FREEDOM OF CONTRACT IN ACQUISITION AGREEMENTS – WHEN WILL PROVISIONS BE VOID AS PENALTY CLAUSES? The Supreme Court in Cavendish Square Holding BV v Talal El Makdessi (Rev 1)  UKSC 67 considered whether two clauses in a share sale agreement (SPA) were unenforceable on the ground that they were penalties. Following breach by the seller of a restrictive covenant in the SPA the first disputed clause triggered the loss of the seller’s additional, deferred consideration. The second required the seller to transfer his remaining target shares at less than market value. The court concluded that the provisions were not penalties, disagreeing with the Court of Appeal. In addition to the factual relevance of the case to those considering terms in corporate transactional documents, the case is particularly interesting because the Supreme Court (in this conjoined appeal with ParkingEye Limited v Beavis  UKSC 67) took the opportunity to reconsider the legal principles behind the penalty rule, stating a revised “true test” founded on a detailed analysis of case law. The court described the “true test” to be “whether the impugned 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” (underlining added for emphasis). In other words, the penalty rule regulates the secondary obligation (being the prescribed contractual remedy) triggered by breach of a primary contractual obligation. A secondary obligation can only be penal if it is out of all proportion to any legitimate interest of the innocent party. The key points deriving from the conjoined appeal are considered generally here. Focusing in this summary only on the application of the “true test” in Cavendish v Makdessi, the Supreme Court found that the provision which resulted in the loss of additional consideration following breach of restrictive covenants in the SPA was “in reality a price adjustment clause” and therefore a primary obligation. The rule on penalties was therefore not engaged as, according to the “true test”, it only applies to secondary obligations. The court reached that conclusion notwithstanding that the provision was triggered by a breach of contract. It was helped in that analysis by, amongst other things: the consideration clause in the SPA stating that monies were payable in consideration of the sale of the shares and the obligations of the seller. Those obligations included the restrictive covenants; and the juxtaposition of the substantial delayed payment for goodwill and a series of covenants intended to protect that goodwill. In any event, the court thought that the buyer had a “legitimate interest” in the observance of the restrictive covenants and that the goodwill of the business was critical to its value. Similar reasoning applied to the application of the principle to the second disputed clause, requiring the seller to transfer his remaining target shares at less than market value. The court accepted that the manner in which the penalty rule is invoked i.e. on breach of contract “means that in some cases the application of the penalty rule may depend on how the relevant obligation is framed in the instrument... However the capricious consequences of this state of affairs are mitigated by the fact that the classification of terms for the purpose of the penalty rule depends on the substance of the term and not on its form or on the label which the parties have chosen to attach to it.” Impact - in practice, following this decision, parties to an agreement may take comfort from drafting provisions so that they are primary obligations not triggered by breach of contract, although the court may in certain circumstances look at the substance of the transaction, not just its form. Establishing a connection between observance of restrictive covenants, the purchase price and any value attributed to goodwill, may also become a feature of acquisition agreements. The potential application of the ‘new’ test to provisions in articles of association such as defaulting shareholder or bad leaver provisions clearly remains to be seen. Where defaulting shareholder provisions are triggered other than for breach of contract e.g. employee resignation, the law of penalties will not, of course, apply. What is clear from this decision is that in order to avoid a contractual term such as a leaver disenfranchisement or forfeiture of consideration provision, potentially being construed as a penalty, careful consideration should continue to be paid, when drafting contracts, to the law of penalties. M&A KEY CASES 2015 - HIGHLIGHTS 2 where, as in this case, the other party had an opportunity to comply with the directors’ request. The judges went on to say that “the misuse of power doctrine has no significant place in the operation of...Part 22 of the 2006 Act”. The Supreme Court roundly disagreed with the Court of Appeal’s suggestion that the proper purpose rule had no application in this context considering that “a battle for control of the company is probably the one in which the proper purpose rule has the most valuable part to play.” The Supreme Court’s judgment (paras 14-24) includes analysis of the proper purpose rule (now stated in section 171(b) of the Companies Act 2006). Lord Sumption, in the leading judgment, notes that courts