Corporate Law Update

In this week’s update: Draft regulations implementing parts of the UK’s national security screening regime are laid before parliament, a 400% increase in interest for non-repayment of a loan was an unenforceable penalty, an FRC review of streamlined energy and carbon reporting, an FRC Lab report on risk, uncertainty and opportunity reporting, new signatories to the FRC’s Stewardship Code, minor changes to the Listing and Prospectus Regulation Rules and an updated version of the ICGN’s Global Governance Principles.

Draft regulations implementing aspects of the UK’s national security screening regime are laid before Parliament
A 400% increase in interest for non-repayment of a loan was an unenforceable penalty
The FRC publishes a review of streamlined energy and carbon reporting (SECR)
The FRC’s Lab publishes a report on reporting on risks, uncertainties and opportunities
The FRC publishes a list of successful signatories to its Stewardship Code
The FCA proposes minor changes to the Listing and Prospectus Regulation Rules
The ICGN publishes an updated version of its Global Governance Principles

National security regulations laid before Parliament

Draft legislation has been laid before Parliament to bring parts of the UK’s new national security screening regime formally into effect.

The first set of draft regulations sets out the 17 “sensitive sectors” in which notification of an acquisition will be mandatory under the new regime. These draft regulations are in more or less the same form as the draft previously published by the Government in July 2021. For more information, see our previous Corporate Law Update.

The second set of draft regulations sets out how to calculate the turnover of a business when deciding the maximum penalty that can be imposed for completing a notifiable acquisition without approval or for breaching an order made under the regime.

The methodology is broadly similar to that which currently applies under the UK’s domestic merger control regime. However, notably, if there is a dispute between the Government and the business in question over the level of turnover, the relevant figure is decided by the Government.

Both sets of regulations will now be considered by Parliament.

400% increase in interest rate was a penalty and unenforceable

The High Court has held that a 400% increase in the interest rate in a loan agreement when the borrower was in default amounted to a contractual penalty and so was unenforceable.

What happened?

Ahuja Investments Ltd v Victorygame Ltd [2021] EWHC 2382 (Ch) concerned the sale of a shopping centre in south-east England.

At the time of completion of the sale, the buyer did not have all the funds it needed to pay the purchase price. The seller therefore agreed to loan the buyer a large of sum of money (effectively, deferring part of the purchase price). The loan terms were set out in a separate loan agreement.

Interest was payable on the loan at the rate of 3% in four instalments. However, if any amount remained unpaid at the end of the term of the loan, interest would be payable monthly at an increased rate of 12%. This represented a 400% increase in interest on a payment default. Moreover, that interest was rolled up if not paid and compounded on a monthly basis.

The buyer argued that the default rate of interest amounted to a contractual penalty and was therefore unenforceable. The seller argued that the requirement to pay default interest was a “primary obligation” and so not capable of amounting to a penalty.

A contractual penalty is a term in a contract which becomes activated, and which attempts to impose some kind of contractual remedy, in response to a breach of some other term of the contract.

For example, a contractual penalty might take the form of a so-called “liquidated damages” clause, which obliges one party to pay the other party a specified sum of money if it fails to honour some obligation in the contract. However, the remedy does not have to be the payment of money. It could involve the removal of a contractual right (for example, the termination of an option) or the transfer of some other property (for example, a forced transfer of shares or other securities).

The default position is that contractual penalties cannot be enforced in the English courts because they contravene public policy and attempt to oust the court’s ability to impose an appropriate remedy. However, it is a core principle of English contract law that commercial parties should be free to negotiate their own bargain. As a result, in some circumstances, a court will enforce a penalty, provided certain conditions are met.

The law on contractual penalties was summarised a few years ago in the landmark combined judgment ([2015] UKSC 67) in the cases of Cavendish Square Holding BV v El-Makdessi (which concerned the sale of shares in a company) and ParkingEye Ltd v Beavis (which concerned a fine for overstaying in a private car park). In short:

To be a contractual penalty, a term must be a secondary obligation that is activated by the breach of some other contractual term (the primary obligation) (for example, a failure to pay a price or to transfer property). A primary obligation cannot be a contractual penalty.
Even if a contractual term does amount to a penalty, it will be valid and enforceable if it protects a legitimate interest of the person who benefits from it and it is not exorbitant, extravagant or unconscionable in comparison with the value of that interest (or, to put it another way it is not out of all proportion to that interest). If either of these conditions is not satisfied, the clause will be unenforceable.

