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Corporate law update: reducing red tape post-Brexit

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In this month’s update, host Sophie Brookes talks us through some changes proposed in the Government’s policy paper aimed at reducing red tape post-Brexit as well as some more immediate changes to the rules on winding up petitions in the wake of the coronavirus pandemic. Sophie also discusses two recent cases which considered whether a company’s directors had breached their duties by issuing shares to defeat resolutions at a general meeting and whether increasing the pre-default interest rate in a loan agreement by 400% post-default was an unenforceable penalty.

In this episode:

  • We consider ways in which the Government's policy paper can reduce red tape and the regulatory burden on businesses following Brexit.
  • We discuss a new proposal which has recently been introduced into parliament that relates to having worker representatives on a board of directors. 
  • We review a case where company directors breached their duties by using their powers for an improper purpose.
  • We consider a decision which found that a default interest rate in a loan agreement was an unenforceable penalty.

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This episode is part of our Talking Business podcast series. Learn more about the series and what we cover. This podcast is available on iTunes, Spotify and Soundcloud.

Read the transcript:

Sophie Brookes: Welcome to Talking Business, your straight talking guide to dealing with corporate matters, whether you are a private or public company, an owner managed business, or an entrepreneur, a director, company secretary, or in-house counsel, this is the podcast for you. My name is Sophie Brookes and I'm a partner in our corporate team. I was a transactional lawyer for a number of years before becoming a professional support lawyer, which means I'm now responsible for know how across our corporate team. Each month, I'll provide an update on the latest developments that matter to you. And we'll be joined by an expert to take a deep dive into a key corporate law topic.

So, first up this month is the government's policy paper, which is aimed at considering ways in which it can reduce red tape and the regulatory burden on businesses following Brexit. So, this is the paper that contains some headline grabbing measures, things like selling goods and Imperial measurements and putting the crown stamp back on pint glasses that you might've seen got some media attention. But there are also some other measures in there, which I thought might be of interest. For example, there's a proposal to set up a new database of all UK regulations affecting businesses which will have additional data in there that will make it easier to understand each regulation and its context. And the government has said that database would be openly accessible so that other organizations and individuals can use it to develop new apps that help people to understand and navigate the UK regulatory regime. The program will also develop a tool for businesses that will help firms to identify the regulations as relevant to them and understand what actions they need to take in response.

So, having that kind of central database that you can go to almost as a one-stop shop to find out everything that's relevant for your business, I think, could be really helpful. Then there's also a proposal to set up an independent industry working group of experts to look at increasing best practice and confidence in using electronic signatures and other electronic ways of executing documents. So this is something that was recommended by a previous law commission report when that report concluded that e-signatures were legally valid for the vast majority of businesses and legal transactions in the UK. But despite that, there is still, I think, some uncertainty or perhaps reluctance in this area. And I think the government hopes that by improving clarity then that group's work will help ensure that businesses can use electronic documentation with confidence, and that hopefully will then enable them to make the most of digital innovations, and in particular, greener working practices.

And then finally, another thing that the paper was proposing is the dematerialization of the minority of shares that are still held in paper rather than electronic form. So the policy paper states that holding shares in paper form is more expensive and it takes longer for the holders of those shares to trade them. And also, obviously there's always the risk of certificates going astray. It isn't actually made clear in the policy paper, but it's assumed that this refers to shares in publicly listed or traded companies and not private companies which almost exclusively hold their shares in paper form. So this policy paper says that the government's going to work with industry and regulators and shareholders to determine the best mechanism for converting those existing remaining paper shares into electronic form, obviously, while preserving the rights of existing shareholders. So those are some things to watch out for at some point in the future, but something which is already come into force, or is literally just on the cusp of coming into force, are some new rules about when a creditor can issue a winding up petition for an unpaid debt.

So back at the start of the coronavirus pandemic last year, the government introduced a whole range of measures that were aimed at protecting businesses from the associated financial uncertainty. And some of those in particular protected a company from actions by a creditor. So those original measures provided that from the 1st of March last year, 2020, there was a blanket prohibition on presenting a winding up petition based on a statutory demand served after the 1st of March. And then there was also a restriction on a creditor winding up a company where the company's inability to pay its debts was due to the financial effects of the pandemic. So those restrictions expire on the 30th of September 2021, this week. But, I think recognizing obviously that the financial effects of the pandemic do continue to be felt, the government's announced some new measures which are aimed in particular at protecting smaller businesses and protecting businesses from creditors who are seeking repayment of relatively small debts.

So we've got some new regulations which amend the Corporate Insolvency and Governance Act of 2020. And the new regulations prohibit a creditor from presenting a winding up petition unless basically four key conditions are met. So the first thing is that the relevant debt has to relate to something other than non-payment of rent or another amount like insurance or service charges or something under a business tenancy. So basically what that means is the existing prohibition on presenting a winding up petition for unpaid commercial rent is effectively retained, so that's going to continue. So the second condition is that the creditor has to have made a formal request to the company seeking proposals for the repayment of the relevant debt. Thirdly, the company has to have not made a proposal for the payment of the debt which satisfies the creditor within 21 days of that formal request being made.