have in the past sought to uphold the integrity of directors’ decision making and to limit intervention into the conduct of a company’s affairs. A director’s decision will be set aside only if “the primary or dominant purpose for which it was made was improper”. The question inevitably arises as to what is the “primary” or “dominant” purpose when there are multiple concurrent purposes. Lord Sumption suggests that the fundamental point is one of principle i.e. the statutory duty of the directors is to exercise their powers “only” for the purposes for which they are conferred. That duty is broken if they allow themselves to be influenced by “any” improper purpose. The question is therefore one of causation i.e. “which considerations led the directors to act as they did”. Whilst noting the relevance of causation to the application of the test it was noted that it was not the company’s case that despite one of the purposes being improper they would have come to the same decision without it and therefore the court did not express any firm or concluded view on the application of the test. Impact - the judgments are a “must read” for anyone considering issuing restriction notices but they also have wider implications for directors when exercising their management powers. The decision’s relevance is not confined to public companies as, in addition to the general discussion of the proper purpose test when considering directors’ decision making, the forthcoming PSC regime which will also apply to private companies, enables companies to issue restriction notices in the absence of sufficient information being provided by shareholders in relation to their beneficial interests. TAKEOVER BID - FRUSTRATING ACTION BY BOARD RESTRICTING HOSTILE SHAREHOLDER VOTING RIGHTS FOLLOWING INCOMPLETE RESPONSE TO RESTRICTION NOTICE – ANALYSIS OF DIRECTORS’ DUTY TO EXERCISE POWERS FOR THEIR “PROPER PURPOSE” In the first instance decision of Eclairs Group Ltd and another company v JKX Oil and Gas plc (JKX) and others  EWHC 2631 (Ch) the judge was clear that: provisions in a company’s articles broadly equivalent to section 793 of the Companies Act 2006 could not be used to manipulate voting in a takeover battle; and directors must exercise their powers for their proper purpose. The fact that the directors’ decision may have been in the best interests of the company as a whole did not mean that they could exercise their powers for an improper purpose. The Court of Appeal subsequently overturned the decision in part and held that the directors power to issue the notices and impose restrictions, where the requested information was not provided, did not need to have been exercised for a proper purpose (Eclairs Group Ltd and another v JKX Oil and Gas plc and others -  All ER (D) 117). The Supreme Court recently handed down its judgment (Eclairs Group Ltd and Glengary Overseas Ltd v JKX Oil & Gas plc  UKSC 71) following a hearing earlier last year, allowing the appeal and restoring the decision at first instance. Whilst it is now clear that the decision to issue section 793 or equivalent notices must be made for a proper purpose, it is not clear whether there is a new test when applying the proper purpose rule. The leading Court of Appeal judgment concurred with the first instance decision that the directors had not exercised their powers for a proper purpose. The judge, considering a number of precedents, considered that the directors’ belief that their action was in the best interests of the company did not override the directors’ duty to exercise powers for a proper purpose. This was particularly so where the exercise of a fiduciary power by the director (i.e. the issuance of the restriction notices) would impinge upon the constitutional balance of power between groups of shareholders. This fairly compelling argument was roundly disagreed with by the other two appeal judges who took a more practical approach. Their thinking was that the failure by the directors to exercise this particular power for a proper purpose was irrelevant 3 the DLNs were freely transferable, subject to compliance with the terms of the intercreditor agreement. The intercreditor agreement did not indicate that any transferee of the DLNs was constrained by a duty towards the holders of the VLN or would be part of a wider class; and Kestrel had a contractual obligation in the VLNI to ensure the VLNs were treated no differently (in relation to certain matters) to the DLNs. If the DLNs were amended it was obliged to amend the VLNs. Scope of modification The VLNI enabled Kestrel to “make any modification” to the VLNI if sanctioned by a resolution of the VLN holders, or unilaterally if the modification was consistent with amendments to the DLN. The claimants argued that the changes to the VLNI went beyond the scope of modification permitted. The judge, considering case law on how the courts have approached the issue of “modification” to the terms of corporate loan stock deeds, in particular amendments postponing redemption, concluded that the cases, whilst not determinative, helped “point the way”. He noted that “In each case amendments providing for a subordination of the indebtedness to other indebtedness (secured or unsecured) or a