A Practical Guide to Private Equity Transactions

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Parting company with a manager

5.4 Employment rights and claims

Chapter 7 sets out more details of the rights and claims that a manager may

have in the context of his employment and its purported termination.

Certain

claims arise by statute, and as a result cannot be excluded by contrary terms

in the service agreement. Possible claims for breach of contract must also be

considered.

As summarised in section 5.1 above, the circumstances in which the deci-

sion is made to terminate the employment of an executive will not always

amount to gross misconduct or otherwise entitle dismissal of the individual

without notice. This can occur (even in businesses that are not underperforming,

of course) and, when it does, the risk of employment claims is much reduced.

More often, however, it arises in less clear-cut circumstances, for example a

breakdown of the trust and condence of the investors or other managers in

that individual that gives rise to the decision to terminate (or, perhaps, that

manager being offered up by his colleagues as a scapegoat – because someone

has to take commercial responsibility for the problems for the rest to move

on). For less senior employees, coaching, mentoring or redening an individ-

ual’s role may address personal underperformance issues. Such steps (and the

period of time that the employer ought to wait to look for improvement) are less

likely to be considered acceptable in the context of a senior manager.

This need for expedition (which can also arise to short-circuit the due pro-

cess of disciplinary procedures, even in a suspected gross misconduct case)

means that there is a higher than average risk of an unfair dismissal claim

arising when the employment of a senior manager is terminated. In effect, this

forms part of the cost to the business of parting with the manager (or, looking

at it another way, of backing the wrong person in the rst place).

5.5 Rights as a shareholder

The termination of employment and the directorship can also give rise to

a potential claim by the manager in his capacity as a shareholder. There is

a respectable line of authorities, going back to the decision in Ebrahimi v.

Westbourne Galleries,

that suggests that a shareholder may be able to peti-

tion for a winding up of the company (based on the ‘just and equitable’ ground

under what is now section 122 of the Insolvency Act 1986) where the company

was in effect a form of quasi-partnership, such that the individual’s employ-

ment was an expected incidence of his membership of the company. That said,

such agreements are harder to apply to private equity cases for two reasons:

(a) the elaborate provisions designed to allow termination of employment, with

related restrictive covenants and a mechanism for the clawback of equity

29 See in particular chapter 7, section 4.

30 [1973] AC 360.

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Living with the investment

shares (which is normally discretionary),

makes it harder to suggest that

there was an implicit agreement that any form of quasi-partnership existed

justifying a winding up on departure; and

(b) more recent case law has suggested that the jurisdiction of the court in

relation to unfair prejudice (a shareholder remedy conferred by what is

now section 994 of the Companies Act 2006, and which did not exist at

the time of Ebrahimi) offers a more suitable approach for the court in

many situations.

The court has a wide discretion as to what is a suitable

remedy if an unfair prejudice claim is successful, such that winding up is

not the only (or even the most likely) outcome. A more typical remedy is

that a successful claimant is bought out at fair value (although in many

cases such valuation may be determined without discount for any minority

interest).

If an unfair prejudice action were successful, the valuation of the leaver’s equity

may be more attractive than under the mechanism contained in the articles of

association on any clawback of shares, especially if the circumstances would

result in a ‘Bad Leaver’ valuation, or treat only part of that manager’s equity

as vested.

For this reason, in many situations, a claim for unfair prejudice is

asserted or threatened following a departure. However, in practice, it is rarely

pursued. Usually, it is alleged as part of a ‘kitchen sink’ negotiation tactic, to

attempt to maximise the value of the departing manager’s compromise pack-

age. Where the company itself is underperforming or in nancial difculty,

the claim may not have much merit in any event, as the difference between the

court’s valuation and the valuation under the relevant articles would be little, if

any.

In practice, and excluding those cases where the matter becomes ser-

iously contentious (which is the minority of cases), the question of valu-

ation of the sale shares is usually a straightforward discussion at the time of

departure. Where the company is insolvent or seriously underperforming (so

that the equity is unquestionably underwater), a nominal consideration, or

perhaps a token larger gure, will be agreed. In these cases, the manager will

usually have little bargaining power beyond any delay that going through the

formal clawback mechanism would cause, and any independent valuation

costs that would be incurred. Where the business is solvent but not strongly

performing, buying out at initial subscription cost, or such cost and a little

extra, may well be a compromise. Cost price is often a key driver for a man-

ager, who may have taken out personal loans to raise funding for his initial

share subscription.

