Corporate Law Update
- The FRC Lab publishes a new report on digital security risk reporting by companies
- A founder shareholder suffered unfair prejudice when he was excluded from the management of a company
- A risk to reputational damage could be taken into account when calculating damages, even though it never materialised
- Lawtech UK is seeking views on a new legal statement on digital securities
- The FCA fines a non-executive chair for unlawfully disclosing inside information to shareholdersCompanies House publishes its corporate plan for 2022/2023
The Financial Reporting Council (FRC) Lab has published a new report on company disclosures relating to digital security strategies, risks and governance, alongside a useful summary document and a set of detailed examples.
The report, which is designed for reporting and risk teams and audit committees, arises from wide engagement by the FRC Lab with various listed companies and investors. It is designed to assist companies with preparing and optimising disclosures on digital security.
Key points coming out of the report include the following.
- A number of factors are driving greater focus on digital security risk disclosures, including high-profile cyber incidents, government proposals to work digital security risk into resilience disclosures, evolving stakeholder demands and intensified geopolitical tensions.
- Participants felt that current disclosures are not sufficient to meet investor and other stakeholder needs, noting that “boilerplate” disclosure, or no disclosure at all, was a flag that a company was not sufficiently emphasising digital security.
- When deciding what disclosures to provide, a company should consider the materiality and potential sensitivity of the information and whether it provides sufficient detail to readers.
- Companies should consider explaining how digital security and strategy are important to their current and future business model, strategy and environment.
- Disclosures should detail the governance structures, culture and processes a company has in place to support digital security and strategy.
- Reporting should identify digital security and strategy risks and opportunities a company is facing, both now and in the future, as well as highlighting the impact of internal and external events and the actions and activities the company takes in response.
The report goes on to suggest useful actions a company’s risk and reporting team and its audit committee can take respectively in relation to digital security risk reporting.
The High Court has found that shareholders of a company suffered unfair prejudice when they were excluded from a project that was the reason for the company’s existence.
Dodson and others v Shield and others  EWHC 1751 (Ch) concerned a company (IAEP) established to supply and service the turnkey installation of certain automotive assembly lines.
In late 2012, two individuals (Mr Dodson and Mr Cotterill) became aware that manufacturing lines (the Lines) for a particular type of car engine were about to become available. They established IAEP as a vehicle to acquire the Lines, with a view to selling the Lines on to a third party as a complete unit.
To fund the acquisitions, the two individuals were introduced to a Mr Shield. Mr Shield agreed to provide financing for the acquisition but wanted his own corporate vehicle (SES) to own the Lines outright as they became available, a position that was not acceptable to Mr Dodson and Mr Cotterill.
Ultimately, the parties reached agreement and entered into arrangements to regulate the project. These included a facility agreement, a shareholders’ agreement, and an option under which IAEP was granted fifteen months to acquire the Lines from SES at a pre-set price.
The shareholders’ agreement contained the following key terms.
- IAEP’s business was to be the design, sale and implementation of turnkey automotive engineering projects on an international basis, with its first project being the acquisition of the Lines.
- Each party was to use reasonable endeavours to promote and develop IAEP’s business to its “best advantage” (the business promotion clauses).
- No shareholder would be interested in any business that competed with IAEP (the non-compete clauses).
- The parties would act in good faith towards each other at all times and conduct any transactions with IAEP on the basis set out in the shareholders’ agreement and on arms’ length terms.
Alongside this, the option agreement stated that, if IAEP were unable to purchase any Lines from SES during the Option Period, the parties will negotiate in good faith to find an alternative mechanism for selling the Lines to IAEP or a third-party buyer.
The project begins
SES acquired the first two Lines. At the same time, the parties began discussions with several potential onward buyers of the Lines.
However, by March 2013, IAEP had exhausted its financing and the possibility of acquiring three further Lines had slipped, causing the project to stall.
In June 2013, without Mr Dodson’s knowledge, Mr Cotterill introduced a Mr Murphy to IAEP with a view to him replacing Mr Dodson as commercial director. From this point, Mr Dodson was excluded from IAEP’s day-to-day business.
Sometime in 2013, Mr Dodson managed to acquire a technical library for the Lines on behalf of IAEP. The library was highly valuable, as it provided installation schematics for the various machines that made up the Lines.
Also in 2013, Mr Cotterill initiated discussions with a potential buyer for the onward sale of the Lines. Under the proposed sale, ongoing turnkey services would be provided to the buyer, not by IAEP (as originally contemplated) but by a separate company (CGI).
CGI was owned by Mr Murphy, but the parties would use it as a joint vehicle for pursuing the turnkey business. To facilitate this, and unknown to Mr Dodson, the library was made available to CGI (and, in turn, SES) with no payment in return to IAEP.
In January 2014, the option expired, allowing SES to sell the Lines without IAEP’s approval.
