Corporate Law Update

In this week's update: effective disclosure against accounting warranties, a report on dividends paid without seeking shareholder approval, transition plans from the FRC and a few other items

Court considers whether accounting matters were effectively disclosed on share sale

The High Court has considered whether certain accounting matters amounted to breaches of warranty in a share sale agreement and, if they did, whether they had been disclosed to the buyer.

What happened?

116 Cardamon Limited v MacAlister concerned the sale of shares in a company that carried on an insurance business.

As is customary, the share sale agreement contained various warranties by the sellers about the state of the business. These included warranties about the target company’s accounts.

Specifically, the sellers warranted that the company’s accounts had been prepared in accordance with generally accepted accounting standards and gave a true and fair view of the company’s state of affairs. This is a standard warranty on any business sale.

The sellers also warranted that the company’s accounts had not been affected by any unusual or non-recurring items, and that they did not overstate the value of any assets.

After the sale completed, it became clear that the business required significant cash injections to keep it going. The next year’s audit revealed several issues which forced the company to revise its accounts (the same accounts that the sellers had warranted).

Ultimately, the buyer brought claims for breach of warranty in respect of various issues. In particular:

  • The accounts had listed a receivable owed by an associated company as an asset. However, the buyer asserted that there was no real value in the receivable and it should have been written off. It had not been, and so the accounts were inaccurate and had overstated the value of an asset.
  • Part-way through its most recent financial year, the company had changed the method by which it paid insurance brokers. This had resulted in a “temporary inflationary effect” on certain items in its accounts. The buyer argued that this change was an “unusual or non-recurring item” and had not been disclosed by the sellers.

The court agreed that both matters amounted in principle to a breach of warranty. The more important question was whether the sellers had effectively disclosed the matters to the buyer before the parties signed the sale agreement. If they had, the buyer would not be able to bring its warranty claims.

Had the true value of the receivable been disclosed?

The company’s accounts had included a provision for doubtful debt, but only in respect of half of the receivable. They did not say anything about the recoverability of the other half. This provision alone would almost certainly have been insufficient to inform the buyer that the debt was worthless.

However, the sellers had specifically stated in their disclosure letter that “only half [of the receivable] was provided for as a doubtful debt but that does not mean the other half is recoverable”.

Also, the company’s financial controller had emailed the buyer before the sale, saying: “There is no agreement in place and it’s likely the remaining balance will be written off”. Unusually, the disclosure letter stated that all communications between the sellers and the buyer were treated as disclosed.

The judge said that the email from the financial controller was “in clear terms”, and the specific disclosure in the disclosure letter effectively echoed it. As a result, the worthlessness of the receivable was “well understood” by the buyer. It was sufficiently disclosed and the buyer could not bring a claim.

Had the change in payment method been disclosed?

The company had changed the method by which it paid insurance brokers from a “referral fee commission” model to a “distribution fee” model. As noted above, this had the effect of temporarily uplifting certain figures in the company’s accounts.

The sellers’ accountant argued that the change in method was apparent from the accounts. He said that a “reasonable valuer” would have been “on notice” of the change in method, particularly as it had been brought about by recent changes in legislation which were known to be affecting insurance businesses generally. He also said the accounts showed a “material increase in prepayments and accrued income”, which could only have arisen from a change to a “distribution fee” model.

The judge did not agree. She said the accountant’s argument was effectively a “reconstruction” with the “benefit of knowledge”. This was the sort of view a forensic accountant would naturally be inclined to take, but it was not the approach of a valuer acting for a reasonable buyer on a share purchase. The uplift in the accounts could have been caused by various factors and could not be an effective disclosure of a change to a “distribution fee” model unless it specifically mentioned that change.

What does this mean for me?

The case shows two different and interesting aspects of disclosure.

On the one hand, the sellers had clearly made the buyer aware of the doubtful worth of the receivable. It is unusual for a disclosure letter to treat all communications between a buyer and seller as disclosed. In this case, it was fortunate for the sellers that it did – it’s not clear whether the specific disclosure in the letter would have been enough on its own to amount to effective disclosure.

On the other hand, it’s clear that the change in the broker remuneration model had not been disclosed. To be effective, disclosure must be sufficiently detailed to allow a buyer to understand the matter in question. It was always unlikely that a mere spike in numbers on the balance sheet would be detailed enough to point towards a change in methodology or practice (unless perhaps it were crystal clear and unequivocal that the spike could be caused only by a change in model).

