UK: UK Corporate Update

In this memo we report on developments in relation to corporate governance in the UK and the following recent UK cases of interest to corporate lawyers: Porton Capital Technology Funds v 3M UK Holdings Limited; and the UK Supreme Court ruling in the Lehman client money case.

Consultation on Enhanced Shareholder Voting Rights

Background

The perception that the current levels of executive remuneration in the UK's largest companies is excessive and that there has been an upward ratcheting in pay levels without a corresponding improvement in long-term performance, has been a source of concern to successive Governments. A consultation exercise on executive remuneration in quoted companies was undertaken last year and Vince Cable, the Business Secretary, recently announced some detailed proposals in this area.

Under the current law, which came into force in 2003, shareholders in quoted companies have an advisory vote on the directors' remuneration report. Although this has allowed shareholders to influence remuneration policy, the Government believes that not all companies are responding adequately to shareholder concerns and has suggested four new measures to be incorporated in "forward" and "backward" sections of the annual remuneration report:

  • introducing an annual binding vote on further remuneration policy;
  • increasing the level of support required on votes on future remuneration policy;
  • introducing an annual advisory vote on the implementation of remuneration policy in the previous year; and
  • introducing a binding vote on exit payments which exceed one year's salary.

Annual Binding Vote on Remuneration Policy

The new proposal would give shareholders a binding vote on a company's remuneration policy. Companies would be required to act within the scope of that policy, including, when recruiting or promoting individuals which will need to be done on terms which are consistent with the approved policy.

In practice, this would allow shareholders an opportunity to approve variable remuneration including salary increases, the level and criteria for performance related pay for the year ahead, material changes in a director's/executive's benefits and pension arrangements, material changes to service contracts and any other discretionary payments.

Where the binding vote on remuneration is lost at a particular meeting, the company will need to rely on the last policy approved by shareholders. Alternatively, a new general meeting would need to be held at which shareholders would be asked to vote on a revised policy section of the remuneration report. If a new vote is to be held the Government proposes that any meeting should be held within 90 days of the

AGM (general meeting) at which the company failed to secure shareholder approval for the original proposals.

Existing contracts will need to be reviewed to ensure that their terms are consistent with the new binding vote on remuneration policy. Companies will also need to avoid entering into new remuneration arrangements which could give a director entitlements which might conflict with the policy agreed by shareholders.

As noted, the terms on which new appointments are made during the year must be consistent with the policy approved of at a general meeting. The Government believes this will help to lessen the upward pressure on remuneration that can result from external recruitment and help to encourage better succession planning within companies.

Level of Shareholder Support

In recent times, advisory votes on quoted companies' remuneration committee reports have usually been supported by a substantial majority of shareholders. However,these resolutions attract more dissent than any other type of resolution and there have been a small number of cases where a large number of shareholders have withheld their support.

However, in spite of what seem to be increasing levels of activism, the likelihood of seeing a majority of votes cast against any resolution seems very low. This fact, and feedback from shareholders, means that the level of shareholder support for binding resolutions has been re-considered. Although a level is not specified in the proposals the possibility of requiring a special resolution (75% majority), or a threshold between 50% and 75% (to reflect the fact that in a small number of UK listed companies a single shareholder owns a holding of 25% or more and is able to block an advisory vote on remuneration) has been suggested.

Annual Advisory Vote on Implementation of Remuneration Policy

It is envisaged that shareholders should retain the ability to comment on payments that have been made to directors. The Government, therefore, proposes to maintain an annual advisory vote on the "backward looking" section of the remuneration committee report. This section of the remuneration report will include:

  • a single figure for the total pay of each individual director;
  • how pay awards relate to company performance and the policy agreed by shareholders at the start of the year; and
  • how spending on executive pay relates to other payments such as dividends, tax, business reinvestment and general staffing costs.

In response to the frustration expressed by some shareholders that companies have failed to respond adequately to the outcome of the existing advisory vote, the Government proposes that companies should demonstrate how the results of the advisory vote have been taken into account by setting this out in the report.

