Corporate Law Update

A round-up of developments in corporate law for the week ending 14 September 2018.

This week:

Director breached fiduciary duties; has part of his sale proceeds clawed back under bad leaver provisions

The High Court has found that a director who sold his shares in a company to his fellow shareholders at a hefty premium, then left to set up a competitor company, was in breach of his fiduciary duties.

What is more, the director’s behaviour was sufficient to trigger the bad leaver provisions in the company’s shareholders’ agreement, meaning that the other shareholders were able to claw back and reduce the price they had paid to the price they would have paid under the bad leaver provisions.

What happened?

Keystone Healthcare Limited and another v Parr and others centred around a healthcare employment agency called Keystone Healthcare Limited (Keystone). Keystone had been founded by husband and wife Mr and Mrs Ward, who were joined in 2008 by a Mr Parr.

In 2011, Mr and Mrs Ward and Mr Parr entered into a shareholders’ agreement relating to Keystone. That shareholders’ agreement contained “bad leaver” provisions. When read alongside Keystone’s articles of association, these provided that, if a shareholder committed a “material breach” of the shareholders’ agreement, either Keystone itself or its other shareholders would be entitled to acquire the delinquent shareholder’s shares at a 50 per cent discount.

Keystone enjoyed financial success from 2008 but, by 2011, its turnover and profitability had declined and by 2013, following a failed sale process, relations between Mr Ward and Mr Parr had deteriorated. In 2014, Mr and Mrs Ward incorporated a new entity – Keystone Holdings Limited – which acquired Mr Parr’s shares in Keystone for a sum of just over £1.2m.

However, unknown to Mr and Mrs Ward, in the run-up to the sale of his shares, Mr Parr had been taking steps to establish a competing business. Only a few days after that sale, Mr Parr incorporated Medipro Recruitment Limited (Medipro) in direct competition with Keystone, persuaded one of Keystone’s IT consultants to transfer funds to an account controlled by him, misused confidential information belonging to Keystone, and diverted custom away from Keystone to Medipro.

When Mr and Mrs Ward found out about this, they brought proceedings to claw back part of the price they had paid to Mr Parr for his shares. In short, they argued that Mr Parr’s behaviour – specifically, concealing his wrongdoings from Keystone – amounted to a breach of fiduciary duty. This breach would have allowed Keystone to dismiss Mr Parr summarily from his employment, which would in turn have triggered the bad leaver provisions in the Keystone shareholders’ agreement and allowed Mr and Mrs Ward to acquire Mr Parr’s shares at a 50 per cent discount to their real value, which they alleged came to no more than £515,000, and not the £1.2m they had actually paid.

What did the court say?

The court agreed with Mr and Mrs Ward. It also found that Mr Parr’s behaviour breached three specific obligations in the shareholders’ agreement – to promote Keystone’s success, to keep accurate accounting records, and to act in good faith towards Keystone and its other shareholders.

It said, therefore, that the price at which Mr Parr should have sold his shares was just over £650,000, and it ordered Mr Parr to pay the excess back to Mr and Mrs Ward.

The judgment interesting for two reasons in particular:

  • Mr Parr breached his fiduciary and directors’ duties, which he owed to Keystone, and obligations in the shareholders’ agreement, which he owed to Keystone and to Mr and Mrs Ward. They are the persons who suffered loss. However, Mr Parr had not breached any duties he owed to the entity that acquired his shares and that had allegedly overpaid: Keystone Holdings. Mr Parr therefore attempted to run a technical argument that Mr and Mrs Ward had no grounds of claim.

    Although perhaps very strictly correct, the court was not persuaded by this and took a more contextual approach. It refused to accept that there was “no sufficient nexus” between Mr Parr’s breach of duty and the price paid to him on his exit. The judge said that Mr Parr’s wrongdoings resulted in him making a profit, which was sufficient to impose liability. In technical terms, the court (self-admittedly) converted a claim for damages into a claim to recover unauthorised profits.

    This is a sensible and pragmatic decision. The courts will always strive to preserve the principle that each company (in this case, Keystone Holdings) is a separate person distinct from its shareholders (in this case, Mr and Mrs Ward). However, this case shows that the courts will not shy away from imposing liability on purely technical grounds in the face of a manifest injustice.

  • The court was happy to construct what was essentially an alternative pattern of events, in which Mr Parr had disclosed his wrongdoings, Keystone had taken the decision to dismiss him or call out his breaches but not to acquire his shares, and Mr and Mrs Ward had decided to acquire his shares with the stipulated 50 per cent discount.

    Although this was clearly an assumption as to what course of action would hypothetically have ensued, the court was inevitably directed down this path by the nature of Mr Parr’s actions and the previous sale by him.

    In the event, the court ordered Mr Parr to pay back the difference between what he had actually been paid (on the one hand) and 50 per cent of what his shares would have been valued at under the bad leaver mechanism (on the other).

Practical implications

We don’t see bad leaver cases all that often, so it is always interesting to witness the court’s approach to resolving issues like this. The judgment in Keystone reiterates some existing but useful points, and highlights some interesting new ones:

  • A director who takes steps in preparation for setting up a rival business while still in office is likely to be in breach of his duties. Quite how far a director has to go before the breach arises is still somewhat unclear, but where, as in this case, a director deliberately conceals his actions, the duty has probably been compromised.
  • The courts will not be deterred easily from imposing liability merely due to the fact that vehicles have been interposed for the purposes of a particular transaction structure. Although it will not always be possible, here the court found a different cause of action from that which Mr and Mrs Ward had brought to justify its award. It is important to think carefully before raising a technical argument as a defence.
  • Generally, the courts are inclined to uphold bad leaver provisions, although (as recent cases have shown) it is always important to ensure a compulsory transfer provision of this kind is not unenforceable as a contractual penalty.