Corporate Law Update

• The Supreme Court finds that a non-compete was invalid because it prevented an employee from holding shares in competitors, but was prepared to amend it
• A buyer of shares was unable to invoke a mechanism for an independent determination of completion accounts, because it had not followed the required procedure
• The High Court finds that the grant of an indemnity by a company to one of its directors did not require shareholder approval
• A few other items of interest

Non-compete invalid without carve-out for minor shareholdings

In August 2017, we reported on a case in which the Court of Appeal said that a covenant preventing a former employee from “being interested in” a competing business was invalid, because it would have prevented her from holding even a minor shareholding in a competitor.

The employer appealed, and the Supreme Court has now delivered its judgment.

What happened?

As a reminder, Tillman v Egon Zehnder Ltd concerned a business executive who left her company to join a competitor. Ms Tillman joined the company as a consultant in 2004 and was rapidly promoted, becoming a partner in 2009 and joint global head of financial services in 2012.

Ms Tillman’s service agreement contained a non-compete covenant stating that, for a period of six months after leaving the company, she would not “directly or indirectly engage or be concerned or interested in any business carried on in competition with” the company’s group.

Ms Tillman left the company in 2017. She claimed that the non-compete covenant was unenforceable. Under English law, a non-compete (like a non-solicitation covenant) is a kind of “restrictive covenant” and will be an invalid restraint of trade unless it protects a legitimate business interest.

In this case, Ms Tillman claimed that the words “or interested” in the non-compete prevented her from holding even a minor stake in a competitor, and so the covenant was unreasonably wide.

Her argument was bolstered by the fact that her agreement contained a separate non-compete covenant that applied while she was employed (rather than after she left). That non-compete included an express exception allowing Ms Tillman to hold “for investment only, shares or other securities in a publicly quoted company of up to a maximum of 5% of the total equity in issue of that company”.

The company applied for an injunction to prevent Ms Tillman from joining the competitor. Initially, the High Court granted that injunction. However, the Court of Appeal later overturned that decision, agreeing with Ms Tillman that the covenant was too wide and therefore void, and setting the injunction aside.

The company appealed to the Supreme Court. It claimed that the non-compete was not unreasonable, because, properly read, it did not prohibit Ms Tillman from holding shares in a competing business. Alternatively, it said, if the covenant was unreasonable the court had the power to strike the words “or interested” out (to “sever” them) in order to make it reasonable and enforceable.

In essence, therefore, the question for the Supreme Court was: were the words “or interested” unreasonable and, if so, could the court simply delete them?

What did the court say?

The court had no difficulty in finding that being “interested in” a business included holding shares in a competing company, even as little as a single share. Its view was strengthened by the fact that the company had not been able to say what the word “interested” actually meant. It had merely argued that it did not include holding shares, but the court was not comfortable with this vague interpretation.

Having decided that, the court said that the non-compete was unreasonable as it stood. It could be rescued only if the words “or interested” could be cut out of the covenant.

The Court of Appeal had previously declined to delete the words, saying the courts had the power to sever separate covenants from each other, but not to sever part of a single covenant. The Supreme Court, however, had no difficulty in deleting the words.

In giving the court’s reasoning, Lord Wilson helpfully re-summarised the key questions a court must ask itself when deciding whether it can sever part of a restrictive covenant:

• Can the words be deleted and the covenant still make sense without needing to add any new words or modify the remaining words?
• Will the contract will be enforceable if the words are deleted?
• Will deleting the words generate a “major change” in the overall effect of the covenant?

In this case, the court felt that the words “or interested” could be deleted without disturbing the grammar or the overall effect of the covenant, and so it did so.

The court considered whether the word “concerned” also captured holding shares in a competitor and concluded that it did not. However, if it had, the court was prepared to delete the words “or be concerned” too in order to render the covenant valid.

What does this mean for me?

Both the company and Ms Tillman gain something from the court’s decision.

