Corporate Briefing

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• “Material reduction in shareholder rights” or a storm in a teacup? 
• Preparing for the implementation of new directors’ duties 
• Derivate claims under the Act 
• Extending the scope of the statutory regime on issuer liability - Enhancing Investors’ confidence or deterring new issuers? 
• Latest guidance from the takeover panel executive on inducement fees 
• Update on taxation of foreign profits 

Companies Act 2006

“Material reduction in shareholder rights” or a storm in a teacup? by Oliver Glynn-Jones 

Shareholder activism

The changes brought about by the Companies Act 2006 (the “Act”) have been the subject of much comment over the past few years.  Most people have been focused, quite rightly, on the key changes that the legislation has brought about and the effect they will have on the corporate landscape.  However, the implementation of these changes by some companies has led both the National Association of Pension Funds (“NAPF”) and the Association of British Insurers (“ABI”) to draw its members' attention to the practice of some companies to use the process of change as a cover to implement an interesting and potentially controversial amendment to their articles of association.

The last few years have seen the advent of a more aggressive form of shareholder activism in this country.  This appears to have grown out of the increasing culture of shareholder activism seen in the US and as a result of the spectacular growth of hedge funds and the large investment positions that these funds have taken in companies.  Perhaps the most high profile example of this development was the recent action taken by those hedge funds that had made large investments in Northern Rock during the troubles leading up to its eventual nationalisation.

There can be no doubt that there is a growing movement away from the traditional method of shareholder agitation in this country, which has historically taken the form of what can best be described as “quiet diplomacy”, with the large institutions using their positions of strength to engage in discussions with a company in order to bring about the change that they believe is necessary.  After all, the options open to shareholders were historically relatively limited and the normal course for those investors concerned about the direction taken by a board has been to vote against the appointment of directors or against remuneration packages, or to apply other pressure behind the scenes.  The increasing proliferation in US class actions and derivative claims is a growing concern to company boards though and some are now seeking to use the cover of the changes that the Act requires to add in an extra layer of protection against this more aggressive form of shareholder action, either in this jurisdiction or abroad.

Arbitration clauses

Changes to a company's articles require shareholder approval and this approval is sought by way of an explanatory circular.  These have been used to explain changes that companies have been forced to make by the new legislation, but the ABI and NAPF have become aware of some companies using these circulars to quietly amend their articles to provide a mandatory arbitration clause for the resolution of disputes that shareholders have with the company or its directors.

To the ABI and NAPF this action is detrimental to shareholders on two levels.  The initial concern that they have is that companies are trying to implement these changes by the back door, in effect hiding them within a number of proposed changes, all of which are voted on at the same time, without giving shareholders sufficient opportunity to consider the impact of the change.  They are sufficiently concerned by this practice to have indicated that they will “red top” such actions - which means that they will voice strong concerns to their members about those companies that attempt it. 

Their concern for the method of change is born out of their underlying concern about the effect of these new dispute resolution clauses.  This concern is highlighted by the NAPF's recent statement on the issue in which it said:

“The introduction or maintenance of a provision in the Company's Articles of Association which prescribes arbitration as the sole mode for settlement of all or a significant class of disputes between shareholders (whether acting in their own right or in the name of the Company, as applicable) and any one or more of the Company, its directors, executive management, or its professional advisors, should be viewed in the first instance as a material reduction in shareholder rights.”

They went on to say that they expect that investors would normally wish to oppose any such attempted change in the absence of the board demonstrating a clear need for the provision which outweighed the prejudice that would be suffered by the shareholders.  In saying this, they suggested that the company would need to show that it was subject to extenuating circumstances in order for this to be the case. 

Conclusion

So the position of those representing the large institutional investors is clear, but what is driving their concerns?  After all, the incorporation of an arbitration clause does not remove the rights of a shareholder to take action.  The attempt by companies to make this change is most probably brought about not only by the changing environment of shareholder actions, but also by the changes that the new Act brings to derivative claims.  It remains to be seen whether these changes will bring a marked increase in shareholder claims against directors, but the majority opinion is that this is the likely outcome.  The introduction of the arbitration clause would therefore keep these disputes out of the glare of the public spotlight, with arbitration being a dispute resolution process that is private to the parties.  It seems that it is this public scrutiny which companies want to avoid, knowing that in some shareholder actions the battle that is fought within the press is a major tactic.  Conversely, the continuing public consideration of shareholder claims by the courts, within the public domain, is something that the institutional investors consider is in shareholders' best interests.  It remains to be seen whether many companies will follow this course and, if they do, what further action it may provoke, but it is safe to say that it is something that no company should contemplate lightly and without justification in the current climate.

