Corporate Law Update
- A majority shareholder did not act “in good faith” when dismissing his business partner and forcing a transfer of his shares
- The court finds that a tax gross-up applied only when tax had actually become due
- The new provisions allowing companies to hold electronic meetings apply to meetings in connection with a scheme of arrangement
- The Court of Appeal upholds a request to inspect a management company’s register of members
- The European Commission is consulting on a roadmap for sustainability activity disclosures
Covid-19 is affecting the way people conduct their business, retain their staff, engage with clients, comply with regulations and the list goes on. Read our thoughts on these issues and many others on our dedicated Covid-19 page.
Shareholder did not act in good faith when dismissing business partner
The High Court has held that the majority shareholder of a company breached an express contractual duty of good faith to his fellow, minority shareholder when he dismissed him as an employee without notice or explanation.
Unwin v Bond  EWHC 1768 (Comm) concerned a small company owned by two individuals – Mr Bond and Mr Unwin – whose business was supplying heating and ventilation systems. (The company operated principally through a subsidiary but, for simplicity, we will refer simply to “the company”.)
Mr Bond, who initially had owned 100% of the company, had brought Mr Unwin in as a minority shareholder in the business in 2011, selling him approximately 20% of his shares. Around the same time, as is not uncommon, Mr Bond and Mr Unwin entered into a shareholders’ agreement to regulate the running of the company and their relationship with each other.
The shareholders’ agreement recognised Mr Bond’s significant stake in the company and gave him a wide range of powers, including the ability to terminate Mr Unwin’s employment by notice. The shareholders’ agreement also contained (among others) the following provisions:
19.2 Each shareholder shall at all times act in good faith towards the others and shall use all reasonable endeavours to ensure that the provisions of this agreement are observed.
19.3 Each shareholder shall do all things necessary and desirable to give effect to the spirit and intention of this agreement…
In addition, the company’s articles of association were amended to include a typical leaver mechanism, under which a shareholder who left the company would need to offer their shares to the other shareholders. If the leaver were a “good leaver”, they would receive fair value for their shares. But if they were a “bad leaver”, they would receive the lower of the fair value and the issue price of their shares. This mechanism, and variants of it, are used commonly to ensure managers who hold shares remain incentivised to perform and do not leave the business early.
In 2014, Mr Bond set up a separate venture with another partner. He mentioned this to Mr Unwin, who initially was comfortable with the arrangement. But when Mr Bond raised the prospect of bringing the new venture within the company and working towards a sale of the combined business, Mr Unwin became upset and raised objections. However, following correspondence and a meeting between the two of them, the disagreement was effectively left to one side and business continued.
In short, over the next two years, a series of mishaps occurred on certain projects the company was working on. The evidence at trial suggested that, as a result of this, Mr Bond came to form the view that Mr Unwin was not performing adequately.
In due course, Mr Bond terminated Mr Unwin’s employment in September 2016. He gave no advance notice of this to Mr Unwin and did not give Mr Unwin an opportunity to respond to Mr Bond’s concerns or to explain his alleged poor performance.
Mr Unwin’s termination activated the leaver provisions. He was treated as a “bad leaver” and his shares were transferred to Mr Bond at their issue price: £14,200.
Mr Unwin claimed that, rather than remove him for poor performance, Mr Bond’s primary motivation was to acquire his shares for less than their fair value. Based on this motive, and on certain other matters and procedural irregularities relating to his termination, Mr Unwin argued that Mr Bond had breached his duties in clauses 19.2 and 19.3 of the shareholders’ agreement (see above). In particular, he claimed that Mr Bond had failed to act in good faith.
What did the court say?
The judge did not agree that Mr Bond had been acting on the basis of an ulterior motive, namely to oust Mr Unwin from the business for a low price. He said that all the evidence was that Mr Bond had begun to perceive a “real risk” that, without replacing Mr Unwin, the company might lose vital business.
However, he also found that, in terminating Mr Unwin’s employment in the manner in which he did, Mr Bond had breached his contractual duty to act in good faith towards Mr Unwin.
