Corporate Law Update

In this week's update: a claim under a tax covenant was not properly notified and was therefore invalid, a reminder from the FCA over inside information and a few other items.

Claim notification under tax covenant was out of time

The Court of Appeal has held that the buyer of shares in a company had failed to notify a claim under a tax covenant within the time period for doing so.

What happened?

Stobart Group Limited v Stobart and Tinkler concerned the acquisition of shares in a company from two individuals.

As is customary on a share acquisition, the sale agreement contained a tax covenant (sometimes called a “tax indemnity”), under which the two individual sellers agreed to reimburse the buyer for any pre-purchase tax liabilities of the target company.

Paragraph 7.1 of the tax covenant stated that, if the buyer became aware of a claim by a tax authority, it was required to notify the sellers within ten business days. This was designed to give the sellers advance warning of a possible claim by the buyer under the covenant.

Paragraph 6.3 of the covenant stated that the sellers were not liable for a claim under the covenant unless the buyer gave written notice of the claim within seven years of the sale. The notice had to state (in reasonable detail) the nature of the claim and (if practicable) the amount being claimed. This is a standard provision of a tax covenant. In this case, the deadline fell on 4 April 2015.

The tax covenant therefore contemplated two separate notices:

  • A notice of a claim by the tax authority (that could in turn give rise to a claim under the covenant).
  • A notice of a claim under the tax covenant itself.

On 13 March 2008, HM Revenue and Customs issued a claim against the target company relating to historic share schemes. The buyer sent the sellers a letter on 9 April 2008, notifying them of the HMRC claim as required by paragraph 7.1.

On 24 March 2015, the buyer sent another letter to the sellers, which it believed amounted to a formal notice of claim under the tax covenant, as required by paragraph 6.3. The contents of that second notice were critical to the dispute. Among other things, that second notice stated:

We hereby give you formal notice pursuant to the SPA of a potential Liability to Taxation under the Tax Covenant contained in Schedule 4 of the SPA.

In particular the potential claim is specifically set out in clause 3.1.2 of Part 3 of Schedule 4 of the SPA being in relation to: [specific details of claim].

We would be grateful if you would confirm pursuant to paragraph 7 of Part 4 of Schedule 4 as to whether you wish to have continued conduct of discussions with HMRC in relation to the Claim.

We have recently sought from BDO an update of the likely estimate of the quantum of the Claim and they presently believe it is circa £3,267,092 (as per the attached sheet) inclusive of interest but exclusive of penalties.

The sellers said this did not amount to valid notice of a claim under the tax covenant as required by paragraph 6.3. As a result, they argued, the buyer had not notified the tax covenant claim within the deadline, and so they were not liable to reimburse the buyer.

The question for the court, therefore, was whether the letter of 24 March 2015 was a valid notice.

What did the court say?

The court said that the second letter was not a valid notice of a claim under the tax covenant.

The judges analysed the letter and applied the established test for a unilateral notice: what would a reasonable recipient have understood by the letter? They said a reasonable recipient would not have understood the letter to be a formal notice of claim under paragraph 6.3 for various reasons:

  • The letter referred to a potential liability to pay tax, but it did not refer to a potential claim to recover that liability under the tax covenant.
  • The letter referred to a “potential” claim and did not make it clear that the buyer was actually pursuing a claim under the tax covenant.
  • The letter invited the sellers to take conduct of the claim with HMRC. In particular, it referred to paragraph 7 of the tax covenant, which, among other things, dealt with notification of claims by HMRC, rather than claims under the tax covenant. It did not refer to paragraph 6.3.
  • The letter set out a “likely estimate” of the claim by HMRC, but it provided no amount being claimed under the tax covenant.

The court said a reasonable recipient of the letter would therefore have understood it to be a notice under paragraph 7.1 of a claim by a tax authority, rather than a notice under paragraph 6.3 of a claim under the tax covenant.

As a result, the buyer had not served a notice of claim under the tax covenant within the seven-year time limit, and so it could not recover the tax from the sellers.

What does this mean for me?

The decision is not surprising. Although it may have been clear in the buyer’s mind that it was notifying a claim under the tax covenant, the wording of its second letter pointed at every turn to a claim by HMRC and therefore (at most) a potential claim that might follow under the tax covenant. The reference in the letter to paragraph 7 of the sale agreement was particularly unhelpful for the buyer.

