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The practical implications of recent corporate case decisions

Gateley Legal

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In this episode, Sophie Brookes discusses the practical implications of four recent cases. She explains what happens when someone asks to inspect a company’s register of members, considers the meaning of “fair value” and “manifest error”, and cautions against using fictitious management charges to clear inter-company balances.

In this episode:

  • We look at some recent cases and have a look at what lessons we could learn from those and what it might mean for you in practice;
  • We explain what happens when someone asks to inspect a company’s register of members;
  • We outline the rules around inspection rights;
  • We outline the consequences a company and its directors face if they refuse inspection of a record when they should have allowed it;
  • We consider the meaning of “fair value” and “manifest error”;
  • We consider cautions against using fictitious management charges to clear inter-company balances.

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 in this episode, I thought we'd look at some recent cases and have a look at what lessons we could learn from those and what it might mean for you in practice. So I am going to be talking about cases. I am going to be quoting judges, but I promise I'll be very gentle with you.

So the first case concerned a member of a company wanting to inspect that company's register of members. So to give you a bit of background, every company has to keep certain records and documents. So things like registers of the company's members, directors, secretaries, its PSCs, that's people with significant control over the company, and then also various documents. So things like the directors' service contracts and charges that have been granted by the company, for example.

So lots of those records have to be made available for inspection by the public and that kind of transparency, that ability for the public to see inside the company is basically the quid pro quo for the company's limited liability status, which then protects its participators.

But some of those records contain personal information. So to protect those individuals and to prevent that public right of inspection from being abused, there are certain rules around inspecting some of those records, in particular, the register of members and the register of PSCs.

So if you want to inspect one of those registers, your request has to include certain information. So you have to state the name and address of the person making the request, the purpose for which the information is going to be used, and whether the information is going to be passed on to anybody else.

If a company gets one of those requests, it's only got five working days within which it either has to comply with the request, so it has to permit inspection of its records, or it has to apply to the court for an order that it need not comply, basically because the request isn't valid.

So it's quite a short period that, and the company has to act quickly because failing to comply with a valid request, so basically you refuse inspection of a record when you should have allowed it. Well, that's a criminal offence by both the company and its directors, and they can be liable to a fine. So the company has to act quickly and understand whether or not the request that it's received is valid and whether or not it needs to allow inspection of its register.

So these rules around this inspection right were introduced in October 2007, and they've been various cases since then which have tried to help shed light on when a company can lawfully refuse to comply with an inspection request. And the latest of those is the case I'm going to discuss now called Sir Henry Royce Memorial Foundation versus Hardy.

So this case was concerned with a charitable company that was aimed at preserving the legacy of Sir Henry Royce. So he was the co-founder of Rolls Royce. The company was run by a board of directors, which was elected by its members, and those directors were all unpaid volunteers because it's a charity.

The company had a sister company, although it wasn't exactly a sister company. It was called the Rolls Royce Enthusiasts Club, so I'm going to call that the club, but actually these two companies, they didn't really have a completely common membership. They didn't have the same members, although some people were members of both of them. But the board of each company could nominate a director of the other, so there was a relationship there between the two companies, between the company and the club.

So, Mr Hardy, he was a member of the company and also for a short period, about five months, he was the finance director of the club. And during that time, Mr Hardy claimed to have discovered some serious wrongdoings in the affairs of the club, and in particular, Mr Hardy alleged that this included instances of fraud, theft, false accounting against some of the directors of the club, but those individuals were also directors of the company.

So Mr Hardy wrote to the company asking to inspect its registered members, so exercising this inspection request that I've been talking about. And he said that the purpose of that request was to convene a special meeting of the company's members for various reasons, including in particular, to remove certain directors from office on the grounds that their alleged wrongdoings as directors of the club had caused irreparable harm to the company.

So he was trying to remove the directors of the company on the basis that their conduct as directors of the club, the other organization, had made them unfit for office. So there was no actual wrongdoing alleged in relation to their conduct as directors of the company.

But crucially, in Mr Hardy's initial request, it didn't state whether the information that was going to be revealed by the inspection, would be disclosed to any other person. So bearing in mind, the short time period that the company has within which it has to deal with a request, within three days of receiving the request, the company informed Mr Hardy by email, that it was refusing him access to the register of members and said it was going to be applying to the court for an order that it need not comply with the request.

Well, Mr Hardy responded to that email within about 15 minutes and emailed back to say that he'd noticed that he had inadvertently omitted to state in his request that he would not be making the information available to anyone else and that he had no intention of doing so. So remember, that's one of the things that your request to inspect the register of members has to state, whether you're going to make that information available to somebody else.