The hardest cases are those where the equity is in value. In theory, the

formal valuation mechanism in the articles may be needed in these cases,

31 See chapter 5, section 4.11.

32 See, for example, Re Woven Rugs Ltd [2008] BCC 903.

33 See further chapter 5, section 4.11.

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Parting company with a manager

although in practice a price is usually agreed in the context of the overall com-

promise package.

Sometimes, the manager is allowed to keep his shares (or at

least some of them), though this is unusual unless there has been a secondary

buyout, or there are other circumstances resulting in part or all of the man-

ager’s equity being outside the leaver mechanism.

The leaver mechanism is an important protection in the circumstances of a

manager’s departure. Properly drafted and exercised, it will enable his shares

to be acquired. As explained in chapter 5, much time and attention is put into

settling these terms at the time of the buyout, and subtle nuances are often

reected in the precise wording. The negotiation of a deal or the exercise of

the formal clawback mechanism can take time. Where there is real value in the

equity it is important for the company and its investors to be mindful of any

time period applicable to the leaver mechanism, to ensure the clawback right is

not lost simply because negotiations drag on beyond such period.

During any period of negotiation, the manager will remain a member.

Depending on the articles, this may entitle him to vote on shareholder resolu-

tions or to participate in a rights issue. This is not always what is desired by the

other shareholders in the circumstances of a departure, however, so the articles

will often contain a provision either expressly removing some or all of these

rights (sometimes by reclassifying the shares to a non-voting class), or at least

entitling the board or the investors to remove the rights in question by written

notice. Typically, such provisions are triggered as soon as notice of cessation

of employment is given (whether by Newco or by the manager), rather than

the date on which the employment actually ends or any leaver provisions are

triggered. The interests of the other shareholders (and in particular the inves-

tors) are often best protected by keeping the leaver and disenfranchisement

mechanisms as independent of each other as possible. In certain cases, it may

not be intended to exercise the clawback rights (or at least not at once), but the

disenfranchisement right may still be useful, especially in an underperform-

ance situation when shareholder resolutions may be needed in a hurry and the

interests of the departing manager (if entitled to vote on the resolutions) may

not be aligned with the other shareholders.

5.6 Non-compete, conﬁdentiality and related matters

One issue of sensitivity in any negotiations around a departing manager is the

non- compete, non-poaching and condentiality restrictions that were put in

place at the time of the buyout. These will typically be found in both the ser-

vice agreement

(made with and in favour of Newco) and in the investment

agreement

(made with and in favour of the investors, and sometimes also in

34 See also chapter 9, section 4.5(d), for discussion on how a sale in these circumstances can

trigger PAYE and National Insurance liabilities.

35 See chapter 7, section 2.6.

36 See chapter 5, section 3.7.

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Living with the investment

favour of Newco). These can be important protections for the group – espe-

cially where the departure is as a result of a manager choosing to leave.

As noted in chapter 7, the restrictive covenant in the service agreement may

be in jeopardy if there is any real suggestion that the dismissal itself (or the

way in which it was done) constituted a repudiatory breach by the employer

company. This is one of the reasons for the separate covenants in the invest-

ment agreement, so that there is no doubt that these covenants will be binding

even if repudiatory breach of the service agreement is alleged. A compromise

agreement will often include a restatement of such provisions, or conrmation

that the original provisions continue in force and effect, to avoid any uncer-

tainty following the manager’s departure.

5.7 Anticipating issues in the original documents

The interaction of employment, directorship, shareholder and possibly contrac-

tual claims can make the decision and process of parting with a manager dif-

cult. The key to a successful outcome (from the point of view of the continuing

shareholders) is to have anticipated the most likely scenarios in advance at the

time of the buyout and to ensure that the documentation (in particular, the art-

icles and the service agreement) provide the maximum exibility and strongest

bargaining position to reduce the risk that the departing manager can assert

claims that would be highly disruptive to the business (especially in an under-

performance or rescue situation).

