Corporate update: the latest corporate law developments September 2024

10 year restrictive covenant linked to loan note repayment was unenforceable

In Literacy Capital Plc v Webb [2024] EWHC 2026 the High Court considered a restrictive covenant in an investment agreement and found that it was unenforceable as it was too widely drafted and lasted too long.

Facts

In 2014 a doctor founded a company that provided medical services to sexual assault referral centres (SARCs) operated by the police. The company did well and in 2018 the founder sold a controlling interest to an investor. The founder received some consideration upfront with the balance left outstanding via a loan note which would be repaid on a long stop date or on an earlier sale of the company.

The founder remained with the company until 2021 when she resigned and renegotiated the sale of her shares which, by then, were worth around £7m. The investor and the founder entered into a new investment agreement and the original loan note was replaced by one which would be redeemed in 2028 (subsequently extended to 2030) or an earlier sale. The loan note carried interest at 7% per annum (around £500,000), which would cease if the founder breached the restrictive covenants in the investment agreement. Those covenants included:

• a non-compete provision which affected all staff paid out in the 2021 deal and which applied for one year after their employment terminated; and
• a further non-compete provision that affected the founder and which applied UK-wide until one year after the 2030 longstop date for redemption of the loan note – effectively a 10 year period.

After resigning, the founder set up another business. Following the end of the 12 month ex-employee non-compete restriction, the new business began to provide services that were competitive with those supplied by the company. In particular, it won a tender for providing SARC services to South Wales Police.

The investor brought a claim for an interim injunction to prevent the founder, via her new business, trading in competition with the company in breach of the longer restriction, linked to the loan note which the founder continued to hold.

Decision

The judge confirmed that, as the restrictive covenant was in restraint of trade, the starting point was that it would be unenforceable unless the investor could prove that it was reasonable. When assessing what was reasonable, the Court would consider the areas of trade or services restricted, the geographical area covered and the duration of the restriction.

In this case, the judge found that the restrictive covenant was void and unenforceable as it was too widely drafted and applied for too long a period. In particular:

• the covenant applied UK-wide but, other than asserting that they had “nationwide ambition”, the investor had failed to provide any evidence of the geographical scope of the company’s contracts beyond Suffolk and Norfolk;
• the scope of the convent went far beyond the company’s core services provided when the founder worked for it and included areas such as management consultancy, supplying administrative staff to HM Courts and mental health services – fields in which the founder had no expertise; and
• the investor had failed to justify the 10-year time period which far exceeded the duration allowed in ex-employee or sale of business cases.

As a result, the covenant went far beyond protecting the investor’s legitimate interests in acquiring the company and protecting the goodwill in that business.

Comment

This was a decision on an interlocutory injunction application so it did not involve a full trial on the facts. As the judge noted, this is not generally the stage for analysing the reasonableness of restrictive covenants. However, he concluded that, exceptionally and on the facts of this case, it was appropriate to rule that there was no arguable issue about the covenants’ lack of validity.

Register of members conclusive of company membership despite “fraud”

The Court of Appeal has confirmed that the identity of a company’s members is to be determined by the entries in the company’s register of members at the relevant time. In the absence of rectification, this principle will apply despite a person’s name having been wrongly removed from the register as a result of forgery or fraud (Bland v Keegan [2024] EWCA Civ 934).

Register of members

Every company is required to keep a register of its members and that register must contain specified information, including the number and class of shares that each member holds.

A person will become a member of a company when they agree to be a member and their name is entered on the register of members. (Subscribers to the company’s memorandum of association will automatically become members on the company’s registration.) The register of members is “prima facie” evidence of a company’s membership.

Where there is an error in the register of members, an application should be made to the court for rectification of the register. However, in the absence of any dispute, directors can correct minor mistakes in the register without applying to court.

Directors need certainty as to the identity of a company’s members, not least to ensure the validity of shareholder resolutions. Resolutions that have been passed as a result of the votes of non-members are open to challenge and are potentially void.

The issue

The issue before the Court of Appeal was whether the liquidators of a company had been validly appointed by a special resolution signed by the purported sole member of the company (Julie).

The validity of the resolution had been disputed by the Appellant in the case, who alleged that Julie had fraudulently executed a stock transfer transferring the Appellant’s 50% shareholding in the company to Julie. The Appellant claimed that as the transfer of shares was void, the special resolution was also void because Julie only held 50% of the company’s shares (rather than the required 75%).

Although the company’s register of members could not be found, the Court assumed that the register would have reflected filings made at Companies House showing the unauthorised transfer (and, therefore, Julie being registered as the sole member of the company).

Court of Appeal decision

The Court of Appeal dismissed the appeal, finding that the special resolution appointing the liquidators had been validly passed.

The Court confirmed the fundamental principle that “except where express provision is made to the contrary, the person on the register of the members is the member to the exclusion of any other person, unless and until the register is rectified.” This principle applied for the purposes of voting on a shareholder resolution “even in a case where a member’s name has been wrongly removed from the register as a result of forgery or fraud.”

On that basis, the only member of the company entitled to vote on the special resolution was Julie.

Comment

It may seem unfair that a shareholder can lose their rights as a member of a company due to the unauthorised or even fraudulent transfer of their shares. However, as confirmed in this case, the Court has the power to undo the effects of any misconduct by ordering rectification of the register and the payment of compensation to affected parties.

A Court will have discretion as to whether any rectification order should have retrospective effect. If the Appellant had applied for (and won) such an order, the special resolution would not have been passed by members holding at least 75% of the shares, and the outcome of this case could have been very different.

First published in Accountancy Daily.