Corporate Law Update

• The Government is consulting on reforms to curb the use of non-compete covenants
• A director was not duty-bound to restrict another director’s access to a company’s bank accounts
• The FRC publishes consolidated Covid-19 reporting advice for companies
• The FCA publishes a summary of changes following the end of the UK/EU transition period
• The QCA and UHY Hacker Young publish their AIM Good Governance Review for 2020/21
• The Law Society and the City of London Law Society publish written evidence on the National Security and Investment Bill
• The Government extends the moratorium on winding-up petitions
• The FRC publishes consolidated Covid-19 reporting advice for auditors
• The ICGN publishes its policy priorities for the 2020/21 season

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 consults on non-compete clauses

The UK Government has published a consultation on reforming the law on non-compete clauses in employment contracts.

Background

A non-compete clause is a promise by someone, usually an individual, to another person that they will not carry on a business that competes with that other person’s business. Non-compete clauses are common in a variety of circumstances, including:

• in employment contracts, where someone leaves for a new employer or to set up a new business;
• in shareholders’ agreements, where a founder exits the business; and
• on business and share sales, where a seller is exiting a market.

In all cases, under English law, a non-compete is enforceable only if it is reasonable. Specifically, it must protect a legitimate business interest and be no wider than reasonably necessary to protect that interest.

A non-compete might be unreasonable if, for example, it applies for too long, across too wide a geographical area or to too broad a range of business lines, or if it prohibits holding any shares at all in a competing business. The same principle applies to other kinds of “restrictive covenant”, such as a promise not to solicit another business’s employees or customers (so-called “non-solicitation clauses”).

Generally, the courts will take a more relaxed approach to enforcing a non-compete covenant where the person under the restriction is gaining some significant benefit in return, such as realising a profit when selling a business or taking on a well-remunerated management role.

But they take a much harder line on non-compete clauses in employment contracts, particularly if the employee in question is junior, has no executive responsibility or occupies a non-specialist position.

What is the Government proposing?

The Government has said it is “exploring avenues to unleash innovation, create the conditions for new jobs and increase competition”. It believes that imposing some constraints on the use of non-compete clauses in employment contracts would give employees the freedom and flexibility to use their skills to drive economic recovery and ensure individuals receive a fair settlement if they are restricted from joining or starting a business within their field of expertise.

It is proposing two possible options for reform.

• Mandatory compensation. Under this option, a non-compete would be enforceable only if the employer compensates the employee in some way throughout the life of the non-compete. Some employers already do this or alternatively implement “garden leave” clauses.
  
  This proposal would effectively make paying an employee during a non-compete period mandatory. The consultation suggests this would create a financial disincentive to impose non-competes and would reduce the “psychological effect” of non-competes on employees. It notes that several jurisdictions, including Germany, France and Italy, already mandate compensation in return for a non-compete.
  
  The consultation moots additional measures to go alongside mandatory compensation. These include creating a requirement for an employer to disclose the terms of the non-compete to the employee before they become an employee and imposing a maximum limit on the duration of non-competes.

• Outright ban (Option 2). Simpler in concept, the second option is simply to prohibit non-compete restrictions in employment contracts entirely. The paper suggests there could be exceptions, but notes that the benefits of an outright ban include clarity for employer and employee and increased labour mobility. It notes that California has already imposed a legal prohibition on non-competes and that the strict approach taken by the courts in Israel amounts to a virtual ban in practice.

The consultation then goes on to ask a series of more specific questions, including whether any limits should also be applied to other kinds of restrictive covenant, such as non-solicitation, non-dealing and protection of goodwill clauses.

The Government has asked for comments by 26 February 2021.

What does this mean for me?

The impact of the proposals on both employers and employees is clear.

As it stands, the consultation would not affect non-compete covenants given on (for example) the sale of a business. However, it may well have an indirect impact where a new owner or investor is looking to bring mid-level management into a business as part of its investment strategy.

In addition, in many cases, the line between an “employment” non-compete and a “commercial” non-compete is blurred. Assuming the Government decides to implement any changes properly, it is unlikely that an employer could circumvent the restrictions merely by moving a non-compete out of an employment contract and into (for example) a shareholders’ agreement.

There is also a question of whether this consultation is the “thin end of the wedge”. Imposing restrictions on non-compete covenants in employment contracts may well increase appetite for imposing similar (if more lenient) restrictions on non-competes in other circumstances.

We will continue to follow and report on the Government’s proposals in this area.

Director was not required to restrict fellow director’s access to company bank accounts

The High Court has held that, when the relationship between the two directors of a company broke down, one director had not been under a duty to put arrangements in place to stop the other director from making payments out of the company’s bank account.

What happened?

Atkinson and Mummery v Kingsley and Smith [2020] EWHC 2913 (Ch) concerned a property development and letting company owned by two individuals. Those individuals were also the company’s only two directors.

In Spring 2010, the relationship between the two directors began to break down and, in Summer 2010, a reduction in rental income meant the company faced a future loss-making position. In December 2010, the directors agreed to wind the company’s activities down and distribute any profits to themselves as shareholders by way of dividend.