At the time of negotiating these documents, individual managers can some-

times be resistant to a number of these mechanisms. It is often persuasive to

explain at that time that a performing manager is far more likely to stay than

to leave, and that the best interests of all remaining shareholders (not just the

private equity investors) are protected by a strong hand being dealt in advance

to Newco in those situations where departures are necessary. While this ‘div-

ide and conquer’ principle may seem to contradict the strong team spirit that is

usually a feature of a good management team, it does reect commercial real-

ity and, properly explained and appreciated, can lead to a robust position being

accepted upfront by all concerned. Having set out the position in this way, it is

important that Newco (and the investors) are careful at the time of departure

to ensure that the mechanisms are followed strictly, and in particular that any

relevant time periods are met.

6 Directors’ duties and conﬂicts of interest

6.1 Background to directors’ duties

In this section, we consider the duties that are owed by directors, and the par-

ticular implications that such duties may create in a private equity environment.

The new codied duties set out in the Companies Act 2006 have provided a

substantial framework from which to begin such analysis, although there is

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Directors’ duties and conﬂicts of interest

other legislation that is relevant (particularly in an insolvency situation) as well

as a substantial body of case law. Throughout this section, we refer to duties

being owed to a company. In the context of a private equity transaction, it is

important to remember that an individual will owe separate duties to every

company in the Newco group structure of which he is a director, as well as any

companies outside that group.

Consideration of the responsibilities of directors in a private-equity-backed

deal emphasises the different relationships that particular individuals may

face. Key managers will be directors of one or more companies in the group,

as well as employees and shareholders. The chairman will usually be both a

non-executive director and a shareholder, often in various different compan-

ies outside the Newco group. The investor directors appointed by the private

equity investors will often be senior executives (and sometimes even directors)

within the relevant private equity manager rm, and sometimes in one or more

of the underlying investors themselves, and will have a direct nancial interest

(in the form of carried interest, and possibly a co-investment) both in Newco

and in other investments in the private equity investors’ portfolio. The investor

director may also be an investor director or observer in other portfolio com-

panies in which that same investor has a stake.

Before the 2006 Act came into force, the regime of directors’ duties was a

mixture of statute and case law, with some of the cases dating back 100 years or

more. One of the aims of the 2006 Act was to make the area of directors’ duties

more accessible, to address the question of ‘In whose interest should companies

be run?’ to reect modern business needs, and to bring corporate social respon-

sibility further into the boardroom. The aim of the new statutory duties was: (a)

to embed in statute the concept of ‘enlightened shareholder value’, by making

clear that directors must promote the success of the company for the benet

of its shareholders, taking into account factors such as employees, suppliers,

customers and the effect of decisions on the environment; and (b) to introduce

a statutory statement of directors’ duties to clarify their responsibilities and

improve the law on regulating directors’ conicts of interests.

The codication of duties under the 2006 Act does not cover all of the

general duties that a director owes to a company. Some will remain unmodi-

ed, such as considering the interests of creditors in circumstances of potential

insolvency.

Directors’ duties are therefore now governed: (a) by the common

law; (b) by the new codied duties under the 2006 Act; and (c) by other specic

statutory duties. There are a large number of specic statutory duties, such as

those under the Health and Safety at Work Act 1974 and employment legisla-

tion; directors must remain abreast of their responsibility under all relevant

legislation.

Under the 2006 Act, there are seven codied duties of directors, which are

considered in turn in sections 6.3 to 6.9 below. Although strictly outside the

37 See further section 6.12 below.

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codied duties, there is also a statutory requirement under section 182 of the

2006 Act for directors to declare their interests in any existing transactions

or arrangements that have been entered into by the relevant company, as out-

lined in section 6.10 below. There are also certain requirements for particular

arrangements between a company and a director to be approved by the share-

holders, which are considered in section 6.11.

For completeness, there are certain specic duties imposed on directors

under the 2006 Act, for example those duties requiring directors:

to maintain proper tax and accounting records giving an accurate statement •

of the company’s nancial position;

to maintain the statutory registers of the company;•

to prepare the company’s annual accounts and return for submission to the •

Registrar of Companies;

in the case of public companies only, to hold an annual general meeting.•

The sections that follow provide an overview of the main duties referred to

above, and, where relevant, offer additional guidance on the ways in which

such duties may have particular implications for a private-equity-backed com-

pany. Finally, an overview is provided of the key duties that must be considered

in an insolvency context.

