Corporate Law Update

In this week’s update: excluding a director from the management of a subsidiary was unfairly prejudicial, updated guidance for audit committees from the QCA and a letter to FDs and audit committee chairs on key no-deal Brexit issues.

This week:

The court finds that excluding a director from the management of a wholly-owned subsidiary amounted to unfair prejudice
The Quoted Companies Alliance has updated its guidance for audit committees of small and medium-sized quoted companies
The Financial Reporting Council has written to finance directors and audit committee chairs setting out critical actions to consider in the event of a no-deal Brexit

Excluding director from subsidiary’s management amounted to unfair prejudice

The High Court has found that a company director was subjected to unfair prejudice when he was excluded from the management of the affairs of one of the company’s subsidiaries. It also effectively invalidated a compulsory transfer notice that had been served on the director.

What happened?

Brown v Bray concerned a group of companies owned by three individuals and their spouses.

The group began life in 2007 when the three individuals, who had previously worked together for some years, incorporated a company (APML) to pursue a new business. Each individual became a director and a shareholder of the company.

In 2010, they entered into a shareholders’ agreement and adopted bespoke articles of association to regulate their relationship and the company’s affairs. As is typical, the documents stated the following:

The company would not do certain things (so-called “reserved matters”) unless all three individuals gave their consent.
Shareholders would not disclose any confidential information relating to the company’s business.
A shareholder who committed a material breach of the shareholders’ agreement could be forced to transfer his shares to the other shareholders for a nominal sum of £1.

Somewhat more unusually, the shareholders’ agreement also required the parties to it to “act in good faith” and to “give effect to the spirit and intention” of the shareholders’ agreement.

In 2012, the individuals decided to acquire one of APML’s sub-contractors. To achieve this, they incorporated a new holding company (AGL), which in turn acquired the shares in both APML and the sub-contractor, making them “sister companies”.

The individuals became directors and shareholders of AGL and put in place a new shareholders’ agreement that largely mirrored the previous agreement. Importantly, the shareholders’ agreement covered the entire group’s affairs, and AGL was a party to it.

The relationship breaks down

As is common in unfair prejudice cases, the relationship between one of the directors (D1) and the other two directors (D2 and D3) broke down over time. At various points over the following months, the three individuals discussed the possibility of D2 and D3 buying D1’s shares to provide him with an exit from the business.

However, no sale materialised, the relationship became more strained, and D1 gradually took less and less part in the management of the group’s affairs.

In Autumn 2017, D2 summoned D1 to a disciplinary hearing to consider “trust and confidence” and whether D1 could continue to fulfil his role with the business, given his decreased participation. The hearing took place in the morning. That afternoon, D2 informed D1 that he had been dismissed from his employment with immediate effect.

At the same time, D2 and D3 told the group’s bankers that D1 no longer had authority to issue instructions and they should no longer communicate with him.

D1 appealed his dismissal under the group’s internal procedures. An appeal hearing took place. Four days later, D3 informed D1 that the decision to dismiss him had been “upheld”.

Importantly, whilst D2 and D3 dismissed D1 from his employment, they did not remove him as a director. (This is because a director can be removed only under a particular procedure in the Companies Act 2006.) D1 therefore remained a full board member.

A month later, in advance of a board meeting, D2 emailed D1 the group’s management accounts for the most recent quarter. Those accounts showed a 36% decrease in gross profit margin, principally due to a change in provisions for accruals and the addition of around £380,000 of “overheads”.

In response, D1 emailed D2, D3 and the company’s bankers to voice his concerns. This resulted in the bank suspending the group’s bank accounts until the dispute was resolved. Finally, at the end of November 2017, D2 and D3 passed a board resolution to remove D1 formally from the bank mandate.

What were the claims?

In response, D1 petitioned the court under section 994 of the Companies Act 2006. Section 994 allows a shareholder of a company to apply for “relief” if the company’s affairs are being conducted in a way which is “unfairly prejudicial” to him or other shareholders. This is commonly called an “unfair prejudice” petition.

In particular, he claimed that D2 and D3 had caused the unfair prejudice by:

excluding him from management in APML’s affairs by restricting his access to information and revoking his bank mandate authority;
dismissing him from his employment with APML to advance their own interests; and
directing APML to carry out reserved matters without his consent (including paying bonuses, engaging four managers and entering into a compromise agreement).

He also claimed that the group amounted to a “quasi-partnership”, because APML had been formed from a personal relationship involving mutual confidence between the three individuals. This meant that D1 was legitimately entitled to expect to participate in the management of the group, whether or not he was formally employed by any of the group companies.

He asked the court to order D2 and D3 to buy his shares at their fair value. A buy-out of this kind is the typical way for a court to resolve an unfair prejudice petition.

In response, D2 and D3 informed D1 that he was required to transfer his shares to them for £1. This was because he had committed a material breach of the shareholders’ agreement by disclosing financial information to the group’s bankers.

What did the court say?

