Corporate Law Update

This week we look at an interesting case in which a company’s board of directors was unable to exercise a contractual power to refuse to issue shares pursuant to an option.

The case raises the question, explored previously in recent case law, of the process that needs to be followed when deciding whether to give consent under a contract.

Board had to act reasonably when approving exercise of option

In Watson and others v Limited, the High Court held that the board of directors of a company that had granted an option over its own shares had to act reasonably when granting consent to the exercise of the option.

What happened? Limited (“Watchfinder”) is a company in the business of buying and selling pre-owned watches. It entered into a services agreement with Adoreum Partners (“Adoreum”), a business development consultancy. Adoreum wished to use its large network of businesses, investors and high net-worth individuals to introduce Watchfinder to appropriate contacts in the lifestyle and luxury goods sector.

At the same time, Watchfinder granted options over its own shares to three directors of Adoreum. The option agreement stated:

“The option may only be exercised with the consent of a majority of the board of directors of the Company.”

Later, when the option-holders attempted to exercise their option, Watchfinder said that its directors had not consented to the exercise and it refused to issue the shares.

The option-holders argued that Watchfinder’s board did not have an unfettered right to refuse consent. Instead, they said, Watchfinder’s board had refused consent “unreasonably, capriciously or arbitrarily” when it was not entitled to do so and so should be deemed to have given consent. They therefore brought an action for specific performance to require Watchfinder to allot and issue the shares.

Watchfinder argued, on the contrary, that no such restriction applied and that the clause amounted to an “unconditional veto” over issuing shares.

What did the court decide?

The judge refused to interpret the clause so as to give Watchfinder’s board an unconditional right to veto the options.

If the clause had amounted to an unconditional veto, the decision whether to issue the option shares would have been “entirely within the gift of Watchfinder”. This would have put the option-holders in no different a position from a person seeking to buy shares in Watchfinder without the benefit of an option and would have rendered the option agreement meaningless.

The judge was satisfied that the options were part of an “overall contractual package” alongside the services agreement with Adoreum. It would have been, in the judge’s words, a “commercial absurdity” to conclude that one part of the package was in fact worthless.

The court acknowledged that it is unusual to find a provision in an option agreement giving the issuing company’s board discretion whether to accept the exercise of the option. Normally, an option agreement would contain an unqualified right to subscribe for shares if and when certain conditions are satisfied. However, the court could not disregard the clause entirely. It had been included in the option agreement on purpose and was clearly intended as a restriction on the option.

Instead, the judge decided that the clause amounted to a discretionary power.

Under English law, if a contract gives someone a discretionary power, the court can require that discretion not to be exercised arbitrarily, capriciously or irrationally. This relates to the process of making a decision, rather than the actual decision itself.

So, for example, if the discretionary powers relate to giving consent to some matter, the person making the decision is entitled to refuse that consent. However, in making that decision, the person in question must follow a proper process. This includes taking into account any material points and not acting on irrelevant considerations. The essentially incorporates a “public law” test that is common for applications such as judicial review.

In this case, the question of Watchfinder’s directors following a proper process in deciding whether to give consent was particularly relevant, as there was a potential conflict of interest for Watchfinder’s existing shareholders. Granting the option would see their shareholdings diluted and may (in the judge’s words) restrict their availability for other investors (who might be prepared to pay much more).

The judge concluded that the central question for Watchfinder’s board when reaching their decision was whether the option-holders had made a contribution to the progress of Watchfinder. On the facts, the board had not considered this factor and had instead proceeded on the basis they had an absolute veto over issuing the shares. For that reason, they had not followed a proper process or exercised their discretion properly.

The court was therefore required to proceed as if they had given consent. It granted the option-holders their order for specific performance.

Practical implications

This is a good example of how traditional public-law tests are being imported ever more frequently into a contractual context.

Following the recent Supreme Court decision in Braganza v BP Shipping Limited, it is now well established that, if a party has a contractual discretion, it is likely to have to exercise that discretion reasonably, rationally and in good faith and not to reach an outcome that no reasonable decision-maker could reach.

As a general rule, parties to a contract must bear in mind that, even if the contract appears to give unfettered discretion when deciding whether to withhold consent or when reaching any other decision, the law will imply certain restrictions and require them to act reasonably.

The judge noted that, if the clause in question had amounted to an absolute veto, it would have denuded the options of any effect. It is tempting to interpret this comment as meaning that any right to approve the exercise of an option might be fundamentally ineffective. However, this is a stretch too far. The court upheld the clause and seemed satisfied that Watchfinder’s board did in fact have discretion to refuse to issue the shares. The question was how they exercised that discretion.

It seems that, if Watchfinder’s directors had properly considered the option-holders’ contribution to the business and concluded that that contribution did not merit an issue of shares, the court may well have found in favour of Watchfinder. However, it was not clear in the contract that this was the basis on which Watchfinder was to reach its decision.

What steps can I take?

To avoid doubt about the limits within which consent can be refused, parties can consider including wording in their contracts setting out factors to be taken into account when making the decision whether or not to give consent. The drafting will need to strike a careful balance between providing important context for the decision without limiting the factors that can be taken into account.

Finally, where a party or group of people (such as a board of directors) make a decision based on a contractual discretion (including, for example, whether or not to grant consent), it would be wise to keep evidence that they have followed a proper process. This could include documenting their discussions and the factors they took into account, as well as their reasons for ultimately refusing (or giving) consent.