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Preparing for the implementation of new directors’ duties by Alastair McDonald 

Introduction

On 1 October 2008, the sections of the Act dealing with conflicts of interest will come into force.  This article summarises those duties and suggests how companies can prepare for the introduction of the new conflict of interest provisions.

The new directors' duties provisions 

Sections 175 to 177 of the Act deal with the following duties: to avoid a conflict of interest; not to accept benefits from third parties; and to declare interests in proposed transactions.

Section 176 provides that a director has a duty not to accept benefits from third parties conferred by reason of his being a director, although the section also provides that this duty is not infringed if it cannot reasonably be regarded as likely to give rise to a conflict of interest.  Companies should consider reviewing their policies regarding the types and degree of corporate hospitality a director may accept from a third party.

Section 177 provides that if a director is directly or indirectly interested in a proposed transaction or arrangement with the company, he must declare the nature and extent of that interest to the other directors before the company enters into the transaction or arrangement.  Sections 182 to 187, which also come into force on 1 October 2008, deal with a director's obligation to declare interests in transactions and arrangements already entered into by the company.

A closer look at the new conflict provisions

Under section 175, a director of a company must avoid a situation in which he has, or can have, a direct or indirect interest that conflicts or possibly may conflict with the interests of the company.  The duty to avoid a situation in which a director has or can have an interest which possibly may conflict with the interests of the company goes beyond the common law duty on which section 175 is based.  It will require a director to look to the future in order to anticipate a conflict of interest which might arise from present circumstances.  The duty applies in particular to the exploitation of any property, information or opportunity regardless of whether the company could take advantage of it.  However, the duty is not breached if the situation cannot reasonably be regarded to give rise to a conflict of interest.  The duty does not apply to a conflict of interest arising in relation to a transaction or arrangement with the company.  Sections 177 and 182, mentioned above, deal with these transactions.

A significant change to the existing law is that under the new statutory provisions, non-conflicted directors are able to authorise a director's conflict of interest.  If the situation is authorised, the section 175 duty is not infringed.

Public companies wishing to take advantage of the change in the law should amend their articles of association to include an express power allowing non-conflicted directors to authorise a situation giving rise to a conflict of interest on the part of a director.  As well as a power to authorise conflicts, companies may also wish to include the procedure for proposing and authorising conflicts in their articles.  Many public companies will, or have already, proposed changes to their articles at their 2008 AGM.

Private companies wishing to take advantage of the change in the law should review their articles of association and, if necessary, amend them to remove anything that would restrict the board authorising conflicts; and, for those companies incorporated prior to 1 October 2008, pass a shareholder resolution allowing future authorisations in accordance with section 175.

Directors cannot authorise a breach of the section 176 duty not to accept benefits from third parties.  Further, certain transactions between a director and the company require approval of the members.  Authorisation by the directors of these transactions will not suffice.

Practical steps 

Assuming that companies have taken the necessary steps to avail themselves of the new authorisation procedure under section 175, what else should companies and directors be doing to ensure a smooth transition to the new regime?

Non-conflicted directors should always be mindful of their own duties as directors, in particular the duty to promote the success of the company, and should not authorise a conflict if they consider that, overall, the approval of the situation would disadvantage the company.  The board will need to consider what limits, if any, to place on any authorisation and what procedures should be put in place to deal with confidential information and actual conflicts should they arise.  Companies should consider how conflict authorisations are to be managed going forward and put in place a formal process detailing how directors should record and review authorisations and report on them to shareholders.  Factors for non-conflicted directors to consider in relation to the management of a conflict may include:

• whether any conditions or time limits should be attached to an authorisation;
  
  
• whether the conflicted director should absent himself from meetings while the  matter giving rise to the conflict is discussed and whether he should receive board papers regarding the matter;
  
  
• how often the authorisation and the conditions attaching to it should be reviewed; and
  
  
• whether there are any circumstances in which the authorisation would be withdrawn.

Conclusion

Directors must ensure that they are aware of their duties, in particular the provisions of the Act regarding conflicts of interest and those relating to transactions with the company.  The ability of non-conflicted directors to authorise a director's conflict of interest is a significant change in the law.  Guidance and procedures should be reviewed and maintained to assist directors and minimise their potential liability for breach of duty.

