In depth

Corporate update: the latest corporate law developments June 2022

Gateley Legal

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In this month’s update we consider

  • consider a case where the buyer failed to follow the proper procedure when calculating an earn out;
  • explain the implications for shareholders of a company being construed as a quasi-partnership; and
  • tell a cautionary tale for directors of the perils of not keeping their registered address up to date!”

Failure to follow earn out procedure - But no loss suffered

In Asher v Jaywing Plc [2022] EWHC 893 (Ch) the High Court considered the impact of the parties' failure to follow the procedure specified in an agreement for the calculation of earn out payments. Whilst the court found the required procedure had not been followed, it also found that the sellers were not entitled to any further payment as the relevant targets had not been met.

Earn outs

An earn out refers to a portion of consideration payable on the sale of a business which is paid after completion based on the target's post-completion performance. It is often used to incentivise sellers who remain with the business post-acquisition and/or to bridge a valuation gap between the sellers' expectations and the amount the buyer is prepared to pay.

Since the earn out is paid by reference to the target's post-completion performance, the agreement will set out how that performance will be measured. Typically this will involve some form of reference accounts with a specific procedure for preparing and agreeing those accounts.

The facts

This case arose out of the sale of a digital marketing business in 2016 where part of the consideration was structured as an earn out consisting of three potential payments depending on the target's performance in the two years following completion. Whilst the first payment was made in full, the buyer did not pay the second and third payments on the basis that the conditions for payment had not been met.

Those conditions were set out in the related sale agreement. This provided for the target's "Contribution" (broadly, revenue less costs) to be measured for each relevant period based on "Reference Accounts" which were defined as "the accounts of the Company including an audited balance sheet and profit and loss account" for the relevant period. The buyer had to deliver the Reference Accounts to the sellers together with an "[Earn-out Statement] prepared by the Buyer's auditors". The agreement went on to set out a process for the sellers to dispute the figures shown in the Earn-out Statement and for those disputes to be resolved by an independent accountant. If the final Earn-out Statement, agreed between the parties or determined by the independent accountant, showed that the target Contribution had been met, the sellers would be entitled to a payment.

In fact, the documents sent to the sellers relating to the second and third payments were an unsigned copy of the audited accounts and an Earn-out Statement prepared by the buyer's CFO. Amongst other things, the sellers argued that because of this the buyer had breached the agreement and, as a result, they were entitled to damages equal to the earn-out payments they claimed they should have received.

The decision

In relation to the documents delivered to the sellers the court found that the unsigned copy of the audited accounts sent by the buyer did satisfy the requirement to send the Reference Accounts (defined as above).

But, in relation to the Earn-out Statement, the court found that this had not been prepared by "the Buyer's auditors" and so did not meet the agreement's requirements. In fact, when the buyer had approached its auditors to prepare the required statement they had declined to act due to independence concerns. So the Earn-out Statement had been prepared by the buyer's CFO. Another firm of accountants had then reviewed the statement before it was provided to the sellers.

The buyer argued that the reference to "auditors" in the definition of the Earn-out Statement should be construed as a reference to any appropriately qualified third party firm of accountants engaged by the buyer. The court declined to adopt this interpretation, holding that as the preceding definition of "Reference Accounts" clearly referred to an "audited balance sheet and profit and loss account", the reference to "auditors" in the next line must mean the buyer's statutory auditors.

The court was prepared to accept the buyer's argument that, on the grounds of business necessity, a term should be implied into the agreement to the effect that if the statutory auditors declined to act, the buyer could engage another appropriately qualified firm of accountants to prepare the Earn-out Statement. But, again, the judge found that the Earn-out Statement delivered by the buyer did not comply with this implied term as it had not been prepared by an appropriately qualified firm of accountants. It had been prepared by the buyer's CFO and although a firm of accountants had reviewed it and suggested changes, the CFO had not accepted all of those amendments.

So the buyer had failed to follow the required procedure for agreeing the earn-out payments. The fact that the sellers had not raised an objection to the buyer's Earn-out Statement within the specified period was immaterial: those provisions did not come into effect given the buyer's breach and the sellers could not be deemed to have agreed to a document that was not an Earn-out Statement (as defined).

But the sellers' success on these points was of no consequence. Having found that the buyer was in breach of the agreement, the court went on to consider the level of damages to which the sellers were entitled. This involved an assessment of the earnout payments to which the sellers would have been entitled under the agreement. But the court found that the relevant Contribution targets had not been met, meaning no payments were due to the sellers. Accordingly, the sellers were not entitled to any damages in respect of the buyer's breach.

Comment

This case is a reminder of the importance of following the specific procedure set out in the related agreement when preparing and agreeing any reference accounts. This procedure will vary from agreement to agreement but unless it is strictly adhered to the parties could easily find themselves adversely affected.

Family company deemed to be Quasi-partnership

The High Court has held that a company run by a mother and son was in fact a quasi-partnership meaning that a relationship of trust and confidence existed between them and, therefore, they were subject to equitable considerations when exercising their strict legal rights and powers.

Quasi-partnership and unfair prejudice

A company is a legal person, separate from the shareholders who own it. Generally, those shareholders are free to exercise their rights relating to the company in any way they wish and they do not owe any duties either to the company itself or to the other shareholders (unlike directors who do owe duties to the company). But in some situations the law recognises that a company has been formed due to the close personal association between its individual shareholders and therefore the rights, expectations and obligations of those individuals as between each other are recognised.

