Corporate Law Update

This week:

• A non-compete covenant given by two sellers in relation to their associates was not capable of being struck out as unreasonable
• The directors of a company were not able to “provisionally” declare dividends and later re-characterise them as salary payments
• The Private Equity Reporting Group publishes its 2018 report on how private equity firms and their portfolio companies have complied with the Walker Guidelines
• The Government announces that it will abolish the Financial Reporting Council and replace it with a new, independent statutory regulator
• A few other items of interest

Non-compete clause was not vulnerable to being struck out

The Sheriff Appeal Court of Scotland has held that a particular kind of non-compete clause in a share purchase agreement (SPA) could not be nullified on the grounds that it was a restraint of trade.

What happened?

In Nekrews and another v PMAC Scientific Limited, Mr and Mrs Nekrews (the sellers) sold all of the shares in a company, Gamm@Chek, to PMAC. Part of the purchase price for those shares was deferred until a later date.

The sellers gave non-compete covenants in the SPA, which required the sellers to procure that none of their “Associates” would compete with Gamm@Chek, or solicit its employees or customers, for three years after the sale. For these purposes, “Associate” included a relative of either seller.

When the deferred part of the price became due, PMAC refused to pay. It alleged that the sellers had breached their non-compete covenants because the brother of one of the sellers had (through a corporate vehicle) traded in competition with Gamm@Chek.

The sellers argued that the non-compete was void because it was a “restraint of trade”. Under English law, a contractual obligation that attempts to restrict someone from carrying on a business or livelihood is invalid unless (broadly speaking) it is reasonable and protects a valid interest.

The context in which the obligation is given is relevant. The courts are more likely to strike out a non-compete covenant in an employment contract (where the employee giving the covenant relies on their employment for a living) than in (say) a share sale agreement (where the seller giving the covenant is exiting his or her business and may be receiving a lucrative payment).

What did the court say?

The court upheld the covenants. It said that, although the non-compete clause in the SPA was a restraint of trade, it was not the kind of restraint that the court could strike out, because it did not deprive the sellers of their ability to compete with Gamm@Chek.

Rather, the clause required the sellers to ensure that their “Associates” did not compete. In that sense, it imposed an obligation on the sellers, rather than their “Associates”. Whilst in practice it might have deterred those Associates from competing against Gamm@Chek, it did not prevent them from doing so if they wanted to.

Practical implications

This is a judgment of the Scottish courts and so is technically only persuasive for the English courts. However, the decision was based on previous English case law and so should carry weight.

The decision highlights an important difference between an obligation not to compete (a “personal covenant”), which may be vulnerable if it is not reasonable, and an obligation to ensure someone else doesn’t compete (a “procurement covenant”), which should be enforceable. Where the seller of a business is a company, it is common for a buyer to ask the seller to give procurement covenants in relation to other companies within its group.

Given this, when seeking the benefit of a non-compete covenant, it is worth considering the following:

• Consider separating out any personal covenants and procurement covenants, rather than mixing them up together. That way, if the personal covenant fails, it shouldn’t automatically bring the procurement covenant down.
• Likewise, consider setting any procurement covenant out in full, rather than linking it to an existing personal covenant. Although this may seem long-winded, it may minimise the chance of the procurement covenant becoming entangled with the personal covenant and so being invalid.

Payments were unlawful dividends after all, not salary

In September 2017 we reported on a case (Global Corporate Limited v Hale) in which the High Court found that payments made by a company to its director-shareholders, although characterised at the time as dividends, were in fact salary payments.

This was in part because the directors had declared the dividends “provisionally”, with the possibility of “undeclaring” them and re-characterising them as salary payments if it turned out the company did not have enough distributable profits to justify the dividends. In the event, the company did not have sufficient distributable profits, and so the judge found that the payments were made by way of salary.

We noted at the time that the decision was problematic for various reasons. In particular, there is no real concept of “provisionally” declaring dividends in English law, and the judge arguably placed too much emphasis on the directors’ intentions, rather than what they actually did at the time.

In a welcome decision, the Court of Appeal has now overturned the High Court’s original judgment. The Court found that, on the contrary, the payments were dividends for four key reasons:

• The company’s directors had expressly characterised them as interim dividends and had declared them as such to HM Revenue & Customs. There was no mention at the time of the payments taking the form of salary payments.
• There was no suggestion that the dividends were declared “provisionally” and, although the court did not delve into the law on this point, the phrasing of the leading judgment seems to cast some doubt on whether it is even possible to declare a dividend “provisionally”.
• In any case, regardless of whether the directors declared the payments as dividends, they were clearly distributions to the company’s shareholders (i.e. the directors), rather than salary payments, not least because the directors did not have service contracts with the company.
• The judge in the original decision had focussed on the intention of the directors, rather than the nature of the payments themselves. Although the knowledge of a company’s directors can be relevant in some cases when deciding whether a payment is a dividend, it is not possible for directors to intend a payment to be something else when in reality it is a distribution.

This is clearly the right result. The original decision was odd, driven partly by the fact that the trial judge had embarked on his own line of questioning that took his decision down the wrong route.

