Ashurst and Practical Law Corporate Update Q2 2024
16 July 2024
The articles below are a selection of those first published in Q2 2024 in the company law section of PLC Magazine, the leading monthly magazine for business lawyers advising companies in the UK.
1. W&I insurance: conflict between insured obligation and policy exclusion
27 June 2024
Summary. The Court of Appeal held that a buyer of a business failed to show that an inconsistency in a warranty and indemnity (W&I) insurance policy that it was insured under was the result of a clear drafting error which the court should correct by interpretation.
Background. When negotiating contractual protections such as warranties in an acquisition agreement, the buyer will usually want the warranties to be broad and extensive to increase the chances of making a valid claim against the seller for breach of warranty, whereas the seller will wish to limit the warranties as much as possible to reduce the chances of a successful claim being made against it.
W&I insurance can bridge the gap and cover financial loss that may arise from a breach of warranty. In a policy taken out by a buyer (a buy-side policy), the W&I insurer or underwriter effectively steps into the shoes of the seller, providing cover with the position agreed in the acquisition agreement and enabling the buyer to claim directly against the insurer without having to pursue the seller.
A court can correct a contract through interpretation if two conditions are satisfied:
There must be a clear mistake, which is ascertained by considering the contract against the background circumstances.
It must be clear what correction ought to be made to cure the mistake (East v Pantiles (Plant Hire) Ltd (1981) 263 EG 61; KPMG LLP v Network Rail Infrastructure Ltd [2007] EWCA Civ 363; G & S Brough Ltd v Salvage Wharf Ltd).
Facts. B was buying shares in a target company, K, and took out a buy-side W&I policy (the policy) with an underwriter, R. The share purchase agreement (SPA) included certain warranties that K had complied with anti-bribery and anti-corruption laws (anti-bribery warranties).
A cover spreadsheet appended to the policy noted that the anti-bribery warranties were covered under the policy. However, the policy contained a clause that excluded R’s liability for loss arising from any “liability or actual or alleged non-compliance” in respect of anti-bribery and anti-corruption laws (policy exclusion).
After acquiring K, B alleged a breach of the anti-bribery warranties and brought a claim against R for loss under the policy. R denied B’s claim under the policy, relying on the policy exclusion. The High Court held in R’s favour, finding that the policy was not contradictory and that B’s claim was excluded by the policy exclusion.
B appealed, arguing that:
There was an obvious drafting error in the policy exclusion (“liability or” instead of “liability for”), the effect of which was that no loss arising from a breach of the anti-bribery warranties could ever be covered under the W&I policy, despite the cover spreadsheet noting that the warranties were covered.
The court should correct the drafting error by interpreting the policy exclusion as excluding any “liability for actual or alleged non-compliance” in respect of anti-bribery and anti-corruption laws, thereby confining the policy exclusion to cases of liability only.
Decision. The court dismissed B’s appeal by a majority decision. The policy exclusion prevailed and B was unable to recover for its loss.
The court acknowledged the apparent conflict between the cover spreadsheet and the provisions of the policy exclusion. However, correcting a drafting mistake in a contract by interpretation requires both the mistake and the cure to remedy the mistake to be obvious.
The court found that the error in the policy, if any, was not obvious. The correction that B was proposing would confine the policy exclusion to cases of liability, thereby bringing within the scope of cover any diminution in the value of K’s shares attributable to unproven allegations of non-compliance with anti-bribery laws. R would wish to avoid that scenario and the absence of such a construction in the policy could not be perceived as a drafting error from its perspective. The existence of such a coherent and rational explanation for why the policy exclusion took the form it did from R’s perspective was a strong indication against a clear drafting mistake. An obvious mistake would be common to both parties.
The court also found that the cure for correcting the error, if any, in the policy was also not obvious as there was uncertainty over whether the error lay in the drafting of the policy exclusion or the cover spreadsheet.
Phillips LJ issued a brief dissenting judgment, finding that the policy exclusion included an obvious drafting error and that the correction sought by B was an obvious cure that would reflect the true intention of the parties.
Comment. This decision demonstrates that a party taking out W&I insurance should not rely on summary provisions in an appending document such as a cover spreadsheet without scrutinising the precise wording in the underlying policy document as a whole, particularly in clauses excluding the insurer’s liability. Here, the omission of a single letter in a single word in the policy exclusion meant that B was unable to claim.
