In a recent judgment (Durose & Ors v Tagco BV & Ors  EWHC 3000 (Ch)), the Court was asked to decide whether the actions of a private equity investor demonstrated "unfair prejudice". In this insight we cover what steps companies should take in light of the Court's ruling.
The circumstances of this case concerned where a private equity investor, on the occurrence of an insolvency event, had invoked enhanced voting rights which effectively caused the original shareholders to lose control of the business.
The original shareholders pleaded that the private equity investor had deliberately engineered the insolvency event in order to obtain majority control. The case brought the court to consider the causes of the insolvency and the actions of the private equity investor to determine whether unfair prejudice had come into play.
Summary of the case
The petition was dismissed. His Honour Judge Bird considered that the petitioners entered into a commercial arrangement where the terms were "tightly regulated by a full suite of professionally drawn contracts and documents". On the evidence, the judge concluded that the private equity investor had always acted in accordance with the agreed terms. In the circumstances, it was fair and just to hold the petitioners to the terms of the legal agreements, and they were not permitted to complain that their treatment was "unfair".
The relationship between the parties was purely commercial. All material dealings were carried out via lawyers. The judge was satisfied that all signatories to the investment agreements had had an opportunity to consider the documents, to input into them and to take legal advice on the contents. He found that the petitioners were well aware "this was not a risk-free endeavour" and that an insolvency event would trigger the enhanced voting rights (swamping rights).
The judge found that the causes of the insolvency arose from a combination of factors that included: (i) failure to control the finances of the company after the investment; (ii) control failures leading to over-spending by the company, so that working capital was exhausted; (iii) failure to raise working capital through sales, at least to the extent needed to fund outgoings; and (iv) failure of the first and second petitioners to pay the sums they were obliged to pay.
The judge also found that the company was entitled to exclude and suspend the first petitioner from the company. They had lost trust and confidence in him because he had failed to pay debt he owed to the company, and had misled them about his ability to pay sums due under the underwriting agreement.
Gas Tag Ltd sought to market and sell the potential of a new gas safety product. The 'gas tag' is a small tag containing an NFC (near field communication) chip that would be attached to a domestic boiler. Its wireless technology allows the transfer of data between two NFC enabled devices. The company created an app that would allow gas engineers to access data fields on the gas tag, e.g. gas safety records. This data would evidence compliance and build a database of gas safety maintenance for any given property. The company focused marketing on the product's potential to improve the safety and wellbeing of tenants, and to revolutionise gas safety in the UK.
While the product had real potential, the court heard that ultimately customers did not buy the product in sufficient volume and, as a result, Gas Tag Ltd entered administration on 14 October 2020 and was dissolved in January 2022.
After pre-contractual discussions, an investors' agreement was executed on 15 December 2017. It provided that the suite of investment documents (including new Articles of Association), comprised the entire agreement and understanding between the parties, superseding and extinguishing any prior agreement.
The Articles of Association provided for the private equity investor to exercise swamping rights in certain circumstances. They also permitted the right for it to make emergency equity investments in return for new shares, while postponing the rights of other members to catch-up.
The investment was to be provided in stages.
Company performance and the efforts to raise capital
After the initial investment, sales were slow. It was clear that the company would run out of cash by February 2019. To address this, the non-investor members suggested that the second and third stage funding should be released early. The private equity investor declined this more flexible option on 11 February 2019 and adhered to the terms of the investment agreement.
A day later, the private equity investor instead offered £500,000 in equity investment on a valuation of £10 million. This offer was rejected by the first petitioner and others. Later that month, the accepted alternative was £750,000 provided by the private equity investor by way of secured convertible loan notes issued by the company pursuant to a loan note agreement. In default of repayment, the private equity investor would be entitled to convert the loan to an equity stake based on a £10 million valuation.
The company continued to seek alternative sources of funding. At the end of February 2019, two of the founder shareholders (the first and second petitioners in the case) offered a plan to inject £1 million in return for a further 4% shareholding and at the same time purchase another shareholder's shares for £2.64 million. It required the private equity investor's consent because it involved the acquisition of shares. This offer was rejected by the private equity investor because it considered the cash injection would be insufficient and that a minimum cash injection, by way of equity, of £2 million was required.
