Corporate Law Update

• The unauthorised sale of an asset to a director was invalid, and a share buy-back was ineffective because the purchase price was deferred
• The Private Equity Reporting Group reports on compliance with the Walker Guidelines
• The BVCA and EY publish a review of private equity portfolio company performance
• The QCA and UHY Hacker Young analyse AIM company corporate governance disclosures
• The Risk Coalition publishes final guidance for risk committees in the financial services sector
• ESMA publishes updated Q&A on the Prospectus Regulation
• The FCA is consulting on changes to publication requirements in the Listing Rules

Court confirms self-dealing by director was void

In early 2017, the High Court invalidated the sale of a property by a company to one of its directors which had not been approved by the board, and a share buy-back with a deferred purchase price. The Court of Appeal has now confirmed that decision.

What happened?

Dickinson v NAL Realisations (Staffordshire) Limited concerned a company that operated a foundry. The company had three shareholders – a Mr Dickinson (D), one of D’s family trusts, and a small pension scheme of which D was a trustee. D was also a director of the company, along with his wife and a third director, although in practice they never held formal board meetings.

Over several years, D entered into various transactions with the company, including the following:

• In 2005, he purchased a factory from the company for less than market value (the “factory sale”).
• In 2010, he, the family trust and the pension scheme sold shares back to the company (the “share buy-back”). The purchase price was left outstanding as a loan.

The company went into liquidation in 2013. The liquidators claimed that the factory sale and the share buy-back were invalid and sought a court order to recover the company’s property.

The High Court considered the issue and declared both the sale and the buy-back void and of no effect. D appealed to the Court of Appeal, but the court dismissed his appeal. We have summarised below the courts’ reasoning for striking down each transaction.

The factory sale

The High Court found that D had no authority to conclude the sale on behalf of the company. It was never approved in a formal board meeting, and D had not involved his co-directors in the decision.

D claimed the sale was valid because all of the company’s shareholders had approved it informally under the “Duomatic principle”. This principle provides that, if all of a company’s shareholders give their informal consent to something, that consent is as good as a formal resolution. But the High Court said it was not clear that all the pension scheme trustees had approved the sale. Alongside D there was a professional trustee, who had not been told about the sale, let alone consented to it.

On appeal, D claimed that the scheme had consented to the sale, because he and his wife were the only members of the scheme and they had approved it. The court disagreed for the following reasons:

• D and his wife were indeed the only members of the scheme, but they were not the only beneficiaries. D needed to show that all of the scheme beneficiaries had consented to the sale, but those beneficiaries included relatives and dependants, who had not approved it.
• In any case, there was no evidence that D’s wife had approved the sale. When cross-examined, she said she had not been aware of the sale. So even if the scheme members’ consent had been enough, that consent had not been given.

The share buy-back

The High Court said the buy-back was invalid because the company had not paid for the shares when it acquired them. Under section 691(2) of the Companies Act 2006, when a company buys its own shares, it must pay for them at the time of purchase. Failure to comply with the Act renders a buy-back void.

Here the price was left outstanding as a loan. The judge rejected the idea that the loan arrangements themselves amount to “payment”, as the very purpose of the loan was to formalise deferral of payment.

On appeal, D argued that section 691(2) merely requires the buy-back contract to provide for payment at the time of the buy-back, and it does not matter if the price is not in fact paid then. But the Court of Appeal said the words “paid for on purchase” in the Act were clear and required actual payment.

(The High Court also said the buy-back was void under section 423 of the Insolvency Act 1986 because it was made at an undervalue and its purpose was to put assets beyond the reach of creditors. However, having declared the buy-back void for lack of payment, the Court of Appeal did not consider this point.)

What does this mean for me?

The factory sale decision shows the importance of formally considering and approving transactions. Although this case revolved around unusual circumstances, the key issue was that the sale had not been approved by the board. Directors should bear the following in mind:

• All significant transactions should be approved by a company’s board, either in a board meeting or (if the company’s constitution allows it) by written resolution. This is particularly important if the transaction is with a director.
• If the transaction involves the sale of a non-cash asset above a particular value, it may require the approval of the company’s shareholders under section 190 of the Companies Act 2006.
• It may be worth obtaining shareholder approval for the transaction anyway to avoid claims that directors are acting in breach of duty.

It is also important to understand the limits of the Duomatic principle. As a general rule, it is not wise to invoke Duomatic to authorise a transaction up front. The principle has limits and, as this case shows, it can be difficult to show shareholder consent where pension schemes and trusts are involved.

But Duomatic can still be useful “after the event”, and this judgment emphasises that courts are prepared to look beyond legal ownership of shares when deciding whether consent has been given.

The share buy-back decision shows the need to structure share re-purchases properly. Failing to comply with statutory requirements will likely render a buy-back totally ineffective. In particular:

• The buy-back contract must require payment on purchase. It is possible to buy shares back in tranches, but payment for each tranche must be made when the shares are acquired. A company cannot pay for its own shares in instalments and payment cannot be deferred.
• In particular, shares must not be acquired in exchange for loan notes or loan stock. This is effectively an agreement to pay at a later time.
• That said, it should be possible in certain circumstances for a company to borrow money from the shareholder from whom it is buying the shares. However, the two arrangements must be structurally separate and not merely a sham to avoid having to pay on purchase.

Interestingly, the Court of Appeal (like the High Court before it) referred to the previous case of BDG Roof-Bond v Douglas and suggested that a company may be able to pay for shares by transferring non-cash assets. Although in that case the judge said that payment need not be in cash, most advisers take a conservative view and advise that there must be a cash price.