A legitimate interest does not need to be commercial; it can be justified by a social element, as was the case in ParkingEye v Beavis. There is no single test for whether a term is exorbitant, extravagant or unconscionable; the courts will decide this on the facts of each individual case.

Whether a term is a primary or a secondary obligation is a question of substance, not form. This is simple in theory: an obligation that is triggered by some external condition, rather than a breach of contract, is a primary obligation and will not be a contractual penalty. However, in practice, it is often difficult to tell whether something is a primary or a secondary obligation, leading the courts to reach different conclusions in strikingly similar circumstances. See our previous Corporate Law Update for an example in the context of bad leaver provisions.

The approach in these cases replaced what had previously been assumed to be the test for a penalty (particularly a liquidated damages clause), namely whether the remedy imposed by the contract was a “genuine pre-estimate” of the innocent party’s loss. However, whether a contractual remedy is a genuine pre-estimate of loss continues to be relevant to deciding whether a penalty is extravagant.

What did the court say?

The court found that the default interest was a secondary obligation.

The judge did not agree with the seller’s argument that default interest was a primary obligation that was activated merely by monies not having been repaid. Non-repayment was itself a breach of the loan agreement, and so payment of default interest was a secondary trigger activated by that breach.

The judge accepted that a lender has a legitimate commercial interest in applying a higher rate of interest to a borrower who is in in default, because a borrower in those circumstances represents an increased credit risk.

In this case, the court did not have the benefit of comparable market rates of interest against which to judge the default rate. However, the judge said there was no evidence that the default interest rate was fixed to reflect the seller’s genuine assessment of the buyer’s creditworthiness in the event of default and that, without any justification, a 400% increase in interest, combined with monthly capitalisation of interest, was “so obviously extravagant, exorbitant and oppressive as to constitute a penalty”.

Interestingly, the judge said he would have been prepared, as a rule of thumb, to accept, without supporting evidence, an increase of up to 200% in the rate of interest to reflect the greater credit risk presented by a defaulting borrower. However, he expected the burden to pass to the lender to justify any greater increase, at least where the lender enjoys security for the loan.

What does this mean for me?

It is unusual to see a default interest rate this high. The commercial loan market has generally moderated interest rate increases to a sensible level. On a “standard” commercial loan facility, we would typically expect to see an increase in the interest rate applied to overdue amounts of 1% or, possibly, 2% on a payment default, although higher rates are sometimes seen for riskier credits.

However, in more bespoke loan arrangements, interest rates can become more unconventional. Sometimes (as in this case) these arrangements will be set out in a formal loan agreement or loan note. But often a loan will be framed in a different way, such as a deferral or retention of part of a purchase price on which interest accrues.

However the loan is structured, any increase in interest – or, indeed, any other charges or fees – which is payable due to a repayment default or some other contractual breach will be subject to the law on contractual penalties and will be struck out if it is disproportionate. It is therefore important to be able to justify any seemingly severe penalty to a court. In this regard, there are certain steps a party can take to increase the likelihood that a contractual term will be enforced.

Record the reason for the penalty. Put in writing the reasons for including the particular remedy and why it has been set at any particular level. For example, is any monetary payment a genuine pre-estimate of loss? Is a forced transfer of shares designed to ensure wayward management cannot influence a business going forward? Is a “fine” being included to deter a party from taking unfair advantage of some part of the contract? This explanation could be set out in correspondence between the parties or in the contract itself.
Make sure both sides take legal advice. Although not a “golden bullet”, the courts are generally more reluctant to interfere and strike a clause out if the parties have taken proper legal advice on it and been informed of the risks. Make sure the person you are negotiating with has legal representation who can advise them on the impact of the remedy and perhaps consider including an acknowledgement in the contract that the parties have taken legal advice.
Alternatively, try to structure the remedy as a “primary obligation”. This means linking the remedy not to a breach of contract but to some external event. This must be genuine, however, and is more difficult than it might first seem. The courts will readily look through any structuring that has clearly been put in place merely to “convert” a secondary obligation into a primary one.

FRC publishes review of streamlined energy and carbon reporting

The Financial Reporting Council has published the findings of a review it conducted on reporting under the Streamlined Energy and Carbon Reporting (SECR) regime.

