Article / 1 Oct 2021
In this month’s update for directors, secretaries and general counsels we:
At the start of the coronavirus pandemic last year the Government introduced a range of measures aimed at protecting businesses from the associated financial uncertainty. Whilst a number of those measures have since been relaxed, new limited restrictions on the use of winding up petitions have recently been announced.
Some of the key measures introduced by the Corporate Insolvency and Governance Act 2020 (CIGA) protected a company from actions by a creditor. In particular with effect from 1 March 2020, there was:
Recognising that the financial effects of the pandemic continue to be felt, the government has announced new measures aimed in particular at protecting smaller businesses and protecting businesses from creditors seeking repayment of relatively small debts.
The new measures, which are contained in the Corporate Insolvency and Governance Act 2020 (Coronavirus) (Amendment of Schedule 10) Regulations 2021, prohibit a creditor from presenting a winding up petition unless:
These new measures came into effect on 1 October 2021 and will initially apply until 31 March 2022.
The provisions will be welcomed by those businesses that continue to feel the financial effects of the pandemic but are unlikely to be popular with commercial landlords who face another six months of being unable to pursue tenants for arrears.
The Government has also announced a mandatory arbitration process to help resolve disputes between landlords and tenants over unpaid rent. However, the exact detail of the scheme is still awaited.
The High Court has found that certain directors of a company that issued shares in order to be able to defeat resolutions to remove some of those directors from office had breached their fiduciary duties to the company.
In TMO Renewables Ltd (In Liquidation) v Yeo [2021] EWHC 2033 (Ch) the board of directors of a company had disagreed about how to raise much needed additional funds for the company which was on the brink of insolvency.
This led to a dispute between four of the directors (the Defendant Directors) and the other two directors (the Dissenting Directors) with the Dissenting Directors refusing to sign a circular to shareholders reporting on the company's business strategy and an intended fundraise. The Dissenting Directors subsequently joined forces with another shareholder to requisition a general meeting of the company, proposing resolutions to remove certain of the Defendant Directors and appoint a new director.
The Defendant Directors duly issued the required notice of general meeting. But, after that notice had been issued and before the meeting had been held, the Defendant Directors issued over 77 million shares to two new shareholders. The bulk of the shares were issued to an entity called Market Place in return for £3 million. But, crucially, those subscription monies were not paid immediately and instead were to be paid over the following two years. Nonetheless, Market Place was still permitted to vote at the upcoming general meeting.
When the resolutions were put to the shareholders at the requisitioned meeting, the new shareholders voted against them and, as a result, the resolutions were defeated.
Just two months later, the company went into administration. Following a sale of its business and assets, a liquidator was appointed who then brought claims against the Defendant Directors for breach of their fiduciary duties in connection with the requisitioned meeting. In particular, the liquidator argued that the Defendant Directors had breached their duty to use their powers only for the purpose for which they had been granted. According to the liquidator the directors had exercised their power to issue shares not in order to raise capital for the company (a proper purpose) but in order to defeat the resolutions proposed at the requisitioned meeting and retain their control over the company (an improper purpose).
The court found that the Defendant Directors had exercised their powers predominantly for an improper purpose and so had breached their fiduciary duties to the company. Various factors indicated that the Defendant Directors had issued the shares in order to defeat the resolutions including:
However, despite having found that the Defendant Directors' breached their duties, the court went on to dismiss the claims against them due to lack of causation. The court found that, even without the Defendant Directors' actions, the company would still have gone into administration in any event.
This case is a warning note for directors that the powers conferred on them as agents of the company they represent must only be exercised for the purposes for which they were conferred. Where, as is often the case, there are mixed purposes behind the directors' actions, the court will look at the predominant purpose and assess whether that was a proper or improper one. In relation to the power to issue shares, case law is clear that this power is conferred for the purpose of raising capital. So, exercising that power for another predominant purpose will risk the directors being in breach of their duties.
The High Court has held that a provision in a loan agreement which increased the pre-default rate of interest of 3% per month to 12% per month post-default was unenforceable as it represented a penalty.
Under English law, a contractual provision which imposes a monetary penalty on a defaulting party which is out of all proportion to the actual harm done to the other party is generally unenforceable.
Whilst historic cases focused on whether or not the penalty imposed was a genuine pre-estimate of the loss suffered by the non-defaulting party, the rule against penalties was reformulated in Cavendish Square Holding B.V. v. Talal El Makdessi [2015] UKSC 67. As stated in that case, the test now is whether the relevant provision is "a secondary obligation which imposes a detriment on the contract-breaker out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation."
The innocent party's legitimate interest is in performance of the contract as agreed or an appropriate alternative to performance. There is no legitimate interest in simply punishing the defaulting party. So the test is whether, in comparison with the value of that legitimate interest, the detriment imposed by a clause is "exorbitant, extravagant or unconscionable".
In the case of default interest rates, the courts have held that the key factor when considering whether the relevant provision imposes a penalty is the size of the uplift between the pre- and post-default rates of interest.
In Ahuja Investments Ltd v Victorygame Ltd and another [2021] EWHC 2382 (Ch) a buyer had agreed to acquire a commercial investment property from a seller. As the time for completion approached, it became apparent that the buyer did not have sufficient funds to complete the transaction and risked losing its deposit. To ensure that the transaction could go ahead, the seller offered to loan £800,000 to the buyer.
The loan was to bear interest at 3% per month, compounded monthly, which would increase to 12% per month, again compounded monthly, if the loan was not repaid by an agreed redemption date. The loan was also guaranteed by two individuals behind the corporate buyer and was secured on a property owned by one of those individuals.
In a subsequent dispute between the parties the buyer argued, amongst other things, that the default interest provision in the loan agreement was an unenforceable penalty.
The court found that the obligation to pay interest at the default rate was a secondary obligation: it arose on a breach by the buyer of the primary obligation to repay the loan by the agreed redemption date.
It was then necessary to consider whether the 400% increase in the interest rate was properly characterised as a penalty and here the onus is on the party alleging that a clause is a penalty to show that it is exorbitant, extravagant or unconscionable. The court 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 that borrower represents an increased credit risk. But the question was whether the default interest rate applied because of that increased credit risk was, in all the circumstances, extravagant, exorbitant, or unconscionable. There was no evidence that the default interest rate in this case was fixed to reflect the seller's genuine assessment of the buyer's creditworthiness, particularly in the context of the additional security that had been given by the individual guarantees and the charge over the property.
Accordingly the court found that the fourfold increase in the interest rate, coupled with the monthly capitalisation of the interest, was "so obviously extravagant, exorbitant and oppressive as to constitute a penalty".
It is common for loan agreements to include an increased rate of interest which applies when the primary obligation to repay the loan is breached. Whilst lenders may be concerned about this decision, it is helpful that the court stated that an increase of up to 200% in the applicable rate to reflect the increased credit risk of a borrower in default would be accepted "without supporting evidence". However, any increase above that level would require additional evidence from the lender.
A noticeable factor in the court's decision in this case was the fact that the interest compounded monthly. This meant that by the time the case came to trial in August 2021, the original loan of £800,000 made in August 2018 had grown to over £30 million.
First published in Accountancy Daily.
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