So when the court looked at all of this, the court said, well, actually, Mr Hardy's request to inspect the register of members was not a valid request and it made a no inspection order. So what the court said was that because the inspection request didn't state whether the information was going to be disclosed to anybody else, Mr Hardy had failed to comply with the relevant statutory requirements. So the judge said, well, that makes it invalid. It doesn't contain all the information required by the statutory provisions.

But if the initial request was invalid, which we say it is, could it then be corrected by the additional information which Mr Hardy then provided in his subsequent email? Well, again, the judge picked up on the short time period, that five working days within which a company has to comply with a valid request or challenge via the courts, and he said, well, the company needs to know where it stands when that request is made.

So if an error was discovered with a request, then the person making the request always have the option to file a new compliant request, but that wasn't what happened here. Mr Hardy hadn't sent a new request. He'd just tried to correct his initial request. So again, the judge said, well, no, the original request was invalid and the company didn't have to comply with it.

So having reached that conclusion, the judge could have just stopped there actually, but helpfully, he did go on to consider the purpose of Mr Hardy's request, and in particular, whether trying to remove directors from office due to their conduct in a different capacity. So in this case, their conduct as directors of a different entity, the club, could ever be a proper purpose to inspect a register of members.

And the judge said, well, yes, it is possible for that to be a proper person because a person's general conduct can reflect on the other institutions or entities that that person's connected with. But if that is the case, then the person making the inspection request had to do more than just make an allegation against the director in their capacity as a director of another entity, which on the face of it doesn't concern the activities of the company, which is the subject of a request.

So Mr Hardy would have had to show how the individual's conduct as directors of the club justified calling a meeting to remove them as directors of the company, and he hadn't done that in this case. So again, the judge said, well, that's not a proper purpose.

So what does that mean for you in practice? Well, if you're a company and you're on the receiving end of a request to inspect your register of members or your register of PSCs, then as I say remember you need to act quickly, within five working days which really isn't very long, and you can only refuse to comply with the request if it doesn't contain all the required information, as in this case, or if it's made for an improper purpose.

And there's a useful guidance note from ICSA, the Institute of Charter Secretaries and Administrators, or the Chartered Institute, it's now known as, about what is or isn't a proper purpose. So it's worth having a look at that if you get this kind of a request in.

But if you're the person who's thinking of making a request to exercise your inspection right, then again, I think this case is a good reminder that failing to comply strictly with the statutory requirements is going to mean that your request is going to be refused.

And given that the company is pushed into requesting a no inspection order from the court in such a short time period, then that failure, so not getting your request right in the first place, could prove costly because you could be ordered to pay the costs of the company's successful court application if the company's forced down that line.

So moving on, there are a couple of cases recently where the courts have looked at the meaning of some commonly used phrases, so in particular fair value and manifest error. So it's always worth remembering that when you're interpreting what's written in a contract, the courts will generally start from the words that are actually used, and if it's clearly written, then that clear wording will prevail.

So it's only if there's some ambiguity, so perhaps there are say two different but equally compelling interpretations in the drafting, only then will the court start to look at the broader context and start to look for the meaning that makes most commercial common sense.

So the first case which was called Euro Accessories Limited. This case looked at the meaning of the phrase fair value in a share valuation. So the shareholders of Euro Accessories were a majority shareholder who held just over 75% of the shares, so he held 75.01% of the shares. And then there was a minority shareholder who held the rest, so 24.99%.

So when the relationship between the two shareholders broke down, they agreed that the majority shareholder would buy the shares of the minority, but they couldn't agree on a price. The minority shareholder wanted £350,000 but the majority was only prepared to pay £175,000.

So having been able to agree a price and sort the transfer between themselves, the majority shareholder then took various steps to resolve that impasse between them. So he proposed and passed various resolutions, which amended the company's articles of association by inserting a provision giving the majority the option to acquire the minority shares, and that provision in the articles said that the consideration payable for the sale shares shall be fair value.

So the majority shareholder then exercise the option by giving notice to the minority shareholder and stated that the fair value of the shares was £175,000. He sent a check for that amount with the notice, but actually, the minority shareholder never cashed that check.

So the minority shareholder then challenged this arrangement, arguing that his shares had been taken off him for less than their fair value. I mean, he didn't actually challenge the amendment to the articles or the exercise of the option or the way the majority shareholder had done this and tried to resolve the impasse. All the minority objected to was the fair value, how much they'd been paid for their shares.