The judge reviewed a series of previous cases that deal with specific instances of contractual duties to act in good faith. He noted that it was difficult to establish that the phrase “to act in good faith” had any particular fixed meaning. Rather, the cases showed that its meaning depends heavily on the context of the contract in which it appears.
However, he did note that a contractual duty to act in good faith did create five minimum standards that dictate how one contract party must behave towards another:
- They must act honestly.
- They must be faithful to the parties’ agreed common purpose.
- They must not use their contractual powers for an ulterior purpose.
- They must deal fairly and openly with the other party.
- They can take their own interests into account, but they must also have regard to the other party’s interests.
In particular, the judge said that dealing “fairly and openly” meant giving the other party “fair warning” of a proposed course of action. In particular, he said that, in cases where a person is contemplating taking a decision that will affect the other party, they should give the other party an opportunity to put their case before the decision is made and consider that case with an open mind.
Here, although Mr Bond had not behaved dishonestly or with an ulterior motive and had acted fully within his authority, the judge felt he had not dealt fairly and openly with Mr Unwin. He had not given Mr Unwin any advance notice that his employment might be terminated, nor had he explored whether any steps could be taken to improve Mr Unwin’s performance. Neither had he instigated any investigation into Mr Unwin’s performance, which the judge said was required to establish fair conduct.
Above all, perhaps the crux of the decision was that Mr Bond had not considered his decision “from Mr Unwin’s perspective”. His sole focus, according to the judge, had been on “what he perceived to be the real risk that a substantial portion of [the company’s] business might be lost”. That was something Mr Bond was entitled to take into account, but he needed to consider Mr Unwin’s interest as well.
What does this mean for me?
It’s not uncommon for commercial contracts of all kinds to include obligations to act “in good faith”. This might be in connection with specific obligations, such as to negotiate a renewal or resolve a dispute. Or, as in this case, the contract might contain a general obligation to act in good faith.
Although including an express obligation to act in good faith can seem constructive and collaborative, it can be awkward in negotiations when presented with a proposal to include a good faith duty to argue against it. But it is important to understand the ramifications of including such a duty.
A party who is subject to a duty to act in good faith will not be required to disregard their own interest. However, it will most likely be necessary to take the other party’s circumstances into account when reaching a decision. This may not change a contract party’s ultimate decisions or course of action, but it will necessarily hamper the person’s freedom to exercise their contractual rights as they wish.
For example, it may be necessary to follow a fair procedure before exercising a right, to give the other party advance notice and keep them informed, and to attempt to work towards a mutually beneficial solution. They will need to act constructively and will not be able to take decisions in isolation.
Questions contract parties should ask themselves include the following.
- If proposing to include a general duty to act in good faith, is there a particular purpose behind the proposed duty? Where does the balance of power lie? Am I more likely to benefit from the duty or to be constrained by it?
- Are there any discrete parts of the contract where a duty to act in good faith may be more useful or relevant? If so, would it be better to apply the duty only to those mechanisms?
- Rather than including a duty to act in good faith, does it make sense to include specific steps which the parties are required to take in particular circumstances? These might include giving the other party notice of a decision, giving reasons for a decision or following a particular process. Although this will create a degree of “red tape”, it will give the parties more certainty as to what is expected of them.
Court interprets the scope of a tax “gross-up” clause
The High Court has held that a “gross-up” clause, which entitled the buyer of a business to claim reimbursement for any tax arising on payments to it under an indemnity, extended only to tax that was actually payable and not tax that might become payable.
AXA SA v Genworth Financial International Holdings, LLC  EWHC 2024 (Comm) concerned the payment of amounts under an indemnity in a share sale agreement. The judgment follows an earlier decision, on which we reported in January 2020. More detail is set out in that update but, by way of brief background:
- AXA agreed to acquire two insurance businesses from Genworth.
- Those two businesses had historically provided payment protection insurance (PPI) and found themselves liable to meet compensation claims for mis-selling.