If there is a lesson from this decision, it is that, when authorising payments to shareholders, the directors of a company should be crystal clear what form the payments are intended to take. They may, for example, be salary payments, or repayments of loans, if there are existing arrangements that support that classification. But if a cash payment to a shareholder cannot be characterised in this way, it will almost certainly be a distribution and will need to be paid out of distributable profits.

PERG issues 2018 report on Walker Guidelines compliance

The Private Equity Reporting Group (PERG) has published its 11th report on compliance with the Guidelines for Disclosure and Transparency in Private Equity, known colloquially as the “Walker Guidelines”.

The Guidelines were last updated in May 2018. They are designed to assist companies owned by private equity (PE) firms (“portfolio companies”) with being transparent in their financial and narrative reporting. Principally, they require portfolio companies to disclose certain information in their annual financial report and to prepare a mid-year update. They also require PE firms to make certain disclosures on their own websites.

In addition, as we noted last week, the Guidelines will also now provide a starting point for those large portfolio companies that are required to report on the corporate governance arrangements they apply during their 2019 financial year.

The 2018 review covers a total of 56 portfolio companies backed by 51 PE firms. The key points arising from the report are as follows:

• Following a dip in compliance from 86 per cent of portfolio companies in 2016 to 79 per cent of companies in 2017, in 2018 all portfolio companies in the sample complied with the Guidelines.
• More portfolio companies published their annual report in a timely manner this year (81 per cent versus 78 per cent in 2017), and likewise their mid-year update (74 per cent versus 72 per cent in 2017).
• However, the overall quality of disclosure appears to have declined. Only 73 per cent of portfolio companies prepared disclosures to a “good standard”, versus 80 per cent on a like-for-like basis in 2017.
• All member firms of the British Private Equity and Venture Capital Association (BVCA) complied with the requirements applicable to them under the Guidelines.

Financial Reporting Council to be replaced by stronger regulator

The Government has confirmed it intends to abolish the Financial Reporting Council (FRC) and replace it with a new, independent statutory regulator with stronger powers.

The move follows recommendations made in the final report of an independent review of the FRC, led by Sir John Kingman, on which we reported in April. That report sets out 83 recommendations for reforming the FRC, including the following:

• Replacing the FRC “as soon as possible” with a new, independent regulator with a smaller board, which would be called the “Audit, Reporting and Governance Authority” (or “ARGA”).
• Giving the ARGA responsibility for approving and registering audit firms that carry out audits on public interest entities (PIEs). (This responsibility currently lies with the UK’s four regulatory supervisory bodies (or RSBs).
• Undertaking more corporate reporting reviews (on a “risk-based basis”), reporting findings publicly and publishing full correspondence.
• Expanding the concept of “public interest entity” to (potentially) major private companies, pension funds and asset management companies, subjecting more entities to mandatory auditor rotation and corporate reporting reviews.
• Tasking ARGA with promoting brevity and comprehensibility in accounts and annual reports, and ensuring that reports are proportionate and valuable.
• Reviewing and reforming longer-term viability statements to make them more effective, or (if that is not possible) abolishing them completely.
• Implementing a pre-clearance procedure for accounts to assist companies with more complex accounting treatments, such as profit recognition and measurement.
• Giving ARGA a power to direct changes to a company’s accounts without having to go to court, providing the regulator with a significant tool to rectify deficiencies.
• Instituting an effective enforcement regime to hold a PIE’s CEO, CFO, chair and audit committee chair to account for failing to prepare true, fair and compliant accounts.

Other items

• Unfair prejudice. In Cool Seas (Seafoods) Ltd v Interfish Ltd, the High Court allowed a majority shareholder of a company to succeed in an unfair prejudice petition. Although the Companies Act 2006 does not place any limit on which “size” of shareholder can bring an unfair prejudice petition, the court will disallow a petition if the shareholder can remedy the unfair prejudice itself. In practice, a petition by a majority shareholder would normally flounder solely on this basis. However, here the majority shareholder couldn’t remedy the prejudice, as the minority shareholder had a veto right over the commencement of proceedings by the company.
• Share sales and earn-outs. In Morris v Swanton Care & Community Limited, the Court of Appeal held that part of an earn-out provision in a share sale agreement was unenforceable. The agreement gave the seller the option to provide consultancy services under an earn-out provision for a specified period and then for “such further period as shall reasonably be agreed between the parties”. The seller tried to extend the earn-out period, but the company refused. The court found that the requirement to extend for a further period was an “agreement to agree” and so was not enforceable.
• Market abuse. The Financial Conduct Authority (FCA) has published Issue 58 of Market Watch, its newsletter on market conduct, in which it has set out the findings from its recent review on how the EU Market Abuse Regulation (MAR) has been implemented. Overall, the review found that many market participants have a good understanding of their obligations under MAR and have configured their systems accordingly. However, there remain areas where firms struggle to comply, particularly order and transaction surveillance.
• Audit. The Government has announced a new independent review into audit standards. The review will be led by Donald Brydon, chair of Sage Group and outgoing chair of the London Stock Exchange, and will examine standards and requirements for the UK audit profession in the future. The announcement follows an update paper published this week by the Competition and Markets Authority, which proposes changes to improve competition in the UK audit sector.