The decision also highlights that it is prudent to leave sufficient time to negotiate and review a W&I policy. Here, the policy was largely negotiated after the exchange of the SPA. Where possible, it is preferable to negotiate a W&I policy in parallel with the relevant SPA.
Finally, the decision confirms the court’s reluctance to step in and rewrite a contract to correct an apparent drafting inconsistency. A party seeking redress from the court will need to demonstrate more than inconsistency between contractual terms. The court will only intervene where there is an obvious drafting mistake and where the cure to remedy the mistake is also obvious.
Case: Project Angel Bidco Ltd (In Administration) v Axis Managing Agency Ltd [2024] EWCA Civ 446.
2. Acquisitions: warranty claims contingent on final determination of earn out
30 May 2024
Summary. The High Court held that breach of warranty claims brought by a buyer of shares against the seller were not time-barred by a contractual limitation in the share purchase agreement (SPA) in circumstances where the buyer was unable to quantify the claims until an earn-out was determined.
Background. Caveat emptor, meaning “let the buyer beware”, is the principle that the buyer alone is responsible for checking the quality and suitability of goods before buying them. In an agreement for the sale and purchase of a target business or the shares in a target company, the buyer is likely to seek protection by obtaining warranties from the seller about the state of the target business or company. The seller will usually seek to limit its liability under the warranties in a number of ways, including restricting the time period within which the buyer can bring claims.
An earn-out arrangement in an acquisition agreement usually involves at least part of the purchase price being payable after completion, which is contingent on, and calculated by reference to, the post-completion performance of the target business or company. A commonly used metric to calculate an earn-out is a multiple of earnings before the deduction of interest, taxes, depreciation, and amortisation (EBITDA) for the target business or company.
Facts. P agreed to sell shares in a group of companies (the target group) to O. The terms of the sale were set out in an SPA. The price for the shares included a cash sum to be paid at completion, which valued the target group on a multiple of EBITDA. The price was to be adjusted by an earn-out mechanism entitling P to a further sum if the target group’s EBITDA in the 12 months following completion exceeded a set figure.
In the event of a claim, the SPA required O to commence proceedings within six months of the end of the time period for notifying a claim to P, except for a claim involving a contingent or unquantifiable liability, in which case the applicable deadline was six months from the date on which that claim became an actual liability or was capable of being quantified (the proceedings limitation).
P and O failed to agree the earn-out sum and the matter was referred to an independent accountant (IA) for expert determination in accordance with the SPA.
O alleged that P had breached the warranties in the SPA, including those relating to various ongoing undisclosed costs that were not reflected in the assumed EBITDA from which the purchase price was calculated. O issued claims against P for breach of warranty.
P applied for strike out or, alternatively, for summary judgment dismissing O’s claims on the basis that they were time-barred by the proceedings limitation. P argued that O’s claims were actual claims that were capable of being quantified within the timeframe envisaged by the SPA and that, although O’s claims had been issued within six months of the conclusion of the earn-out determination by the IA, this was still over six months since the end of the time period specified in the SPA for notifying claims.
O argued that, as the subject matter of the relevant claims also affected the earn-out calculation, the claims were contingent on, and incapable of quantification until, the earn-out determination by the IA. This meant that under the terms of the proceedings limitation, the period for O to commence legal proceedings in respect of its claims did not start to run until the date of the IA’s report and therefore the claims were not time-barred.
Decision. The court refused to strike out O’s claims.
The court rejected P’s argument that O’s claims were actual claims capable of being quantified for the purposes of the proceedings limitation. A breach of warranty claim involves a claim for damages for loss, the assessment of which requires knowing both the claimant’s actual position and the counterfactual position; that is, the position if the breach had not occurred. O’s actual position, in terms of the price it had to pay for the target group, could not be known until the IA’s determination of the earn-out consideration. This fitted in with the natural meaning of the proceedings limitation: that O’s claims were neither actual claims nor capable of being quantified until the IA reported, and a reasonable commercial person would construe the provision in that way.
This approach did not mean that all warranty claims remained contingent or unquantifiable until the earn-out consideration was determined. That would be the case only for warranty claims that were based on facts that also affected the earn-out calculation.
