Corporate Law Update

• The European Union has formally approved new measures to allow Member States and the European Commission to screen foreign direct investment into the EU
• The Court of Appeal has found that a non-compete restriction embedded in a non-disclosure agreement was unenforceable because it was not reasonable
• The Government has published its proposals and a consultation on replacing the Financial Reporting Council with a new independent statutory regulator
• Other items of interest

EU approves new rules to screen foreign direct investment

The European Council has formally approved new rules that will allow the European Commission, on behalf of the European Union (EU), to screen foreign direct investments into the EU (FDIs) on the grounds of security or public order.

The draft regulation was approved by the European Parliament on 14 February 2019 and by the Council on 5 March 2019. It will become law in 2020. The key points are as follows:

• The Regulation creates a framework for EU Member States to screen FDIs on the grounds of security or public order. As at present, they will be able to adopt their own screening procedures, although they must apply the same procedures to all non-EU countries. Member States must notify the Commission of their procedures, but the Commission will not have a veto over how those procedures are formulated.
• In addition, the Commission will be able to screen an FDI if it believes the investment “is likely to affect projects or programmes of Union interest on grounds of security or public order”, including where a project receives substantial EU funding. The initial list of projects is set out in the Regulation, although the Commission will be able to amend this list from time to time.
• The Commission will not be able to block an FDI, but it may issue an opinion to the Member State where the FDI is taking place, which may influence the Member State’s decision.
• The Regulation sets out a non-exhaustive list of factors Member States and the Commission may take into account when screening FDIs, including the potential effects on critical infrastructure, technologies and inputs. These cover a long list of areas, such as energy, transport, water, health, telecommunications, media, data processing, aerospace, defence, electoral and financial infrastructure, sensitive real estate, dual-use items, artificial intelligence, robotics, cybersecurity, quantum and nuclear technologies, nanotechnology and biotechnology.

Assuming the Regulation is published on 21 March 2019 as planned, it would apply across the EU from October 2020. In the event that the UK’s withdrawal from the EU is delayed beyond October 2020, the Regulation would automatically form part of UK law following Brexit unless the UK decided to modify or dis-apply it. Given that most of the Regulation relate to co-operation between Member States and with the Commission, it seems likely the UK would need to dis-apply most of it.

The UK has recently been consulting on its own longer-term proposals for intervening in FDIs in the UK on the grounds of national security. For more information on those proposals, see our update from 3 August 2018.

Court finds non-compete in NDA was unenforceable

The Court of Appeal has found that a non-compete restriction in a non-disclosure agreement (NDA) (or confidentiality agreement) was unenforceable because it was an unreasonable restraint of trade.

What happened?

Harcus Sinclair LLP v Your Lawyers Limited involved two law firms that agreed to collaborate together on a piece of group litigation.

Your Lawyers (YL) (a relatively small firm) had been representing a group of thousands of claimants in a group action. Their funding broker suggested they collaborate with a more experienced firm and introduced them to Harcus Sinclair (HS).

The two firms signed an NDA so that YL could provide HS with information on the group action. HS agreed in the NDA to keep that information confidential.

The NDA also stated that HS would not act for any other group of claimants on the same group action for a period six years from the date of the NDA, unless it first obtained YL’s consent. However, HS was subsequently instructed by its own claimants. It issued litigation on their behalf and, a few months later, transferred that litigation to an associate company staffed by its own secondees.

In response, YL sought an injunction to stop HS from breaching the non-compete covenant.

When is a non-compete unenforceable?

A non-compete covenant is a type of restraint of trade. Broadly speaking, the English courts will not allow someone to enforce a restraint of trade unless it protects a valid interest of the party that wishes to enforce it and it is reasonable.

In some cases, the court may also refuse to enforce a restraint of trade on the basis it is not in the public interest, normally because it is detrimental in some way to the general public.

What did the courts say?

The High Court initially found that the non-compete restriction was valid and enforceable, and that HS had breached it.

The Court of Appeal, however, took a different view. It said that HS’s behaviour, including providing secondees to an associate company to work on the claim, fell within the wording of the non-compete covenant. However, the covenant itself was unreasonable and, therefore, unenforceable.

Cases involving unreasonable non-competes are frequent, but what makes this case interesting is the context of the restriction and the court’s approach. In deciding whether the covenant was reasonable, the court asked two questions:

• Was the non-compete reasonably necessary to protect the legitimate interests of YL?
• Was the non-compete commensurate with the benefits secured to HS under the NDA?