But in this decision, Lord Justice Newey specifically said: “[The] decision in BDG Roof-Bond Ltd … indicates that payment need not necessarily be in money.” This may well open the door further to non-cash share buy-backs, although in many cases it is possible to achieve the same result by entering into a separate asset sale transaction and setting the two arrangements off against each other.

PERG publishes annual report on Walker Guidelines compliance

The Private Equity Reporting Group (PERG) has published its 12th report on compliance with the Guidelines for Disclosure and Transparency in Private Equity (also known as the “Walker Guidelines”).

The Guidelines are designed to assist private equity firms and their portfolio companies with improving transparency in financial and narrative reporting. They require portfolio companies to make certain disclosures in their annual report, publish their report and a mid-year update in a timely manner, and share certain data to gauge the contribution of UK private equity to the economy.

They also require private equity firms to make certain website disclosures.

The key points coming out of the report are as follows:

• There were 55 portfolio companies and 47 firms within the scope of Guidelines. All portfolio companies complied with the disclosure requirements in their annual report.
• However, only 53% prepared disclosures to “at least a good standard”, a significant drop from 2018 (73%). Board composition and gender diversity disclosures were good, but better disclosure is needed in relation to non-financial KPIs, business model, strategy and human rights.
• 80% of portfolio companies published their annual report in a timely manner (roughly equivalent to 2018). However, only 68% published a timely mid-year update, down from 74% in 2018.
• All BVCA member firms complied with their website disclosure obligations.

In addition, 89% of portfolio companies provided data to EY for the purpose of reporting on the UK private equity industry, leading to the BVCA’s most recent report (see below).

PERG has also published an updated Good Practice Guide, which is designed to provide guidance to portfolio companies and PE firms on how to apply the Guidelines.

BVCA publishes annual report on PE-backed company performance

The British Private Equity and Venture Capital Association (BVCA), in association with EY, has published its 12th annual report on the performance of PE-backed portfolio companies. The report has been prepared using data provided under the Walker Guidelines (see above).

The key items coming out of this year’s report are as follows:

• The average timeframe of PE ownership for a portfolio company is 5.8 years.
• The average leverage ratio of portfolio companies was 6.7 debt to EBITDA at acquisition and 6.2 debt to EBITDA on exit, although the spread was wider when excluding infrastructure assets.
• Organic employment growth at portfolio companies was 1.8% p.a. (0.2% above the UK private sector benchmark (“PSB”), but below the public company benchmark (“PCB”)). Average employment cost per head (reflecting employee pay) has grown by 2.9% p.a. (0.2% above PSB). 40% of jobs at portfolio companies were part-time (double the private sector average) and 6.2% were on zero-hours contracts (0.7% above the economy-wide benchmark).
• Capital productivity growth and revenue growth among PE-backed businesses are 6.9% and 7.1% per annum respectively (5.7% and 2.7% respectively above the equivalent PCBs).
• Finally, equity returns from portfolio companies are 3.4 times the PCB.

QCA publishes report on AIM company corporate governance

The Quoted Companies Alliance (QCA), in collaboration with UHY Hacker Young, has published a report on AIM companies’ corporate governance arrangements. The report covers governance disclosures during 2019 by 50 AIM companies chosen at random.

Interesting points coming out of the report include the following:

• Companies are still struggling to explain their business model and strategy without using boilerplate in their strategic report. The QCA states that an understanding of a company’s strategy is a “minimum for prospective investors”. It should give meaning to the company’s financials and include key performance indicators (KPIs).
• Only 66% of companies explained how they have engaged with shareholders. The QCA urges companies not just to disclose the number of meetings with shareholders, but also the objectives that arise during that engagement.
• 84% of companies identified which directors they considered independent and explained any grounds for questioning their independence. But companies are still struggling to describe which operational matters are delegated to committees and which are reserved to the board.
• Only 46% of companies described the skills, experience and personal capabilities their directors brought to the board. Not all companies are explaining the mix of experience provided by their board composition or how each director keeps their skills up to date.
• 48% of companies described their succession planning arrangements, suggesting it is becoming more prominent on board agendas. Investors acknowledge that board succession is a difficult topic to broach, but it is essential to ensure continuity of operations.

Risk Coalition publishes final guidance for board committees

The Risk Coalition has published final guidance for board risk committees and risk functions in the UK financial services sector. There have been a few changes to the consultation draft published in July, but the main principles and structure of the guidance remains the same.

For more information, see this previous Corporate Law Update.

ESMA updates its Q&A on the Prospectus Regulation

The European Securities and Markets Authority (ESMA) has published updated Q&A on the EU Prospectus Regulation.

The new Q&A clarify that, under the new regime, a base prospectus must not include a pro forma summary. This is because the summary is drawn up only once the prospectus contains final terms.

They also provide new guidance to entities that wish to issue securities that do not fall neatly into one of the categories contemplated by the prospectus regime.

FCA consults on changes to Listing Rules and DTR

The Financial Conduct Authority (FCA) has published Consultation Paper CP19/33, in which it is consulting on two amendments to the Listing Rules:

• Class 1 agreements. When the EU Prospectus Regulation came into effect, the Listing Rules were changed to require an issuer that enters into a “class 1” transaction to publish a copy of the sale and purchase agreement on its website. The FCA is proposing to reverse this change, so that issuers will once again be able to make the agreement available for inspection in hard copy.
• Details of listed securities. The FCA is proposing to require listed issuers to ensure details of their listed securities are available to the public through the National Storage Mechanism (NSM) (currently operated by Morningstar). This could be done in a variety of ways, including by publishing the prospectus or listing particulars relating to the securities.

The FCA has asked for comments on the first proposal by 6 January 2020 and on the second proposal by 6 February 2020.

The consultation also contains proposed consequential amendments to various parts of the FCA Handbook to cater for a potential no-deal Brexit.