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Derivate claims under the Act by Anna Morgan 

Historically, the ability of a member to bring a derivative action was governed by common law and in particular, the rule in Foss v Harbottle.  This meant that a derivative action could only be brought in very limited circumstances to enforce a cause of action vested in the company on the company's behalf.

Part 11 of the Act, which came into force on 1 October 2007, contains a new statutory procedure for derivative claims (arising on or after 1 October 2007) which is intended to reflect the recommendations of the Law Commission that there should be a “new derivative procedure with more modern, flexible and accessible criteria for determining whether a shareholder can pursue an action”.

This article outlines the key changes made by the Act to the law on derivative claims and considers the practical application of these new provisions in light of the recent case of Franbar Holdings Ltd v Patel and others (“Franbar”), one of the first reported cases regarding the new statutory procedure.

Key provisions of the Act

• An action may only be brought in respect of an actual or proposed act or omission involving negligence, default or breach of trust by a director (section 260(3)). There is no longer a requirement for the director to have benefited personally from the breach.
  
  
• It is immaterial whether the cause of action arose before or after the person seeking to bring a claim became a member of the company (section 260(4)).
  
  
• A member who brings a derivative claim must apply to the court for permission to continue it (section 261(1)). If the application and accompanying evidence does not disclose a prima facie case for giving permission, the court must refuse it (section 261(2)).
  
  
• In considering whether permission to continue the claim as a derivative action should be given, the court must have regard to certain factors set out in section 263(2).  If any of these factors are considered to apply in light of the facts of the case, permission must be refused. Furthermore, the court must take into account certain additional factors for consideration set out in section 263(3) when considering whether to give permission. These factors were considered in detail in the Franbar case and are discussed below.

Franbar - facts of the case

A shareholders' agreement was entered into between F Ltd and C Ltd in relation to their shareholdings in M Ltd (the “Company”).

Disputes arose between the parties and F Ltd issued three sets of proceedings:

• a claim for breach of the shareholders' agreement;
  
  
• a petition under section 994 of the Act (a petition by a member against unfair prejudice); and
  
  
• permission to continue a derivative claim against C Ltd and those directors of the Company appointed by C Ltd (the “C Directors”).

The allegations concerned, amongst other things, the diversion of business opportunities from the Company to C Ltd and a failure of the C Directors to provide adequate financial information.

Application of sections 260 - 263 of the Act

The court acknowledged that the claim was a derivative claim in accordance with section 260 of the Act, as it arose from acts and omissions alleged to have involved negligence, default, breach of duty or breach of trust by the C Directors.

The court then considered whether any of the factors listed in section 263(2) of the Act were applicable and concluded that the only circumstance capable of being relevant was the one described in section 263(2)(a), namely whether a director acting in accordance with his duty in section 172 of the Act (duty to promote the success of the company) would seek to continue the claim.  In light of the fact that there was sufficient evidence to show that the conduct of the Company's business by those directors in control had given rise to actionable breaches of duty, it was not possible to be satisfied that a director acting in accordance with section 172 would not seek to continue the claim.

The court then went on to consider the factors set out in section 263(3) (factors to take into account when considering whether to continue a derivative claim):

• it held that it was not possible to conclude at this stage that the claim was not being pursued in good faith;
  
  
• it considered at length the importance that a person acting in accordance with section 172 would have attached to continuing the derivative claim.  In light of the fact that several of the complaints would be more naturally formulated as breaches of the shareholders' agreement and acts of unfair prejudice, which were already the subject of proceedings, it held that a hypothetical director would be less likely to attribute importance to the continuation of the derivative claim as several of the complaints could more naturally be formulated as breaches of the shareholders' agreement and acts of unfair prejudice;
  
  
• it held that it was no more than a possibility that ratification of all the breaches would prove to be effective; and
  
  
• the court considered in detail the question of whether the cause of action could be pursued by F Limited in its own right rather than on behalf of the Company and concluded that the availability (and use) of both the claim for unfair prejudice and the shareholders' action weighed against the grant of permission to continue the derivative action.

In conclusion, although the court acknowledged that there was substance in the complaints which could give rise to breaches of duty which may have been incapable of ratification, considerable weight was given to the fact that the claimant should have been able to achieve its goal through the claim for unfair prejudice and the shareholders' action.  Having regard to these considerations, the permission to continue the derivative claim was refused.

