Corporate Law Update

• The Financial Reporting Council reports on compliance with the UK Corporate Governance Code in 2018/2019
• The court finds that an obligation in a share sale agreement to compensate the buyer for historic claims was a covenant to pay, not an indemnity
• Companies House publishes guidance on reporting discrepancies in entities’ PSC information

FRC reports on compliance with Corporate Governance Code

The Financial Reporting Council (FRC) has published its annual report on compliance with the UK Corporate Governance Code for the 2018/2019 reporting season.

The report covers the last season of reporting against the 2016 version of the Code, as well as early adoption of the 2018 Code (which applies to financial years beginning on or after 1 January 2019).

It reminds issuers that the aim of the Code is not “full strict compliance”, and that detailed explanations for any departures from the Code offer greater insight into how issuers operate.

In relation to compliance with the 2016 Code, the report makes the following key points (which, going forward, will be relevant to the equivalent provisions of the 2018 Code):

• The most frequently disapplied provisions were B.1.2 (at least half of the board, excluding the chair, to be independent), A.3.1 (chair to be independent on appointment), D.2.1 (remuneration committee to comprise at least three independent NEDs) and A.2.1 (separate chair and CEO). This is not surprising. These four provisions are consistently the most frequently departed from.
• 66% of companies with a combined chair and CEO said this was a temporary arrangement, usually because one of the roles had been vacated early. The FRC praised one company for dealing with this by revising its delegation framework so as to de-concentrate decision-making.
• Explanations for the chair not being independent on appointment were poor. However, the FRC praises some companies for strengthening the role of the deputy chair or senior independent director or consulting shareholders in advance.
• 17 companies disclosed that less than 50% of their board was independent. The FRC notes that explanations were “average or poor” and that, where non-compliance resulted from the loss of a director, companies may need to improve their succession planning.
• When reporting on significant votes against resolutions, the FRC expects companies to consider abstentions as indicating a lack of support and to report accordingly.
• Most companies continued to consider longer-term viability over a three-year period. Not all companies explained adequately how their business risks had changed or been mitigated over the year. The FRC says that, since its introduction in 2014, the viability statement has not achieved its aims and is encouraging companies to pay more attention to FRC guidance when compiling statements. (It is worth remembering that one recommendation of the recent Brydon review report was to replace the viability and going concern statements with a single, three-tiered statement).

On early adoption of the 2018 Code, the report notes the following (which issuers should bear in mind when reporting in 2020):

• There was a tendency to mix up a company’s “mission and vision” with its “purpose”. Too many reports simply used a slogan or marketing line for their company’s purpose, or restricted it to achieving shareholder return. The FRC says this suggests companies are not adequately considering their culture, strategy or stakeholders and is not acceptable for the 2018 Code.
• The FRC praises companies for committing themselves to working on their culture in 2019. But it is disappointed that few boards received reports on culture or included it as an agenda item.
• Some companies stated which method they intend to use to engage with their workforce, but the FRC suggests that boards may have given insufficient thought to whether their chosen method is the most effective or appropriate. A key point for issuers going forward will be to explain information flow (in both directions) between the board and the workforce. (For more detail on how companies intend to engage with their workforce, see our previous Corporate Law Update.)
• There was “limited discussion” of stakeholder concerns and the extent to which boards considered them. The FRC will expect more detailed disclosure on this point in future.
• Generally, companies need to include more detail on succession planning. Reports focussed more on the appointment process, rather than planning for future appointments.
• There was positive reporting on diversity, but it was not always clear whether companies had set targets at senior management level. There was also limited reporting on diversity beyond gender. The FRC expects improved reporting in these areas next year.
• All companies used financial KPIs to measure director incentive awards. Some companies also used non-financial metrics (such as diversity and EHS targets), which the FRC has endorsed.
• Generally, there was good reporting on how the remuneration committee exercised discretion to override formulaic pay outcomes. Examples disclosed included granting good leaver status, modifying performance measures, reducing salary and applying malus or clawback to bonuses.
• Finally, the FRC expects more detailed reporting in 2018 on how companies intend to align executive director pension contributions with those of the workforce generally.

The FRC has also confirmed that it will be reviewing its Guidance on Risk Management, Internal Controls and Related Financial and Business Reporting, which was last updated in September 2014.

Payment clause in share sale agreement was a covenant to pay, not an indemnity

The High Court has held that a clause in a share sale agreement designed to protect the buyer against historic claims was a covenant to pay, not an indemnity.

What happened?

AXA SA v Genworth Financial International Holdings Inc. [2019] EWHC 3376 (Comm) relates to the acquisition of two insurance businesses. In September 2015, global insurer AXA agreed to acquire (indirectly) the shares in two companies – referred to in the judgment as FICL/FACL – from Genworth.

FICL/FACL had historically provided payment protection insurance (PPI) in relation to store credit cards provided to consumers. When it came to light that there had been wide misselling of PPI products across the industry, FICL/FACL started receiving claims for compensation.

For several years, these claims were reimbursed by the intermediary that had marketed the PPI. But in July 2014 the intermediary halted reimbursement for misselling that had occurred before January 2005, on the basis that marketing PPI products became a regulated activity only from that date.

This left FICL/FACL to fund the compensation for a substantial number of new claims. However, Genworth was expecting the intermediary to enter into a new arrangement that would enable reimbursement to recommence. Genworth informed AXA about this as part of the sale process.