postponement of its redemption have been held to be a permissible modification of rights”. The judge held that each amendment to the date of repayment of the VLNs and subordination of the VLNs to another class of creditor was within Kestrel’s power to “make any modification”. Impact – the court’s decision in this case not to imply a duty of good faith when amending a loan note, as well as not limiting the scope of permitted modifications, will be welcomed by those whose “extensive and detailed” drafting was intended to record all the parties’ intentions. It is clear from recent case law (e.g. Compass Group UK and Ireland Ltd (t/a Medirest) v Mid Essex Hospital Services NHS Trust  All ER (D) 200 (Mar)) that courts are willing to uphold an express provision of good faith in a binding agreement. What is also increasingly apparent is that courts are open to implying a duty of good faith, or its equivalent, in certain circumstances (e.g. Yam Seng Pte Ltd v International Trade Corporation Ltd  EWHC 111; Bristol Groundschool Ltd v Intelligent Data Capture Ltd & Ors  EWHC 2145 (Ch) and D&G Cars Ltd v Essex Police Authority  EWHC 226). ABILITY TO “MODIFY” LOAN NOTES – NO IMPLIED OBLIGATION TO MAKE AMENDMENTS IN GOOD FAITH In Myers and another v Kestrel Acquisitions Ltd (Kestrel) and others  EWHC 916 (Ch) the High Court was not willing to imply a term of good faith into a power to modify loan notes. The court also held that changes to the date of repayment of the notes and their subordination to further loans were within the terms of the power to amend the notes. In summary, the claimants had sold their shares in a target company (Target) to Kestrel. Part of the consideration for their shares was the issue of fixed rate loan notes in Kestrel (the VLNs). As part of the same transaction, loan notes had also been issued by Kestrel to its investors, to fund the cash consideration payable by Kestrel to the claimants (the DLNs). Since the VLNs had been issued, a number of amendments had been made to them which had postponed their repayment date from 2010 to 2018. They had also been subordinated by the issue by Kestrel of further loan notes. Implied duty of good faith The claimants argued (amongst other things) that the power to amend the terms of the VLN instrument (VLNI) was subject to an implied term that the modification had to be in good faith and for the benefit of the holders of the VLNs and the DLNs as a whole, viewing them for this purpose as a single class. It was accepted that there was no general duty of good faith in commercial contracts but that such a duty could be implied dependent on the context. Looking at the context in this case, there were a number of factors which the judge took into account, such as the fact that the overall documentation entered into at the time of the sale and purchase of Target was extensive and detailed. The judge was not willing to imply a duty of good faith for several reasons including that: the VLNs and DLNs were not in fact a single class and therefore there was no requirement for the majority (the DLN noteholders) to act bona fide in the interests of all the noteholders. The VLNs and DLNs were created by different instruments; the DLN instrument made no reference to the VLNI; the noteholders were not parties to the other instrument; and nothing in the VLNI entitled the views of the holders of the VLNs to be invited or heard or stated that their interests should be considered in any way. A clause in the VLNI requiring Kestrel to treat the DLNs in the same manner as if they constituted a single class for certain purposes, implied that the notes were not a single class for all purposes; 4 REMINDER OF THE JOINT AND SEVERAL LIABILITY OF PARTNERS FOR WRONGFUL ACTS OF A PARTNER ACTING IN THE ORDINARY COURSE OF BUSINESS The Court of Appeal’s decision in The Northampton Regional Livestock Centre Company Ltd v Cowling & Anor  EWCA Civ 651 is a reminder of the potential liability of partners of a general partnership. In this case, a partner (partner A) was held jointly and severally liable for his partner’s (partner B) breach of fiduciary duty pursuant to s.10 of the Partnership Act 1890 (Section 10). The Court of Appeal, overturning the first instance decision, was clear that although partner A’s conduct was reasonable and he had neither acted negligently nor authorised partner B’s breach of duty, the principle of joint and several liability applied. The Northampton Regional Livestock Centre Company Ltd (NRLCC) had hired a commercial property partnership (the Partnership) to assist it in selling a piece of land (the Property). The Property was sold to a third party buyer who immediately sold it on at a significant profit. Prior to the sale, partner B resigned from the Partnership to pursue independent opportunities, although was not authorised to pursue any that would put him in a position of conflict with the Partnership including the Partnership’s continuing mandate to market the Property. Partner B, in his individual capacity, in fact acted as an adviser to the buyer and following the onward sale of the Property received a substantial commission from the buyer as well as his share of a fee paid by NRLCC to the Partnership. At first instance, partner