6.2 To whom are the duties owed?

Generally, directors owe their duties to the company alone, which means to the

present and future shareholders of the company and not to any one shareholder

individually. Before October 2007, if the directors had breached their duties,

then, generally speaking, the members had to look to the board to enforce such

breach on behalf of the company, although if the board failed to take action

the members could resolve that the company do so. In general, minority share-

holders cannot sue for the wrongs done to their company, although there were

certain statutory and common law exceptions to this general rule, for example

where the wrongdoers are themselves in control.

This has meant that deriva-

tive claims brought by shareholders in the name of the company have been

very scarce.

However, this may change as a result of the new derivative claims proce-

dures under the 2006 Act. Under sections 260–264 of the 2006 Act, a deriva-

tive claim may be brought by any shareholder in respect of a cause of action

arising from an actual or proposed act or omission involving the negligence,

default, breach of duty or breach of trust by a director of a company.

Any shareholder can bring a claim under this provision – all they need is

one share and, critically, they do not have to have been a shareholder at the

time of the alleged wrongdoing. There has therefore been speculation that this

38 The principle established in the case of Foss v. Harbottle (1843) 2 Hare 461.

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Directors’ duties and conﬂicts of interest

new action will allow activists or other pressure groups to bring troublesome

claims, or could lead to spoiling tactics in the context of transactions. A good

example might be in relation to a recommended takeover, which might result

in redundancies, where a trade union acquires a shareholding to bring a claim

against the directors (on the basis that the interests of the employees have not

been properly considered in light of the concept of enlightened shareholder

value)

to frustrate a transaction.

There are, however, some safeguards against speculative claims. First,

the new derivative action is a two-stage process. A claimant must establish a

prima facie case before being given permission by the court to proceed with

any claim.

Secondly, the 2006 Act contains a list of matters that the court

must take into account when considering whether or not to grant such permis-

sion. These include:

(a) whether the shareholder is acting in good faith;

(b) the importance that a hypothetical person acting in accordance with the

duty to promote the success of the company would attach to continuing the

claim; and

be likely to be, authorised or ratied by shareholders.

At the time of writing, it is unclear how rigorously the courts will interpret the

new legislation. The rst cases will be crucial. Notwithstanding the statutory

safeguards, and the historic reluctance of the courts to become involved in

second-guessing the commercial judgments of directors, the fear remains that,

unless the courts throw claims out at the initial permission stage, sharehold-

ers will achieve their objectives even if they lose their case, because they will

have delayed (and possibly therefore frustrated) implementation of the board’s

decision and damaged the company as a result.

Since directors’ principal duties are owed to the company, the company

may ratify the actions of a director who is in breach of his duties, or who has

exceeded his authority, by way of a shareholder resolution. There are excep-

tions to this, the main one being that the company cannot ratify an act which

the company itself has no power to do. Also, where the director concerned (or

any connected person) is a shareholder, they will not be counted in any vote to

ratify such a breach of duty.

Although directors’ duties are owed mainly to the company, directors must

also have regard to the interests of creditors and employees, and must not treat

minority shareholders unfairly or oppressively. The duties that directors owe to

creditors are relevant mainly in the context of an insolvency or potential insolv-

ency of the company concerned, discussed further in section 6.12 below.

39 Under section 172 of the Companies Act 2006: see section 6.4 below.

40 Section 262 of the Companies Act 2006.

41 Section 263 of the Companies Act 2006.

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Living with the investment

6.3 Duty to act within company’s powers (section 171)

This provision is a simple codication of the law that was in force before the

2006 Act

and states that a director of a company must:

(a) act in accordance with the company’s constitution; and

(b) only exercise powers for the purposes for which they are conferred.

A good example of how this duty might be breached in a private equity context

would be if the directors used their power to issue shares (a power designed to

raise capital) to dilute a minority shareholder when no real need to raise the

capital existed. In a takeover scenario, such power might also be abused by

Target to ward off an unwanted bid by the strategic selection of shareholders to

whom shares are issued.

