Corporate Law Update
Founders and minority investors were unfairly prejudiced when investors took control
There have been no substantial legal developments in the past week. We have therefore taken the opportunity to revisit an interesting case from 2021 that highlights the need for investors to take care when setting or influencing the strategic direction of a company in which they have invested.
The High Court has held that the 70 minority shareholders in a company – including its two founders – suffered unfair prejudice when the majority financial investors in the company excluded them from the management of the business and removed them from office.
Unfair prejudice cases are inevitably complex and fact-heavy and often comprise numerous, interlaced claims and allegations. This case was no different. The factual background is always important to an unfair prejudice claim. We have attempted to distil it to the most salient points.
The initial stages
Re Compound Photonics Group Ltd [2021] EWHC 787 (Ch) concerned a company set up to produce audio-visual equipment.
The business was established in 2004 by a Dr Sachs and two colleagues to develop a compact projector that could be attached to a mobile phone. That vision arose out of years of academic research by Dr Sachs into gallium arsenide and liquid crystal technology.
In 2005, Dr Sachs met a Mr Faulkner through a tech start-up fund. Mr Faulkner introduced dozens of individual investors, who, along with Mr Faulkner, invested and subscribed for shares in a new vehicle, which later became a subsidiary of the company in question.
In due course, the business required more capital. In 2010, a new investor – Vollin Holdings Limited – agreed to inject a substantial amount into the company. Dr Sachs, an associate of his and Mr Faulkner were appointed as directors. Vollin was entitled to nominate two further directors (and did so).
In 2013, Vollin increased its investment, resulting in it holding around 80% of the company’s shares. The company adopted new articles of association and the parties entered into a new shareholders’ agreement (SHA). Those documents contained (among others) the following provisions:
- The SHA stated that the shareholders would “at all times act in good faith in all dealings with the other [shareholders] and with the [company] in relation to the matters contained in the [SHA].”
- It also required them to “co-operate with the [board] in the running and operation of the company”.
- The articles listed certain circumstances in which the directors would automatically leave office. These included where the board resolved to remove the director from office, or where the director became bankrupt or made an arrangement with their creditors.
- However, the articles specifically prevented the board from removing Dr Sachs and Mr Faulkner as directors. They also said that neither Dr Sachs nor Mr Faulkner would cease to be a director if they became bankrupt or made an arrangement with their creditors.
- The company’s directors would take decisions by majority vote, but a decision would be effective only if both Dr Sachs and Mr Faulkner voted in favour of it.
In 2014, another company – Minden Worldwide Limited – invested in the business and nominated a director. So, by 2014, the board comprised three “founder directors” and three investor nominee directors. The investors held around 80% of the company’s shares. The remaining 20% were held by Dr Sachs, Mr Faulkner and the other minority shareholders.
The business struggles
The business failed to develop as anticipated. The company was unable to manufacture the product that had generated so much interest. The investors began to lose faith in management, specifically in Dr Sachs and Mr Faulkner, and started to form their own vision for the future of the company.
In 2016, the investors told Dr Sachs that they were not prepared to make any further investment in the company while he remained a director. This ultimately led to Dr Sachs resigning from the board.
Over time, the investor nominee directors began to restrict the flow of information to Mr Faulkner and started to hold discussions on the company’s future without involving him.
Mr Faulkner made various requests for detailed information on the company, attempted to involve himself in meetings organised by the nominee directors, and ultimately began to communicate directly with the company’s shareholders in relation to further funding.
The investors became concerned with Mr Faulkner’s actions. They used their powers under the Companies Act 2006 to requisition a general meeting, at which they removed Mr Faulkner as a director.
What was the claim?
Dr Sachs and Mr Faulkner launched an unfair prejudice petition. They claimed their exclusion from the business and removal as directors had unfairly prejudiced them and the other minority investors.
In particular, they alleged that there had been an understanding that Dr Sachs and Mr Faulkner would remain involved in the business and that, by removing them from office and excluding them from business decisions, the investors had breached this understanding and their obligations of good faith in the SHA and the company’s articles.
They also claimed that, by acquiescing in these decisions, the nominee directors had breached their statutory duties to the company.
What did the court say?
The judge agreed. Although he did not accept all aspects of the claim, he found that the majority investors had “effectively usurped” control of the board and imposed their own vision for the business on the company and its shareholders.
This was at odds with the “constitutional settlement” the company and its shareholders had agreed. The company had attracted investment based on Dr Sachs’ expertise. The minority shareholders had “bought into” Dr Sachs’ vision. To cite the judgment, he was the “jockey they were backing”. They had not decided to invest in a technology business, so much as a “start-up business headed by Dr Sachs”. Mr Faulkner had introduced the minority shareholder to the company. For them, Dr Sachs and Mr Faulkner were “two key individuals in terms of realising the vision they had invested in”.
By removing Dr Sachs and Mr Faulkner and excluding them from managing the business, the investors had broken that constitutional settlement and breached their obligations under the SHA.
In addition, the nominee directors had breached their duties to the company. By co-operating in removing Dr Sachs and Mr Faulkner from office and disregarding the minority’s interest in keeping them in post, they had failed to act in accordance with the company’s constitution or to have regard to the need to act fairly between the company’s shareholders.
These breaches, collectively, amounted to unfair prejudice.
It is important to note that the judge did not doubt the sincerity of the investors’ motives. He felt they had been acting in the way they believed would promote the business, and there was good reason to believe they were right. He also felt that, in the round, Mr Faulkner’s behaviour justified his expulsion, and he acknowledged that, although pressured, Dr Sachs had resigned, rather than being removed.
But, despite the justification of these actions, the investors had unfairly prejudiced the minority by compromising the agreed basis on which the company and its business had been founded – the so-called “constitutional settlement”. In this respect, the fact that the shareholders had agreed to subject themselves to a duty of good faith cannot be emphasised enough.
The court did not consider what remedy to impose at this stage. The typical remedy on an unfair prejudice petition is an order for the majority to buy out the minority at market value (subject to any appropriate adjustments). But, in a case like this, where the unfair prejudice refers to the exclusion of the minority and the court does not criticise the subsequent conduct of the company, significant adjustments are unlikely. The consequences of the judgment might not, therefore, extend beyond an exit for the minority on terms which the court deems fair.
What does this mean for me?
This is an important case for sponsors, VC funds and other institutional investors, as well as angel investors, who may be looking to take an equity stake in a business. We normally expect unfair prejudice of this kind to apply to small, closely-held companies – so-called “quasi-partnerships”. The decision that it can arise in relation to a company with significant majority investors is significant.
An investor taking a substantial stake in a company will inevitably want a degree of control and oversight over how the business is run. An investor may want the ability, if need be, to remove and replace directors if they are underperforming or the business is struggling. Significant investors will naturally seek influence over key decisions, if not day-to-day management, of the business.
Majority investors must tread carefully before taking this kind of action, particularly where the business in which they are invested revolves around particular personalities. Questions an investor might ask themselves include the following.
- Have shareholders backed a particular business model or are they invested more in the expertise, skills, track record or flair of a particular individual?
- Is there an understanding that particular individuals should remain part of the business? Does the company’s constitution reflect this?
- In particular, is the investor subject to any obligations to act in good faith, to co-operate or to take other shareholders’ interests into account before taking action? There are strong arguments to resist terms like these from the outset so as to minimise the risk of unfair prejudice allegations down the line.
- Is there an independent minority shareholder base? On what basis did they invest in the company? Is what the investor is proposing to do in their interest? Would they approve of it?