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Corporate Finance

Extending the scope of the statutory regime on issuer liability - Enhancing Investors’ confidence or deterring new issuers? by Inbar Zilberman 

In June 2007, Professor Paul Davies QC published his final report on issuer liability for misleading statements to the market. Having considered his recommendations, the government has published a consultation paper proposing various extensions to the current statutory regime. The draft regulations extend the potential liability of issuers to a wider variety of markets including AIM and introduce a broader range of disclosures.  Issuers will therefore be required to take greater care to ensure prompt and accurate disclosures in order to escape potential liability.

Section 90A of the Financial Services and Markets Act 2000 introduced in January 2007 a statutory civil liability regime for false or misleading statements in certain company publications (namely those required to be made under the Transparency Directive and which are now contained in chapter 4 of the Disclosure and Transparency Rules of the FSA).  This regime supplements the existing criminal provisions, which impose criminal liability for dishonest concealment of material facts if the concealment is for the purpose of inducing someone to take, or not to take, a certain course of action (ie to take or not take an investment decision).

Professor Davies QC carried out an independent review of the law relating to issuer misstatements in March 2007 and reported his recommendations in June 2007.  He concluded that the basis of the regime was sound and recommended that its scope be extended in order to improve issuer incentives for prompt and accurate disclosure.  On 17 July 2008 the Treasury published a consultation paper and draft regulations to extend the statutory regime so that:

• it applies to UK and non-UK issuers of securities traded on UK multilateral trading facilities (“MTFs”) (eg AIM and PLUS-quoted market) and issuers of securities traded on EEA regulated or EEA MTF markets provided that they have a registered office in the UK or the UK is their home state under the Transparency Directive; 
  
  
• it applies to all disclosures to markets by means of a recognised information service (RIS) and not just those periodic disclosures required under the Transparency Directive;
  
  
• a person claiming damages does not have to show that they obtained their information from a RIS, provided that the information was published on a RIS;
  
  
• sellers, as well as buyers, are able to claim for losses suffered as a result of their reliance on a misstatement;
  
  
• claimants are able to recover losses resulting from a dishonest delay in issuing a disclosure through a RIS, such delay having been made for the purpose of enabling a gain to be made or to cause loss to another or expose another to a risk of loss;
  
  
• liability of an issuer of underlying shares is extended to holders of depositary receipts and other secondary securities provided the secondary securities concerned have been admitted to trading by or with its consent.  Otherwise, an issuer of depositary receipts or other secondary securities will be liable.

The following aspects of the current regime are proposed to remain unchanged:

• liability to be based on fraud in the civil standard (knowingly or recklessly making an untrue or misleading statement) and not to be extended to negligence;
  
  
• liability to apply to issuers only and therefore no statutory liability to third parties will be imposed on directors or advisers in respect of misstatements in RIS announcements.  This means that the responsible directors may be able to escape liability if the board is unwilling to bring proceedings against the directors in default and no shareholder is able or willing to pursue a derivative action against the directors; and
  
  
• assessments of damages to continue to be a matter for the courts in order to avoid formulating effective rules in statute which could tie the courts' hands in an undesirable way.

The draft regulations are in line with, but go beyond, Davies' recommendations.  The extent to which issuers should be liable for misstatement is perceived to be a fine balance between achieving accurate, timely and complete dissemination of information and exposing issuers to speculative litigation.  One point of contention is likely to be in relation to the prospect of liability for dishonest delay in making RIS announcements which will create a liability where none currently exists due to the difficulties in inferring honesty or dishonesty from the circumstances of any delay. 

The government is seeking comments on the consultation paper and draft regulations by 9 October 2008.

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M&A

Latest guidance from the takeover panel executive on inducement fees by Richard Stewart and Patrick Johnson 

Introduction

On 10 July 2008 the Executive (the “Executive”) of the Takeover Panel (the “Panel”) published Practice Statement No. 23 to clarify the way in which the Executive applies Rule 21.2 of the Takeover Code (the “Code”).  Rule 21.2 relates to inducement fee agreements (also known as “break fees”).  The Practice Statement clarifies the mechanism for calculating the maximum amount permitted to be paid by way of an inducement fee.  The Panel has also extended the content requirements of the written confirmations which must be provided to the Panel by the board of target and its financial adviser.

Background

Rule 21.2 of the Code provides that certain safeguards must be observed prior to agreeing to pay an inducement fee to an offeror.  These include a requirement that the inducement fee must normally be no more than 1% of the offer value, calculated by reference to the offer price. 

