Corporate Law Update
- The High Court finds that a director’s behaviour amounted to unfair prejudice and provides interesting comments on the nature of a “quasi-partnership” and the valuation of shares
The High Court has held that a shareholder of a company suffered unfair prejudice when the company’s chief executive and principal shareholder exploited potential opportunities without informing the company and authorised his own excessive remuneration.
The facts of Re Edwardian Group Limited are long and complex. In a nutshell, two brothers incorporated a company which, from 1979, ran a successful business of developing and running hotels. The older brother served as the company’s chief executive. The younger brother was appointed as a director later, in the mid-1980s.
Following restructurings in the 1990s, the vast majority of the company’s shares came to be owned by trusts on behalf of the two brothers’ families, with each brother holding a small portion directly.
The brothers’ relationship subsequently became strained. Ultimately, the younger brother and one of his family trusts petitioned the court for a declaration that the company’s affairs had been conducted in a way that was unfairly prejudicial to his interests. Specifically, he complained about the following:
- The company had removed the younger brother as a director, and then as an employee, in order to deprive him of his participation in the company. This argument relied on the notion that the company was a “quasi-partnership” (see below).
- In 1983 and the early 1990s, the older brother had exploited opportunities that he should have told the company about and allowed himself to be in a position of conflict for over 20 years.
- When the company did investigate the older brother’s behaviour, the investigation itself was unfair and resulted in the company sending its shareholders a misleading report.
- Over four years, the company had paid the older brother improper distributions of its profits disguised as unreasonably high remuneration.
What is unfair prejudice?
Under section 994, Companies Act 2006, a member of a company can petition the court for relief if the company’s affairs are being conducted in a way that is unfairly prejudicial to his interests as a member.
There is no fixed list of actions or omissions that can amount to unfair prejudice. Examples can include excluding a shareholder who is also a director from the management of the company, allotting shares to dilute a minority shareholder’s interest, misappropriating company funds, failing to pay dividends in certain circumstances, paying excessive remuneration (especially in order to disguise a dividend or a return of capital) and deliberating failing to comply with the company’s constitution.
The scope of behaviour that can amount to unfair prejudice is wider if the company is a “quasi-partnership". A quasi-partnership is a company where there is a relation of mutual confidence between the members and an understanding that they are entitled to be involved in running the company's business in a way similar to the partners of a partnership. Unfair prejudice may occur if a quasi-partnership’s affairs are run in a way that is inconsistent with that understanding.
The court have very wide discretion to grant almost any remedy they thinks fit if unfair prejudice has occurred. The Companies Act 2006 sets out five examples, but the most common remedy the courts have applied is to require other members of the company (or the company itself) to acquire the injured party’s shares.
What did the court say?
In short, and not surprisingly, the Court agreed with the younger brother and found that unfair prejudice had occurred. It ordered the older brother and the company itself to buy the younger brother’s shares.
However, there are two notable points of interest in the judgment.
Was the company a “quasi-partnership”?
First, the court took the opportunity to discuss, in detail, when a “quasi-partnership” will arise. In particular, it considered whether it is possible for a company to be a quasi-partnership where only some of its active members were parties to an informal understanding or relationship of mutual trust and confidence. Until now, for a quasi-partnership to exist, all of its members (other than purely “sleeping partners”) had to be party to that understanding or relationship.
The judge did not close the door to this possibility. He suggested that it might be possible for a quasi-partnership to exist where one or more minority shareholders stand outside of that understanding or relationship (or “outside the ring”, as the judge put it), such as if they acquired their shares by transmission from a deceased member.
However, ultimately he rejected the possibility of a quasi-partnership between some but not all of a company’s members in other circumstances. He noted that the concept of a quasi-partnership relates primarily to the way in which the members expect the company to be run. If some members are not part of that informal understanding, they would expect it to be run in accordance with the company’s constitution, which may differ from the informal understanding.
In the end, the court decided that, on the facts, the company was not, and had never been, a quasi-partnership. (This meant that the argument for unfair prejudice based on the younger brother’s dismissal failed.) However, the judge’s comments are interesting and will no doubt fuel arguments in a future case where the factual backdrop is less clear-cut.
What was the remedy?
Also interesting was the Court’s approach to the remedy. The Court granted the typical remedy and required the older brother to buy the younger brother out.
Normally, the shares to be bought are valued using a market valuation as at the date of the court’s order, because this is the date on which the unfair prejudice is brought to an end. However, in this case, the younger brother had delayed bringing his petition for four years while his parents attempted to bring their own claim. To recognise this and to protect the older brother from any unfair consequences of this delay, the court ordered the shares to be valued as at four years earlier.
In addition, where the company is a trading company and the shares to be bought represent a minority interest, unless there are exceptional circumstances, the market valuation will apply a discount to reflect the lack of strategic value attaching to the shares. By contrast, where the company is a quasi-partnership, the court will not apply a discount to a minority shareholder.
However, this is not a fixed rule, and, in this case, even though the company was not a quasi-partnership, the Court decided not to apply a discount. The judge decided that it would be wrong to value the shares using a market valuation, as there was no open market for them and they were subject to transfer restrictions.
Moreover, the shares were not being purchased by an unconnected investor. Rather, they would be purchased by an existing shareholder and increase his interest to more than 75%, giving them a particular value. The purchase would, in the judge’s words, release the “marriage value” of the shares.
The Court therefore declined to apply a market valuation for the shares, instead adopting a valuation to reach a price that “commercially-minded but reasonable persons in the actual positions of the two brothers in notional arm's length negotiations” would have agreed, having regard to any marriage value that would be released on such a sale and purchase. This tends more towards what valuers call the “equitable value” of the shares (formerly the “fair value”).
Above all, the case illustrates the flexibility the courts have when granting remedies for unfair prejudice. The weight of case law with similar outcomes can sometimes make it tempting to view unfair prejudice through a narrow lens.
However, a person thinking of bringing a petition should not be put off merely because the claim does not necessarily meet the usual tests. Questions an injured party should ask itself include:
- Do the facts indicate that the company is a quasi-partnership? Have all the members been involved in setting the company up? Would they all say that they expect to be involved in managing it?
- What remedy does the petitioner want? Although the usual remedy is for the petitioner to be bought out, would it be more appropriate for the petitioner to buy the culpable parties out? Or should the court put an order in place restraining certain behaviour or requiring the company to bring legal proceedings?
- If a buy-out is the preferred option, what value should the petitioner seek? Is there an argument against applying a minority discount? Should the price in fact be higher than the market value? Is there a more appropriate date for the valuation than the date of the court’s order?