Corporate Law Update

This week we look at a case where the court implied a duty of good faith into a joint venture agreement, a case where a company was denied Enterprise Investment Scheme (EIS) relief after it acquired a company limited by guarantee and changes to the AIM Rules following the London Stock Exchange’s recent consultation.

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Oral joint venture contract was subject to duty of good faith

The High Court has held that a joint venture contract made orally between two individuals was subject to a duty of good faith.

What happened?

In Al Nehayan v Kent, two individuals – Sheikh Tahnoon bin Saeed bin Shakhboot al Nehayan and Mr Ioannis Kent – agreed to invest together in a venture to develop luxury hotels in Greece.

In a conversation between the two men in 2008, Sheikh Tahnoon agreed to acquire a 50% stake in the business in exchange for investing an amount equal to half of what Mr Kent had already invested.

Over the course of a few years, the business acquired more hotels but suffered continual cash-flow problems. On successive occasions, Mr Kent asked Sheikh Tahnoon to provide more money to the business to keep it solvent, which the Sheikh did.

By February 2011, the business was suffering severely from civil unrest relating to the Greek bail-out and a dip in tourism caused by the eruption of the Eyjafjallajökull volcano in Iceland. From this point, Sheikh Tahnoon declined to provide any further funding to the business.

In March 2012, in an attempt to rescue the business, Mr Kent entered into negotiations to sell off the business’s travel booking operations to a third party – FTI.

In April 2012, Sheikh Tahnoon and Mr Kent decided to part ways. They signed a framework agreement setting out how they would achieve this. At the same time, Mr Kent signed a promissory note in favour of the Sheikh for a substantial sum.

Under the framework agreement, the Sheikh would transfer his shares in the travel booking operations to Mr Kent. However, unknown to Mr Kent, the Sheikh’s representatives had also been negotiating directly with FTI to sell those same shares to FTI. These negotiations with FTI ultimately led to no deal.

Later, in 2013, Sheikh Tahnoon brought proceedings against Mr Kent to recover monies owed under the framework agreement and the promissory note that Mr Kent had not paid.

In response, Mr Kent claimed (among other things) that Sheikh Tahnoon had owed a duty of good faith to Mr Kent in relation to their business venture, which he had breached. He counterclaimed for damages in the same amount so as effectively to wipe out the Sheikh’s claim.

What did the court say?

The court agreed with Mr Kent.

It found that the arrangement between Mr Kent and Sheikh Tahnoon amounted to an oral joint venture agreement. Furthermore, that agreement was a “relational contract” and so it was appropriate to imply a duty of good faith into it.

The judge did not say what exactly the implied duty of good faith involved. However, he was satisfied it had been breached when the Sheikh’s representatives conducted undisclosed negotiations with FTI.

He also found that the duty of good faith had been breached when the Sheikh’s representatives used his position as a shareholder in the business to block the sale to FTI that Mr Kent was negotiating.

As a result, Mr Kent’s counterclaim matched and nullified the Sheikh’s claim, and neither party was entitled to recover money from the other.

So is there a duty of good faith?

The case dealt with other points, but the highlight is the judge’s comments on the duty of good faith.

Since Yam Seng v International Trade Corporation in 2013 (where the court found that a duty to act in good faith was implied into a contract for the distribution of certain football-branded products), there has been a large number of cases where parties have argued for an implied term of good faith.

An important part of the judge’s reasoning in that case was that the contract in question was “relational”. Its operation required a high degree of communication, cooperation and predictable performance based on mutual trust, confidence and loyalty.

Following Yam Seng, the courts’ responses have been slightly mixed. However, over the past couple of years the courts have adopted a fairly consistent approach, namely:

  • There is no general doctrine of good faith in English law.
  • The courts will imply a duty to act in good faith into certain kinds of contract, such as employment contracts and contracts between parties whose relationship is a “fiduciary” one.
  • In other types of contract, the court will imply a duty to act in good faith only if the usual test for implying terms into contracts is satisfied. This is more likely to be the case for a “relational” contract, such as a franchise, distribution or joint venture agreement.