It was unclear how the construction submitted by P would sensibly operate in the case of an alleged breach of warranty, the subject matter of which was ultimately entitled to an adjustment to the earn-out consideration. On P’s approach, O would nonetheless be obliged to notify the warranty claim and commence proceedings, even though it might eventually transpire to have no claim at all on the outcome of the earn-out determination. The alternatives would either have been a stay of the proceedings pending the outcome of the IA process, which would have the same practical outcome as the approach taken by O but waste costs and court time, or proceeding with a claim that might result in double recovery, which would be even more wasteful and have the potential unacceptable outcome of O recovering twice for the same loss. O’s approach led to the outcome that was most consistent with business common sense.
Comment. One of the first steps that a party on the receiving end of a breach of warranty claim will usually take is to determine whether the claimant has complied with the time limits for giving notice and commencing legal proceedings. The court is likely to dismiss a claim if the facts show that the claimant failed to do so within the relevant time periods. This decision shows how the provisions in an acquisition agreement that are intended to limit a seller’s liability can be inadvertently affected by a price adjustment provision such as an earn-out clause. Here, the time period for commencing proceedings was effectively extended until the accountants reported on the earn-out consideration and the claims became capable of being quantified.
The decision reiterates the importance for parties of ensuring that there is clarity between how the provisions in an acquisition agreement dealing with limitation of liability interact with the provisions that adjust the price.
Case: Onecom Group Ltd v Palmer [2024] EWHC 867 (Comm)
3. Shareholders’ agreement: breach of exit clause
2 May 2024
Summary. The High Court held that a minority shareholder in a company was unfairly prejudiced when the company breached an exit clause in a shareholders’ agreement requiring it to work in good faith towards a sale of the company by a specified date.
Background. A shareholder may petition the court for relief where the affairs of the company are being, or have been, conducted in a manner that is unfairly prejudicial to the interests of some or all of the shareholders, including the petitioning shareholder (section 994, Companies Act 2006) (section 994). The unfair prejudice can take many different forms and the court has a wide discretion to grant relief as it sees fit, typically obliging the petitioning shareholder’s shares to be bought by other shareholders or the relevant company.
An exit clause in a shareholders’ agreement (SHA) provides for the shareholders or investors to manage their exit from the company and realise their investment by a specified date. Common mechanisms for an exit include a sale of the company’s shares or business or an initial public offering.
Facts. P was a minority shareholder in a company, S. C was the chairman and director of S, as well as a controlling indirect investor in S.
In 2016, S’s shareholders entered into an SHA with S, which contained an exit clause requiring S to work in good faith toward an exit and, if the exit had not occurred by 31 December 2019, to engage an investment bank to effect the exit. “Exit” was defined as including the sale of all, or substantially all, of S’s share capital.
P issued proceedings against C, claiming that:
C had failed to engage appropriately with other directors, shareholders and potential buyers, and had instructed the investment bank to act in terms that were broader than simply effecting an exit.
S had breached the exit clause and had not worked in good faith towards an exit. By breaching the exit clause and failing to effect a sale, S caused unfair prejudice to P in its capacity as a shareholder, which should be remedied by an order for C to buy P’s shares.
P did not seek relief against S or any other shareholder, either for breach of contract or for unfair prejudice under section 994.
C argued that S had acted in good faith by working towards an exit and that, on a true construction of the SHA, S had not breached the provisions of the exit clause, meaning that P was not unfairly prejudiced. In particular:
The provisions in the exit clause were subject to implied directors’ duties; including the duty to promote the success of S. As the directors believed that a sale that complied with the exit clause did not maximise value for shareholders, they were excused from complying with it. Had they complied with the exit clause in these circumstances, the directors would have been in breach of their fiduciary duties to S.
There was also no breach of the exit clause in relation to a potential sale to a private equity buyer that envisaged some of S’s existing management shareholders retaining significant indirect shareholdings in S by rolling over their interests into the private equity buyer. This did not constitute an exit for the purposes of the exit clause, that is, a sale of all or substantially all of S’s shares, and so the directors were under no obligation to entertain it.
The exit clause did not impose a particular timeline for exit after the exit deadline.