Binding Vote on Exit Payments

Substantial termination packages for directors have become commonplace. Given that directors commonly accrue substantial rewards over their careers, including pensions, the Government sees no clear case for them to receive termination packages which are particularly generous in relation to those of other employees.

Although the widespread adoption of one year rolling contracts and disclosure of severance terms have been beneficial in curbing severance payments, substantial exit payments still occur. The Government is therefore proposing to amend the law on payments for loss of office to include a provision giving shareholders a binding vote on any exit payment to a director exceeding one year's base salary. This would apply where a director's contract had been terminated early and without due notice by either the company or the director. Approval would be by way of shareholders' resolution at a general meeting. The

company would have to send to shareholders a memorandum setting out details of the proposed amounts and the rationale for any payment in excess of a year's salary.

The Government believes that this vote will allow shareholders a true voice in relation to "rewards for failure" as well as having the potential to reduce lengthy negotiations in respect of termination payments.

Again, existing contracts and arrangements will need to be amended.

Timing

The consultation closes on 27 April and the Government expects any resulting legislation to come into force in Spring 2013, to take effect for companies' financial years ending on or after 1 October 2013 and for directors whose contracts are terminated after that date.

Porton Capital Technology Funds and others v 3M UK Holdings Limited and others

A recent case has provided helpful guidance on the interpretation of earn-out provisions in a share purchase agreement, as well as on the effect of an obligation not to unreasonably withhold consent in the context of whether one party's consent to termination of the agreement had unreasonably been withheld.

The case related to the sale of the shares in Acolyte Biomedica Ltd. in February 2007. Acolyte's only product was Baclite, a product used to detect the superbug MRSA. The consideration was £10.4 million in cash, together with an earn-out provision based on net sales for the calendar year 2009, with the maximum payment under the earn-out capped at £41 million.

With a view to maximising sales during the earn-out period, the share purchase imposed additional undertakings on the purchaser, 3M, including:

  • an obligation actively to market Baclite in the US, the EU, Canada and Australia;
  • (to the extent needed) to obtain regulatory consents in those jurisdictions; and
  • not to cease carrying on Acolyte's business or the marketing of Baclite without the seller's consent, that consent not to be unreasonably withheld.

3M initially continued to market Baclite in the EU. It also started the clinical trials necessary to gain regulatory approval in the US. Late in 2007 the clinical trials were halted following poor initial indicators. These trials were not resumed, and 3M took no further steps to gain regulatory approvals in North America after March 2008.

In July 2008 3M sought the seller's consent to terminate Acolyte's business in accordance with the agreement. This request was repeated twice more in 2008. Consent was not given, but 3M nevertheless unilaterally terminated the business.

In November 2008 the sellers indicated that they would seek damages as a result of 3M's breaches of its obligations under the agreement.

The High Court's decision was as follows:

  • Marketing: In order to fulfill its obligation to market Baclite in the US, the EU, Canada and Australia, 3M had to do more than take some active marketing steps. Its marketing effort needed to be characterised by action in each major market. 3M had fulfilled this requirement in relation to the EU before June 2008, but not after that. In relation to the other markets, the obligation to market would only have become material once regulatory approvals had been obtained.
  • Regulatory approval: The obligation on 3M to act diligently in obtaining regulatory approval imposed a requirement to act with reasonable industry, application and perseverance and what was reasonable depended on the circumstances. 3M had ultimately breached this obligation by abandoning the clinical studies and not pursuing the approval.
  • Seller's withholding of consent: The court applied the following principles:
  • The burden of showing that the sellers were acting unreasonably in withholding consent was on 3M because it claimed the sellers had acted unreasonably.
  • The sellers did not need to show that their refusal of consent was justified, only that it was reasonable in the circumstances.
  • It was reasonable that the sellers should have regard to their own interests in maximising the earn-out payment and considering whether to withhold or grant consent.
  • The sellers were not required to balance their interests with those of 3M in deciding whether to grant consent.