In January 2011, the company received the proceeds of the sale of a development. A week later, one of the directors (K) instructed a payment from the company’s bank account by way of banker’s draft to a third party without the knowledge of the second director (S). This caused the relationship between the two directors to deteriorate further. S froze the company’s bank account until the bank mandate was changed to require two signatures for any transfers.

The company was placed into administration in September 2011. That administration converted to a liquidation in August 2012.

The liquidators brought claims against the two directors to (among other things) recover the payment. They claimed that the payment had been made for no consideration to the company and that (among other things) the directors had been in breach of their duties to the company, requiring them to reimburse the company.

It became clear that K had instructed the payment without S’s knowledge. When K himself went bankrupt, the liquidators discontinued their claim against him and focussed their claim on S.

They argued that the relationship between K and S had broken down so severely that S should have put arrangements in place to prevent K from dealing with the company’s assets without her authorisation, including drawing a banker’s draft on the company’s funds. In failing to do so, they argued, S breached her statutory duties under the Companies Act 2006 to:

• promote the success of the company (section 172); and
• exercise reasonable care, skill and diligence (section 174).

What did the court say?

The court disagreed with the liquidators.

The judge noted that, when deciding whether S had breached her duty under section 172, it first had to apply a “subjective test”: had S honestly believed that not restricting K’s unilateral access to the company’s bank account was in the interests of the company?

However, S had not actually considered the question at all. The court therefore had to apply an “objective test” instead: would an honest and intelligent person in S’s position have left K in a position of trust with unfettered access to the company's accounts?

The judge said that the question was whether an intelligent and honest director of the company could, in the circumstances, reasonably have anticipated that steps would need to be implemented before K made the payment to prevent K from having unrestricted access to the company's accounts.

In her view, the liquidators were relying too heavily on hindsight to make their case. There was no evidence that the disagreement between the directors regarding the company’s management dented their mutual trust enough to warrant restricting access to the company's bank accounts. K had never previously abused his right as a director to access the company's bank accounts.

Even if S had breached her duties, the judge felt that S ought to be excused. S had not acted other than honestly in relation to the payment and had not benefitted from it in any way. Once she discovered the payment, she took steps immediately to prevent it from happening again.

What does this mean for me?

Decisions concerning breaches of directors’ duties are always very fact-specific and so it is often difficult to draw too many conclusions from them.

There are, however, two useful points to take away from this judgment.

First, the decision is a reminder of the dual subjective-objective test a court will apply when deciding whether a director has breached their duty under section 172 to promote the success of a company.

A court will start by asking whether the director honestly believed they were acting in the best interests of the company and its shareholders. This will be judged based on the available evidence, but, if the facts show that the director was acting honestly (however objectively reasonable their actions were), the court will be reluctant to second-guess them and the matter is unlikely to go further.

But this does not mean a director can simply switch their mind off to important matters. If the director did not in fact consider whether their actions will benefit the company, the court will apply an objective standard. For this reason, directors should always conduct themselves to high standards of prudence and propriety.

The second is that directors should always be alert to potential risk of misfeasance by their fellow board members. In this case, the facts showed that the director in question had no reason to suspect her co-director would behave improperly, and her case would in any event have been helped by the fact that she took prompt action to prevent any further unauthorised payments being made.

However, once any impropriety is discovered, directors should take swift action to prevent damage to the company. It can often be difficult to gauge what measures to take without over-stepping the mark and infringing another director’s rights to take part in the management of the company. In these circumstances, it is sensible to take legal advice.

FRC publishes consolidated Covid-19 reporting advice for companies

The Financial Reporting Council (FRC) has published consolidated Covid-19 reporting guidance for companies. The guidance brings together and supersedes the FRC’s previous guidance.

The key points appearing in the guidance are as follows.

• Financial statements. The FRC encourages listed companies and AIM companies to make use of the extensions for publishing their financial statements granted by the Financial Conduct Authority and the London Stock Exchange.
• Corporate governance. Companies should develop and implement mitigating actions and processes to ensure that they can continue to operate an effective control environment, noting that historic controls may not prove effective in the current circumstances.
• Information flow. The flow of financial information from significant subsidiary, joint venture and associated entities may have become disrupted. Companies should consider how to secure reliable information on a continuing basis and how to complement any missing information.
• Risk management. Relocation of staff and inaccessibility of business locations may render existing risk management processes unworkable. Boards should monitor any changes carefully and introduce alternative controls where necessary and practicable.
• Liquidity and viability. Although boards cannot predict the extent of the pandemic and its consequences, investors expect companies to explain their expectation of the possible impacts on their specific business in different scenarios so that they can understand the company’s resilience and the key assumptions and judgements the board made when assessing this.
• Capital maintenance. Companies should pay attention to capital maintenance, ensuring that sufficient reserves are available not just when a dividend is proposed but also when it is paid, and that sufficient resources remain to continue to meet the company’s needs.

The guidance also contains specific advice on accounting matters, including going concern and material uncertainties, significant judgements and estimation uncertainty, events after the reporting date, exceptional items, alternative performance measures (APMs), leases and interim reports.