In summary, the court allowed the petition. The judge said the business had been run in a way unfairly prejudicial to D1 for all of the reasons D1 had given. In particular, he noted some interesting points:

D1’s dismissal was particularly unfairly prejudicial because, although D2 and D3 had followed the letter of the disciplinary process, they had already covertly made their decision to dismiss him before beginning that process. They did not listen to his representations or consider other options, such as issuing a warning. They should not have dismissed him peremptorily as they did.
D1 was a shareholder of AGL (the holding company), not APML (the subsidiary), and so he had had to show that AGL’s affairs had been conducted prejudicially. However, AGL controlled APML and conducted its affairs. Because of this, the court was happy effectively to attribute APML’s conduct to AGL.
AGL was a party to the shareholders’ agreement. The shareholders’ agreement regulated AGL’s (and APML’s) affairs, and so any attempt to deviate from or disregard it was capable of amounting to unfairly prejudicial conduct of AGL’s affairs (and, in this case, did).
APML had indeed been formed as a “quasi-partnership”. Although the court did not put it in this way, this characterisation effectively transferred to AGL when the group was restructured. By restricting D1 from participating in APML’s affairs, AGL was prejudicing D1 unfairly.

Conversely, the judge refused to uphold the forced transfer of D1’s shares. He acknowledged that D1 had in fact committed a material breach of the shareholders’ agreement which would normally have entitled D2 and D3 to force him to sell out.

However, he had done so in response to D2 and D3’s behaviour, which included failing to act in good faith (as required by the shareholders’ agreement) and unfairly withholding information from him. With that in mind, the court refused to order D1 to sell his shares for £1. Instead, he granted the petition and ordered D2 and D3 to buy D1’s shares at a price to be determined at a later date.

What does this mean for me?

Unfair prejudice cases are always fact-heavy and turn on their individual circumstances. However, this case shows just how widely the courts will be prepared to examine circumstances when deciding whether a shareholder has been marginalised from a business.

The court was not fazed by the fact that the improper conduct had taken place at subsidiary level, rather than by the company in which D1 actually held shares.

The judge was also prepared effectively to overlook the fact that the original company had since been restructured by inserting a new holding company.

The decision shows the need for company directors to act calmly and handle matters carefully when dealing with rifts or breakdowns in board relationships. In particular:

Do not simply shut a director out. A company director has a right (both under statute and under common law) to whatever information they need to carry out their role and duties. A board may be able to pare down the volume of information it provides to a director, or even withhold information completely, if the director intends to use it to injure the company or for his own personal purposes. However, it is dangerous simply to withhold information in other circumstances.
Follow due process for any dismissal. This means not merely going through the motions, but hearing any representations, considering all potential courses of action and not reaching a decision prematurely. Apart from the fact that this could lead to a dismissal being unfair, it may also amount to unfair prejudice.
Keep your hands clean. The fact that a given director might be acting inappropriately will not excuse other board members from the high standards expected of them. Continue to take decisions in board meetings, comply with any shareholders’ agreement and other contractual arrangements, and exercise powers only for proper purposes.

QCA publishes updated audit committee guidance

The Quoted Companies Alliance (QCA) has published an updated version of its Audit Committee Guide.

The Guide (which was last updated in 2014) is aimed at small and medium-sized quoted companies. It sets out the QCA’s views of best practice to help members of audit committees (particularly those new to the role) to be effective. It is designed to accompany the QCA’s more general Corporate Governance Code.

The guidance also covers the roles and responsibilities of other persons, including a company’s finance director, secretary and head of internal audit, and provides advice on risk management, internal control and relations with the external auditor.

The Guide is available at no cost for members of the QCA or for a fee of £85 + VAT for non-members.

FRC writes to FDs and audit committees on no-deal Brexit

The Financial Reporting Council (FRC) has published a letter it has written to audit committee chairs and company finance directors to assist them with preparations for the possibility of the United Kingdom leaving the European Union without an implementation agreement (a “no-deal Brexit”).

The letter sets out a “small number of the most critical generic actions” that companies should consider in advance of Brexit. These include:

Asking employees whether they need to apply to the EU Settlement Scheme. Under the Scheme, EU citizens who are resident in the UK before Brexit can apply to remain and continue working in the UK. Assuming a no-deal Brexit occurs on 31 October 2019, the deadline for applications would be 31 December 2020. You can read more on the Scheme in our note.
Checking whether the company may face additional barriers. These include legal, regulatory and administrative barriers, which may result from the UK leaving the European Economic Area (EEA) and so no longer taking advantage of the EU/EEA regime for cross-border services.
Checking in with customers and suppliers. The FRC recommends that companies ensure that their supply chain has undertaken stress-testing and scenario-planning. It recommends that larger firms, in particular, may need to assist small and medium-sized enterprises with no-deal planning.
Engaging with industry organisations. The FRC suggests that companies liaise with their local chamber of commerce and attend one of the Government’s Brexit Business Readiness events.
Reporting on related risks. Finally, the FRC has reminded firms of things they should consider when reporting on Brexit-related risks in their annual report. In particular, companies should distinguish between “specific and direct challenges to their business model” on the one hand and “broader economic uncertainties” resulting from Brexit on the other. Companies may wish to “recognise or remeasure” certain items in the balance sheet, and to consider a wide range of reasonably possible outcomes when performing sensitivity analyses on cash flow projections.