Corporate Law Update

• The directors of a company did not breach their duties (including their duty to consider the company’s creditors) when paying an interim dividend
• The Law Commission is seeking views on the prevalent method of holding shares in a publicly traded company (“intermediated securities”)
• The FCA publishes guidance on whether polling information can constitute “inside information”
• A few other items of interest

Court considers whether demerger by dividend was valid (part 4)

Over the last three weeks, we have been looking at Burnden Holdings (UK) Limited v Fielding and anor, in which the High Court said that a company had validly distributed shares in a subsidiary to its shareholder, notwithstanding several alleged defects in declaring the distribution.

Last week we looked at whether the distribution was invalid because the directors did not hold a board meeting to approve it. The week before, we looked at whether certain errors and overvaluations in the accounts used to justify the distribution rendered the distribution invalid, and the week before that, we looked at whether those accounts had to be set out in a single document for the distribution to be valid.

This week, we conclude our analysis by looking at whether the directors had approved the dividend in breach of their duties to the company.

What happened?

As a reminder, the purpose of the distribution was to sell down a proportion of the shares in one of the company’s subsidiaries to a third party, ultimately (although indirectly) generating cash for the company. Within a year of making the distribution, the company was placed into administration. A year later, it entered compulsory winding-up.

The liquidator tried to claw the distribution back. He claimed that making the distribution caused the company to become insolvent and that the directors knew this would happen. As a result, they had breached their duty under section 172 of the Companies Act 2006 to promote the company’s success.

In particular, the liquidator argued that the directors had failed to comply with section 172(3) of the Act. This states that a director’s duty under section 172 is subject to any legal requirement to consider the interests of a company’s creditors. Under English law, a company’s directors are required to put the interests of a company’s creditors first once it becomes or is likely to become insolvent.

Strictly speaking, a breach of directors’ duty of the kind alleged would not by itself have rendered the dividend unlawful. The liquidator would not therefore have been able to unwind the distribution. However, he would have been able to force the directors to pay compensation up to the value of the distribution, and this is what he claimed.

What did the court say?

The judge devoted some time to deciding whether the company in question was insolvent when the distribution was made, or was likely to become insolvent.

Under English law, a company is insolvent generally if one of two tests is satisfied:

• The company cannot pay its debts as they fall due (the “cash flow test”).
• The company’s assets are not sufficient to discharge its liabilities (the “balance sheet test”).

In this case, because the company was a pure holding company, funded by loans from its shareholders, the court considered its solvency based on the balance sheet test.

Having considered the company’s assets and liabilities, including the value of its subsidiaries, the court said that the liquidator had not demonstrated that the company’s liabilities exceeded its assets.

The judge therefore concluded that the company was not insolvent before the distribution, nor did it become insolvent as a result of the distribution. As a result, the directors could not have breached their duty to the company merely by failing to consider its creditors, as the requirement to do so had not been triggered.

However, in case he was wrong about that, the judge went on to consider whether the directors knew that the company was insolvent or would become so as a result of paying the distribution. He concluded that they did not. In doing so, he noted the following points:

• The company’s financial adviser at no point suggested to the directors that the company was insolvent.
• The fact that the directors took advice on the potential insolvency of one of the company’s subsidiaries did not mean they were aware that the company was (or might be) insolvent.
• It was not correct to equate the financial circumstances of the company’s group as a whole with the company’s individual financial circumstances. The fact that one of the company’s subsidiaries might be cash-flow insolvent did not mean the directors were automatically aware that the company itself might be insolvent.

What does this mean for me?

We have noticed an increasing trend for liquidators and administrators who are seeking to claw money back for creditors to pursue claims under the Companies Act 2006 (alleging a breach of directors’ duties or unlawful dividend), rather than traditional actions under the Insolvency Act 1986 (such as for wrongful trading or misfeasance). Often these claims can be easier and quicker to bring.

However, actions relating to unlawful dividends and any resulting breach of duty always depend to a significant extent on the facts. As this judgment shows, the courts are reluctant to interfere in what they regard as commercial decisions and judgments by the directors of a company, based on the information available to those directors at the time.

In this case, whilst the judge went to great lengths analysing whether the company was in fact solvent, he was not prepared to second-guess the directors’ judgment on the matter.

That said, the test for whether a director has breached their duty to promote their company’s success is a double “subjective/objective” test. Not only must the directors have actually believed they were promoting the company’s success (the subjective test), but they must also have acted in the way in which a reasonable director with their experience would have done (the objective test).

The liquidator’s challenge in this case was based only on the subjective test. Had he also claimed that the directors ought to have known the company was insolvent, the outcome might have been different.

When deciding whether to pay a dividend or other distributions, in addition to considering whether the distribution is lawful, directors should ask themselves:

• Is paying the dividend consistent with the directors’ duties? If paying the dividend will leave the company unable to meet potential claims, it may be that the directors are not promoting the success of the company.
• Should the directors be thinking about the company’s creditors? If the company is insolvent or likely to become insolvent, the directors must have regard to the company’s creditors and will need to put their interests before those of any other stakeholders (including shareholders).
• In reaching their conclusion, have the directors taken the steps a reasonable director in their position and with their experience would have taken? In particular, have they obtained professional advice on the company’s actual and likely solvency?
• Is there any scope to ask the shareholders to ratify the directors’ actions in paying the dividend? This should protect the directors from any challenge later down the line that they have breached their duties.

