The COVID-19 pandemic has had a significant and unprecedented impact on individuals and businesses around the globe. Whilst there have been various issues of immediate concern, ranging from health and safety precautions, employment law rights and insurance coverage, the business world will soon need to grapple with the inevitable fall-out of litigation from the COVID-19 pandemic. As time goes on, the initial expected bounce-back and V-shaped economic recovery looks more unlikely to materialise. Numerous investment projections will no longer be realised, promises made months or years ago will be broken and, as is often the case in times of crisis, unscrupulous behaviour, misconduct and breach of duties which result in losses will all lead to litigation. Multi-national companies, high net worth individuals, directors, office holders, and even employees will need to carefully consider their risk of exposure to litigation, and undertake a cost-benefit analysis of whether to pursue claims to recover losses.
In recent months, we have seen an increase in breach of warranty claims, disputes regarding earn-out agreements, derivative claims by disgruntled shareholders and unfair prejudice petitions by minority shareholders, a trend we expect to continue.
Shareholder Breach of Warranty Claims
Sale and purchase agreements invariably contain warranties and representations made by the seller. These can cover a wide range of issues and, where they are false or not entirely accurate, they give rise to the possibility of the buyer pursuing a claim for breach of contract. Claims for breach of contract seek to put the parties in the position they would have been had the contract been performed, and in the case of a breach of warranty claim, the Court will look to calculate damages on the basis of the warranties having been true. So an assessment will need to take place as to the difference between the value of the shares had the warranties been true, and the true value of the shares. The parties will no doubt disagree on the true value of the shares and the impact of COVID-19 will have a significant impact on this assessment. It will be for the Court to decide, almost certainly with the assistance of expert evidence, the correct level of damages to be awarded and the impact of COVID-19.
Earn Out Disputes
An earn-out involves part of the purchase price for the shares of a company being split out over time where part of the price is paid on completion and further payments deferred to a later date. This is often a measure related to earnings (such as EBITDA) over a specific period but could also be linked to turnover or number of products sold. Earn-outs are often used when the value of the company being purchased cannot be agreed or where there are financing constraints. It is also often used to incentivise management who are also required to remain with the business being sold for at least a transitional period. There are potential advantages and disadvantages to both parties, with sellers benefitting from reaping the full benefit of selling a profitable business and buyers locking in an accurate valuation of the target company and in turn reducing the risk of overpaying.
Despite the obvious benefits, earn-outs often lead to disputes with the parties disagreeing on how to measure the targets set and whether factors not envisaged at the time of agreeing the earn-out should have an impact on the assessments to be made. COVID-19 is more than likely to be an example of an unforeseen event in future earn-out disagreements that will have an adverse impact on almost all businesses. The expected downturn in the economy will almost certainly reduce expected earnings and profits, and in turn make it much more difficult for earn-out targets to be met.
Whilst we envisage sellers facing a shortfall in the expected profits and therefore their expected consideration pursuant to the earn-out for the period in 2020, we also envisage purchasers facing difficulties in making payments which are likely to fall due based on figures for the period ending in December 2019. In these circumstances, sellers and purchasers will need to discuss their respective positions on the earn-out and explore whether there is appetite on both sides to consider amending the Share Purchase Agreement, which could result in an extension to payment periods and payment being made through an alternative to cash.
Inevitably, if the parties cannot agree on how to proceed, they will then start to consider their options and explore dispute resolution mechanisms in the Share Purchase Agreement and possible litigation. The Share Purchase Agreement is likely to include considerable detail on calculating the earn-out consideration as well as the procedure for resolving any disputes. Often an independent accountant is involved in reviewing the relevant procedures to make the determination but every Share Purchase Agreement is different. It would be a sensible course for the Share Purchase Agreement to be carefully considered by lawyers experienced in business disputes as, amongst other things, compliance with the notification provisions of the Share Purchase Agreement will be key.
A derivative claim relates to proceedings commenced by a shareholder of a company in respect of a cause of action vested in the company and seeking relief on behalf of the company. It can only be brought in respect of a cause of action arising from an actual or proposed act or omission involving negligence, default, breach of duty or breach of trust by a director of the company or another person.
In light of the difficulties the COVID-19 pandemic will create for all businesses, we expect to see more shareholders complain about decisions made by directors. Whether such decisions relate to negligence or breach of duty will very much depend on the specific circumstances. Claims can arise from a failure by directors to implement contingency plans efficiently or to follow government guidance, whilst others may arise where a director's own interests conflict with the interests of the company. For example, in the search for funding in light of the expected downturn, a director may seek financing or investment from a party connected to them (which has not been disclosed to the other directors and shareholders) where the terms are uncommercial or onerous. It may become apparent that alternative financing or investment could have been sought from unconnected parties on more favourable terms. In those circumstances, the director has arguably breached their duty and if the company fails to take action against them, it potentially opens the door for a shareholder to commence a derivative claim to recover the losses suffered by the company.
