Private equity - Autumn 2014 newsletter

11 minute read
07 October 2014

We have enjoyed a busy summer in the Private Equity team, closing some exciting deals and working alongside a broader team of experts following our merger earlier in the year.

Also during the summer, there have there been several developments in the law. Of particular interest to our private equity and investor clients are the potential liabilities arising from holiday pay claims and the court's inference of drag-along provisions into an investee company's articles of association. Another issue to watch out for is the impact of sanctions - EU and US foreign policy can directly affect targets and investee companies, with a knock-on effect on your investments and transactions.

Read on to find out more.

To pay or not to pay?

That really is the question.

Employers will be familiar with the right of workers to 20 (now 28 including public holidays) days' paid holiday following the introduction of the Working Time Regulations on 1 October 1998.

What could not have been foreseen at the time, and what has arisen as a consequence of litigation by pilots employed by British Airways, is that the whole basis for calculating holiday pay could be thrown into disarray.

Once there was certainty that overtime and success-based commission payments did not fall to be included in holiday pay. Now, as a result of the British Airways litigation, any payments that are 'intrinsically linked to the performance of the tasks' under an employment contract must be included in the calculation of holiday pay. This is part of a worker's 'normal remuneration' and should form part of holiday pay to ensure that the worker is not deterred from taking holidays by fear of losing earnings.

The issue of success-based commission is settled. The Court of Justice of the European Union (CJEU) decided in the case of Lock v British Gas Trading Limited that commission directly linked to the employee's work must be included in holiday pay.

But what of overtime? It is looking likely that the Employment Appeal Tribunal will find in the case of Bear Scotland v Fulton that the same approach should be adopted when considering overtime. In other words, voluntary overtime should be taken into account when calculating holiday pay.

What are the risks for employers? Employment tribunal claims from employees for unlawful deductions of wages could cover periods as far back as 1 October 1998 or the start of the employee's employment (if later). The potential liability could be significant for investee companies. In each case, it will all depend on the number of long-serving employees affected and the level of commission payments and/or overtime payments received. Employees in some sectors are now being actively targeted by no-win no-fee advisers.

Employers and investors will need to understand the extent of any past liability. This involves interrogating payroll and employee data to quantify the potential liability and deciding how to remedy any problem disclosed by that exercise.

For potential liabilities, investors may consider warranty or indemnity protection. Where there is an ongoing issue, employers will need to decide how to calculate holiday pay going forward. This might include revising overtime rates or amending commission structures.

Trade unions and the no-win no-fee advisers have indicated that failure to resolve these issues will result in litigation, and that such claims could give rise to the next wave of mass tribunal litigation on a scale reminiscent of the public sector equal pay litigation.

If your remuneration structures (or those of your portfolio companies) include any elements of variable pay, it is time to take a proactive approach to the issue of holiday pay calculation in order to minimise past liability and put in place measures to address the issue going forward.

Wragge Lawrence Graham & Co's experts are here to help.

Compulsory transfer provisions - no longer such a drag to enforce?

Drag-along provisions are a very familiar part of a private equity transaction. They operate to enable a (usually) majority shareholder to force a minority shareholder to join the sale of the company on the same terms as the other shareholders. They are incorporated into an investee company's articles to ensure that the private equity investors are able to procure a sale of 100% of the issued share capital of the company, maximising their returns.

So what would happen if there were no drag-along rights, or if the existing rights didn't work as they need to in the particular circumstances of the sale? The risk is that a disgruntled or unwilling shareholder may be able to hold the company to ransom, either refusing to sell, or demanding more money in order to do so.

The facts of the case

Inserting new, or amended, drag-along rights prior to a sale to apply to such an unwilling shareholder could result in that shareholder arguing that his interests have been unfairly prejudiced. He may argue he is being forced to sell against his will on terms he did not agree to.

This is what was argued in the case of Arbuthnott v. Bonnyman and ors [2014] EWHC 1410 (Ch), which involved the private equity firm Charterhouse Capital. Over time a number of senior executives had left the company, Charterhouse Capital Limited ("CCL"), leaving a misalignment between the shareholders and the active executives running the business. An MBO team of the remaining executives was formed to purchase CCL primarily in order to correct this misalignment.

