Corporate Law Update
We also catch up on audit developments from the FRC’s recent report, the Pre-emption Group’s position on disapplying pre-emption following changes to the Prospectus Rules, and a case on “reflective loss”.
In Tillman v Egon Zehnder Limited, the Court of Appeal found that a non-compete covenant given by a former employee was invalid because, hypothetically, it would have prevented her from holding even a minor shareholding in a competitor company.
Ms Tillman was an employee of Egon Zehnder for 13 years. In January 2017, she gave notice to end her employment in order to join a competitor. Her contract required her not to “directly or indirectly engage or be concerned or interested in any business carried on in competition with” Egon Zehnder’s business at it stood when her employment ended.
Ms Tillman claimed the covenant was unreasonable, as it prohibited her from holding even a minor shareholding in a competitor. It was therefore a restraint of trade and unenforceable. Egon Zehnder argued that the covenant could be amended by removing the words “or interested”, leaving it intact and allowing Ms Tillman to hold a minor shareholding in a competitor.
The court agreed with Ms Tillman. It found that the entire non-compete covenant was unenforceable. The leading judge said the court had no ability to remove only two words of the covenant, and the simple meaning of the covenant’s wording showed it was trying to prohibit shareholdings of any size.
Although this concerned a non-compete clause in an employment contract, it can be translated easily to a corporate context. Non-compete and other restrictive covenants are often found in share and business sale agreements, as well as in subscription and shareholders’ agreements on private equity or venture capital fundraisings. Whilst the courts subject restrictive covenants in employment contracts to particular pressure, they apply the same principles to restrictive covenants in other arrangements.
The judgment highlights three key points:
- It is important to phrase a non-compete covenant carefully. If using generic and undefined terms such as “concerned” and “interested”, the parties should be aware that the courts may interpret these very widely.
- When including a non-compete covenant, it is advisable to include a carve-out to allow the person giving the covenant a degree of shareholdings in other companies. This carve-out does not have to be unlimited. It is common to restrict it to shareholdings of no more than 3% to 5%, and then only in a listed company. However, the carve-out should not be so narrow that the non-compete covenant becomes too broad.
- If including multiple restrictive covenants in a single contract (such as obligations not to compete, solicit employees or solicit customers), it is vital to ensure that each covenant stands separately and individual covenants are not woven into a single clause. A court cannot pick a single covenant apart to make it enforceable, but it may be able to delete one covenant without affecting others.
On 20 July 2017, the FCA amended the Prospectus Rules to modify certain exemptions from publishing a prospectus so as to implement certain early provisions of the EU Prospectus Regulation.
As a result, issuers with securities admitted to trading on a regulated market do not need to publish a prospectus if they are admitting new securities that represent (over a period of 12 months) less than 20% of a class of securities already admitted to trading. Among other things, this has increased the previous threshold of 10% to 20%, giving issuers more freedom to admit without a prospectus.
For more information on the changes to the Prospectus Rules, see our Corporate Law Update for the week ending 14 July 2017.
The Pre-Emption Group has confirmed that the change to the threshold for the prospectus exemption does not affect the limits for general disapplications of pre-emption rights set out in the Statement of Principles. It expects issuers, when proposing to issue shares, to continue to limit general disapplications to 5% for general corporate purposes and a further 5% only in connection with an acquisition or specified capital investment.
FRC reports on audit developments
The Financial Reporting Council (FRC) has published its report on developments in audit in 2016/2017. The report presents a mixed view, with the standard of audits for FTSE 350 companies showing continuous improvement, but with an increasing number of audits for companies outside the FTSE 350 requiring more than limited improvement. Key points from the report include:
- Audit tendering is producing tangible effects, with 61% of FTSE 350 companies tendering their audit in 2016/2017 and 74% of those tenders resulting in a change of auditor.
- Whilst the Big Four continue to dominate the audit market for the FTSE 350, there has been greater competition based on quality between firms within that market. This has not led to a simple downwards pressure on audit fees.
- There has been greater involvement in audits by senior team members. The FRC has found good examples of auditors demonstrating greater scepticism when evaluating management assumptions and conducting root cause analyses in both good- and bad-case scenarios.
- However, these are also areas where the FRC finds the greatest number of issues and problems. The FRC is concerned about “differential quality”, and specifically that improvements in FTSE 350 audit quality may be coming at the cost of quality elsewhere.
- The FRC remains concerned about auditors failing to be sufficiently independent of their clients or demonstrating the willingness and ability to provide robust challenge to management. It will continue to take enforcement action to address these cases.
- The FRC’s key focuses in 2017/2018 will be audit firm governance and culture. The FRC will carry out a thematic review of how firms are promoting, measuring and assessing their own culture.
- The FRC is concerned that firms may at times be applying a “rules-based mentality” to auditor independence. It intends to engage with stakeholders and firms to address this.
Claim by shareholder not prohibited by reflective loss principle
In Latin American Investments Ltd v Maroil Trading Inc and another, the High Court found that the principle of reflective loss did not prevent a shareholder of a company from seeking specific performance and damages that would result in payments being made to the company.
What is “reflective loss”?
A shareholder of a company cannot recover loss that merely represents loss sustained by the company itself. This is called “reflective loss”. If a company suffers loss, it is the company that must claim. A shareholder can claim only if it has its own cause of action and has suffered loss separate and distinct from that suffered by the company.
The principle is intended to respect a company’s autonomy, to ensure that companies’ creditors are not prejudiced by actions of individual shareholders, and to avoid a party from recovering twice by claiming compensation for loss suffered by someone else.
The case concerned two tankers, each owned by a joint venture company (the “JVCos”) with three shareholders that included Oceanic Trans Shipping Est (“Oceanic”) and Maroil Trading Inc. (“Maroil”).
Under shareholders’ agreements, each JVCo made its tanker available to Sea Pioneer Shipping Corp. (“Sea Pioneer”). Sea Pioneer in turn entered into an affreightment contract with PDVSA, then assigned its rights under that contract to the JVCos. Disputes later arose between the JVCos and PDVSA, and the JVCos alleged that PDVSA had failed to perform its obligations under the affreightment contract.
Maroil and Sea Pioneer settled the disputes for $30 million. Oceanic alleged that Maroil and Sea Pioneer had no authority to settle the claims and had done so in breach of fiduciary duty and the shareholders’ agreements. It argued the claims should not have been settled for less than $89 million and that it was owed a share in a related commission arrangement relating to the settlement.
Oceanic therefore sought orders that Maroil and Sea Pioneer reimburse the JVCos for (among other things) the commission payment and any profits made from its use.
What did the court decide?
Oceanic did not dispute that its own loss merely reflected loss suffered by the JVCos. However, it argued for the order because the monies would be paid to the JVCos, and not to it. This respected the principle of company autonomy, and would neither prejudice the JVCos’ creditors nor enable Oceanic to recover in respect of the JVCos’ loss.
The court agreed. The judge laid emphasis on the fact that Oceanic had its own right of action under the shareholders’ agreements and was seeking specific performance to require payments to the JVCos. Furthermore, if Oceanic was entitled to seek specific performance in favour of the JVCos, it was hard to see why it could not also seek damages for the JVCos.
Ultimately, the key point is that Oceanic was not in fact seeking to recover “reflective loss”. Rather, it was attempting to use its own cause of action to restore monies to the JVCos. This appears to have been pivotal in the judge’s decision.
The purpose of the hearing was merely to decide whether or not a freezing order should be lifted. The decision could therefore be rejected on appeal. However, it is worth noting as a potentially useful elaboration on the principle of reflective loss.