The court said that, in order to answer these questions, it was necessary to look at the reason for the parties entering into the NDA and the protections given by that agreement.

Critically, the court said that the purpose of the NDA was to allow YL to disclose confidential information to HS so that it could obtain legal advice from HS, with the comfort that HS would keep the information confidential. The NDA was not a “collaboration agreement” regulating how YL and HS would pursue or co-operate on any group actions.

With this in mind, the court found that YL’s legitimate interest under the NDA was the protection of the confidential information. The non-compete was not necessary to protect this interest. It served a much broader, collateral purpose. It might have protected a different interest of YL, but not one that arose under the NDA.

It also said that the benefit secured to HS under the NDA was the ability to obtain confidential information and (perhaps) the opportunity to provide legal advice. In the court’s view, the non-compete restriction was “out of proportion” to this benefit.

Interestingly, the court also noted that YL had approached other law firms and persuaded them to sign a NDA containing a similar non-compete. It said that, if the restriction had been valid, members of the public with a potential claim would have a significantly limited choice of firm to use. In this sense, the court was effectively saying that the non-compete was not in the public interest.

Practical implications

This decision is a useful reminder of points to consider when drafting or negotiating a non-compete restriction in a commercial contract. These include the following:

• The non-compete must protect some valid and legitimate interest linked to the agreement containing the restriction. Simply inserting a non-compete restriction into an agreement with a different principal purpose may not work.
• In deciding whether a non-compete is reasonable, the parties must consider their position when they enter into the contract. The fact that their relationship develops later down the line such as to warrant a non-compete is irrelevant if the covenant was unreasonable when it was signed.
• The parties should also consider whether the non-compete might have an impact on the public at large. (In many cases, this is now dealt with specifically by competition legislation, which prohibits (for example) anti-competitive agreements and cartel arrangements.)
• Attempting to circumvent a non-compete restriction by using another corporate vehicle is a high-risk strategy. Depending on the wording of the covenant, a court may find that the restriction is breached indirectly or even look through the other entity (by “piercing its corporate veil”).
   

Government will replace FRC with a new independent regulator

The Government has confirmed it will replace the Financial Reporting Council (FRC) with a new independent regulator to be named the Audit, Reporting and Governance Authority (the ARGA). The move follows the recent independent review of the FRC (the “Kingman Review”), which recommended replacing it with a stronger, statutory regulator.

The ARGA would have a smaller board than the current FRC, and all appointments would be approved by the Department for Business, Energy and Industrial Strategy.

The Government is also consulting on certain recommendations coming out of the Kingman Review. The consultation sets out the Government’s position and proposals in relation to each of the Kingman Review’s 83 recommendations.

Certain, more straightforward recommendations will be implemented immediately. These include:

• publishing anonymised audit quality reports;
• ramping up corporate reporting reviews by the FRC (until it is replaced by the ARGA);
• extending the corporate reporting review process to a company’s entire annual report and accounts;
• reducing the amount of guidance published by the FRC; and
• reviewing and reforming longer-term viability statements (and, if they cannot be made more effective, abolishing them completely).

In relation to other recommendations, it is seeking views on the following:

• The ARGA’s proposed strategic objective of protecting users of financial information and the wider public interest by setting high standards for statutory audit, corporate reporting and corporate governance.
• The ARGA’s proposed new duties, which would include regulating the audit profession, taking responsibility for the UK Corporate Governance Code and the UK Stewardship Code, and appointing inspectors to investigate a company’s affairs where there are public interest concerns.
• Whether the ARGA’s new powers should focus solely on public interest entities (PIEs). The Government is concerned this might create a “gap in oversight” for other corporate entities.
• How any “pre-clearance procedure” operated by the ARGA should work to address novel and contentious matters in company accounts.

It will consult at a later date on the remaining, longer-term recommendations. These include proposals to formally establish the ARGA and set its remit, to give it direct responsibility for supervising audits, and to give it the power to require rapid explanations from companies about reasonable concerns raised by the ARGA. They also include proposed new powers for the ARGA to bring direct action against directors for failing to prepare true and fair accounts and for not acting honestly with their company’s auditor.

The Government has asked for responses to the consultation by 11 June 2019.

Other items

• Audit. The Financial Reporting Council (FRC) has published a position paper following its November 2018 call for feedback on its post-implementation review of changes it made in 2016 to its auditing and ethical standards. The position paper makes several proposals in relation to non-audit services provided by statutory auditors of public interest entities (PIEs). The paper is therefore of particular relevance to listed companies, banks and insurance companies.