Corporate Law Update

In this week’s update: new merger scrutiny powers, new ESMA guidelines on the contents of a securities prospectus, the Supreme Court reviews the rule against reflective loss, a company could amend the terms of a scheme of arrangement after it had been approved by shareholders and a few other items.

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.

Government brings further types of merger under increased scrutiny

The Government has expanded the categories of mergers that can potentially be reviewed on public interest grounds by bringing additional types of business within lower thresholds for merger control. This will allow the Competition and Markets Authority (CMA) to intervene in a wider range of acquisitions. Where appropriate, the Government will also be able to intervene in mergers of these kinds on the basis of public interest considerations.

Under the UK’s domestic merger control regime, the CMA can intervene in transactions that satisfy one or both of two conditions:

  • The turnover of the target being acquired exceeds £70 million (the “turnover test”).
  • The merger will result in the creation of a combined share of supply or purchases of any goods or services of a particular description of 25% or more within the UK (the “share of supply test”).

In June 2018, these tests were amended where the merger involves a “relevant enterprise”, namely a business whose activities involve developing or producing goods that are subject to export controls (including dual-use technology), quantum computing, and computer hardware, firmware or software that performs critical security or low-level control functions (such as “rooting” software).

In these cases, the tests are modified as follows:

  • The threshold for the turnover test is £1 million (and not £70 million); and
  • An additional share of supply test that applies, namely whether the relevant enterprise has an existing share of supply of at least 25% of the goods or services that make it a relevant enterprise. This test can be satisfied even if the combined group’s share of supply does not increase as a result of the merger.

The Enterprise Act 2002 (Turnover Test) (Amendment) Order 2020 and the Enterprise Act 2002 (Share of Supply) (Amendment) Order 2020 (the “SST Order”) have now expanded the list of activities that make a target a “relevant enterprise” and so invoke the stricter regime.

These activities now include the development and production of and research into advanced materials (and materials used to manufacture advanced materials), cryptographic authentication and artificial intelligence. “Advanced materials” is defined extensively in regulation 3 of the SST Order (which amends section 23A of the Enterprise Act 2002).

The amendments come into effect for mergers taking place on or after 21 July 2020.

ESMA publishes new guidelines to replace CESR recommendations

Following its consultation (published on 12 July 2019), the European Securities and Markets Authority (ESMA) has published new final guidelines for how issuers can comply with the disclosure requirements in the new EU Prospectus Regulation.

The new guidelines will replace the existing recommendations issued by the former Committee of European Securities Regulators (CESR) (known informally as the “CESR recommendations"), which provided guidance on disclosures under the EU Prospectus Directive.

The new guidelines generally follow the content and order of the CESR recommendations, although there are some changes and they are now framed as formal guidelines, rather than recommendations.

They will be published on ESMA’s website in due course and will come into effect two months later. The guidelines will apply on a “comply-or-explain” basis, meaning the issuers will need either to adhere to the letter of the guidelines or give an explanation for any respects in which they depart from them.

ESMA has made several changes to the draft guidelines it issued for consultation. The key points to note, and the key changes from the CESR Recommendations, are set out below.

  • The CESR recommendations on selected financial information (20-26) have not been carried forward, as this information is no longer required under the Prospectus Regulation.
  • The new guidelines contain more detail information on how restated financial information should be presented in a prospectus. Specifically, the guidelines state that restated information should be prepared under the same accounting principles as the issuer’s next financial statements. The guidelines retain the “bridge approach” from the CESR Recommendations that applies where not all required historical financial information needs to be restated.
  • When deciding whether there will be a “significant gross change” for the purpose of the requirement to include pro forma financial information, if an issuer undertakes or commits itself to several individual transactions that do not, by themselves, meet the threshold for a “significant gross change” but do meet that threshold collectively, it will need to “aggregate” them and include pro forma financial information (unless to do so would be “disproportionately burdensome”).
  • The new guidelines set out when an issuer can include the proceeds of an offer in its working capital statement. As a general rule, issuers will be able to do this only to the extent the offer has been underwritten on a firm commitment basis or it has received irrevocable undertakings.
  • The CESR recommendations relating to specialist issuers (128-145) will not be converted into guidelines. They will remain in place and can continue to be applied on an optional basis.

Some of the other CESR recommendations will not be converted into guidelines, as they are now dealt with by legislation or ESMA’s prospectus Q&A or are not compatible with the new regime.

