Corporate Law Update

This week we look at whether a majority shareholder was entitled to amend a company constitution to force out a minority shareholder with whom he had come into disagreement, and whether a seller was impliedly allowed to disclose a confidential licence to a potential buyer.

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Attempt to force out minority shareholder was valid – to a point

The Privy Council has decided that an amendment to a company’s constitution to insert a mechanism to force out a minority shareholder was not invalid. However, it went on to find that the conditions for using that mechanism hadn’t been satisfied.

What happened?

In Staray Capital Limited and another v Cha, a Mr Chen and a Mr Cha had established a company in the British Virgin Islands with a view to pursuing a Canadian mining venture, with Mr Chen holding 80% of the company’s shares and Mr Cha holding 20%.

However, the relationship between the two men had deteriorated. Mr Chen claimed that Mr Cha had misrepresented his status as a partner and a qualified lawyer in China and New York when he acquired his shares in the company.

Mr Chen passed a special resolution to amend the company’s constitution to insert a mechanism allowing the company’s to redeem a shareholder’s shares if that shareholder had made material misrepresentations when he acquired them. He then tried to use that mechanism to redeem Mr Cha’s shares (and so remove him as a shareholder), citing the alleged misrepresentations above.

Mr Cha challenged the amendment, claiming it had been directed solely at him and had not been made in good faith in the interests of the company.

In response, Mr Chen acknowledged that his motivation had been to force Mr Cha out, but he claimed that the amendment was valid nonetheless and was part of a “clearing-up” of the company.

What did the Privy Council say?

The Council said the amendment was valid. Although it had been aimed squarely at forcing Mr Cha out, Mr Chen had been acting in what he genuinely believed to be the company’s best interests. It was reasonable to expect a company to support a proposal to redeem shares acquired by a shareholder as a result of misstatements.

However, although the Council upheld the amendment, it found that Mr Cha’s misrepresentations had not been material. As a result, Mr Chen could not use the mechanism to redeem Mr Cha’s shares.

Practical implications

There is a line of established case law on amending a company’s constitution. Most recently, in Re Charterhouse Capital Ltd (or Arbuthnott v Bonnyman), the court summarised seven tests for deciding whether an amendment is valid. The Council followed these principles in reaching its own decision in Staray.

The case shows how reluctant the courts will be to interfere in the private affairs of companies and shareholders. It also provides reminders to persons looking to force out a minority shareholder:

  • If amending the company’s constitution, make sure the amendment has a genuine benefit to the company that you can explain to a court, if need be.
  • Do not direct amendments at specific shareholders, but instead ensure they apply more generally in a particular set of circumstances.
  • When invoking a mechanism to force a shareholder out, make sure to follow the procedure correctly and that any conditions for invoking it have all been met.

For minority shareholders facing the prospect of being forced out, the case contains key lessons:

  • To challenge an amendment to insert a force-out mechanism, certain conditions must be met. In particular, the court must be persuaded that the amendment was made in bad faith or was not in the company’s interests. These are high hurdles to clear.
  • A court will assume a company’s shareholders are best placed to decide what is in its interests. You will need strong evidence that an amendment was really intended to benefit the majority.
  • However, a valid amendment is not an effective force-out. Check carefully whether the majority has the right to activate the force-out and whether they have followed the procedure properly.

No implied ability to disclose confidential contract to potential buyer

The Court of Appeal has decided that it was not an implied term of a confidential contract that a party could disclose it to a potential buyer of its business.

What happened?

In Kason Kek-Gardner Limited v Process Components Limited, a company that went into administration sold different parts of its business to two new companies controlled by its former directors: Process Components Limited (“PCL”) and Kason Kek-Gardner Limited (“Kason”).

PCL and Kason entered into a licence, under which PCL gave Kason the right to use certain intellectual property that PCL had acquired in the administration.

The licence contained a clause requiring the parties to keep it confidential. It also allowed PCL to end the licence if Kason committed a material breach that could not be remedied. It specifically stated that a breach of the confidentiality clause was considered a non-remediable material breach.

Around six years later, the shares in Kason were acquired by one of PCL’s competitors. As part of the sale process, Kason provided a copy of the licence to the buyer.

On becoming aware of this, PCL ended the licence agreement, claiming that Kason had breached the confidentiality clause.

In response, Kason argued the licence was subject to an implied term allowing it to disclose the licence where “reasonable to do so for necessary business purposes”, including to a “would-be purchaser”.

What did the court say?

A court can imply a term into a contract only if it is necessary to give business efficacy to the contract, or if it is so obvious that it goes without saying.

The court did not agree that a sale of Kason’s business was a necessary business purpose of the licence, still less a sale by Kason’s shareholders of their shares in Kason. Although a sale may have been a “wider business purpose” of Kason, it was not necessary to ensure the licence worked.

On the same note, the court said that it was not obvious that PCL would have permitted Kason to disclose the contract, especially to a competitor, without setting out precise limits on disclosure.

The court therefore upheld PCL’s right to end the licence.

Practical implications

A seller on a share or business sale will often face the difficult question of whether (and when) to disclose confidential contracts to a potential buyer. Understandably, a buyer will not want to acquire a business without knowing with which other organisations the target deals and on what terms.

Sellers usually disclose a degree of material at the outset of negotiations, often in redacted form in an attempt to comply with confidentiality restrictions. However, ultimately the time will come for full disclosure, and even disclosing redacted contracts arguably breaches confidentiality restrictions.

An important step, therefore, is to evaluate the risks of disclosing confidential contracts to a potential buyer. This might include asking questions such as:

  • How far the does confidentiality clause in a contract go? Is the seller actually allowed to disclose? Sometimes (albeit rarely) a contract will allow disclosure to a potential buyer.
  • What is the consequence of breaching confidentiality? Could the contract come to an end? Can the counterparty claim damages?
  • How material is the contract? Does the sale opportunity merit the risk of termination, or would termination significantly affect the target business?
  • Is it possible to approach specific commercial counterparties for consent to disclose? Will the buyer be happy with this, and at what point should the seller do this?

These are all questions that a seller will need to consider from contract to contract.

Throughout all of this, listed buyers and sellers will need to bear in mind that negotiations for the sale of a business or subsidiary will usually constitute inside information. In this case, it may not be possible to approach commercial counter-parties for consent.