In May 2019, the company decided to raise funds by share issue. The offer to members contained both: (1) an offer to purchase new shares; and (2) an offer to purchase another shareholder's shares. By the wording of the share offer, the new shares offer was to complete prior to the sale shares offer. The sale shares offer was conditional upon more than £2 million of share issue offers being taken up.
In June 2019, the company was in crisis and in August 2019, it was reported that the business had insufficient liquidity to meet payroll obligations.
Despite assurances from the first petitioner that it would be "sorted", the sums required could not be raised. The full amount due in relation to the new shares was not paid. As a result, no obligation to pay for the sale shares arose under the terms of the share offer.
On 23 August 2019, a voting adjustment notice was served by the private equity investor because there had been an "insolvency event" as defined in the investment agreement. The first petitioner was suspended from the company pending a review.
Unfair prejudice petition
Section 994 Companies Act 2006 allows a member of a company to apply to the court by petition for an order under Part 30 of the Act on the ground that the company's affairs are being, or have been conducted, in a manner that is unfairly prejudicial to the interests of members generally, or of some part of its members.
The parties in this case agreed that His Honour Judge Bird should determine if there had been unfairly prejudicial conduct before considering what, if any, remedy might be granted.
Among other issues, the judge was invited to consider:
- whether a particular email sent from the private equity investor to the first petitioner revealed an early intention to use swamping rights to gain a majority i.e. gave rise to equitable considerations that displaced legal rights in the formal documentation;
- the proper construction of the conditions in an offer letter to raise funds by share issue;
- whether the company faced an "insolvency event" as defined under the Articles of Association. And if so, whether this was caused by the private equity investor's refusal to raise funds by share issue. And, should this be the case, whether the private equity investor was entitled, contractually and governance-wise, to proceed in the way that it did when it invoked the "swamping" mechanism by which it became the majority shareholder in the company. Furthermore, whether the consequent dilution of the petitioners' shareholdings as a result was unfairly prejudicial; and
- whether there were any equitable considerations in respect of the first petitioner's role within the company, or whether his exclusion from the company gave rise to any unfair prejudice.
The judge cited Lord Hoffman in O'Neill v Phillips  1 WLR 1092, noting that the concept of "fairness" depends on context, and that in a company situation this required consideration of the terms on which members of the company had agreed to deal with each other. Generally speaking, conduct that is "within the rules" should not be considered as "unfairly prejudicial".
The starting point therefore, the judge said, is to ask if the conduct complained of is in accordance with the "rules" that govern the conduct of the company. If it is, the next question is whether in the particular circumstances of the case, equitable considerations mean the strict legal rights cannot be relied on (because "legitimate expectations" have arisen on which the aggrieved party should be entitled to rely).
Relying on further case law, he explained that before equitable considerations could arise, there would typically need to be a personal relationship, involving mutual confidence between the founding members giving rise to "special underlying obligation in good faith or confidence". Following that, there would usually need to be "mutuality", or detrimental reliance or change of position so that it would be inequitable to deny the obligation.
What steps should companies take in light of this ruling?
- Parties should ensure that all investment agreements are properly documented, and reflect the bargain reached by the parties in relation to their investments and the way that the company is to be run. The (usually complex) suite of documents accompanying a private equity investment will establish the "rules of the game" for the future conduct of the company.
In this case, the investment agreement and supporting documentation were all negotiated and drawn up by professional legal teams. It was therefore difficult for the petitioners to rely on the hunch that they felt a "long established collateral agenda" on the part of the private equity investor when things started to go wrong. For private equity investors, the protection and security afforded by a comprehensive suite of investment documents can protect them in circumstances where investments sour, particularly where founder shareholders remain in the business.
- When things go wrong, contemporaneous documents speak louder than retrospective words. The judge in the case commented that disclosed documents in cases such as these are likely to be of far greater assistance than oral evidence. By reviewing the disclosed documents, the judge was able to examine the parties' conduct at the relevant times and in context. For example, the judge noted that at the first potential "insolvency event" the equity investor did not exercise "other rights" (i.e. the swamping rights), even though it could have done. The judge found that this conduct indicated the investor had "no fixed desire" to obtain a controlling interest at any cost.
Similarly, when the company accepted a loan note on onerous terms, the willingness of the company to accept the loan led the judge to conclude this "show[ed] that [the company] was well aware that absent the loan it would be insolvent". Again, this finding went against the petitioner's case.
To discuss any of the points raised here and how you might improve your suite of investment documents for an upcoming deal, please contact Charlotte Howell.