B was required to account to NRLCC for the commission and fee he had received, on the basis that by acting for both the buyer and the seller he had been in breach of his fiduciary duties. On appeal, NRLCC argued that partner A should also be found jointly and severally liable for partner B’s breach of duty. The Court of Appeal agreed. It held that the applicable test in Section 10 clearly provides that where any partner acting in the ordinary course of the business of the firm causes loss to another party, the partnership is liable to the same extent as the partner directly responsible for the loss. The court considered previous case law when considering whether this situation was, as held by the judge at first instance, one where partner B had been “engaged solely in pursuing his own interests: on a ‘frolic of his own’” and therefore fell outside Section 10. It held that partner B was not “moonlighting” but carrying out the Partnership’s business. Despite partner B’s resignation it was clear that he was still a partner and acting for NRLCC when heads IMPLIED DUTY OF GOOD FAITH IN A SHARE AND BUSINESS SALE AND PURCHASE AGREEMENT (SBSA)? In T & L Sugars Ltd v Tate & Lyle Industries Ltd  EWHC 2696 the High Court considered claims by T&L Sugars Ltd (the Buyer) that Tate & Lyle Industries Ltd (the Seller) had breached express or implied terms of a SBSA. The Buyer’s claim, relating to the transfer of certain futures contracts to it, is particularly interesting. The Buyer argued that the SBSA should be interpreted to include an implied term that the Seller was obliged to make an assessment and ensure that it was only “legitimate” futures contracts that were transferred. The Buyer’s claim was rejected on the facts and the law. The judge however went on to comment that “while it would be right to imply a term that the Defendant would act in good faith and honestly in carrying out the process…” there was no basis for implication of the more onerous term argued for by the Buyer. In contrast the judge interpreted a different provision in the SBSA, potentially reducing the purchase price, in favour of the Buyer. The provision reduced the price if “…a performance certificate showing an efficiency level of less than 95 per cent...” was issued in relation to a particular biomass plant. No certificate had been issued because the plant could not be tested due to significant operational problems. The judge roundly rejected the Seller’s argument that the certificate operated as a condition precedent to its liability, instead finding that the focus of the clause was on the efficiency level of the plant. Impact – as mentioned above whilst it is clear that courts are willing to uphold an express provision of good faith in a binding agreement and are open to implying a duty of good faith, or its equivalent, in certain circumstances, there remains no general doctrine of good faith under English law. This case raises the spectre that a duty of good faith may be implied into a provision of an acquisition agreement; although it should be borne in mind that the Buyer’s claim failed and the judge’s comment is obiter. MACFARLANES LLP 20 CURSITOR STREET LONDON EC4A 1LT T: +44 (0)20 7831 9222 F: +44 (0)20 7831 9607 DX 138 Chancery Lane www.macfarlanes.com This note is intended to provide general information about some recent and anticipated developments which may be of interest. It is not intended to be comprehensive nor to provide any specific legal advice and should not be acted or relied upon as doing so. Professional advice appropriate to the specific situation should always be obtained. Macfarlanes LLP is a limited liability partnership registered in England with number OC334406. Its registered office and principal place of business are at 20 Cursitor Street, London EC4A 1LT. The firm is not authorised under the Financial Services and Markets Act 2000, but is able in certain circumstances to offer a limited range of investment services to clients because it is authorised and regulated by the Solicitors Regulation Authority. It can provide these investment services if they are an incidental part of the professional services it has been engaged to provide. © Macfarlanes January 2016 CONTACT DETAILS If you would like further information or specific advice please contact: MATTHEW BLOWS PARTNER CORPORATE AND M&A DD: +44 (0)20 7849 2339 firstname.lastname@example.org ELAINE O’DONNELL SENIOR SOLICITOR AND PROFESSIONAL SUPPORT LAWYER CORPORATE AND M&A DD: +44 (0)20 7849 2210 email@example.com JANUARY 2016 of terms for the sale of the Property were agreed. On principle and authority the court held that the Partnership was therefore vicariously liable for partner B’s wrongdoing and partner A was jointly and severally liable to account for partner B’s commission and share of the fee received by partner B from NRLCC. Impact – the case is a clear reminder that the legal policy underlying partners’ vicarious liability does not depend on whether the wrongdoing was authorised, but whether the wrongful conduct may fairly and properly be regarded as done by the partner while acting in the ordinary course of the business of the partnership. For a summary of these and other key cases we reviewed in 2015 click here.