Assessment of Damages

Damages were assessed on a loss of profits basis by reference to what the net sales of Baclite in 2009 would have been had 3M not breached the share purchase agreement. This meant that the claimants received US$1,299,808, being the claimants' 60.4 % share of the value of what the sales would have been, as determined by expert evidence.

Comment

This case is a good illustration of the inherent difficulty with many earn-out provisions of predicting the various contingencies that may affect the company in the earn-out period. If required to do so, as in this case, the courts will interpret the agreement in its commercial context. The lesson for buyers is to ensure that they have sufficient flexibility to operate the Target's business on a proper commercial basis and do not leave sellers in a position where they can in effect compel the buyer to continue unprofitable activities, or face a damages claim from the sellers.

The UK Supreme Court ruling in the Lehman client money case

On 29 February 2012, the UK Supreme Court handed down its judgment concerning the treatment of client money in the long-running administration of Lehman Brothers International (Europe) ("LBIE").

The uncertainties as to which funds had the benefit of the protection of the Financial Services Authority's (the "FSA's") client money rules and which funds did not have such protection, has been one of the main reasons for the length of time it has taken to resolve the LBIE administration. This distinction has had a great significance for LBIE's clients because where LBIE held their funds under the FSA's client money rules, they should, at least in theory, be entitled to the return of their money, in full. On the other hand, those clients who were not afforded these protections would merely rank as general creditors in the estate of LBIE, and so would achieve a much lower recovery.

There were three issues before the Supreme Court: (i) the point at which client money became subject to a statutory trust and therefore "belonged" to the client and not Lehman; (ii) did the client money pool available to be distributed include both segregated and unsegregated accounts; and (iii) was a client's right to participate in the client money pool dependent on whether their money was actually segregated.

The Court agreed unanimously that the statutory trust that protects client money arises on receipt of the money from the client, rather than when (or if) such money is actually segregated from the investment firm's own funds.

The second and third interrelated issues were only decided by a 3:2 majority. On the second issue, the Supreme Court held that the client money pool available for distribution on insolvency comprises all funds identifiable as client money, whether or not those funds were actually segregated by the firm from its own money.

On the third issue, the Court held that all clients with a contractual entitlement to have their money segregated should be entitled to participate in the distribution from the client money pool, irrespective of whether their funds were actually segregated.

Given that the text of the FSA's client money rules are ambiguous, the Court chose the interpretation, which best promoted the purpose of the client money rules as a whole, namely to provide a high level of protection for client money (or money which should have been treated as client money). The majority held that to exclude identifiable client money in house accounts from the funds available for distribution would run counter to this policy, because it would provide different levels of client protection according to whether or not the firm had, for whatever reason, actually segregated the money.

The consequence of this decision is that investors do not have to enquire as to how money is actually held by an FSA authorised investment firm in order to rely on these protections. The judgment means that clients who go to the effort of checking with an investment firm that their funds have been properly segregated may nevertheless find that their funds are diluted on insolvency by the claims of those clients who have been less diligent and who have not performed such checks and whose money has not been segregated by the firm (in breach of the rules). Whilst the Court's decision was good news for many LBIE clients, it was bad news both for LBIE clients whose money was actually segregated who will now receive a lower entitlement to the funds in the client money pool, and for the administrators who now have to face the task of identifying which of the accounts held by LBIE contained client money, and which clients were entitled to client money protections. The judgment therefore means that the length of time it will take to complete the LBIE administration – which has already been progressing for three and a half years – will now be even longer.

The Court's ruling also has implications for the administrators in the MF Global UK administration, who face similar problems in identifying which funds constitute the client money pool and who is entitled to a share of that pool. Until these matters are finalised, it will not be possible to ascertain the residue left for distribution to general creditors. The judgment will therefore delay final distributions in the MF Global UK administration.

All these difficulties and the uncertainties surrounding the FSA client money rules have resulted in widespread criticism of the UK client funds regime. The position in the UK has been compared unfavourably to that in other jurisdictions, where, in the Lehman and MF Global insolvencies, there has been a much swifter return of client funds. It is probable that the FSA will re-write their client money rules to address these criticisms and to take account of the Supreme Court's judgment.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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