The guidelines do not constitute EU legislation and so will not form part of UK law once the UK-EU implementation (or transition) period ends on 31 December 2020. It will be up to the Financial Conduct Authority (FCA) to decide whether or not to introduce equivalent guidance under the UK’s prospectus regime going forward.

Supreme Court confirms the rule against reflective loss

The Supreme Court has reviewed the so-called “rule against reflective loss” in a series of judgments that perhaps raises more questions than it settles.

What happened?

Sevilleja v Marex Financial Ltd [2020] UKSC 31 concerned two companies incorporated in the British Virgin Islands (BVI) which were owned and controlled solely by an individual, Mr Sevilleja. In 2013, Marex, a trade creditor of the companies, obtained judgment against the companies for more than US$7.15 million (including costs).

Shortly after the judgment was handed down, Mr Sevilleja allegedly arranged for more than US$9.5 million to be transferred from the companies into his personal control, leaving the companies with no more than US$5,000 of disclosed assets from which to satisfy Marex’s award.

Marex brought proceedings directly against Mr Sevilleja, claiming that he had induced a violation of Marex’s rights under the court’s order and that he had intentionally caused Marex to suffer loss by unlawful means.

In response, Mr Sevilleja argued that Marex was barred from claiming against him, because the loss it was claiming was merely “reflective” of the two BVI companies’ losses. Rather than Marex, it was the two BVI companies that should be claiming against Mr Sevilleja.

What is the “rule against reflective loss”?

Put simply, the rule applies where both a company and its shareholder have a right of action against the same third party in relation to the same wrongdoing, and the shareholder is seeking to recover a drop in the value of its shares (or in distributions by it) which is a consequence of the loss sustained by the company itself.

In those circumstances, the law regards the shareholders’ loss as merely “reflective” of the company’s loss and the shareholder is barred from recovering the drop in the value of its shares. This is the case whether or not the company in fact takes any action against the third party.

The rule is often justified as a way to prevent “double recovery”. If both the shareholder and the company were able to claim, so the logic goes, the shareholder would receive both a direct payment from the wrongdoer and an additional reward in the uplift of the value of its shares. In the same way, the wrongdoer would be doubly penalised, having to pay out twice in respect of the same loss – once to the shareholder and once to the company.

The rule was originally formulated in the case of Prudential Assurance Co Ltd v Newman Industries Ltd (No 2) [1982] Ch 204. However, in subsequent years, it has been applied in numerous cases, with the potential to apply to persons who are not shareholders, such as (in this case) a creditor, or who are both shareholders and creditors. It has even been suggested in the past that the rule could extend to claims by employees.

The Court of Appeal agreed with Mr Sevilleja and barred Marex’s claim. From Marex’s perspective, this posed a problem: the two BVI companies had been placed in liquidation and were operating under the auspices of their liquidator whom, according to Marex, Mr Sevilleja had deprived of the resources needed to bring any claims against him.

Even if the companies did bring claims, Marex would need to prove in the companies’ liquidation alongside its other creditors, who were all persons associated with Mr Sevilleja.

Marex therefore appealed to the Supreme Court. This gave the Supreme Court a welcome opportunity to review the both the rationale for and the extent of the rule against reflective loss.

What did the court say?

The court agreed unanimously with Marex, finding that the rule against reflective loss did not apply where the person claiming was a creditor, and not a shareholder, of a company.

However, the court was split 4-3 in its reasoning and, in particular, in its opinion on the fundamental basis for the rule against reflective loss.

All seven of the judges agreed that the rationale for the rule given in previous cases was flawed. They said it was rarely possible to say that a loss suffered by a company would result in an equal and equivalent drop in the value of the company’s shares. That could happen only in the most simple of scenarios: where the value of the company’s shares reflects exactly the value of its assets – in other words, where they are valued on a strict “net asset value basis”.

But the judges all noted that the value of a company’s shares will often be based on other factors, such as its prospects and reputation and supply and demand for its shares. A drop in the value of a company’s shares could exceed any loss suffered by the company, such as if the very existence of a claim indicates poor management by the company’s directors, so depressing investor confidence.

However, this is where their agreement ended.

The rule is here to stay

A bare majority of the judges, led by Lord Reed, said that the rule was a hard and fast tenet of company law. It had developed out of the Prudential case as a way to prevent shareholders from by-passing one of the fundamental concepts of company law: that a company is a legal person separate from its shareholders (the so-called “rule in Foss v Harbottle”).