Despite the continuing lack of clarity, we can discern two key points from the judgment in Al Nehayan:

  • If a contract does not contain an express duty of good faith, the court can only imply one if the relevant tests are satisfied. Essentially, the duty must be necessary to give “business efficacy” to the contract and it must so obviously form part of the contract that it goes without saying.

    Here the contract was oral. A court is less likely to imply a duty of good faith into a detailed written contract between sophisticated and legally advised parties.

  • A court is more likely to imply a duty of good faith into a relational contract. This is an agreement under which the parties commit to collaborate together, usually on a long-term basis, in ways that respect the spirit of their venture but which they have not set out exhaustively in writing.

    Whether a contract is relational will therefore depend on the circumstances of the case and the nature of the contract. It is therefore difficult to predict whether a contract will be “relational”, but franchise agreements and (as here) joint venture agreements are prime candidates.

Practical implications

The decision shows that individuals and businesses need to be careful when entering into potentially long-lasting ventures with others. These are the kinds of arrangement where a court may well impose obligations on the parties (beyond the terms of their written contract) to act honestly and in good faith.

However, the court can only do this if the term is needed to make the contract work. Parties entering into a long-term arrangement should therefore ask themselves whether they want to be subject to a duty to act honestly or in good faith.

  • If they do, it may be better to set this out explicitly in the contract, including what is expected of each party. A term will not be implied if it contradicts the express provisions of a contract. An express duty will also provide much greater certainty for the parties.
  • Alternatively, if the parties do not want to be subject to a duty of good faith, they should consider explicitly excluding the duty in the contract, or acknowledging that it does not apply.

This need not be as confrontational as it might first seem – a party might justify resisting a duty of good faith on the basis that the concept is quite vague. (The judge in Al Nehayan noted that it was “perhaps impossible to spell out an exhaustive description” of what an implied duty of good faith entails). If the parties agree that they intend to take (or not to take) particular steps, they should set this out in clear terms in the contract.

EIS relief denied when company limited by guarantee was acquired

The First-tier Tribunal has held that a company limited by guarantee was not a “qualifying subsidiary” for the purposes of Enterprise Investment Scheme tax relief.

What is EIS?

The Enterprise Investment Scheme ("EIS") was introduced in 1994 to encourage investment in small, higher-risk companies. Broadly, if a company qualifies for EIS then, subject to completing a minimum holding period, the shares qualify for a number of tax reliefs. These include that:

  • a person subscribing for shares in that company can claim relief against their income tax liability for 30% of the amount invested (up to an annual limit of £1 million); and
  • a sale of those shares is exempt from capital gains tax ("CGT").

To qualify for EIS, a company must satisfy numerous detailed and prescriptive conditions set out in the Income Tax Act 2007 (“ITA 2007”). Two of these conditions are that:

  • the company seeking to claim EIS must not “control” any company that is not a “qualifying subsidiary” and
  • all of the company’s subsidiaries must be “qualifying subsidiaries” for a period of three years following the issue of the shares in respect of which EIS is being claimed.

To be a “qualifying subsidiary”, a company must be a “51% subsidiary”

Finally, a company is a 51% subsidiary if more than 50% of its ordinary share capital is owned by another body corporate.

What happened here?

Hunters Property plc v HMRC concerned Hunters Property plc (“HPP”), which was the holding company of an estate agency business.

In May 2015, one of HPP’s subsidiaries acquired a company limited by guarantee (CLG) that operated another estate agency business.

For a brief period until December 2015, HPP’s subsidiary was the only member of the newly-acquired CLG. After that time, Hunters’ subsidiary was replaced as the CLG’s sole member by an individual.

HPP applied to HMRC for certification under the EIS regime. HMRC refused certification on the basis that HPP had controlled the CLG, and the CLG has been a subsidiary of HPP, between May and December 2015, and the CLG was not a “qualifying subsidiary”.