As a result, the parties included a clause in the share sale agreement stating that Genworth would reimburse AXA for 90% of any compensation paid by FICL/FACL after they came under AXA’s control, but that this obligation would expire when the intermediary entered into the new arrangement.

The parties therefore envisaged that the clause would be short-lived, but (in theory) it could last indefinitely if no new arrangement were concluded. In fact, that is what happened. The intermediary never entered into a new arrangement, and the clause did not expire.

What was the dispute?

In October 2017, AXA formally requested payment under the clause from Genworth for a substantial sum. Genworth refused to pay. It said the clause amounted to an indemnity, with two consequences:

• Before claiming payment, FICL/FACL were required to assert all reasonable defences available to them against any PPI claims. This, Genworth said, was because an indemnity is a promise to protect against a loss, and AXA was under a duty to mitigate that loss.
• If Genworth paid out under the payment obligation, it would then be “subrogated” to FICL/FACL, allowing it to counterclaim against the intermediary. (Genworth maintained that the intermediary was still obliged to reimburse FICL/FACL for historic misselling).

In response, AXA said the clause was not an indemnity, but rather a “covenant to pay” (essentially, a debt), meaning that these two consequences did not arise.

What did the court say?

The court agreed with AXA.

The judge was not prepared to attempt to “classify” the clause as either an “indemnity” or some other pre-determined type of obligation, then identify the consequences flowing from that. Instead, he examined the meaning of the clause to decide what its effect was. It was perfectly possible for the clause to be a “bespoke” provision, and not a “classic” example of any familiar contractual provision.

The clause was complex and layered with defined terms, which the judge had to consider. However, he noted that wording of the clause was that Genworth “hereby covenant[s] … that [it] will pay [AXA] … on demand” an amount equal to any losses and costs arising out of PPI misselling. In particular, he emphasised that the clause used the terms pay and on demand, rather than indemnify.

This, he said, indicated that the clause was an “absolute” obligation to pay. It was not merely a promise to protect AXA against any losses suffered. There was no requirement in the share sale agreement for AXA to mitigate any loss or assert any defences.

The clause was therefore more in the nature of a debt than an indemnity. As a result, AXA was under no obligation to assert any defences to PPI claims to claim reimbursement from Genworth, and Genworth was not “subrogated” to FACL/FICL (and so not entitled to claim against the intermediary).

AXA was therefore entitled to recover the full amount claimed.

What does this mean for me?

Where a buyer of a business discovers material historic issues during due diligence, it is typical for it to seek an “indemnity”. This is because, once known, the buyer will not generally be able to sue for breach of the specific warranties in the sale agreement.

This case shows how important it is to ensure that protection is constructed properly. Often a buyer will simply assume that an indemnity will, as with a debt claim, provide “pound for pound” recovery (i.e. that it will not be under a duty to mitigate its loss and will be able to recover all loss, however remote).

But this is not correct. Although the courts will try to understand what exactly the parties to a contract meant by their words, judges have historically (and consistently) said that an “indemnity” is simply a promise to protect another person against loss. It is not a promise to pay a fixed (or, in legal terms, “liquidated”) sum of money. In this sense, the indemnity effectively gives rise to nothing more than a simple claim for damages and may well not result in pound for pound recovery.

When drafting this kind of protection, a buyer should therefore consider the following:

• Phrase the clause as a covenant to pay a sum of money, and not an indemnity against loss. This should increase the chance it will be interpreted as a debt, rather than a damages claim.
• Link the covenant to the underlying matter or event, rather than to a breach of the agreement (for example, a breach of warranty). Again, this will reduce the possibility that the court will regard the covenant as merely providing compensation for contractual damages.
• Consider including a mechanism for calculating the amount payable. This could refer to the amount stated in (for example) invoices, tax assessments or regulatory penalties.
• Make the amount payable on demand. This will help to establish that the payment obligation arises independently of any damage the buyer suffers, again suggesting it is a debt.

Conversely, a seller should consider whether to include any constraints on the protection, including any steps the buyer has to take before claiming reimbursement. In particular, as this case vividly shows, a seller should consider imposing a deadline on any covenant to ensure it is not liable to make payments without limit in time.

Companies House publishes guidance on reporting PSC errors

Last week we reported that new laws had come into effect requiring certain regulated persons to inform Companies House of any discrepancies they discover between a potential client’s PSC register and the information they gather through their client due diligence procedure. The new obligation applies to people and organisations that are required to conduct anti-money laundering checks, including financial and credit institutions and professional services firms – so-called “relevant persons”.

Companies House has now published its own guidance on this new reporting duty. The guidance makes the following key points:

• Although client due diligence will focus on a potential client’s beneficial owners, the new reporting obligation applies only to discrepancies in the details of the client’s persons with significant control. In some cases, these will be different people.
• Relevant persons should only report material discrepancies. The focus is on factual errors, not on mere typing mistakes. The guidance gives examples of the kind of information to be reported.
• Reports are required for discrepancies discovered after 10 January 2020.
• Relevant persons should report a discrepancy as soon as possible. They should not carry out periodic bulk reporting.
• Reports should be made using the dedicated online form. The guidance sets out what information the report should contain.
• A discrepancy report is not a substitute for a suspicious activity report (SAR).