So the two shareholders applied different approaches when calculating and deciding what the fair value of the relevant shares was. The minority shareholder argued that the value of his shareholding, so his just under 25% shareholding, should just be a pro-rata value of the value of the entire issued share capital of the company. So basically the minority said, well, you work out a value for the whole, and then you give me my 24.99% share of that whole.

But the majority shareholder said that wasn't right, and you had to take into account the fact that the shares that were being sold were a minority interest. So you had to think about what a willing buyer and a willing seller would agree to pay for the shares. Because it's a minority interest, the value should be discounted to reflect that because that's what a buyer would do if they were buying those shares generally.

So in the decision, the judge agreed with the majority shareholder here, and the reason for that was that in the amended articles, what had to be fair value was the consideration that was payable for the sale shares. So the focus, therefore, was on the value of the property, the sale shares that were owned by the minority shareholder and was going to be transferred to the majority.

So the general principle with share valuation provisions for compulsory transfer, like this, is that what has to be given fair value is what is being acquired unless there's something in the relevant document that makes it clear that there's some other basis for valuation that should be used. And in this case, that was a minority interest, that was what was being transferred.

And so the court said the minority couldn't insist on being paid for something which his shares didn't entitle him to and which he didn't in fact own. So the minority was only entitled to receive an amount that was discounted to reflect the fact that his holding was indeed a minority interest.

The second case on contractual interpretation called Flowgroup versus Co-operative Energy. Well, this one considered what we mean by the phrase manifest error. So in this case, a buyer and a seller had entered into a share purchase agreement, and that agreement contained a working capital adjustment, under which a completion statement would be produced to verify the target working capital at completion.

So the agreement said that if there's any dispute in relation to the completion statement which the parties can't resolve and agree between themselves, then that dispute has to be referred to an expert for final determination.

And it also said, the agreement also said that the expert's written decision on the matters referred to them will be final and binding, save in the absence of manifest error. So those are fairly standard provisions in that kind of agreement, where you've got a working capital adjustment. The parties try and work it out between themselves. If they can't, they refer the relevant matter to an expert and they agree that the expert's decision is going to be final and binding so they will abide by it unless the expert has made a manifest error.

So in this case, after completion, the buyer prepared the draft completion statement and served it on the seller, and the seller disputed certain items that were in that statement. When the parties couldn't agree on them between themselves, they referred those items of dispute to an expert.

The expert's determination was largely favourable to the buyer, and in particular, it reduced the value of three categories of assets below the values attributable to them in the target's most recent management accounts. So the seller not happy with the expert's determination, brought a claim to set aside that determination for manifest error, including in relation to the way the expert had treated those three categories of assets.

So had the expert made a manifest error? That was the question here because remember the parties had agreed that they would be bound by the expert's decision unless there was a manifest error. So in order to challenge it, the seller has to show that there has indeed been a manifest error. So what is a manifest error?

Well, the parties agreed that this was an error that was obvious or easily demonstrable without extensive investigation. So they agreed on that basic theory about what a manifest error is, but then they disagreed on what that actually meant.

So the seller argued that that definition, so obvious or easily demonstrable, that meant basically there was a visibility test. So the error had to be capable of being demonstrated on the face of the record, and it didn't matter how complex or difficult the question was, an error would be manifest if it could be shown when set against the correct answer.

So the seller's argument was based on a case called Amey from 2018, but the buyer said that actually manifest errors were oversights and blunders so obvious and obviously capable of affecting the determination as to admit of no difference of opinion.

So what the buyer's saying was, well, a manifest error has to be more than just a wrong answer. It has to be a howler, and the buyer's argument was based on comments that were made in an earlier case called Veba Oil from 2001.

So the court, in this case, agreed with the buyer and dismissed the seller's claim to set aside the expert's decision for manifest error. The judge said that the test from that earlier Veba Oil case had not been incorporated into and replaced by the visibility test from the later decision in Amey. The Veba Oil case identified an important and necessary component of the manifest error exception.

So generally the courts have sort of emphasized that the circumstances in which an expert's decision can be challenged are tightly constrained, and if you just accepted the seller's simple visibility test, then that wouldn't really add any context to the word manifest in the phrase manifest error. You might as well just say error because that kind of plain visibility test would just allow all errors to be challenged, which would effectively make the courts the forum for anyone dissatisfied with an expert's decision, which kind of defeats the point of agreeing to allow an expert to resolve any differences and agreeing to be bound by that expert's decision.

So that case appears to confirm that a manifest error has to be one that's more than just wrong. It has to indeed be a clear and obvious howler.