- Genworth agreed in the share sale agreement to indemnify AXA against 90% of the costs of compensation for a specific period of time.
- Following a dispute, the High Court determined the extent of Genworth’s liability to AXA under the indemnity. (In particular, the court noted that the indemnity was in fact a “covenant to pay”, meaning that AXA was not under a duty to take steps to mitigate its loss.)
The second hearing concerned the precise amount Genworth was required to pay AXA, including (among other things) the interpretation and effect of a “tax gross-up”.
The purpose of a gross-up clause is to ensure that, if the beneficiary of an indemnity is required to pay tax on a payment under that indemnity, the party making the payment (the “indemnifier”) will “gross it up”, so that the beneficiary receives the amount it would have received if no tax liability had arisen.
For example, a beneficiary might be entitled to a payment of £100 under an indemnity, but then finds it has to pay tax on that payment at the rate of 20% (so, £20). This would leave the beneficiary with only £80. Under the gross-up, the indemnifier will instead pay the beneficiary £125, so that, once the 20% tax (now £25) has been deducted, the beneficiary is left with the £100 it was expecting.
The purpose of the gross-up is to shift the risk of any tax on indemnity payments to the indemnifier, rather than the beneficiary. It is relatively common on share and business sales for payments by the seller to the buyer to be subject to a tax gross-up.
The share sale agreement contained such a tax “gross-up”. That gross-up was activated by (among other things) payments under the indemnity. In that scenario, it required Genworth to assume liability for any tax payable by AXA on payments under the indemnity. In particular, the gross-up applied to payments that were “subject to Taxation in the hands of the receiving party”.
The parties disputed the meaning of this language. AXA argued that the wording applied to any payment made under the share sale agreement that was “within the scope of a tax and not exempt”. In other words, provided it was possible for tax become due on the payment, the gross-up applied.
Genworth, by contrast, argued that the wording applied to a payment under the share sale agreement only if the payment actually became subject to tax, and not simply because it was taxable in principle.
These differing interpretations gave rise to two key commercial issues:
- Under AXA’s interpretation, Genworth would be required to cover any potential tax liability of AXA, even if that liability never became payable. Genworth would be required pay the grossed-up amount at the same time as it made the payment under the indemnity, and it might potentially leave AXA overcompensated. (The share sale agreement did not contain any mechanism for AXA to make any repayments back to Genworth should the tax not become due.)
- Under Genworth’s interpretation, it would be required to cover a tax liability only once the tax authority had made an assessment and determined that it was payable. This meant the gross-up payment could not be made until much later, potentially long after the indemnity payment, creating a theoretical credit risk for AXA.
What did the court say?
The court agreed with Genworth.
Central to the judge’s decision was the meaning of the words “subject to Taxation in the hands of the receiving party”. The parties referred to previous cases and to manuals produced by HM Revenue & Customs to assist the court with interpreting this phrase. However, the judge decided not to follow these authorities, noting that the gross-up clause was a “bespoke commercial clause” whose meaning depended on the context.
Instead, the court said that the words should bear their ordinary meaning as reasonable people would understand them. In this case, they referred to amounts that were actually taxed in the hands of the receiving party. This required “no extrapolation” and “no re-writing” of the language. Put simply, if the sum were not actually taxed, it would not be “in the hands of” the receiving party.
This was reinforced by the clause immediately preceding the gross-up, and whose mechanism the gross-up itself adopted. That clause required a paying party to reimburse the payee for any deductions or withholdings on account of actual tax. The judge was in no doubt that this gross-up applied only when tax actually became due. Because the gross-up adopted the same mechanism, it was natural to apply the same interpretation to it.
Finally, the court noted that Genworth’s interpretation of the gross-up was a “business-like” one that made “perfect commercial sense”. There was no reason why the parties would have intended to gift AXA a “windfall” – the purpose was merely to make AXA whole should tax become payable. To achieve AXA’s proposed result would have required “clear and distinct terms” to that effect.