Law Commission seeking views on intermediated securities

The Law Commission is asking for views on securities issued by companies but held indirectly through intermediaries (so-called “intermediated securities”). The call for evidence forms part of a one-year scoping study by the Commission into the intermediated system.

What are intermediated securities?

Traditionally, when a UK company issues shares, it provides its shareholder with a share certificate and enters the shareholders’ name on its register of members. The shareholder gains formal title to the shares by virtue of appearing on the register. The share certificate stands as evidence of title.

However, this system is impractical for publicly traded companies, where shareholdings may change hands many times a day between numerous shareholders. As a result, publicly traded companies issue shares in “dematerialised form” through the CREST depositary system.

Under this regime, the company does not provide share certificates to shareholders. A person gains legal title to shares when their name is entered in the CREST system (although, for administrative purposes, the company will keep a “mirror register” of members which is updated daily).

However, investors in publicly traded companies do not normally hold their shares directly. Rather, the shares are normally held by a nominee or custodian (such as a financial institution or broker), who acts as an intermediary for investors. In some cases, there may be several “layers”, with one intermediary holding shares on behalf of another intermediary, who in turn holds its interest in those shares on behalf of investors (or even another intermediary…).

What problems can this pose?

This creates a legal disconnect. As a matter of law, the person who can exercise the rights attaching to shares (such as to vote at general meetings, receive dividends or participate in a rights issue) is the shareholder of record (i.e. the person whose name appears in CREST). In the intermediated system, this is the intermediary, not the ultimate investor.

An ultimate investor who holds shares through an intermediary, therefore, is unable (for example) to exercise their voting rights directly at general meetings. Instead, they must rely on their intermediary to convey their voting instructions. There are ways for an intermediary shareholder to pass these rights directly on to the real investors, but these are rarely used. Instead, intermediaries pass on voting instructions under their terms of business with their investor clients.

In practice, this does not seem to give rise to significant widespread problems. However, the Commission is concerned that this system may not function adequately and may act as a barrier to investors participating in voting.

Intermediated securities can also pose a problem where a company wants to carry out a statutory scheme of arrangement. (There are various reasons to do this, including to facilitate a takeover of the company, to demerge a business or to redomicile by inserting a new holding company.) A company cannot implement a scheme unless it is approved by a majority in number of shareholders attending a meeting of the company. However, where shares are held by an intermediary, the intermediary will count as a single person, even though it may represent dozens of real investors.

The Commission is therefore asking for views on the following:

• Does the current system make it difficult to investors to exercise their voting rights and check that they have been counted? Are there any systems that could facilitate this better?
• Does the system pose problems for the “majority in number” test on a scheme of arrangement? What could be done to solve this?
• In practice, are investors prevented from bringing claims or objections against issuers because they do not hold their shares directly (the so-called “no look-through principle”)?
• Are investors at risk from the insolvency of any intermediary that holds shares?
• Could distributed ledger technology (DLT) have the potential to assist investors with exercising their rights? If so, how?

The Commission has asked for views by 5 November 2019.

FCA clarifies status of polling information under MAR

The Financial Conduct Authority (FCA) has published guidance on whether information gathered through polling can constitute inside information under the Market Abuse Regulation.

It is not uncommon in the run-up to, or during speculation of, a General Election for organisations to commission opinion polls to gauge voter sentiment. This allows them to plan for likely outcomes of an election, including potential changes in policy arising from a change in administration.

The FCA reminds firms that polling data can constitute inside information. In particular, it notes that polling data, when made public, may have an effect on the price of government bonds traded on regulated trading venues. It also notes:

• A person who trades in relevant government bonds on the basis of unpublished polling results may commit an offence of insider dealing.
• A person who shares unpublished polling data with someone else may commit an offence of disclosing inside information, unless disclosure is necessary in the normal exercise of employment, a profession or duties.
• Although trading in spot foreign exchange cannot amount to insider dealing, it may be restricted under other legislation. It may also amount to “market manipulation” under MAR if it has an impact on financial instruments, such as certain spot FX options.

Other items

• ICSA and FT publish boardroom survey. ICSA: The Governance Institute and the Financial Times have published the results of their biannual survey of FTSE 350 boards on the business environment and key governance issues. From a legal perspective, the survey reveals boards’ perceptions and concerns around gender and ethnic diversity, risk management, workforce engagement, executive pay and gender pay-gap reporting.
• NEX issues new Growth Rules. NEX Exchange has announced that it has published revised versions of its Growth Market Rules for Issuers and its Corporate Adviser Handbook. The Growth Market Rules now include an updated suitability review process for applicants to the NEX Exchange Growth Market, which was previously set out in a separate practice note, and a revised procedure for submitting application documentation.