So basically what that means is there's a compulsory 21 day period between a demand for repayment and presentation of a winding up petition. Although actually, in exceptional circumstances, the court can shorten that period, and in fact even waive the requirement for a formal request altogether. And then finally, the debt, or if there's more than one debt included in the petition, that the combined total of the debt has to be £10,000 or more. So that's gone up. It was £5,000 or more under the original measures. So as I say, these new measures come into effect on the 1st of October, and they're going to initially apply for six months until the 31st of March next year, 2022.

So I think for those, obviously for those businesses that continue to feel the financial effects of the pandemic, those new provisions are going to be very welcomed. They potentially were facing a cliff edge of the protective measures falling away on the 30th of September and possibly a deluge of winding up petitions. Obviously for commercial landlords, it's not great news because they're going to face another six months of being unable to pursue tenants for arrears.

Another possible, though I'll have to admit very unlikely change, that I just thought I'd mention, is one that relates to having worker representatives on a board of directors. So this is a proposal that's contained in the employment bill which has recently been introduced into parliament. And if that bill becomes law, then it would require companies of a certain size, so basically with a minimum number of employees or pre-tax profits, to ensure that at least a third of their board comprises directors that are responsible for bringing the perspective of a worker to the boardroom. As I say, it is very unlikely, this change, because actually the legislation has been introduced as a private member's bill into Parliament by the Scottish National Party, actually, and so it's not officially endorsed by the UK government and the likelihood of it being passed and making its way onto the statute book is slim.

There is minimal chance of that. But I thought it was just an interesting one to mention given the increased focus that we've had in recent years on the consideration of workforce issues at board level. So those are some changes which might come into force, which have already come into force, to just some things on the horizon to be aware of. And then there were a couple of cases that I thought I would finish off with this month. So the first one relates to some company directors who were found to have breached their fiduciary duties in connection with the general meeting. So the case is called TMO Renewables Limited versus Yo. And it concerned a company that was basically on the brink of insolvency. It had six directors, but they basically disagreed about how to raise the additional funds which the company really needed in order to keep it afloat.

So that led to a dispute when two of the directors, and I'm going to call them the dissenting directors, they refused to sign a circular to shareholders reporting on the company's business strategy and an intended fundraising event. Those dissenting directors then joined forces with another shareholder in order to requisition a general meeting of the company at which they were proposing resolutions to remove certain of the other directors and appoint a new director. So the other directors, the other four directors, and I'm going to call them the defendant directors, because they were the ones that were then the subject of the claim in the court case, when they got this request for a general meeting from the dissenting directors, the defendant directors issued the required notice of general meeting, so they did what they needed to do. But, crucially, after the notice had been issued, but before the meeting was held, the defendant directors issued over 77 million shares to two new shareholders.

Now the bulk of the shares were issued to an entity called Marketplace in return for 3 million pounds. But, the subscription monies were not paid immediately and instead they were going to be paid over the following two years. So basically, shares were issued to Marketplace, but it hadn't yet paid for them. Except that, under the terms of the share issue, even though it hadn't paid for its shares, Marketplace was still permitted to vote at the upcoming general meeting. So at that meeting, when the resolutions were put to the shareholders, the new shareholders voted against them, casting the votes attached to their new 77 million shares, and as a result of that, the resolutions were defeated. Now unfortunately, just two months later, the company went into administration. And following a sale of its business and assets, a liquidator was then appointed who brought claims against the defendant directors for breach of their fiduciary duties in connection with that requisition meeting.

So, in particular, the liquidator argued that the defendant directors had breached their duty to use their powers only for the purpose for which they are granted. According to the liquidator, the defendant directors had exercised their powers to issue shares, not in order to raise capital for the company, which would have been a proper purpose, but instead in order to defeat the resolutions proposed at the requisitions meeting and so retain their control over the company, which was an improper purpose. So the court, when it looked at all of this, essentially agreed with the liquidator and said that, yes, the defendant directors had exercised their powers predominantly for an improper purpose and so they had breached their fiduciary duties to the company. There were various different factors which indicated that the defendant directors had issued the shares in order to defeat the resolutions, including, for example, the fact that the defendant directors agreed to defer the payment for the shares issued to Marketplace.

So the court said, well, that's completely inconsistent with the defendant director's argument that actually the shares had been issued to alleviate the company's immediate cash problems, because they didn't alleviate those cash problems because Marketplace didn't actually have to pay for the shares for two years. And then also, some of the language that the defendant directors used in emails and board minutes, things like references to winning the vote and bringing in the votes, and again, the court said, well, that indicated that actually defeating the resolutions was a primary motivation behind the share issue. So the court said, yes, the defendants have breached their duty because they have not exercised their powers for the purpose for which they'd been granted. But, plot twist, despite that, the court actually went on to dismiss the claims against the directors due to lack of causation. And basically what happened here was the court said, well, even if the defendant directors hadn't done that, the company would still have gone into administration in any event.