On the one hand, by striking out the words “or interested”, the court removed any restriction on Ms Tillman holding shares in a competitor. In theory, she would be able to hold any number of shares and the company would not be able to stop her (although presumably there might come a point at which the sheer size of shareholding, and the control and influence that come with it, would mean she is “indirectly engaged” in a competitor).

On the other hand, at the expense of this protection, the company was able to prevent Ms Tillman from seeking employment or active engagement with a competitor. This was obviously a sacrifice the company felt worth making and it will no doubt feel the victor following this decision.

Although set in an employment contract, the judgment once again highlights some key things to consider when drafting restrictive covenants on the sale of a business or as part of management incentive arrangements:

• Be careful when using generic language, such as “concerned in” or “interested in”. The courts will interpret these words in each case according to the context. If the court feels they are too wide, it might refuse to enforce the covenant.
• Include a carve-out to allow the employee or seller to hold shares in a competitor for investment purposes. Normally, it is sensible to limit this to small shareholdings (normally up to around 3% to 5%) in a publicly traded company, although this must be set in the context of the business. Nowadays, this is also often extended to holdings in managed funds and unit trusts.
• Separate the restrictive covenants into as many different covenants as possible. For example, keep the non-compete covenant separate from any non-solicitation covenants, and split the non-solicitation covenants up by subject (e.g. employees, customers, suppliers). This maximises the court’s ability to sever an individual covenant if it is too wide.
• State explicitly that the covenants can be severed if any of them are found to be unreasonable.

Independent procedure for settling completion accounts was not validly invoked

The High Court has said that the seller of a company was not entitled to invoke an independent procedure to finalise completion accounts for the sale, because it had not complied with earlier steps in the procedure.

What happened?

O’Brien v TTT Moneycorp Limited concerned the sale of the shares in a company that ran a foreign-exchange business.

As often happens on share sales, the agreed price for the shares was to be adjusted after the sale completed to reflect the actual level of the company’s assets and liabilities at completion of the sale. This is commonly known as a “completion accounts” or “true-up” mechanism.

The completion accounts procedure included several steps that are standard for this kind of adjustment mechanism:

• The buyer would prepare draft “completion accounts” and send them to the sellers to review.
• The sellers were entitled to dispute any items in the completion accounts with which they disagreed. If they did not do so within a specified time, they were deemed to accept the accounts.
• The buyer was to give the sellers access to “all relevant files and/or working papers” reasonably required to review the completion accounts, and to take copies of those files and papers.
• If they could not agree the completion accounts, either the buyer or the sellers could refer the matter to an independent chartered accountant, who would resolve the dispute.

The buyer sent final completion accounts to the sellers. In response, the sellers asked for various documents to verify certain balances, including databases of client balances, copies of bank statements and copies of client account reconciliations.

The buyer supplied certain items in response to the sellers’ request, but refused other information on the basis that the request was not reasonable. The sellers responded that not all of the information requested had been supplied and that, as a result, they were unable to verify the completion accounts.

Around three weeks later, the buyer sent the sellers a notice invoking the independent dispute resolution procedure. They ultimately instructed an accountant, who requested various documents from the sellers.

The sellers argued that the buyer was not entitled to invoke the resolution procedure, because it had failed to comply with its duty to supply documents to the sellers. They said that supplying those documents was a precondition (or “condition precedent”) to invoking the procedure.

What did the court say?

The court agreed with the sellers. It said that the mechanism involved a “series of steps to be taken”, each of which was a “precondition to the next”.

This made “good commercial sense”, as the mechanism envisaged that the precise ambit of any dispute to be referred to an accountant would be defined first. That in turn required each party to have all relevant information so that it could define the scope of the issues to be decided by the accountant.

What does this mean for me?

Completion accounts mechanisms are a popular way of ensuring a buyer does not over-pay for a business. However, they are often fraught with difficulty and overly ambitious. Finalising the balance sheet of a target business can often take considerably longer than the parties anticipate. Depending on the complexity of the business, it is not uncommon for the process to take six months or even a year.

