Ben Hopps solicitor in Sykes Anderson LLP’s Litigation and Dispute Resolution Department discusses problems that can arise when buying the shares in a company from a buyers’ perspective.
The scenario
You have bought 100% of the issued share capital in a private limited company. It all appeared perfect for your purposes, healthy finances, full order book, loyal customer base and no significant liabilities…and then you start getting to grips with the day-to-day situation.
You start to realise that the company’s assets were artificially inflated by debts, which now appear unrecoverable, or there are hidden tax liabilities, or the outgoing directors had authorised inappropriate or unprofitable contracts.
Maybe key employees are leaving and taking a substantial proportion of your client base, or an employee has a serious claim against the company for discrimination or unfair dismissal.
You may even find that the company is liable for debts or questionable activity by a former parent company. In any event, you suddenly discover that the company is worth a whole lot less than you paid for it.
Since the company is a separate legal personality from its shareholders, the liabilities belong to the company and cannot usually be passed on to the seller.
This is where a well-drafted share sale agreement can help. Even if you do not have an agreement, or the agreement has been breached, all may not be lost.
Identify the problem
Can the problem be dealt with internally?
If, for example, there is a contractual dispute with a customer can it be resolved informally at a minimal cost? If so, it is probably more cost effective to deal with the dispute internally and allow the company to take the loss.
If the issue is more serious you will need to consider whether you have a cause of action and, if so, against whom before you take steps to recover your loss.
Breach of contract – suing the seller
The most straightforward cause of action in a share sale dispute will always be breach of contract. This will usually be the buyer suing the seller, based on either breach of an express term of the contract or breach of warranty.
The more warranties (promises made by the seller) and the more widely they are drafted, the greater the chance of a successful warranty claim against the seller.
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If properly advised, the buyer will have required there to be a sum of money retained from the purchase price to meet warranty claims.
A retention gives the buyer more security and is useful for negotiating purposes as the seller will have an incentive to resolve warranty claims to ensure the release of the balance of the retention monies.
There are sometimes adjustments to the price to make after completion depending on the financial position of the company as at completion when compared with the position as reflected in the target company’s accounts used for completion.
If there is potentially a balance of price due to the seller the buyer might try to withhold this if only as a negotiating tactic.
The wording about payment in share sale agreements is important. Buyers may seek to set-off deferred purchase money they owe the seller against money the seller allegedly owes them under other terms in the contract but beware as the agreement can sometimes try to exclude this right.
An express exclusion of any right of set-off should be approached with extreme care as, any attempt to withhold retention monies where there is such a provision in the contract will not be regarded favourably by the court and you may find that, not only are you ordered to pay the retention monies, you are also faced with paying the legal costs of the seller.
The courts will not usually imply terms to remedy unfairness in share sale agreements.
A recent example of this is the High Court case of Powell & Others –v- General Electric Company in which the purchaser refused to release retention monies pending resolution of outstanding issues under the contract. The court construed the agreement strictly and found in favour of the purchaser, based on a literal interpretation of the contract.
The principle that the courts should be reluctant to imply terms into commercial agreements was clearly underlined.
Unless you can point to a clear term in the contract which has been breached, it is unlikely that the court will uphold a claim. Simply claiming the seller is acting unfairly will not get you your money.
Unexpected claims
Share sale agreements are complex and unexpected claims can jump out at you. It is of vital importance to understand the terms of the agreement that you have signed.
As an example, the court decided that a provision in a share sale agreement for the buyer to provide a release for guarantees and indemnities given by the former parent company was sufficient to found a cause of action for the parent company against the buyer even though no such release was actually given.
In the recent case of Eurodis Electron plc –v- Unicorp Inc, the High Court held that the buyer was liable to refund the former parent company for the monies paid under a guarantee given by the parent company. In that case, not only did the buyer end up with an insolvent company, but also was faced with personal liability to the parent company under the contract.
Sue the advisers
Chances are that a number of professionals were involved in your decision to purchase the company.
If you were given negligent advice, or the agreement or accounts were negligently drafted, you may have a claim against the professionals (be they solicitors, auditors, accountants, surveyors) for professional negligence.
If you believe that you may have such a claim, you should seek legal advice as soon as possible.
The company as claimant
Don’t forget that the company you have purchased can have causes of action in its own right.
It may have claims against former directors for negligence, breach of fiduciary duty and breach of contract (if the directors have contracts).
There are a multitude of sins for which directors can be liable and the company may be able to bring a claim against them, if it (rather than you) has suffered loss.
This could apply, for example, where the company has entered into inappropriate contracts which it is unable to meet and lost clients as a consequence.
The new legislation on director’s indemnities may have an effect on this area and care should always be taken to ensure that the company has not indemnified the director against liability as this will effectively bar such claims.
It may also be possible for shareholders and others to bring derivative claims although this is outside the scope of this article.