Broadly speaking, SECR (which came into effect for financial years beginning on or after 1 April 2019) requires large UK companies (both quoted and unquoted) and limited liability partnerships (LLPs) to report on Scope 1 and 2 greenhouse gas (GHG) emissions and energy usage arising from their operations. It also requires them to provide other related information, including intensity metrics, calculation methodology and energy efficiency measures.

Quoted companies are required to report on both UK and worldwide emissions and usage, whilst reporting for unquoted companies and LLPs is limited to emissions and usage within the UK.

The review notes that all entities sampled disclosed their emissions, and the majority disclosed their energy use. However, the FRC identified a number of entity-specific disclosure errors or omissions.

Calculation methodology. Reports did not always provide sufficient information about the methodologies used to calculate emissions and energy use. It was also not always clear which entities were included within group SECR disclosures.
Integration with narrative reporting. SECR metrics could be better integrated into narrative reporting on climate change to make them easier for users to navigate. Emissions metrics and trends may represent an important aspect of an entity’s broader strategic narrative.
Emissions ratios. It was sometimes unclear whether the ratios selected were the most appropriate for an entity’s operations.
Audit. In most cases, companies did not adequately explain the extent of third-party assurance over the SECR information.
Energy efficiency. Disclosures about energy efficiency measures did not always clearly describe the “principal measures” taken by an entity.

The report also identifies some emerging good practice which the FRC has endorsed.

Voluntary disclosures. Several reports disclosed additional information beyond that required by SECR. This included Scope 3 emissions, information on the use of renewable energy, and location-based and market-based emissions.
Emissions reduction targets. Many reports disclosed emissions reduction targets, with better examples also explaining “net zero” or other reduction commitments and including more specific details on pathways and interim targets.
Presentation. All quoted entities, and several others, either reported disclosures in a format consistent with the Taskforce on Climate-related Financial Disclosures (TCFD) Recommendations or stated that they intended to do so in the future.

Finally, the report sets out the FRC’s expectations for future SECR reporting.

FRC Lab publishes report on risk, uncertainty and opportunity

The Financial Reporting Council’s Financial Reporting Lab has published a new report on reporting on risks, uncertainties, opportunities and scenarios.

The purpose of the report is to promote ways to create more connected reporting in these areas and to highlight the kind of information investors wish to see to understand a company's business model, longer-term strategy, resilience and viability.

Key points arising out of the report include the following.

Investors want to understand how a company’s board and management identify, monitor and manage risks, uncertainties and opportunities and respond in an agile way. This helps to build a picture of a company and confidence in management.
Investors want disclosures addressing the company’s market position, how the company views macro and micro trends and themes, and how it identifies and classifies risks and aligns them with opportunities and the wider company narrative.
Investors require information about how risks and opportunities link to the company’s wider strategy, business models and metrics, what management is doing and has done to mitigate risk and take forward opportunity and how this affects wider viability and resilience.
Investors want to understand more fully what is on a company’s horizon and how this is integrated into the risk and opportunity process. In particular, investors expect companies to undertake scenario-testing and want to understand how company-specific scenarios provide insight into the range of possible futures and influence the company’s strategic decisions and business model.

Other items

FRC publishes list of Stewardship Code signatories. The Financial Reporting Council (FRC) has published a list of the successful applicants to its Stewardship Code. There were 125 successful applications this time round. The Code, which is voluntary for most organisations, sets out standards of stewardship for asset managers, asset owners and service providers. From 1 January 2020, the Code has applied not only to listed securities but also to other asset classes, including bonds, infrastructure and private equity holdings.
FCA consults on consequential changes to Listing and Prospectus Regulation Rules. The Financial Conduct Authority (FCA) has published Quarterly Consultation No. 33 (CP/21/27), in which it is proposing (among other things) to make minor consequential changes to its Prospectus Regulation Rules and Listing Rules. The changes are designed to reflect the FCA’s proposals in its recent Primary Market Bulletin 34 to adopt the European Securities and Markets Authority (ESMA) prospectus disclosure guidelines in the UK (subject to some modifications) and would take effect if those proposals are implemented. For more information on those proposals, see our previous Corporate Law Update.
ICGN publishes updated Global Governance Principles. The International Corporate Governance Network (ICGN) has published an updated version of its Global Governance Principles (GGP). The revised version follows the ICGN’s consultation in December 2020. The revised Principles place greater emphasis on company purpose, directors’ fiduciary duties, sustainability, board diversity, stakeholder relations, systemic risks, ESG frameworks and board independence.