IAEP’s final board meeting took place in January 2015, at which it became clear that IAEP’s commercial purpose was at an end. By late 2015, SES had sold some of the Lines.
What did Mr Dodson claim?
Mr Dodson brought a petition alleging that he had suffered unfair prejudice, alleging that he had been excluded from the day-to-day running of the business. He also argued that the other parties had acted in several respects contrary to the understanding on which IAEP had been formed.
- They had failed to initiate negotiations between IAEP and SES to sell the Lines owned by SES to either IAEP or a third-party buyer, which he said amounted to breach of the option agreement.
- They had effectively “given away” the valuable library to CGI and SES without securing any payment in return for IAEP, which he said amounted to a breach of fiduciary duty.
- They had attempted to divert the turnkey business from IAEP to CGI, which was a breach of their promise not to compete with IAEP.
Importantly, these allegations (particularly the allegations relating to a failure to involve Mr Dodson in negotiations and of diverting IAEP’s business) rested on IAEP being classified as a “quasi-partnership” (see box “What is unfair prejudice?”).
Under section 994 of the Companies Act 2006, a member (for example, a shareholder) of a company can petition the court for relief if the company’s affairs are being conducted in a way that is unfairly prejudicial to that person’s interests as a member.
There is no fixed list of actions or omissions that can amount to unfair prejudice. Examples can include excluding a shareholder who is also a director from the management of the company, allotting shares to dilute a minority shareholder’s interest, misappropriating company funds, failing to pay dividends in certain circumstances, and deliberately failing to comply with the company’s constitution.
The scope of behaviour that can amount to unfair prejudice is wider if the company is a “quasi-partnership". A quasi-partnership is a company where there is a relation of mutual confidence between the members and an understanding that they are entitled to be involved in running the company's business in a way similar to the partners of a partnership. Unfair prejudice may occur if a quasi-partnership’s affairs are run in a way that is inconsistent with that mutual understanding, whether or not that amounts to a breach of duty or the entity’s constitution.
The courts have very wide discretion to grant almost any remedy they think fit if unfair prejudice has occurred. The most common remedy the courts have applied is to require other members of the company (or the company itself) to acquire the injured party’s shares.
What did the court say?
The court agreed that there had been unfair prejudice.
A critical question was whether the parties had created a “quasi-partnership” between them. In this case, the court said that IAEP was a quasi-partnership, because all its shareholders were entitled to be directors and take part in its management. This was underscored by the fact that the parties undertook express duties of good faith to each other and agreed not to compete with each other.
This conclusion was not changed by the fact that the shareholders’ agreement contained a standard clause stating that the parties had not intended to create a partnership. It was evident that IAEP, as a company, could not be a partnership, but this did not mean there was no quasi-partnership.
This meant that the court was able to consider a wider range of conduct when deciding whether unfair prejudice had taken place. The judge reached the following conclusions.
- By the time of the alleged failure to initiate negotiations between IAEP and SES, the opportunity to acquire the further Lines required to present the entire turnkey solution had disappeared, and so there was no real basis for negotiations for a sale to IAEP or a third party. Mr Dodson could not, therefore, have suffered any prejudice. (The court therefore declined to rule on whether the parties had breached their duties of good faith.)
- Making the library available to CGI and SES at no cost, when the library had considerable value to IAEP, was a clear breach of fiduciary duty and amounted to unfair prejudice to Mr Dodson as a shareholder of IAEP.
- Arranging for the turnkey services to be provided by CGI, rather than IAEP, was a “clear breach” of the business promotion and the non-compete clauses, which again amounted to unfair prejudice to Mr Dodson as a shareholder of IAEP.
What does this mean for me?
Unfair prejudice claims are very fact-specific. However, this is a good illustration of the court applying established principles when deciding whether unfair prejudice has occurred.
The case also shows the dangers of side-lining a founder from a business. Generally, shareholders have no right to take part in a company’s business and excluding a shareholder from doing so will not give rise to a claim. But where a business is set up on the basis that all shareholders will be entitled to a say in how it is run, preventing a shareholder from taking part may well give rise to unfair prejudice.
When looking to take a proposed course of action, therefore, companies, directors and significant shareholders should ask certain questions.
- Would the proposed action breach any terms of the company’s constitution? If so, there is a greater risk of unfair prejudice. In this respect, it is important to remember that a company’s constitution comprises not only its articles of association, but also any special resolutions and, potentially, other agreements between the company and its shareholders, such as a shareholders’ agreement, investment agreement or joint venture agreement.
- Would the proposed action amount to a breach of duty by the directors? Directors owe their statutory and fiduciary duties to the company itself, and normally it is the company which must sue for any loss. But if the breaches become part and parcel of the company’s conduct, they may well tip over into unfair prejudice and entitle an aggrieved shareholder to petition for relief.
- Was the company set up on a mutual understanding that all shareholders would be allowed to take part in management? If so, acting contrary to that understanding risks exposing the company to an unfair prejudice petition, even if the company and directors are acting in full compliance with the company’s constitution and their statutory duties.
