Corporate update: the latest corporate law developments June 2023

Material adverse change: when will a change be material?

The High Court has set out some useful guidance on how to assess whether there has been a breach of a “material adverse change” (MAC) provision in a share sale agreement.

MAC provisions

MAC provisions are designed to protect a buyer from a significant change in the commercial position of a transaction. They can take various different forms, such as:

• a clause giving the buyer the ability to “walk away” from a deal if there is a MAC in the target between signing and closing; or
• a warranty giving the buyer the right to claim compensation if there is a MAC between the target’s financial position at a particular date (often the date of its last audited accounts) and its actual position on signing.

To bring a successful claim for breach of a MAC provision the buyer will need to be able to show not only that there has been a change in the relevant metric but also that any such change is material. The question of what is “material” will sometimes be expressly set out in the agreement. But often it is not defined meaning, if there is a dispute, the court has to determine what is material in the context of the relevant transaction. This was the approach taken recently in Decision Inc Holdings Proprietary Ltd & Anor v Garbett & Anor [2023] EWHC 588 (Ch).

Facts

In October 2018 the buyer agreed to acquire the shares in an IT consultancy company. The share purchase agreement contained a warranty from the sellers to the buyer that “Since [31 December 2017 (the date of the target’s last accounts)]…there has been no material adverse change in the turnover, financial position or prospects of the Company” (the MAC Warranty).

The parties agreed that, in assessing the value of the company, the key factor was its ability to generate future revenues and the key metric was the company’s future gross profit. The sellers provided various documents in relation to the company’s existing sales, pipeline and forecasts. In particular, information about four key contracts was included in the pipeline which showed that all those contracts would begin generating revenue soon after the acquisition.

The transaction completed on 8 October but not long after that it became clear that the company’s position was much worse than that shown in the pipeline, particularly in relation to the progress of the four contracts. Having made a small profit of £1,078 in November 2018, the company made losses of £97,387 in December 2018 and £95,708 in January 2019.

The buyer brought a claim against the sellers for breach of the MAC Warranty on the basis that there had been a material adverse change in the company’s prospects since 31 December 2017.

Decision

The court agreed with the buyer. The judge said that assessing whether the MAC Warranty had been breached involved a three stage test:

1. a baseline figure had to be determined – that is, the expected or forecast level of the relevant factor at the time of signing;
2. the actual figure had to be determined – that is, the actual amount of the relevant factor at the relevant time; and
3. the difference between the baseline and the actual figures had to be considered to determine whether that so great as to be “material”.

The baseline figure had to be determined using an objective test: what would a reasonable buyer and seller have agreed to be the most likely estimate of the relevant factor over the relevant period? In this case, the judge said that the baseline figure was that the company would generate around £1m EBITDA in 2018.

The actual EBITDA for that period was assessed as being £0.3m. So was the difference between the baseline and the actual figures “material”? With the agreement containing no express guidance as to what the parties considered “material”, the judge said it was “an ordinary English word, and its application to a set of primary facts is itself a question of fact.” The question of materiality had to be determined by reference to an objective test: would a reasonable person, entering into the transaction with the aims and objectives of the buyer, have sought to withdraw from or renegotiate the transaction had they known of the change?

In this case, the judge said a reasonable buyer would have attempted to renegotiate the sale price had it known the true state of the company’s affairs.

Comment

As there is very little English case law on what is meant by “material” in the context of a MAC provision, the judge made reference to case law on the subject from Delaware which confirmed that what was relevant was the effect when viewed from the long-term perspective of a reasonable buyer. For example, a short-term “hiccup” in earnings was not sufficient.

The judge also rejected arguments that the test of materiality for this purpose should be linked to whether the relevant matter was material for accounting purposes, where around 5% of profit before tax is often used as a measure of materiality. The judge said that the two tests were separate, performing entirely separate functions, and there was no need to read across between them.

Perhaps the key lesson from the case is that the parties may be better setting out in the contract exactly what they consider to be material in the context of the specific deal. This would allow them to take into account their own subjective opinions rather than leaving this to an objective assessment by the court should a dispute subsequently arise.

Expulsion of LLP member for “serious and persistent” breaches

In a recent case the High Court adopted a commercial approach to the interpretation of an expulsion clause in order to avoid a member of an LLP being required to consent to their own expulsion.

Facts

THJ Systems and another v Sheridan and another [2023] EWHC 927 (Ch) involved a limited liability partnership (the LLP) which had been set up as a vehicle for a business venture between two individuals: Mr Mitchell, a software developer who had written the source code for a piece of software to assist in options trading; and Mr Sheridan, a former options trader who now provided training and mentoring services to people interested in options trading. The LLP was established to exploit the software written by Mr Mitchell and had as its members Mr Sheridan and THJ Systems Limited (THJ), the corporate vehicle of Mr Mitchell.

The parties entered into an LLP agreement which, among other things provided that:

• Mr Sheridan would take certain steps to advertise the software and would ensure that all materials relating to the software contained “appropriate copyright marks”;
• THJ would carry out the day-to-day running of the LLP and would take all day-to-day decisions;
• certain matters were expressly reserved for the “unanimous decision of the Members” but this did not include the expulsion of a member; and
• the LLP could, by notice, expel a member for any serious or persistent breach of the agreement.

The relationship between the two individuals gradually deteriorated as Mr Mitchell accused Mr Sheridan of breaching the advertising and copyright obligations set out in the LLP agreement. In December 2015 Mr Sheridan received a “notice of expulsion” signed by Mr Mitchell as a director of THJ “for and on behalf of [the LLP]”. The notice purported to expel Mr Sheridan as a member of the LLP on the grounds that he had committed serious and persistent breaches of the LLP agreement. Mr Sheridan disputed the validity of the notice.