Calculation of the maximum amount payable

The Executive has now specifically confirmed that the 1% limit on inducement fees should be calculated on the basis of the fully diluted equity share capital of target (but only taking into account those options and warrants that are “in the money”).  When determining the value of the fully diluted equity share capital, the value to be given to warrants and options is their “see through” value (being their value by reference to the value of the offer for the shares to which they relate, net of any exercise price).

The Executive has also clarified that:

• any VAT payable as a result of the payment of an inducement fee counts towards the 1% limit (except to the extent that such VAT is recoverable by target); and
  
  
• in a securities exchange offer, the value of target will be fixed by reference to the value of the offer as stated in the firm offer announcement and will not fluctuate as a result of subsequent movements in the price of the consideration securities.

Where an inducement fee is agreed prior to the announcement of a firm intention to make an offer, the Executive has clarified that the 1% limit may be calculated by reference to either:

• the expected value of the offer at the time the inducement fee is agreed; or
  
  
• the value of target by reference to the offer price as stated in a subsequent firm offer announcement.

If the inducement fee is calculated by reference to the former, the Executive considers that the break fee agreement should provide that, if the actual value of target is lower than anticipated when the break fee agreement was signed, the maximum inducement fee payable shall be scaled back to any amount representing no more than 1% of that lower value.

The Executive has also stated that it interprets Rule 21.2 as permitting a target to agree inducement fees with two or more offerors (or potential offerors) each up to the relevant 1% limit, notwithstanding that the aggregate amount payable by target in respect of all such inducement fees might exceed 1% of the value of target.

Content of confirmations to the Executive 

The Executive now stipulates that the written confirmations required of target and its financial adviser should include the following:

• confirmation that the inducement fee was agreed as a result of arms' length commercial negotiations;
  
  
• an explanation of the circumstances in which the inducement fee will become payable and the basis on which such circumstances were considered appropriate;
  
  
• any relevant information concerning possible competing offerors, for example, the status of any discussions, the possible offer terms, any pre-conditions to the making of an offer and the timing of any such offer;
  
  
• confirmation that there are no side agreements or understandings in relation to the inducement fee that have not been fully disclosed; and
  
  
• confirmation that, in the opinion of target's board and its financial adviser, the agreement to pay the inducement fee is in the best interests of target's shareholders. 

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Corporate Tax

Update on taxation of foreign profits by Richard Cory

Richard Cory is a Knowledge Development Lawyer in Corporate Tax

The latest Government announcement about its review of corporate taxation of foreign profits is broadly good news for UK companies.  The Government has confirmed that it will no longer be proceeding with what was one of the most contentious aspects of the reforms of the controlled foreign companies regime, namely its proposals for the taxation of intellectual property.

The Government is instead going back to the drawing board on the whole programme for taxation of foreign profits and will be consulting with business on two main options: reforming the controlled foreign companies regime along the lines of the June 2007 consultation document, or instead, keeping the current entity-based regime albeit with amendments. 

This further consultation means that it is unlikely legislation will be introduced before 2010.  A decision will have become more pressing with the High Court decision in Vodafone 2 in which the judge ruled that the current controlled foreign companies regime (as it operated before December 2006) was incompatible with EU law and therefore did not apply to Vodafone's European subsidiary.  There is likely to be an appeal against the decision but the Government will be concerned that even with the amendments it introduced in December 2006, the regime as it currently stands will also not be compatible with EU law.

The Government also announced that it remains attracted to introducing a wide a dividend exemption for dividends from foreign companies as possible but is concerned about the cost in tax revenues.  There is likely to be considerable consultation on this. It has also helpfully restricted the scope of the amendments that it had originally intended to make to the anti-avoidance rules on interest relief.

While it is unlikely, therefore, that a change to the law will be imminent, scope remains for changes in due course which will affect the UK tax treatment of overseas investments.  Taxpayers making such investments should have in mind the potential for substantive changes to their tax treatment within a relatively short timeframe.

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Contacts

Oliver Glynn-Jones
oliver.glynn-jones@blplaw.com

Alastair McDonald
alastair.mcdonald@blplaw.com

Anna Morgan
anna.morgan@blplaw.com

Inbar Zilberman
inbar.zilberman@blplaw.com

Richard Stewart
richard.stewart@blplaw.com

Patrick Johnson
patrick.johnson@blplaw.com

Richard Cory
richard.cory@blplaw.com

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