According to Lord Reed, by signing up to take shares in a company, a shareholder agrees that its fortunes will be tied to those of the company and entrusts the management of the company to its decision-making organs (i.e. its board of directors). If the value of the shareholder’s shares drops because of some wrong done to the company, the shareholder must suffer that loss.

In those circumstances, the shareholder does not incur a loss that is regarded by the law as “separate and distinct from the company’s loss”, and so the shareholder has no claim. This means that, even if the drop in share value exceeds the company’s loss, the shareholder cannot recover it.

The rule shouldn’t exist

Lord Sales, leading the minority judgment, took a different approach. In his view, the rule (if it exists) is not a novelty of company law; rather, it is a way of guarding against double recovery.

The courts can achieve this in various ways, including by taking payments to the company into account when calculating a shareholder’s loss, preventing a shareholder from claiming until the company has had a chance to do so, or joining a shareholder and company into the same legal proceedings.

On this basis, a shareholder would be entitled to claim against a third party, even if the company also has a claim. It would be up to the courts to decide how to award damages. The likely end result is that the shareholder could recover a drop in the value of its shares, less any increase in the value of those shares as a result of the company receiving any payment. That increase might not be the same as the amount of the payment to the company.

To deny a shareholder any claim at all, according to Lord Sales, would be to deprive the shareholder of a personal right of claim without sufficient justification.

Effectively, although Lord Sales didn’t say as much, this would amount to abolishing the rule against reflective loss entirely and relying purely on principles preventing double recovery.

What does this mean for me?

Cases such as this, with differing judgments, can make it difficult to understand the state of the law going forward. However, for the time being, the majority judgment delivered by Lord Reed is binding.

This means that, not only does the rule against reflective loss persist, but it is even stronger than before. In effect, there are virtually no exceptions to the rule.

Indeed, the Supreme Court specifically overturned previous cases, such as Giles v Rhind [2003] Ch 618 and Perry v Day [2005] 2 BCLC, in which courts had said that a shareholder could claim where the wrongdoer had, by their actions, deprived the company of the ability to bring its own claim. From now on, a shareholder will not be able to recoup a drop in the value of its shares, whether or not the company can bring a claim itself.

Creditors, however, can breathe more easily. It is now clear that a creditor can claim against a third party, even if the debtor company also has a claim against that third party, provided the claim is brought by the creditor in that capacity and relates to the debt owed by the company. However, if the creditor is also a shareholder, there will need to be an exercise of working out whether loss is caused by a drop in share value or arises merely out of a failure to pay the unpaid debt.

The judgment gives rise to the following practical points, all of which a shareholder who is considering bringing a claim should discuss with its legal advisers:

  • Is the shareholder seeking to recover a drop in the value of its shares? If so, it will be important to examine whether the loss is merely “reflective”.
  • Does the shareholder’s loss arise in consequence of a loss to the company? If so, it is likely to be unrecoverable, even if it exceeds the loss suffered by the company. However, in some cases, the shareholder’s loss may be totally distinct from any loss suffered by the company (and so recoverable), even if the loss is caused by the same person.
  • If the loss is merely “reflective”, are there any other options open to the shareholder? Does it have any power to require the company’s directors to take action against a third party? If they refuse to do so or they settle for too low an amount, can the shareholder bring a derivative claim on behalf of the company against its directors for breach of their duty to the company, or even a personal claim for unfair prejudice?
  • If none of that helps, does the shareholder have any alternative rights of claim against the third party that would not be barred as reflective loss? For example, does the shareholder have the benefit of a separate indemnity or covenant to pay, which could be enforceable as a debt?

Court allows changes to scheme of arrangement after shareholder vote

The High Court has approved changes to the terms of a scheme of arrangement after the scheme had been approved by the company’s shareholders.

What happened?

In the matter of Aon plc [2020] EWHC 1003 (Ch) concerns well-known insurer Aon plc, a UK company listed on the New York Stock Exchange (NYSE), which proposed a scheme of arrangement with its shareholders in order to insert a new Irish holding company (“Aon Ireland”), which would be listed on the NYSE in place of Aon plc.

Under the terms of the scheme that were put forward to its shareholders, each of Aon’s shareholder’s would surrender their shares in Aon plc and instead receive new shares in Aon Ireland. The shares would be issued with a nominal value of US$150 each, which would subsequently be reduced to US$0.01 each through a reduction of capital under Irish law.