Where a buyer or seller wants to avoid this and be able to cut straight to an independent determination, it will need to state this specifically in the share sale agreement. It is unusual to do this, and any power of this kind would most likely need to be restricted. For example, it may be worth stating that a party cannot invoke the determination procedure if it is in wilful default of its obligations under the mechanism or until a minimum period of time has passed.

Grant of indemnity was not a substantial property transaction

The High Court has held that the grant by a company of an indemnity in favour of a shareholder, who happened also to be a director, was not a substantial property transaction requiring shareholder approval under section 190 of the Companies Act 2006 (the Act).

What happened?

Terry and others v Watchstone Limited concerned the sale of the shares in a technology development company.
Shortly before the sale completed, the company granted an indemnity to one of its directors, who was also a shareholder. The indemnity was designed to protect the director against any tax liability he might incur when selling his shares in the company (other than capital gains tax).

Following the sale (when it was now under the control of a new group), the company claimed that the grant of the indemnity was void because it was a “substantial property transaction” under section 190 of the Act and it had not been approved by the company’s members.

What is a “substantial property transaction”?

Under section 190, a company may not enter into (among other things) an arrangement under which any of its directors will acquire a non-cash asset from it, unless its members approve the acquisition. The prohibition applies only if the non-cash asset has a value above a specified amount. This kind of arrangement is known as a “substantial property transaction” (or SPT).

The purpose of section 190 is to prevent a company’s directors from taking advantage (whether deliberately or inadvertently) of their position of trust by directing the company to enter into transactions to its disadvantage and to the directors’ advantage. If a company enters into an SPT without approval, it can apply to court to set it aside.

There are certain exceptions to the prohibition, including where a company enters into a transaction with someone “in [their] character as a member of [the] company” (section 192(a)).

Section 1163 of the Act defines “non-cash asset” as any “property or interest in property, other than cash”. It also says that the acquisition of a non-cash asset includes the “creation or extinction of an estate or interest in, or a right over, any property” and the “discharge of a liability of any person, other than a liability for a liquidated sum”.

What did the court say?

The court said the grant of the indemnity was not an SPT. In a nutshell, it gave four reasons:

• There was no “property”. For section 190 to apply, there must be some property that amounts to a non-cash asset. This does not mean “everything other than cash”. There must be something the law recognises as “property” or an “interest in property”. However, the indemnity was neither.
  
  The company had argued that the indemnity created contractual rights, and that those rights amounted to property. But the court said that any rights under the indemnity amounted to “no more than non-marketable contractual rights”. The judge was not persuaded that they could properly be regarded as property or an interest in property.
• There was no “acquisition”. For section 190 to apply, a director must acquire an asset. The court said that, for there to be an “acquisition”, the asset must already exist at the time the transaction takes place. However, in this case, the rights under the indemnity were created by the grant of the indemnity itself. They did not exist before the transaction took place, and so, even if they did amount to property, they could not have been “acquired”.
• Capacity as member. The company had granted the indemnity to the director in his capacity as a member of the company. The indemnity had nothing to do with his office with the company. Rather, it was connected with the sale of his shares. This was underscored by the fact that the company had granted a similar indemnity to other shareholders who were not directors.
• The grant had been approved. On the evidence, the court found that the company’s shareholders had in fact approved the grant of the indemnity (although, for the reasons given above, they had not needed to).

Practical implications

There are a lot of issues raised by this relatively short judgment. The company has appealed and the appeal will be heard in November. To succeed, the company will need to persuade the Court of Appeal that the judge was wrong on all four points above. This may be tricky.

The court did not explain exactly how it came to the conclusion that the company’s members had approved the indemnity, and so it is difficult to gauge how successful an appeal on that point might be.

It is hard to see how the company can appeal against the decision that the indemnity was given to the director in his capacity as a member. The judge said that the indemnity covered tax liabilities and costs incurred “as a consequence of the sale”. Those liabilities related to the director’s holding of shares, not his actions or office as a director. The company will presumably need to challenge the judge’s decision on the scope of the indemnity.