- Will the proposed action actually cause any individual shareholders or group of shareholders damage or loss? If not, it will be harder for a shareholder to show that they have suffered any prejudice.
The Court of Appeal has clarified the circumstances in which it is possible to take account of a contingency that has not in fact materialised when calculating damages for breach of warranty.
MDW Holdings Ltd v Norvill and others  EWCA Civ 883 concerned the share sale of a waste disposal company.
Following the sale, the buyer discovered that the business had contravened various environmental regulations. This in turn amounted to breaches of warranties in the sale agreement, including that the business had been conducted in accordance with all applicable laws and regulations.
The buyer sued the sellers for breach of warranty and in the tort of deceit. The High Court agreed that there had been a fraudulent breach of warranty and awarded the buyer damages. For more information on the High Court’s decision, see this Corporate Law Update (in relation to deceit) and this Corporate Law Update (in relation to breach of warranty).
The sellers appealed the High Court’s calculation of those damages, arguing that the judge had been wrong to take into account a contingent risk of reputational damage to the business which the parties now knew had never in fact materialised.
The Court of Appeal dismissed the appeal, noting that the High Court had been “fully justified” in adjusting damages to reflect this risk. At the time of the sale, the existence of a risk to goodwill would have materially impacted the value of the business, even if that risk was contingent at that time and never in fact came to pass. A willing buyer would have factored that risk into any appraisal of the value of the business and “would not have been likely to pay as much for the [business]”.
For more information on the case, you can read this in-depth piece by our colleagues.
The UK Jurisdiction Taskforce, an initiative of Lawtech UK, has published a consultation seeking views to inform a new legal statement it intends to publish on digital securities.
The purpose of the legal statement is to support the issue and transfer of equity or debt securities on blockchain and other distributed ledger technology (DLT) systems.
The consultation lists 12 specific questions, which focus on how English law might apply existing securities rules to digital securities and how DLT might legally be used for any necessary registers of securities. It asks for comments on those questions and whether there are any other material issues the questions do not cover.
The Taskforce has asked for responses by 23 September 2022. It will also be hosting a public event on 14 September 2022 to receive feedback in person.
The Financial Conduct Authority (FCA) has imposed a financial penalty on the former non-executive chair of a premium-listed company for unlawfully disclosing inside information.
The individual in question was appointed as the non-executive chair of the company, which was premium-listed and admitted to the Exchange’s Main Market of the London Stock Exchange (the Exchange), in October 2016.
As chair, the individual was responsible for governance over, and closely involved in the preparation of, the company’s issuance of RNS announcements to the Exchange.
In October 2018, he disclosed inside information concerning an expected RNS announcement relating to the revision of the company’s financial guidance and the retirement of the company’s CEO. The information was disclosed to a senior individual at one of the company’s shareholders, then shortly afterwards to a senior individual at another of its shareholders.
Under articles 10 and 14(c) of the European Union Market Abuse Regulation (EU MAR), which applied in the UK at the time of the disclosures, it is unlawful to disclose inside information except to the public as required by MAR or “in the normal exercise of an employment, a profession or duties”. Unlawful disclosure of inside information is classified as a form of market abuse.
The FCA concluded that the individual acted negligently in disclosing the information. He had received training on EU MAR and, given his considerable experience and position, should have realised that it may have amounted to inside information. It was not in the normal exercise of his employment, profession or duties to disclose it selectively to shareholders.
It is notable that the FCA decided to impose the penalty, notwithstanding certain mitigating factors in the individual’s favour. These included the following.
- At the time of disclosure, the company had not yet classified the information as “inside information”, as it had been advised to seek further information so as to make an announcement.
- The company’s board and brokers had been informed in advance that the individual was intending to disclose the information to shareholders.
- The company had imposed no-dealing restrictions on one of the shareholders, and the individual had imposed similar restrictions on the senior individuals to whom he disclosed the information.
The FCA imposed a financial penalty of £80,000 but declined to make a public censure.
The decision shows the significant risks involved in selective disclosure to shareholders. Although a director or senior executive may genuinely feel that disclosure is appropriate and may enhance stakeholder relations, this kind of behaviour will almost certainly fall foul of market abuse restrictions in the UK (now embodied in the UK version of the Market Abuse Regulation).
Separately, it could also give rise to allegations that directors have treated some shareholders more preferentially than others, or that they have breached their duty in section 172 of the Companies Act 2006 by failing to consider the need to act fairly as between members of the company.
Before disclosing any confidential information to shareholders or other stakeholders, a director should discuss with the other directors and the company’s sponsor or brokers whether the information is likely to amount to inside information.
The views of the company’s financial advisers will be key to this question, as they are in a more objective position to advise on whether the information, if made public, would be likely to have a significant effect on the price of the company’s shares.