Importantly, the scheme terms stated that they could be amended if both Aon plc and Aon Ireland agreed and the English courts sanctioned the amendment. However, the scheme terms did not set out any conditions or test for the court to follow when deciding whether to sanction the amendment.

Aon’s shareholders comfortably approved the scheme on 4 February 2020, with 85.71% by number and 99.8% by value of those attending voting in favour of the scheme.

However, following the shareholder vote, Aon wished to make two modifications to the scheme terms. Of these, the more material amendment would be to change the nominal value of the shares that would be issued under the scheme by Aon Ireland from US$150 each to US$0.01 each.

This change was driven by technical concerns caused by uncertainties arising out of the on-going Covid-19 pandemic, including that the Irish courts might not be able to sanction the proposed reduction of capital in the timeframe envisaged.

What did the court say?

The court (on a recommendation from the company’s counsel) adopted the following test when deciding whether to sanction the amendments: would the change have caused a reasonable shareholder to take a different view in relation to the scheme if it had been put before them?

The judge also referred to a well-known earlier case – In the matter of Equitable Life Assurance Society [2002] BCC 319 – in which the court considered an amendment provision in the context of a scheme with a company’s creditors and concluded that it would not be possible to use that kind of a clause to “foist on a class of creditors something substantially different” from what they had approved.

In the judge’s view, there had been a material change of circumstances (namely, the Covid-19 pandemic) and the changes were designed to address. The company had not been intending to “foist” the changes on its shareholders.

What does this mean for me?

It is common for the terms of a scheme of arrangement to include a provision allowing the company to make amendments. Until now, the court has not had to consider an amendment under this kind of provision in the context of a scheme between a company and its shareholders.

In this case, the court was no doubt assisted by the fact that the proposed change was designed to achieve the same ultimate outcome of the reorganisation, namely to provide the shareholders with shares in the new holding company with a nominal value of US$0.01 each. And it is worth noting that the on-going Covid-19 pandemic amounted to a convincing change of circumstances.

The situation may well have been different, however, if Aon had sought more radical changes to its scheme, or changes that were not precipitated by the pandemic. A company looking to amend a scheme after it has been approved will need to establish a clear reason for making the change and explain clearly what the change is intended to achieve.

Finally, it perhaps goes without saying that a company will not be able to amend a scheme that has been approved unless the scheme terms specifically allow it to do so. A company that proposes a scheme should therefore ensure that the scheme terms include a power to make amendments with the sanction of the court.

Also this week…

  • FCA consults on permission to approve financial promotions. The Financial Conduct Authority is seeking views on whether an FCA-authorised firm should need to pass a suitability assessment before it can approve financial promotions by unauthorised firms under the UK’s financial promotions regime. Currently, any authorised firm can approve a financial promotion without needing any particular permission to do so. The FCA is concerned that this is not a strong enough safeguard for investors. The consultation closes on 25 October 2020.
  • FCA consults on bringing cryptoassets within financial promotions regime. Separately, the Financial Conduct Authority is consulting on bringing certain types of cryptoasset within the UK’s financial promotions regime. Under the proposal, any promotion of a “qualifying cryptoasset” would need to be approved. “Qualifying cryptoasset” would be defined as a “cryptographically secured digital representation of value or contractual rights that uses a form of distributed ledger technology” that is both “fungible” and “transferable” (other than e-money and security tokens, which already fall within the regime). This would include cryptocurrencies, such as Bitcoin. The consultation closes on 25 October 2020.
  • BVCA publishes report on investment activity in 2019. The British Private Equity and Venture Capital Association has published a report on investment activity in 2019. According to the report, UK PE and VC investment reached £22.33 billion in 2019 (an increase of £1.6 billion on the previous year); VC investment increased by 67% year-on-year to £1.65; and tech sector saw the largest amount of in 2019, accounting for 26.8% of total investment.
  • FRC publishes first review of company reporting since Covid. The Financial Reporting Council has published its first thematic review of company reporting since the onset of the on-going Covid-19 pandemic. We will be covering this in more detail in our update next week.
  • HMRC consults on stamp duty. HM Revenue & Customs has launched a call for evidence on the existing frameworks for stamp duty and stamp duty reserve tax (SDRT). Stamp duty or SDRT is normally payable on the transfer of marketable securities, such as company shares. (The consultation does not apply to stamp duty land tax (SDLT), which is commonly referred to a “stamp duty”.) We will be covering this in more detail in our update next week.