So again, what do those cases mean for you? Well, I think really the key takeaway, and this is kind of the key takeaway frankly with any case where you are looking at contractual interpretation, is that it's always better to ensure that your contract says exactly what you mean it to say and be as specific as possible in that contract, rather than relying on a judge to interpret it in the way that you want, given that a judge may well interpret it in a completely different way.

So the final case that I thought I would talk about is all about the relationships between parent and subsidiary companies and the dangers of trying to dress those up in an artificial way. So the case was about a company called SSF Realisations Limited, which was a subsidiary of Loch Fyne Oysters Limited.

The subsidiary sourced and supplied fish and seafood at its own cost to its parent's customers. So, because the subsidiary was just doing that at its own cost, but the customers were customers of the parent, that meant that there was a substantial intercompany balance that had grown up over time and was owed by the parent to the subsidiary. So it was almost £950,000 by the time the events that we're talking about here came to pass.

So as it happens, the companies began to suffer financial difficulties and negotiations were started to sell them. The parent and the subsidiary were going to be sold to separate buyers, and it was agreed that there'd be a clean break. So there would be nothing owed from the parent to the subsidiary when those sales, those disposals took place.

So to do that, remember the companies had to deal with this big intercompany balance that had developed over time. So to get rid of that if you like, a board meeting of the subsidiary was called at which it was agreed to make a distribution to the parent, so to pay a dividend to the parent, and also to pay the parent a management charge. And each of those was then set off against the debt due from the parent to the subsidiary in order to reduce that intercompany balance to zero.

The subsidiary later went into liquidation, and the liquidator argued that in fact, the management charge was really a disguised distribution and that both the management charge and the distribution were in fact unlawful.

So here the judge in his decision agreed basically with the liquidator and said that the assumption of the management charge by the subsidiary was in fact a voluntary distribution by the subsidiary to the parent. The parent had never previously charged a fee for any services, any management services if you like, that it provided to the subsidiary, and there was no liability for that. No liability to the parent for those kind of management charges recorded in the subsidiary's books.

So the judge looked at the relationship between a parent company and its subsidiary and said, well, generally it's going to be in the interests of the parent that its subsidiary business is successful, and the parent would benefit from that success through increased value in the shares it holds in the subsidiary.

So it's perfectly possible that a parent might choose to support a subsidiary financially by contributing capital as opposed to debt, or by providing benefits in kind so providing goods or services of some sort to a subsidiary, but without requiring the subsidiary to pay for them because the parent is going to benefit in other ways, rather than just requiring a payment.

So in this case, there was no agreement between the parent and the subsidiary for the subsidiary to reimburse the parent via a management charge for any of the services that the parent provided to the subsidiary.

So the judge said, well, that meant that the legal relationship under which the parent provided that support must have been that of shareholder and company, not creditor and debtor. So the parent's entitlement to benefit from having provided services to the subsidiary is just via its rights conferred on it as a shareholder. So for example, by the increased value of its shares, or maybe by dividends.

And when the subsidiary later agreed to assume a liability to pay for services made available to it by the parent by agreeing to pay a management charge to the parent. Well, the judge said it was agreeing to make that payment for no consideration because there was no expectation that the subsidiary would have to pay for it. And that was basically a voluntary distribution by the subsidiary of its assets to its shareholder.

And because the combined total of the dividend and this disguised distribution, that was represented by the management charge, exceeded the subsidiary's available distributable profits, then that meant it was an unlawful distribution. Remember distributions by a company can only be made out of available distributable profits, and here, if you added up the amount of the management charge and the proposed dividend, well that was more than the subsidiary had available to distribute.

So that meant that the parent was liable to repay that amount, the unlawful distribution, back to the subsidiary. But also two of the directors of the subsidiary who had authorized the unlawful distribution, so the directors who'd authorized the payment of the management charge and unlawful distribution to the parent, well they were also liable to compensate the subsidiary for that amount because they had breached their duties to the subsidiary in authorizing the payment of that unlawful distribution.

So again, well, what does that mean for you in practice? How could it affect you? I think it's a good reminder that using things like fictitious management charges to clear intercompany balances can be open to challenge if that doesn't actually reflect the circumstances in which those balances originally arose and the commercial realities of the relationship between the parties.

So if a parent is expecting to be paid for something that it provides to a subsidiary, then that needs to be documented at the time it's provided.

So that's it for this months roundup of recent developments, a bit of a run through some cases. I hope that was of interest, and you could see how those decisions could have some practical impact for you. I'll be back next month with another roundup of other developments of interest.

Thank you for listening to Talking Business. To find out more about the series, please visit Gateleyplc.com/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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