What does this mean for me?
We have set out above only a condensed summary of the judge’s reasoning. In fact, he devoted numerous paragraphs of his judgment to this particular issue. It seems clear that he was not prepared to interpret the clause in a way that could leave one party overcompensated at the other’s expense.
This is a sensible result, but it nevertheless shows the importance of drafting payment provisions clearly and explicitly. The following remain useful tips.
- Make it clear when the payment obligation is triggered, such as on presentation of an invoice or demand or the occurrence of some other condition.
- Separately, make it clear when the payment is due. This might be at the same time as the trigger occurs, but equally it could be at some later point or within a pre-defined period of time.
- Carefully scrutinise any boilerplate provisions. Generic gross-up clauses are often included in the miscellaneous provisions or interpretation section of a contract. It is difficult for these clauses, which cater for a wider range of payment obligations, to incorporate specific language around payment triggers and deadlines. If there are any important payment obligations, consider including a specific gross-up for them, but ensure it interacts properly with any generic gross-up.
Scheme of arrangement meetings with members can be held electronically under CIGA
The High Court has held that the provisions of the new Corporate Governance and Insolvency Act 2020 (“CIGA”) that allow company meetings to be held electronically extend to meetings of a company’s members under a scheme of arrangement (a “scheme”).
Under paragraph 3 of Schedule 14 to CIGA, certain company meetings can be held by purely electronic means, without needing to take place in a single location and without members being able to attend in person (provided they can still vote on the matters put to the meeting).
This flexibility was introduced to allow companies to continue with business in spite of social distancing restrictions imposed during the on-going Covid-19 pandemic. It is currently applies to any meeting held between 26 March 2020 and 30 September 2020.
According to paragraph 3(2) of Schedule 14, the ability to hold meetings electronically applies to a “general meeting” of a company or a “meeting of any class of members of a qualifying body” (such as a meeting of a class of member to approve a variation to the rights attaching to their shares).
This provision seemed to be aimed solely at general meetings. Indeed, the explanatory notes to CIGA note that the purpose of this provision was to enable companies to hold “AGMs and other meetings in a manner consistent with the need to prevent the spread of Covid-19”. Normally, the words “other meetings” would be interpreted in a similar way to “AGM”, suggesting they apply to general meetings.
However, in Re Columbus Energy Resources plc  8 WLUK 20, in connection with a scheme for the takeover of an AIM company, the High Court confirmed that Parliament had intended for the new provisions in CIGA also apply to a meeting of a company’s members for the purpose of a scheme under Part 26 of the Companies Act 2006 (the “CA 2006”).
What does this mean for me?
The court’s decision in this case is clearly helpful for a company that intends to propose a scheme with its members. Schemes between a company and its members are used mainly to implement a recommended takeover, to insert a new holding company (for example, to re-domicile a group in another jurisdiction) or to demerge assets to shareholders.
Following this decision, until 30 September 2020, a company that needs to convene a meeting of its members (or a class of its members) in connection with a scheme under Part 26 can do so electronically. The same position must also apply to a scheme under the new Part 26A of the CA 2006.
However, it will still be sensible, if proposing to adopt this approach, to obtain confirmation from the court in its order to convene the scheme meeting(s) so as to put the question beyond doubt.
One curious outcome of the court’s decision is that Schedule 14 to CIGA creates an arguably arbitrary distinction between meetings of members on a scheme and meetings of creditors. Schedule 14 specifically applies to meetings of members and so does not allow a meeting of creditors (or a class of creditors) on a scheme to be held purely electronically. There seems to be no logical reason for this.
Fortunately, the High Court has held in two previous cases – Re Castle Trust Direct plc  EWHC 969 (Ch) and Re African Minerals Ltd (in administration)  EWHC 1702 (Ch) – that it can order a meeting of creditors in connection with a scheme to be held purely electronically.