So it wasn't as a result of the defendant's actions that the company went into administration, so there wasn't a direct causal link between their breach of duty and the losses suffered. So I just thought that was quite an interesting warning note, if you like, for directors, that when they are given powers in their capacity as agents of the company that they represent, they must only be exercised for the purposes for which those powers are conferred. And if, as in fact it is often the case, there are mixed purposes behind the director's actions, then the courts will look at which one is the predominant purpose and assess whether that was a proper or improper one. And in particular, in relation to the director's power to issue shares, while case law there is very clear that that power is conferred on the directors in order to raise capital for the company. So exercising that power for another predominant purpose, like defeating resolutions at a general meeting, will risk the directors being in breach of their duties.

Okay. Then finally, I thought I would mention a case in which the high court 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 because it represented a penalty. Now, 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. And the relevant test to decide whether a provision is in fact a penalty is whether that provision is a secondary obligation which imposes a detriment on the defaulting party, which is out of all proportion to the legitimate interest of the innocent party in the enforcement of the primary obligation. So, the courts have said previously that the innocent party's legitimate interest is basically in performance of the contract as agreed or an alternative appropriate, sorry, an appropriate alternative to performance, and there's 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 or extravagant or unconscionable. And in the case of default rates of interest, which obviously are very common, the courts have held that the key factor when considering whether the relevant provision imposes a penalty is basically the size of the uplift between the pre and post default rates of interest. So this case related to, it is called Ahooya Investments Limited versus Victory Game Limited. And in the case, a buyer had agreed to acquire a commercial investment property from a seller. But as the time for completion approached, it became apparent that actually the buyer wasn't going to have sufficient funds to complete the transaction. And if the buyer hadn't completed the transaction by the required date, it would have lost its deposit.

So to ensure that the transaction could go ahead, what happened was the seller offered to loan £800,000 to the buyer. So in the relevant loan agreement, it said that the loan would bear interest at 3% per month, compounded monthly, which would then increase to 12% per month, again, compounded monthly, if the loan was not repaid by an agreed redemption date. And then, as well as that, the loan was also guaranteed by two individuals who were behind the corporate buyer, and it was secured on a property owned by one of those individuals. So under the overall documentation, we've got that increased interest rate, and the seller has the protection of guarantees from two individuals and also a charge over property. So in a subsequent dispute between the parties, one of the arguments that the buyer put forward, amongst other things, was that the default interest provision in the loan agreement was an unenforceable penalty.

Because, as I say, the party argued that the clause basically imposed an exorbitant or extravagant or unconscionable detriment in the context of the seller's legitimate interests. So when the court looked at the arrangements, the court said 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 agreement by the redemption date. So we have got a secondary obligation here, so that's the first sort of hurdle in construing the clause as a penalty. So then you have to go on to consider whether the four-fold increase in the interest rate from 3% to 12% was properly characterized as a penalty. And here the court said, well, the onus on that is on the party alleging that the clause is a penalty to show that it is indeed exorbitant or extravagant or unconscionable.

And the court interestingly accepted that, yes, a lender has a legitimate commercial interest in applying a higher rate of interest to a borrower who is in default, because obviously that borrower represents an increased credit risk. But the question was whether the default interest rate applied because of that increased credit risk was actually in all the circumstances exorbitant or extravagant. There was no evidence that the default interest rate in this case was fixed to reflect the sellers genuine assessment of the buyer's creditworthiness, particularly in context, as I say, of the additional security that had been given by virtue of the individual guarantees and also the charge over the property. So as a result of all of that, the court said that actually the fourfold increase in the interest rate, coupled with the monthly capitalization of the interest, was so obviously extravagant, exorbitant and oppressive as to constitute a penalty.

So, as I say, it's very common for loan agreements to include an increased rate of interest which applies when the primary obligation to repay the loan is breached. And lenders might be a little bit concerned about this decision, I think, but I think it is helpful that in the judgment, the court actually said that they felt an interest 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. But any increase above that level, the court said, would actually require additional evidence from the lender.

I think another noticeable factor in this case was the fact that the interest compounded monthly. And that meant that actually, by the time the case came to trial in August 2021, the original loan of 800,000 pounds made in August 2018 had actually grown to over 30 million pounds. So I think when you put it in a context like that, you can start to see why the court might begin to say, hang on a minute, this is extravagant or exorbitant, and therefore, is an unenforceable penalty. That's it for this month. Hope you found that interesting and we'll see you next time. 

Thank you for listening to Talking Business. To find out more about the series, please visit gateleyplc.com/podcast/talkingbusiness. From there, you can subscribe for all updates, meet our speakers and get more information on all of the topics being discussed.

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