The upshot in both cases is that there is no substitute for a seller setting out any matters that might be a breach of warranty in a good level of detail. A seller should do this by including specific disclosures in its disclosure letter and refer to any documents that contain more information on the matter, rather than simply assume that a buyer will understand what is going on.

Investment Association reports on prevalence of interim dividends

The Investment Association (IA) has published a report on dividends by UK listed companies. The report follows concerns expressed by the Government that listed companies may be paying interim dividends, rather than final dividends, in order to avoid seeking shareholder approval at their AGM.

The IA examined 545 companies in the FTSE All-Share index. It found that 22% of companies which paid dividends did not seek shareholder approval for the payment. This practice was particularly prevalent in the largest FTSE companies and in companies that paid quarterly or monthly dividends. It was also common in the financial services sector, particularly among investment trust vehicles, although over half of these entities had previously submitted a dividend policy to shareholders for approval.

The IA subsequently engaged with FTSE 100 companies to find out why they did not submit their dividends to shareholders. The report sets out the IA’s findings.

It notes that, in some instances, there are legitimate reasons for companies not putting their dividends to shareholders for approval. However, the IA believes that many companies are making assumptions about investor expectations, which is in turn leading to shareholders being denied the opportunity to approve or disapprove a “key component of a company’s capital allocation policy”.

The IA is therefore recommending that companies articulate a “distribution policy” that clearly sets out their approach to making decisions on the structure, timing and amount of returns to shareholders.

FRC outlines plan for transition to the ARGA

The Financial Reporting Council (FRC) has published a “transition pathway” for its replacement by the new Audit, Reporting and Governance Authority (ARGA).

Key areas of focus in the pathway include supporting the transition to the ARGA, improving the quality of audits and corporate reporting, promoting corporate governance and investor stewardship, using enforcement powers effectively, and ensuring an effective regulatory framework following Brexit.

In particular, the FRC has said that it intends to take the following steps:

  • Introduce a “robust market intelligence function” and begin a “wider and deeper dialogue” with investors, building on the concept of its proposed Investor Advisory Group.
  • Enhance its programme of audit quality inspections, including by contributing to and co-ordinating with the independent Brydon review into the effectiveness of audit.
  • Increase the number of corporate reporting reviews, including extending the review to the whole of a company’s annual report and monitoring compliance with the new UK Corporate Governance Code.
  • Expand its Enforcement Team.
  • Scrutinise the procedure for adopting international financial reporting standards (IFRS) in the UK and for registering EU auditors in the UK following Brexit.

Other items

  • Changes to directors’ pay reporting. New regulations amending the current regime for reporting on directors’ remuneration have now been published, along with an explanatory memorandum. The regulations are designed to implement changes required by the Second EU Shareholder Rights Directive (SRD II). For more information, see our previous Corporate Law Update here.
  • Modern slavery statements. The final report of the independent review of the Modern Slavery Act 2015 has been published. The report is essentially a compendium of the previous four interim reports, including the review’s recommendations for strengthening the current requirement for organisations doing business in the UK to publish a slavery and human trafficking statement. For more information on the review’s proposals, see our previous Corporate Law Update here.
  • FRC appoints new corporate reporting head. The Financial Reporting Council (FRC) has appointed David Rule as its new Executive Director of Supervision in anticipation of its transition to the ARGA (see above). David joins on secondment from the Prudential Regulation Authority (PRA). He will lead the FRC’s audit quality and corporate reporting function, with responsibility for overseeing the supervision and monitoring of audit and company reporting.
  • AIM provides guidance on Nomad staffing. In its latest Inside AIM newsletter, the London Stock Exchange (LSE) has set out answers to frequently asked questions on staffing at nominated advisers (Nomads). The guidance covers Nomad experience on Relevant Transactions under the AIM Rules, applications for recognition as a Qualified Executive (QE), team-working arrangements, “good” compliance and maintaining knowledge and experience.
  • AIM extends Designated Market Route. In the same edition of Inside AIM, the LSE has extended the range of AIM Designated Markets so as to include EU Regulated Markets and SME Growth Markets. Companies whose shares have been traded on these markets for 18 months may now be able to benefit from a fast-track admission to AIM without the need to produce an AIM admission document.