Although this case related to a claim under a tax covenant, the same principles will apply to a claim by a buyer under any other covenant or indemnity, or under the warranties, in a sale agreement.

The case gives rise to several take-away points for a buyer proposing to bring a claim:

  • Make sure that the claim notice specifies in meticulous detail whether the buyer is actually bringing a claim under the sale agreement or may be making a claim in due course.
  • Make sure the notice specifies the type of claim being brought, be it a warranty claim, indemnity claim or tax covenant claim. If there is any confusion, the court will in practice give the recipient of the notice the benefit of the doubt. It will not, for example, re-characterise a notice of warranty claim as a notice of indemnity claim (or vice versa).
  • In particular, refer to the correct provisions of the sale agreement. In this case, the letter should have referred to “paragraph 6.3”, rather than “paragraph 7”.
  • Provide as much detail of the claim as possible (although be careful the notice does not become so exhaustive that it effectively rules out other avenues of claim).
  • Above all else, make sure the notice contains all the information required by the sale agreement. Accidentally omitting any information may result in the notice being invalid.

FCA reminds firms of control over access to inside information

The Financial Conduct Authority (FCA) has published issue 60 of Market Watch, its newsletter on market conduct and transaction reporting.

Among other things, the FCA has reminded firms that they must control access to inside information. In particular, it highlights the case of an individual who was convicted of five counts of insider dealing.

Under the Market Abuse Regulation, an issuer and each person acting on its behalf must draw up a list of all persons who are working for them and have access to inside information – a so-called “insider list” – for each transaction. (Issuers can also draw up a “permanent insider list” of people who will always have access to inside information. This is normally the issuer’s board of directors.)

However, an insider list is merely a record-keeping requirement. It is unlawful to disclose inside information to someone except “in the normal exercise of an employment, a profession or duties” (or, as the FCA says, if there is a “business need”). Being named on an insider list does not automatically entitle a person to access inside information.

In this case, the individual was named on the insider list but she had no business need to access the information. However, she did access it, and she passed it on to an individual who used it to trade in contracts for difference (CfDs) referenced to the issuer’s securities.

The FCA also notes that it frequently encounters instances of insider lists omitting the names of people who have been provided with or accessed inside information. It clarifies that firms must take active measures to restrict access to inside information, and that it regards any failure to respond effectively to questions on insider lists as indicative of underlying weaknesses in controls.

When storing and providing inside information, issuers and advisers should consider the following:

  • Who am I proposing to disclose inside information to? Does that person need to know that information to carry out their duties? Are they listed on the insider list?
  • Is there anyone on the insider list who does not realistically need access to inside information? If so, they should be removed so that inside information is not subsequently and inadvertently disclosed or made available to them in breach of law.
  • Is there anyone on the insider list who does not actually have access to inside information? If so, the list may not be (to use the FCA’s words) “fit for purpose”.
  • If I maintain a “permanent insider list”, is there a good and obvious reason why each person named on that list appears on it? A permanent insider list should not simply blanket-list all members of a firm’s compliance or risk department.
  • Are there controls in place to stop people accessing inside information? Has it been segregated from any general team folders?
  • In particular, if the information is in electronic form, who is able to see it? Where possible, have file, folder and directory names been “coded” so that members of the IT department can carry out their work without access to inside information?
  • Do I have a procedure for regularly reviewing who should have access to inside information?

Other items

  • Voteholder notifications. The European Securities and Markets Authority (ESMA) has published an updated version of its practical guide to national rules on notifications of major holdings. The guide sets out the percentage threshold in each European Economic Area (EEA) state (other than Liechtenstein) beyond which a person must publicly notify the level of voting rights they hold in a publicly traded entity, and how that notification should be made.
  • Carbon reporting. The Financial Reporting Council (FRC) is consulting on a taxonomy for companies and LLPs that are required to report on energy usage and emissions. The new taxonomy is a supplement to the FRC’s XBRL taxonomy suite and is designed to assist with reporting under the extended reporting regime that came into effect on 1 April 2019.
  • Beneficial owners. The UK Government has published a report on how the UK’s regime for recording persons with significant control (PSCs) has been implemented. The report concludes that most businesses have engaged with the regime, the cost of compliance is relatively small, and many businesses are using the public register to look up information on other businesses.