Share options?
What happens if you discover that the company you have bought has previously granted option agreements over some or all of its shares to someone else? Some recent cases indicate that option agreements can be specifically enforceable contracts.
This means that, if the third party chooses to exercise the option to buy, you have no choice but to sell. If you don’t, the court can order the sale of the shares and you may be faced with criminal sanctions if you fail to comply with its order. There may also be costs consequences.
In this situation, you would almost certainly have a remedy against the seller for damages and you may be able to set the entire agreement aside for misrepresentation or breach of warranty as to title of the shares.
If you were aware of the option, or it had been disclosed in the letter of disclosure, this remedy would not apply and you may find that you are locked into the company with a minority (or even a majority) shareholder.
There may also be further problems associated with this type of arrangement if the option agreement contains a mechanism for determining the price of the shares.
You may find that you lose a proportion of your shareholding and possibly even control of the company and do not recover an equivalent proportion of the purchase price and that, as a trustee of the shares, you are liable in damages for any bad business decisions which cause the company (and therefore the shares) to devalue.
Take, for example, the case of Blue Pumpkin Software Inc –v- Mitchell & Others in the High Court. This was a case where the directors of a company subject to an option agreement attempted to disperse funds by means of ‘connector agreements’ to another company owned by them. They also intended to declare a dividend to strip the company of cash before the change in ownership.
The proposed buyer issued a claim to restrain the company from these actions. The court granted an injunction, holding that the shares were held on trust for the buyer and that the directors were acting in breach of their fiduciary duties. The main reason for this finding was that the option agreement related to a private company and was specifically enforceable; the only issue was a dispute over the price of the shares, which had delayed completion.
It is essential therefore that you do not attempt to dissuade the potential purchaser from exercising his option by intentionally harming the company. Not only could you be liable to the option-holder, you may also cause the company to become insolvent and may be personally liable for breach of fiduciary duty and wrongful or fraudulent trading.
Your remedy in this event must be against the seller and there are a number of options available to you. The first port of call, as ever, is the contract.
It may be that the contract provides an express remedy if the option has been disclosed and your advisers have taken proper account of it.
There may also be warranties as to title to the shares – an option creating a trust of shares is an issue relating to title to sell them and therefore the seller could be liable for damages for breach of warranty. There may also be remedies in misrepresentation or possibly even mistake.
Minority shareholdings
If, rather than owning 100% of the issued share capital, you are a minority shareholder you are usually in a weak position. You are entitled to protection under statute.
If your interests are unfairly prejudiced by the actions of majority shareholders, you can ask the courts to intervene. Recent cases in this area have shown the courts willingness to find ways to give relief to minority shareholders.
In a recent case, Fisher –v- Cadman & Others, allowed a minority shareholder to resurrect her rights under the articles of association, in spite of the fact that the management of the company had, with her consent, been carried out for many years on an informal basis.
This may become a problem if you buy a majority shareholding (rather than all of the issued share capital) in a company with informal management practices and articles of association, which have not been amended to take these into account.
Getting Your Money Back
Having established that the problem can’t be easily remedied, you take appropriate advice and discover that you have a number of options. The first option is always to do nothing. This is the easy way out – if the company (and ultimately you) can fund any loss. It is unsatisfactory but, if your changes of success are slim, may ultimately be more cost effective than pursuing a claim.
The next option will usually depend very much on the contract.
Many share sale agreements will contain a mechanism for dealing with disputes arising within a certain time after completion.
Increasingly, clauses specifying forms of alternative dispute resolution are included in the contract to minimise the risk (and expense) of litigation.
The problem with this kind of dispute resolution is that it is ultimately not enforceable and litigation may have to follow in any event – causing increased delay and expense.
There may also be recourse to any retention account although, as discussed above, care should be taken in exercising this tactic.
Finally, litigation will be the last resort. In this context, claims will usually involve breach of an express warranty or a failure to disclose information. Claims will depend almost entirely on their own facts, so it is vital to keep records of important events.
As ever, there are a myriad of variations on the themes discussed in this article, depending on the exact wording of any agreements, the extent of disclosure, the quality of advice you received and many other factors.
Principle remedies, as discussed, would be based on breach of contract, mistake, misrepresentation and, possibly, professional negligence – never forgetting that the company may have independent rights of action of its own so that, even if you cannot recoup your losses, the company may be able to do so.
More information
Whatever your situation Sykes Anderson LLP can give focussed, sensible and commercially sound advice on how to minimise or recoup your losses. Please contact Ben Hopps in our Litigation and Dispute Resolution Department for more details.
Please note that this area of the law is a complex subject and you should not take or refrain from taking any step without full legal advice on the particular facts of your case. The content of this article is of a general nature and no liability is accepted in connection with it or if any reliance is placed on it.
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