However, this ability derives from the court’s inherent powers and not from statute. As a result, to hold a meeting of creditors electronically, a company will need to persuade the court that this is warranted. In particular, it will need to satisfy the “test” laid out in Castle Trust Direct and African Minerals, namely that it is appropriate for the meeting to be held electronically in light of the circumstances at the time (which will vary from cases to case). It would appear that no such test applies for a meeting of a company’s members in connection with a scheme.
As we have previously noted, the new provisions do not apply to meetings of a company’s board. A company should check its articles of association to see whether its directors are able to hold board meetings electronically.
Finally, it is worth remembering that a company will often hold an additional general meeting of its members in connection with approving a scheme. Indeed, this is standard on a takeover scheme. Until 30 September 2020, it will also be possible to hold this meeting electronically.
Request for copy of register of members upheld as “proper”
The Court of Appeal has upheld an earlier decision that a request by a member of a management company to inspect its register of members was made for a proper purpose.
Houldsworth Village Management Company Ltd v Barton  EWCA Civ 980 was an appeal from a decision of the High Court. We covered that earlier decision in a previous Corporate Law Update.
In short, an individual member of a property management company made a request under the Companies Act 2006 (the “Act”) to inspect its register of members. Under the Act, a company must comply with such a request unless the request is not being made for a “proper purpose”.
In this case, the purpose of the request was to seek a general meeting of the company’s members to consider replacing its directors and, subsequently, the managing agent for the property. The company refused the request, stating that the decision whether to replace the managing agent was a matter of company business and a decision for its directors, not its members, and so the request was improper.
However, the High Court found that the request was proper. The company’s purpose was to manage the property, and so it was legitimate for members to seek to replace the board with one that would replace the managing agent. That was a “constitutional change” that was appropriate in the context.
The company appealed. It said the High Court had mixed up the individual’s rights as a member with his rights as a tenant of the property. By seeking to replace the managing agent, the company argued that the member was moving beyond “corporate governance” and into management of the property.
What did the Court of Appeal say?
The court dismissed the appeal. It said there was indeed a proper purpose to the request.
Although there was a clear distinction between the individual’s rights as a member of the company and his rights as a tenant, those rights were not mutually exclusive. The judges said that, where a person has a number of rights that afford a remedy, they can choose which right to exercise to reach that goal.
There was no bright line between the two sets of rights. The court reiterated the High Court’s finding that the only purpose of the company was to manage the property, and so the appointment of an agent to run it was directly relevant to the governance of the company.
What does this mean for me?
This decision is not surprising. The appeal was a re-run of the argument before the High Court, and the Court of Appeal was not persuaded to take a different view. Although set in a particular context, this is a good reminder of some practical points when requesting a copy of a shareholder register.
- Does the purpose of the request benefit the company’s members? The courts do not like attempts to pursue personal matters, harass a company’s board or resurrect historic matters.
- Check the “proper purpose” guidance published by The Chartered Governance Institute (available free from the Institute after registering on its website). This sets out various cases that are likely to be “proper”, which the courts will take into account when reaching a decision.
- If the applicant is a member of the company, are they making the request in their capacity as a member? The purpose of the request must relate to a person’s rights as a member and not some other capacity (e.g. as a creditor, supplier, employee or tenant).
- If the applicant is not a member, how will granting the request affect the company’s members? In this case, the court will focus less on the right of a person to gain access to the information and more on the potential harm to the company.
Also this week…
- EU consults on roadmap for sustainability disclosures. The European Commission is consulting on a roadmap for disclosures on sustainable activities. Under the EU Taxonomy Regulation ((EU) 2020/852), from 1 January 2022, large public interest entities will be required to state in their non-financial information statement the extent to which their activities are associated with economic activities that qualify as environmentally sustainable. The roadmap is the first step towards delegated legislation setting out the content and presentation of that information. The consultation closes on 8 September 2020.
Although the Taxonomy Regulation is already law, because it does not come into effect in the UK until 1 January 2022 at the earliest, it will not form part of UK law after 31 December 2020. It remains to be seen whether the UK will decide to adopt similar legislation.