The High Court has held that the fair value of shares to be sold by departing directors under a compulsory transfer mechanism could not be calculated using a mechanism in a private contract, even though the articles defined “fair value” by reference to that contract.

What happened?

Lord v Maven Wealth Group Ltd [2021] EWHC 2544 (Comm) concerned the holding company of a financial advisory services group.

In August 2019, the group’s founders sold certain of their shares in the holding company to another wealth management business (IWP). However, they retained some ordinary shares in the company and continued to serve as directors of the company and directors and employees of a subsidiary.

On the sale, the company adopted new articles of association, and the company and its shareholders (that is, IWP and the sellers) entered into a separate private contract described as a “call option and shareholders’ agreement” (COSA).

In April 2020, two of the founders were dismissed as directors and suspended from their employment on the grounds of gross misconduct. On ceasing to be directors and employees, they became required, under a compulsory transfer mechanism in the company’s articles of association, to offer to sell their shares to the other shareholders in a prescribed order.

The price for the two individuals’ shares depended on whether they had in fact committed gross misconduct, which remained in dispute. However, either way, the price was to be calculated by reference to the “Fair Value” of their shares.

The articles set out a procedure for determining the Fair Value. This required the relevant founder and the company’s directors to agree the value. If they failed to do so, they would appoint the company’s auditors to determine it. If the auditors were unable or unwilling to do this, they would appoint an independent chartered accountant nominated by a shareholder majority. The decision of the auditors or the accountant would be final and binding.

The articles defined “Fair Value” by reference to the COSA, which used that term for a separate purpose (to value the founders’ shares in connection with the exercise of certain put and call options).

The COSA defined “Fair Value” as an amount to be determined in accordance with Schedule 2 to the COSA. Schedule 2 in turn referred to Schedule 3 to the COSA, which contained a mechanism for determining the Fair Value. That mechanism differed from the mechanism in the articles in three principal respects.

  • The COSA mechanism required the company to instruct the auditors to determine the Fair Value immediately. It did not envisage the parties attempting to agreeing it between themselves.
  • There was no “back-up procedure” if the auditors refused or were unable to act.
  • Each party was entitled to dispute the auditors’ determination. If any of them did, IWP and the founders were required to try and resolve the dispute by agreement. If they could not, any party could ask the President of the Institute of Chartered Accountants in England and Wales to determine the Fair Value. That determination would be final and binding.

The COSA contained a “prevail clause” stating that, if there were a conflict between the terms of the company’s articles and the terms of the COSA, the COSA would apply.

A dispute arose over which valuation mechanism applied. IWP purported to appoint an independent accountant under the company’s articles. The leavers claimed that the procedure in the COSA applied, in particular because the articles defined “Fair Value” by reference to the COSA, and the COSA defined that term specifically by reference to the valuation methodology and determination procedure set out in the COSA.

What did the court say?

The procedure in the company’s articles applied.

The definition of “Fair Value” in the COSA incorporated both a calculation methodology and a determination mechanism, whereas the articles incorporated only a determination mechanism. However, requiring the parties to use the determination mechanism in the COSA would have explicitly contradicted the specific mechanism in the articles, which could not be right.

The court therefore interpreted the articles as requiring the calculation of “Fair Value” to be carried out according to the COSA, but the determination of that calculation to be carried out under the articles.

The judge also noted that the mechanism in the COSA dealt with determining the Fair Value for the purposes of the put and call options, not a compulsory transfer under the articles.

Because the articles, properly read, did not incorporate the determination mechanism in the COSA, there was no conflict and the prevail clause did not apply.

What does this mean for me?

The judge clearly considered this a straightforward case, describing the litigation as “unfortunate and unnecessary” and noting that, in the time dedicated to the litigation, the parties could have reached an outcome on the Fair Value.

However, these matters are not always so clear-cut. It is common for different documents in a single transaction to cross-refer to and “borrow” definitions from each other. This usually makes sense, as it can create clarity of meaning across a suite of documents and ensures that there is harmony and consistency in the way the arrangements operate.

However, it is important to ensure that any borrowed terms fit properly with the relevant document and do not contradict any express terms and not to resort to “lazy” cross-referencing. This is particularly important because the courts will interpret a term or phrase in one contract in a particular way that may not be appropriate when used in another document.

One reason parties may wish to include a valuation mechanism in a separate document outside of the articles is to ensure it remains private and out of public view. A company’s articles are a publicly available document, whereas a shareholders’ agreement is almost always a private document. However, again it is important to take care. If it is necessary to read a shareholders’ agreement to understand the articles properly, the company may be required to file the shareholders’ agreement itself publicly, in turn defeating the objective of keeping the valuation mechanism private.