Finally, it will be interesting to see whether the company successfully appeals the other two points. Those points related to the trickier questions of whether granting an indemnity can ever amount to an SPT. There are three particularly interesting issues here:

• The judge’s interpretation of “acquisition” is arguably narrow. There is logic to the idea that a person cannot “acquire” something unless that thing already exists.
  
  But equally, it could be said that the director here did “acquire” a right, in the sense that he did not have that right before the company granted the indemnity, and it was the company granting the indemnity that led him to get it. If the purpose of section 190 is to prevent directors from self-dealing, this narrow interpretation does not seem to do much to promote it.
• Likewise, the judge’s interpretation of “property” seems restricted. It seems clear that the court did regard the indemnity as creating contractual rights. The decision not to treat those rights as “property” stemmed from the fact that they were “non-marketable”.
  
  The judge’s conclusion seems to have been based heavily on the Scottish case of Lander v Premier Pict Petroleum. But that case concerned rights under an option in a service agreement that were not capable of being assigned onwards. That is different from this case, which involved an indemnity that, quite conceivably, might be assignable.
  
  In addition, neither section 190 nor section 1163 says anything about “marketability”, and there are no doubt many kinds of asset that are comfortably within those sections but which are not “marketable”. A company that transfers a “non-marketable” asset to a director at an undervalue presumably loses out as much as if the asset were marketable.
• Finally, as noted above, the Act treats an acquisition of a non-cash asset as including the “discharge of a liability of any person, other than a liability for a liquidated sum”.
  
  In this case, the company appears to have promised to discharge the director’s potential tax liabilities. Those liabilities surely cannot have been “liquidated” when the indemnity was granted, because it was not clear how much they would amount to, nor whether they would arise at all. This indemnity does look, therefore, like an agreement to discharge an unliquidated liability.

The case is useful but, in some ways, it raises more questions than it answers. We will be monitoring the appeal closely and provide an update in due course.

Other items

• FCA delays changes to electronic prospectus submissions. The Financial Conduct Authority is delaying certain changes to the way in which issuers submit prospectuses to it electronically. In January, the FCA announced that from 21 July 2019, issuers would need to provide certain information to the FCA which the FCA must in turn send to the European Securities and Markets Authority (ESMA). However, ESMA has deferred its own system changes until mid-2020, and so the FCA will not be requiring this information for the time being. The other changes needed to accommodate the Prospectus Regulation will take effect, as planned, on 21 July 2019.
• FCA to update Knowledge Base. The Financial Conduct Authority has confirmed that it will be updating its Knowledge Base in due course to reflect the EU Prospectus Regulation, which comes into effect in the UK on 21 July 2019. The Knowledge Base currently refers to the prospectus regime under UK domestic law and the EU Prospectus Directive. In the meantime, the Knowledge Base will apply to prospectuses under the new Regulation to the extent they are compatible.
• Revised Stewardship Code in October. The Financial Reporting Council (FRC) has announced that it will be publishing the revised version of its Stewardship Code in October. The FRC launched a consultation on the Code in January 2019 designed to strengthen the Code and broaden its scope. For more details of that consultation, see our previous Corporate Law Update.
• Government publishes Green Finance Strategy. The UK Government has announced details of its Green Finance Strategy, setting out steps it intends to take to integrate climate-related and environmental risks into financial decision-making. In particular, the Government expects that all listed companies and “large asset owners” will disclose against the recommendations of the Financial Stability Board's Task Force on Climate-related Financial Disclosures by 2022.
• BVCA publishes report on women in limited partners. The British Private Equity and Venture Capital Association, together with Level 20, has published a new report looking at the number of women who work for limited partners of PE and VC funds. The results, whilst an improvement from previous reports, show that only 25% of investment professionals in LPs are women and only 21% of senior investment roles are occupied by women.