THJ and the LLP applied to court for a declaration that Mr Sheridan had been validly expelled from the LLP.

Decision

The first issue for the court to decide was whether Mr Sheridan had committed serious and persistent breaches of the LLP agreement:

• The judge said that a serious breach was a material one which is more than trivial but less than a repudiatory breach. It was a breach that had a serious effect on the benefit that the innocent party would otherwise derive from the performance of the contract in accordance with its terms. When deciding whether a breach was serious or not the court had to consider all the relevant circumstances, including the nature of the contract, the nature of the contractual term that had been breached, the nature of the breach and the consequences or potential consequences of the breach.
• In relation to a persistent breach, the judge said that as well as the relevant breaches being repeated, there must also be some gravity to them, that is they should be non-trivial. The repeated breaches must together amount to something which is serious in all the circumstances, including those matters referred to above.

When applying those principles to the specific actions of Mr Sheridan in this case, the judge found that he was in breach of the obligations in the LLP agreement requiring him to advertise the software in his presentations. The judge said that these actions amounted to serious and persistent breaches of the agreement.

That finding meant that the LLP’s ability to expel Mr Sheridan had been triggered, so the court went on to consider the validity of the expulsion notice:

• The LLP agreement vested the power to expel a member in “the LLP”.
• Expulsion of a member was not a day-to-day decision, meaning it was not a decision which could be taken by THJ under the provisions of the agreement relating to those decisions.
• But nor was it one of the matters which the LLP agreement specified as requiring unanimity.
• That meant it was something which could be decided on by a majority of the members.
• In a two member LLP, that would ordinarily mean both members had to agree. But to construe the clause as requiring Mr Sheridan to vote for his own expulsion would be absurd and would render the clause ineffective.
• So the clause giving the LLP the ability to expel a member should be read as “the LLP (acting for this purpose by the Members other than the Member concerned)”.

Comment

The commercial approach adopted by the court when interpreting the expulsion clause is to be welcomed. Mr Sheridan had argued that the clause should be interpreted strictly, requiring a meeting to be held at which all the members had to participate in good faith in reaching a decision. But, in a two member LLP, such an approach is unlikely to have ever produced a satisfactory result.

Many commercial contracts contain termination rights linked to serious and/ or persistent breaches of the contract terms. This case provides useful guidance on the meaning of those terms and how they will apply in practice.

Government policy on future regulation kicks off with employment law reforms

The Government has issued a policy paper, Smarter regulation to grow the economy, setting out its plans to improve regulation across the UK by reducing burdens, reducing the cost of living and driving economic growth. At the same time, it has had to re-evaluate its proposals to repeal all retained EU law at the end of the year.

The “Great Repeal Bill”

The Retained EU Law (Revocation and Reform) Bill which is currently making its way through Parliament contained a “sunset provision” under which all retained EU law in domestic secondary legislation and retained direct EU legislation was to be repealed on 31 December 2023. While the Government intended this as a post-Brexit deregulation measure, aimed at removing and reforming what were potentially seen as burdensome EU laws, concerns had been expressed from many sides, including the Law Society, that it would have a “devastating impact” on legal certainty and business confidence. It has been estimated that more than 4,000 pieces of legislation would fall away under the provision.

The Secretary of State for Business and Trade, Kemi Badenoch, has now issued a Written Statement which confirms that the sunset provision will be replaced by a list of the specific pieces of legislation which it intends to revoke at the end of the year. The Written Statement confirmed that this would be around 600 laws. More than 1,000 laws have already been revoked since the UK left the EU and a further 500 will be repealed when the Financial Services and Markets Bill and the Procurement Bill become law.

Policy Paper

According to the Policy Paper, when businesses are “tied up with red tape” their ability to innovate is limited and prospects for national growth are hampered. The Government proposes reforming the Better Regulation Framework so that non-regulatory approaches are considered and new regulatory proposals receive earlier and more rigorous scrutiny.

The Paper highlights that the Government is committed to reforming existing regulations and, in the first instance, sets out proposed changes to employment that it believes will cut red tape for businesses while safeguarding the rights of workers.

The specific measures proposed are:

• Non-compete clauses: The Government proposes limiting the length of non-compete clauses in employment contracts to three months. It believes this will enable workers to more easily switch jobs and apply their skills elsewhere by joining a competitor or setting up a rival business. While the Government recognises that non-compete clauses play an important role in protecting businesses, it believes the proposed change will help businesses to compete and innovate by recruiting new staff.
• TUPE: Where a business transfers to a new owner, the Transfer of Undertakings (Protection of Employment) Regulations (TUPE) require the business to elect employee representatives with whom it can consult about the proposed transfer. The Government intends to remove this requirement for businesses with less than 50 employees or transfers affecting less than 10 employees. Such a business will simply consult directly with the affected employees.
• Working time: The Government intends to remove the requirement, derived from case law related to the Working Time Regulations, for businesses to keep working hour records for almost all its workforce. It is also proposing reforms to reduce the burden and complexity of calculating holiday pay.

Comment

While businesses may welcome the reduced scope of the TUPE and Working Time Regulations, the changes to non-compete clauses may be seen as a double-edged sword. Greater freedom to recruit will be coupled with an increased risk of workers using their knowledge to erode the business and goodwill of their former employer. Businesses will need to rely more on non-solicitation and non-dealing restrictions which are outside the scope of the proposed reforms.

First published in Accountancy Daily.