Decision. The court found in favour of P. It ordered C to buy P’s shares in S, at a value to be determined at a quantum hearing.
C had exclusive control of the sale process but had failed to conduct it in accordance with the obligations on S to work in good faith towards an exit, including a sale to the private equity buyer and other potential buyers. S had breached its obligations under the exit clause as a result of which P suffered prejudice by being locked into S, from which an exit had been legitimately sought. The prejudice was unfair as it arose from a breach of the terms agreed in the SHA. C was sufficiently connected to the unfairly prejudicial conduct that it was appropriate to order it to buy P’s shares.
The court rejected C’s key arguments. In the circumstances, the exit clause was not subject to directors’ fiduciary duties and the directors would not have been in breach of those duties if they had complied with the clause. The directors were not released from the obligation to procure acceptable offers for S and they were not precluded from pursuing a less profitable exit earlier compared with a potentially more profitable exit later.
The potential sale to the private equity buyer could constitute a true exit for the purposes of the exit clause, that is, a sale of all or substantially all of S’s shares, if the buyer’s capital structure was entirely different to that of S, so that the shareholders were in fact selling an investment with a particular set of characteristics and acquiring another investment with very different characteristics. Therefore, the directors were obliged to assess the proposed sale to the private equity buyer.
There was an implied term that the exit should take place as soon as reasonably practicable and within a reasonable time after the exit date. Time was of the essence of the whole arrangement and a construction requiring no further urgency after the exit date was, in the absence of relevant facts, entirely counterintuitive.
Comment. This decision shows that a party that acts in its own interests in contravention of an exit clause runs the risk of claims being made against it, not only for a breach of contract but also, as in this case, for unfair prejudice under section 994. It also reiterates the wide discretion available to the court grant such relief for unfair prejudice claims as it sees fit.
The decision is a reminder for companies and investors of how important the exit clause can become when a party is exiting and the need to ensure that sufficient time and thought is given to the language and mechanics of the clause when it is drafted. An exit clause will usually benefit from precise language that clearly delineates the responsibilities of the parties and details the acceptable parameters for suitable exit opportunities. The decision also highlights the need for a consistent and collaborative practical approach to complying with an exit clause. Directors and investors should be fully engaged in the process so that appropriate exit opportunities are diligently investigated and assessed.
In addition, the decision shows that, in order to increase the chances of complying with an exit clause, a financial adviser who is engaged to procure an exit should be instructed in a manner that is consistent with the exit clause and should be aware of the language used in that clause. Here, there was inconsistency between the narrower language used in the exit clause for the sale of the company and the broader language used in the financial adviser’s engagement letter, which included scope for additional investment and reorganisation, as well as a sale of the company.
Case: Saxon Woods Investments Ltd v Costa [2024] EWHC 387 (Ch)
4. Regulations: Corporate directors
2 May 2024
Summary. The Small Business, Enterprise and Employment Act 2015 (Commencement No 8) Regulations 2024 (SI 2024/270) (2024 Regulations) have been issued.
Background. A company must have at least one director who is a natural person (section 155(1), Companies Act 2006) (2006 Act). Subject to this requirement being satisfied, any UK or non-UK legal person, including a company or limited liability partnership, may be a company director.
The Small Business, Enterprise and Employment Act 2015 (2015 Act) amended the 2006 Act to provide that a person may not be appointed director of a company unless the person was a natural person (section 156A, 2006 Act) (section 156A). Section 156A was originally scheduled to come into force in October 2015 but implementation has been delayed.
The 2015 Act also provides that the Secretary of State may provide regulations for exceptions to section 156A (section 156B, 2006 Act).
Facts. The 2024 Regulations permit the government to make further regulations setting out the circumstances in which legal persons may be appointed as director, as derogations to the proposed general prohibition on corporate directors, provided that the company also has at least one natural director. However, these further regulations are still awaited.
Companies House anticipates that the reforms relating to corporate directors will only come into effect once the new director identity verification systems under the Economic Crime and Corporate Transparency Act 2023 are in place. Companies will then only be able to appoint a corporate director if all the directors of the corporate director are natural persons who have had their identity verified. Existing companies will be given 12 months in which to ensure that their corporate directors comply with the new requirements.