Critically, HMRC argued that, in order to be a “qualifying subsidiary”, a company had to have share capital. It said a company with no share capital could be a subsidiary, but not a qualifying subsidiary.

What did the Tribunal say?

The Tribunal agreed with HMRC.

The judge said that HPP did control the CLG for the brief period of time, and that the CLG had briefly been a subsidiary of HPP.

However, because it did not have any share capital, it could not have been a “51% subsidiary”, and so it was simply impossible to fit it within the definition of “qualifying subsidiary”.

Finally, the Tribunal approved the Upper Tribunal’s statement in Flix Innovations Ltd v HMRC that, where legislation is highly detailed, prescriptive or “closely articulated”, there is little scope for the courts to interpret purposively rather than literally.

Practical implications

The judgment highlights the care required when analysing group relationships. In particular, the case shows how an entity can be a subsidiary for one purpose (e.g. accounting) but not a subsidiary for a completely different purpose (in this case, a “qualifying subsidiary” under the EIS regime).

The decision also highlights the care that companies and directors should take when attempting to apply for EIS or Seed Enterprise Investment Scheme (SEIS) relief. In particular:

  • Before issuing shares that are to qualify for EIS or SEIS relief, ensure the company does not have or control any entities that do not have share capital, as these will not be “qualifying subsidiaries”.

    This is not limited to CLGs but extends to any entity that does not have share capital. So, for example, a company that holds a majority of the voting rights in a limited liability partnership (LLP) or an unlimited company with no share capital may find itself unable to claim EIS or SEIS relief.

  • After applying for or receiving certification for EIS or SEIS relief, be careful not to acquire an interest in any entities that do not have share capital.

    In this case, it was plain that HPP was acquiring an entity without share capital. However, in other cases, the situation might not be so clear. For example, a company that acquires the shares in a holding company may find itself disqualified from EIS or SEIS relief if, by doing so, it indirectly acquires control of a CLG or an LLP owned by that holding company.

LSE confirms changes to AIM Rules

The London Stock Exchange (the “Exchange”) has published AIM Notice 50. The notice summarises responses to the consultation the Exchange published in AIM Notice 49, which we covered in our update for the week ending 22 December 2017.

The Exchange has also published a mark-up showing the changes to the AIM Rules for Companies ("the Rules").

Broadly, the Exchange is making the following key changes to the AIM Rules:

  • AIM companies will be required to report against a specified corporate governance code on a “comply or explain” basis.

    This will be similar to the current regime for premium-listed companies, which are required to comply with the UK Corporate Governance Code and explain any areas of non-compliance. However, AIM companies will be free to report against a recognised code of their choosing.

    Companies must select and announce their chosen corporate governance code by 30 March 2018, but they will not need to report against it until 28 September 2018. From that date, they will need to review compliance against their chosen corporate governance code annually.

    New applicants to AIM will need to provide the name of their chosen code before admission and to disclose the name of that code in their admission document.

  • Where a company is applying for admission, its nominated adviser (“nomad”) will need to submit an early notification form to the Exchange as soon as reasonably practicable “in the form prescribed from time to time”.

    The notification will need to contain the information required by the form, as well as matters known to the nomad that may be relevant in considering the application and understanding whether admission may be detrimental to the orderly operation, reputation and/or integrity of AIM.

    If any of the information required in the notification is not available, the nomad should state this in the form and update the Exchange once it has that information.

    The amended Rules warn that a notification that does not allow adequate time for discussion with the Exchange may contribute to a delay. Nomads should therefore consider, on an application-by-application basis, when is the most appropriate time to submit their notification and how much information to include so as to enable a meaningful dialogue with the Exchange.

    The Exchange’s template early notification form can be found here.

  • In addition, the AIM Rules for Nomads have been amended to include a new non-exhaustive list of criteria for deciding whether and when to engage with the Exchange before applying for admission. These are designed to help assess an applicant’s appropriateness for admission and will feed into the early notification.

Save for the requirement to report against a corporate governance code (see above), the changes come into effect on 30 March 2018.