FCA summarises capital markets arrangements following end of transition period

The Financial Conduct Authority (FCA) has published Primary Market Bulletin 32, which summarises the changes and arrangements for the UK’s market abuse and prospectus regimes towards and following the end of the UK/EU transition period at 11:00 p.m. (UK time) on 31 December 2020.

The Bulletin notes the following:

• The EU Market Abuse Regulation (EU MAR) will be absorbed into UK law as the UK Market Abuse Regulation (UK MAR). UK MAR will continue to apply to the full range of financial instruments to which EU MAR applied, including those admitted to an EU regulated market.
• Where an issuer is subject to both UK MAR and EU MAR, certain notifications will need to be made both to the FCA and to the appropriate authority in the EU. These include where an issuer delays the disclosure of inside information, where a manager or closely associated person deals in an issuer’s securities, and where an issuer carries out a buy-back or stabilisation programme.
• Prospectuses approved in an EU Member State and passported into the UK before the end of the transition period will remain valid in the UK until their expiry. However, after the transition period ends, it will not be possible to passport an EU-approved prospectus into the UK, and UK-approved prospectuses will automatically cease to be valid in the EU. Given the fact that the transition period ends during a holiday season, the FCA is encouraging issuers to submit any passporting requests well in advance of 31 December.
• Issuers should continue to have regard to any non-legislative materials published by ESMA (such as Q&A on the Prospectus Regulation) before the end of the transition period. Where ESMA publishes any Q&A after the transition period ends, the FCA will set out its expectations on the subject matter and consult on them where appropriate.
• As the FCA noted in Primary Market Bulletin 31, the new ESMA guidelines on disclosure requirements under the Prospectus Regulation will not come into effect before the end of the transition period. Issuers should therefore continue to apply the CESR Recommendations for prospectuses approved in the UK.
• The European Commission has proposed legislation to set out the minimum content requirements for an exemption document, which takes the place of a prospectus on a takeover, merger or division. However, that legislation may not be in force by the end of the transition period and so may not apply in the UK. If it does not, the FCA notes that it has power under EU exit legislation to specify minimum standards for exemption documents.

QCA publishes AIM Good Governance Review

The Quoted Companies Alliance (QCA) and UHY Hacker Young have published a joint review of AIM company corporate governance during the 2020/21 season.

The report is based on a review of 50 annual reports and corporate websites and interviews with four investors in small and mid-sized publicly traded companies. The review highlights three key themes for small and mid-sized companies over 2020/21: Covid-19, executive remuneration, and environmental, social and governance (ESG) issues.

Key points arising out of the review include the following:

• Covid-19. Feedback about companies’ responses to the on-going Covid-19 pandemic was positive. Investors noted better communication, including increased use of video-calling, but also supported a return to face-to-face meetings when appropriate to do so. Importantly, investors want to see information in forthcoming annual reports about the big decisions companies made in relation to Covid-19 and how those decisions were considered and documented.
• Executive remuneration. The report notes that, under the current economic circumstances, fund managers want to know whether a company’s senior team actually “shared the pain”. Investors also want to know that, where a company obtained government support, this went into shoring up its balance sheet and not into executive rewards. In the future, an emerging challenge will be how to reward key people when a company is not reaching targets for reasons beyond its control.
• Corporate governance. Investors want to know how companies plan to operate in the future as the pandemic continues into 2021. The report cites the difficulty for junior colleagues not being able to learn from watching and interacting with more experienced people in the workplace.
• Disclosure against the QCA Code. Disclosure against the QCA’s Corporate Governance Code was generally high. However, there were low levels of disclosure when explaining the time commitment required from directors, how directors kept their skillsets up to date, and companies’ proposed response to a significant proportion of votes cast against a resolution. A full breakdown of compliance with each Code Principle is set out in the report.

Also this week…

• Law Societies publish written evidence on national security bill. The Company Law Committees of the City of London Law Society and the Law Society of England and Wales have jointly published written evidence to the House of Commons Public Bill Committee on the proposed National Security and Investment Bill. The evidence follows the publication by the Law Society last week of a briefing on the Bill. The written evidence raises concerns in several areas, including in relation to the scope of the regime, the definition of “national security”, the Government’s proposed new call-in power, the scope of mandatory notifications, the absence of minimum notification thresholds and safe harbours, and the extra-territorial reach of the regime.
• Moratorium on winding-up petitions extended. New regulations have been published which extend the temporary restriction on using statutory demands and winding up petitions. The Corporate Insolvency and Governance Act 2020 (Coronavirus) (Extension of the Relevant Period) (No. 2) Regulations 2020 extend the moratorium until 31 March 2021.
• FRC publishes consolidated Covid-19 guidance for auditors. The Financial Reporting Council (FRC) has published consolidated guidance for auditors during the Covid-19 pandemic. The guidance brings together and supersedes the FRC’s previous Covid-19 guidance, as well as introducing some new guidance on planned audit approach and compliance with laws and regulations.
• ICGN publishes policy priorities for 2020/21. The International Corporate Governance Network (ICGN) has published its policy priorities for the forthcoming reporting year. The policies, which inform the work of the ICGN through the year, complement its Global Governance Principles, on which it launched a consultation last week (see our previous Corporate Law Update).