In order to pursue a derivative claim, permission must be sought from the Court. The Court has discretion on whether or not to permit a shareholder to continue a claim and will take into account various matters including whether the shareholder is acting in good faith, whether the company has decided not to pursue the claim and the views of the shareholders of the company who have no personal or direct interest in the matter. The shareholder can also seek an order from the Court indemnifying it for the costs of pursuing the litigation by the company. The derivative claim provides an attractive route for pursuing wrongdoing by directors and potentially having the costs of the litigation met by the company.
Unfair Prejudice Petitions
Where the affairs of a company are being or have been conducted in a manner that it is unfairly prejudicial to the interests of a shareholder, or an actual or proposed act or omission would be so prejudicial, a shareholder can apply to the Court through what is commonly known as an unfair prejudice petition.
Unfairly prejudicial conduct can encompass a wide range of scenarios including (i) diluting a shareholding, (ii) paying excessive remuneration to the directors, (iii) failing to pay dividends in certain circumstances, and (iv) breaches of fiduciary duty that damage trust and confidence between the parties. Whilst the list is not exhaustive, the conduct complained of must be both prejudicial and unfair. Prejudice can be shown where the financial position of the shareholder is damaged. Unfairness is an objective assessment and ordinarily requires an examination against the background of the relationship between the parties, any agreements they have entered into and the corporate structure under consideration.
Again, COVID-19 will be putting pressure on director shareholders which may result in them behaving in a way which is perceived as taking unfair advantage of other shareholders. The decision on whether to pay dividends and other decisions on whether management should reduce the directors' salaries during the pandemic will be closely scrutinised by shareholders. Any situation which sees shareholders' expected returns reduced through the cancellation of dividends but where management still receive their ordinary pay (and/or excessive bonuses on top) are likely to lead to unfair prejudice petitions.
Where the Court is satisfied that the petition is well founded, it may make "such order as it thinks fit for giving relief in respect of the matters complained of". The Court has a wide discretion in terms of remedies and can make orders (i) regulating the conduct of the company's affairs, (ii) requiring the company to refrain from doing or continuing an act complained of or to do an act it has omitted to do, (iii) providing for the purchase of the shares of any shareholder of the company by other shareholders or by the company itself. The share purchase is the most common remedy and often involves the majority shareholder buying the minority shareholder's shares.
In addition to the areas identified above, from our own experience we are aware that an economic crisis exposes previously undetected frauds, leads to an increase in unscrupulous behaviour and gives rise to opportunities for fraudsters to take advantage of the panic and anxiety caused by difficult times.
The UK Finance half-year fraud report published in September 2020 highlighted the increase in online scams during COVID-19. In particular, they identified an increase in (i) investment scams (with the number of cases, number of payments and the total value of losses all significantly increasing when compared to statistics from the first half of 2019), (ii) impersonation frauds (where victims are contacted by criminals purporting to be from a third party organisation or the police or the victim's bank and convinces the victim to make a payment), and (iii) authorised push payment frauds (APP - in the first half of 2020, a total of £207.8 million was lost to APP fraud with an increase in the number of cases). Action Fraud also reported that between September 2019 and September 2020, it received just over 17,000 reports of investment fraud, amounting to £657.4 million in reported losses which amounts to a 28% increase when compared to the same period last year. Action Fraud also confirmed that the reports spiked in May, June, July, August and September 2020 when the UK was in the first COVID-19 lockdown.
In addition, times of economic hardship also often lead to a considerable number of businesses and entrepreneurs engaging in questionable activity when reporting revenues, profits and losses. A desire to avoid breaches of covenants with lenders, or to maintain higher share prices and investor demand during difficult trading periods could lead to profits and revenues being overstated or expenses and losses understated. This same attitude could lead to increased risk taking which blurs the line between acceptable business behaviour and fraudulent wrongdoing. Some will continue to trade despite being insolvent (i.e. unable to pay debts when they fall due) but hoping that things will improve which could lead to allegations of wrongful trading under the Insolvency Act 1986. Others will continue in business having no intention of paying their debts and instead seeking to misappropriate as much as possible and then disappearing before creditors realise what is happening.
All businesses, individuals and office holders should be vigilant to the risks identified above and should ensure they have implemented a comprehensive risk assessment policy in respect of customers, suppliers, employees and external third parties which is robust and actively reviewed and implemented.
Whilst the full consequences of COVID-19 are yet to be felt, the expectation by many businesses and individuals is that it will have an unprecedented and severe impact on their lives and the operation of their businesses. Some businesses will survive and thrive in this new world, but for many it will be a disruptive event which changes the way they operate. That in turn will put pressure on directors to make defendable decisions on how to navigate the new environment and what will be the new normal. Whatever decisions are taken, some will benefit from them and others will feel like they have lost out. Those that feel aggrieved may consider that they have no alternative but to pursue the matter through the Courts.
Contact our Fraud Defence and Business Disputes Team to discuss the issues raised in this article.