS, and that the sum of £1 was merely the price agreed on such a transfer. On that basis, the “bad leaver” provision was simply incapable of being a penalty. It is worth nothing, though, that the court considered the point only in brief and emphasised the limited evidence and time available to it.

However, even if the provision had been a secondary obligation, the court was prepared to find that there was nothing unconscionable in it, as it had been arrived at on arms-length terms with the benefit of extensive expert advice. So, had it been a secondary obligation, it would have been enforceable.

Gray

In Gray and others, Re Braid Group (Holdings) Ltd [2016], the Scottish Court of Session also had to decide whether a “bad leaver” clause, this time in a shareholders’ agreement, amounted to a penalty. Here the issue was not whether the provision could be activated, but whether its potential unenforceability meant it was incapable of being to calculate an award for unfair prejudice.

Mr Gray, a director of Braid Group (Holdings) Limited (BGHL), had over time been excluded from BHGL’s business and denied access to certain information relating to it and its subsidiaries.

At the same time, other directors of BHGL discovered that Mr Gray had been involved in, or at least aware of, certain arrangements concerning BGHL’s subsidiaries that amounted to bribery contrary to the Bribery Act 2010. This culminated in Mr Gray being suspended and dismissed.

In response, Mr Gray launched an action in unfair prejudice against BGHL under section 996 of the Companies Act 2006. He claimed that his exclusion from the business, the withholding of information from him and the conduct of his disciplinary proceedings unfairly prejudiced him as a shareholder.

At first instance, the court found that unfair prejudice had occurred on some (but not all) grounds and made an order for Mr Gray’s shares to be sold at market value.

The other shareholders contested the value, claiming that Mr Gray’s involvement in the bribery and his dismissal made him a “bad leaver”. In those circumstances, they said, Mr Gray was entitled only to the nominal value of his shares, and this was the proper basis for calculating the award. Mr Gray argued that the “bad leaver” provision constituted a penalty and could not form a basis for that calculation.

The court unanimously found that the “bad leaver” provision was a secondary obligation, triggered by the breach of a primary obligation, namely compliance by Mr Gray with his service contract. The court was split on whether the provision was a penalty, but a majority held it was not.

In particular, the court emphasised the facts that the provision had been the subject of negotiation carried out with specialist legal advice and that the parties had an interest in the “faithful and diligent performance” by the signatories of their duties as employees and/or directors. The court also noted that the effect of the provision had to be judged on the date it was entered into, and any subsequent disparity between market value and nominal value, however great, was to be ignored.

The court therefore upheld the “bad leaver” provision. However, as in Richards, the penalty point was not relevant to the ultimate outcome, and so this judgment too sets no law.

Comment

Where does this leave us? The comments in both cases are obiter, so it would not be wise to rely on them to conclude that “bad leaver” provisions are enforceable. However, it is heartening that, in both cases, the provision set a transfer price at a potentially significant discount to market value, and, in both cases, the court was prepared to find that the provision was proportionate and enforceable.

Of more frustration is the fact that the two courts reached different conclusions on whether the “bad leaver” provision was a primary or secondary obligation, even though the circumstances surrounding the provisions in question were broadly analogous. The dividing line between primary and secondary obligations was already, and these conflicting decisions do not help.

“Bad leaver” provisions are often invoked on a breach of employment or service contract. In these circumstances, it feels instinctive to regard them as secondary obligations triggered by a breach of contract and to take careful steps to demonstrate their legitimacy. Practitioners may therefore feel more at ease with Gray than Richards. However, Gray was a Scottish decision and may carry less weight than Richards, a decision of the English High Court.

We will need to wait for further cases to clarify this discrepancy. However, for now, lawyers and clients can probably feel that little bit more comfortable when negotiating “bad leaver” provisions.

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