In such a case, the participants in the company will be deemed to have a partnership-like relationship – a relationship of mutual trust and confidence - with all the associated equitable considerations. On a practical level, this would typically include an understanding that all or some of the shareholders will participate in the conduct of the company's business as well as restrictions on the shareholders' ability to transfer their shares.

Acting in a way which is inconsistent with this relationship of trust and confidence could amount to unfairly prejudicial conduct, even though the relevant acts may be permitted on a strictly legal basis. Where a company's affairs have been conducted in a manner which is unfairly prejudicial to the interests of one or more of its members, the affected member(s) can petition the court. If unfair prejudice is proven, the court has a wide range of remedies available to it, with the most drastic being an order that the company be wound up but the most common being an order that the shares of the unfairly prejudiced member(s) be bought out at their fair value.

The facts

Re Clive Smith (Oxford) Ltd [2022] EWHC 1035 (Ch) involved a dispute between a mother and son in relation to a company operating a garage in Oxford. The mother and her husband, the son's father, each originally owned 50% of the shares in the company and together were its only directors.

The son was appointed as an additional director and, on the father's death, shares were transferred to the son so that he held 20% of the shares and his mother held the remaining 80%.

When serious disagreements subsequently arose between them, the mother used her position as the majority shareholder to cause the company to dismiss her son as an employee and then passed an ordinary resolution removing him as a director under section 168 Companies Act 2006.
The son brought an unfair prejudice petition, arguing that the nature of the relationship between the mother and son in relation to the company was such that it should be construed as a quasi-partnership. This would mean that the mother was subject to equitable constraints when exercising any power to dismiss the son as an employee or remove him as a director, and could not simply rely on her strict legal rights and powers.

The decision

The court agreed with the son that the company was a quasi-partnership, holding that the following facts led to this conclusion:

  • the company was a quasi-partnership when the mother and father first became involved in it – they acquired it together, as husband and wife, with the intention of running it together;
  • there had always been an understanding within the family that the son would eventually take over the business;
  • the father had asked the son to give up his studies in Brighton and return to Oxford to take a more active role in the company;
  • the company was always run on an informal basis, with no formal or regular directors' meetings and no contracts of employment; and
  • the son was appointed as a director with a view to him having a greater involvement in the company and the shares were transferred to him with an implicit understanding that he would continue to participate in the company's management, and be employed by it, for so long as he remained a shareholder.

By causing the company to dismiss the son as an employee, and exercising her power to remove him as a director, all without offering to buy the son's shares for fair value, the mother had caused the company's affairs to be conducted in a way that was unfairly prejudicial to the son as a shareholder. 

Accordingly, the court ordered the mother to acquire the son's shares in the company for fair value on a non-discounted basis.

Comment

The courts are generally reluctant to restrict a party from exercising its legal rights and so it is quite rare for them to construe a company as being a quasi-partnership. Where they do step in to impose equitable considerations on a party's rights it is often in a case like this involving a family business. The problem for the individuals involved is that they will often not realise they are in such a relationship. It is not possible to designate a company as being (or not being) a quasi-partnership so it is often not until there is some form of dispute that the company's status, and therefore the nature of the obligations owed by the shareholders to each other, will be determined.

Serving claims on directors: Section 1140 companies Act 2006

In Farrer & Co LLP v Meyer [2022] EWHC 362 (QB) the Court confirmed that section 1140 Companies Act 2006 permits documents to be validly served on a director at their "registered address," whether or not the claim relates to their activities as a director and even if they reside outside of the jurisdiction.

Section 1140 Companies Act 2006

For the purposes of section 1140, a director's "registered address" means any address shown as a current address in the publicly available section of the Companies House register.  Once registered, the director can then be validly served with any document at that current address and the reason for the service need not be connected in any way with their directorship of the registered company.

The facts

The claimant was a solicitor's firm (F&Co) that had previously acted for the defendant (M). F&Co issued proceedings against M for failing to pay their invoices, with service of claims being effected at two London addresses used by M for companies of which she was then a director. The addresses were registered at Companies House. M was resident in Switzerland at the time of service and failed to respond to the proceedings.

F&Co successfully obtained a default judgement in respect of its claims against M. M then applied to set aside the default judgement on various grounds, including that service of proceedings at the two London addresses had not been valid.

The decision

The High Court refused to set aside the default judgement on the grounds of invalid service. The documents served at the addresses registered at Companies House were effectively served under section 1140 and there was no limit to the purpose for which that service could be effected.  
There was also nothing unfair about using section 1140 to serve a claim even if the director was not resident in the jurisdiction. A company director who made use of the privilege of incorporation in the UK had to accept the consequences of doing so - including the need to monitor receipt of documents at their registered address.

Comment

This decision serves as a useful reminder to directors (and company secretaries) of the importance of monitoring mail sent to them at their registered address, particularly if they are not resident in that jurisdiction. 

Directors of UK incorporated companies are required to register a service address with Companies House and that service address is publicly available. It can then be used to validly serve the director with any document and for any purpose – even if it is purely a personal matter - whilst the address remains current. A registered address can be changed by giving notice to Companies House, but proceedings can still be validly served at that address for a further 14 days after the change has been registered.

A director's registered address does not have to be in the UK and for ease of monitoring, non-resident directors may choose to register an address in the same jurisdiction as where they reside. Alternatively, the director's service address can be the same as the company's registered address, though this does have to be within the UK.

Section 1140 may also prove useful for anyone needing to serve documents on a director of a UK company, particularly where no personal address is available or where the individual resides outside of the jurisdiction.

This update was first published on Accountancy Daily.

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