CCL did have existing drag-along rights in its articles but they were amended to fit the particular circumstances of the impending sale, such amendment being a condition of the MBO offer. Arbuthnott argued that the alteration was unfair and invalid "as its most direct effect was to allow the majority to expropriate his shares at an undervalue".

The test for determining the validity of an amendment to the articles was set in Allen v Gold Reefs of West Africa (1900) and requires that the power to alter the articles must be exercised in good faith for the benefit of the company as a whole and must not be exceeded. Any resolution which offends this principle will inevitably be unfair.

On finding that the alteration to the articles was not unfair the Judge relied on the following points:

  • The original articles contained a form of drag-along rights which "formed the commercial bargain between the Founders of which Mr Arbuthnott was one" and the amendments were more of a "tidying up" exercise;
  • He did not accept that the change in the articles was targeted purely at Mr Arbuthnott and intended as expropriation. Many of the independent shareholders were in the same position as Mr Arbuthnott, having received the same offer for their shares, and had voted in favour.
  • The lack of alignment was a serious issue which would be an impediment to raising a new fund and needed to be resolved in order to secure CCL's future. The sale, and the amendment to the articles needed to achieve that sale, was therefore in the best interests of CCL.


The fact that the articles already contained a form of drag-along may well have a played a key part in the decision in this case, but how likely is it that a different decision would have been made if the original articles contained no reference to drag-along rights?

On these facts it is hard to imagine a different decision would have been made. Mr Arbuthnott was to receive the same price for his shares, on the same terms, as the other shareholders who had all agreed the terms of the deal and, given the misalignment issues, he would arguably have been in a much worse position had he remained a minority shareholder and the MBO was unsuccessful.

The Companies Act does provide for a statutory sweep-up if at least 90% of the shareholders have accepted the offer. This is a longer and more cumbersome process, but it would suggest that in a commercially sound transaction the insertion of a drag-along may be an acceptable alternative to pursuing this statutory process. That said, Mr Arbuthnott has been given leave to appeal and so we'll be watching this case with interest.

Sanctions - is your deal bankable?

Investors are taking sanctions legislation very seriously, and they need to. If a stakeholder commits to an entity which becomes (or whose business becomes) affected by sanctions, this could have a number of adverse consequences. These could include the inability of an entity with frozen assets to make repayments of debt, as well as reputational risks for the investors.

As a result, debt and equity investors alike are likely to spend more time in due diligence on the ownership and type of business of an entity and the areas in which it operates. In drafting finance documentation, there is an increased demand from the lender for protections which guard against the risk of funds being used in a way that would be in breach of sanctions, for example, within the borrower group or by onward funding.

While these can't override the impact of sanctions, they are likely to flush out issues from the outset and maximise options for the stakeholder in the event of their breach. Lenders are increasingly including specific notification requirement/representations relating to sanctions to get early warnings of any issues from the borrower group.

Why does this matter to you? Target businesses with assets or revenue streams that are affected by sanctions can become unbankable, with knock-on effects to larger transactions of which they form only part.

There is also an increasing awareness of the distinctions between the source of sanctions and their reach. EU sanctions will apply to nationals of and entities incorporated in member states (amongst others) in addition to any sanctions that the individual member states may make. They may implement UN sanctions regimes or autonomous EU regimes.

Similarly, US sanctions will affect dealings of US persons but are not confined to this group. For example, they can extend to transactions taking place through the US financial system, including the use of US dollar facilities.

The targets of the EU regimes often overlap with, but do not mirror, those issued out of the US and other non-European jurisdictions, as evidenced by the latest series of sanctions issued against Russian individuals, entities and business areas. This has the potential to cause conflict for an investor whose business or portfolio is subject to more than one set of sanctions, particularly in transactions where other parties are subject to different restrictions.

It goes without saying that sanctions regimes can be complex and the degree to which they impact on an investment is going to be fact-specific. Much will depend upon the type of business and the stakeholders.

If you have concerns about whether these issues affect an existing or potential investment opportunity, then please contact us.

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