6.4 Duty to promote the success of the company (section 172)

This new duty replaces the pre-2006 Act duty of loyalty, i.e. to act in what

the director in good faith considers to be the best interests of the company.

Arguably, this is the most demanding provision of the entire 2006 Act, as it is

this new duty that introduces the concept of ‘enlightened shareholder value’

into UK legislation.

There are effectively two limbs to this duty:

(a) rst, a director must act in a way which he considers, in good faith, would

be most likely to promote the success of the company for the benet of its

members as a whole; and

(b) secondly, in doing so, the director must have regard to (amongst other

matters) the six factors listed in Figure 11.1. The words ‘amongst other

matters’ make the list non-exhaustive; the list simply illustrates the broad

areas of particular importance, reecting a wider expectation as to what

constitutes responsible business behaviour.

The decision as to what will promote success, and what constitutes suc-

cess, is one for a director’s good faith judgment. This ties in with the histor-

ical approach of the English courts, which has been to defer to the honest

commercial judgment of the directors (who were chosen by the shareholders,

at least in theory, to run the company’s business) as to what is in the best

interests (or, under the new regime, most likely to ‘promote the success’) of

the company.

Given the extensive and non-exhaustive nature of the list of factors to be

considered, it is quite difcult to imagine what else might be included. Possible

additions include the interests of subsidiaries, and consideration of health and

safety issues. The important point to bear in mind is that the overriding duty of

42 See, for example, Howard Smith Ltd v. Ampol Petroleum [1974] AC 82.

43 See, for example, Charterbridge Corporation Ltd v. Lloyds Bank Ltd [1970] Ch 62.

335

Directors’ duties and conﬂicts of interest

a director is to promote the success of the company. This avoids the numerous

contradictions that would otherwise arise. For example, if an energy company

is considering building a new power station, this is likely to have an adverse

environmental impact, but that does not mean per se that the power station

should not be built. Building the power station may be fundamental to the

success of the company, but the environmental impact must be borne in mind.

Another example of where a conict may arise is in the case of redundancies,

where the interests of the company and those of a number of its employees are

likely to be at odds. Helpfully, the UK government has stressed that the over-

reaching principle needs to take precedence, i.e. to promote the success of the

company.

6.5 Duty to exercise independent judgment (section 173)

This is a codication of the principle that directors must exercise independent

judgment, i.e. they must not fetter their discretion.

The provision states that

the duty is not infringed by a director acting:

(a) in accordance with an agreement duly entered into by the company that

restricts the future exercise of discretion by its directors; or

The duty to promote the success of the company requires that a

director must act in the way he considers, in good faith, would be

most likely to promote the success of the company for the benefit

of its members as a whole, and in doing so have regard (amongst

other matters) to:

•

the likely consequences of any decision in the long

term

• the interests of the company's employees

• the need to foster the company's business

relationships with suppliers, customers and others

• the impact of the company's operations on the

community and the environment

• the desirability of the company maintaining a

reputation for high standards of business conduct

• the need to act fairly as between members of the

company.

Figure 11.1 Promoting the success of the company – the six factors to consider

44 See Kregor v. Hollins (1913) 109 LT 225.

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Living with the investment

(b) in a way authorised by the company’s constitution.

From a practical perspective, this means that there is no problem, for example,

in a company entering into a contract for the sale of one of its subsidiaries

and agreeing not to compete with the business of that subsidiary for a period

of time. That amounts to a commercial agreement permitted by this provi-

sion. Where this provision may prevent a fetter on the directors’ discretion by

agreement is if, for example, they decided to undertake never to recommend

a takeover bid. Whilst they might contractually agree to do this, it is hard to

imagine that a court would uphold such a decision as it is depriving them of

their independent judgment in the future. Also, whilst it must be independent

in the sense of its being a director’s own judgment, it is not intended to prevent

a director from relying on advice (e.g. legal advice), and indeed in some cases

not taking advice may amount to a breach of a director’s duty in itself.

In a private equity context, this can give rise to a particular concern for

an investor director who has a role to represent the interests of the private

equity investors on the board of the company. In exercising his discretion,

what weight can he attach to the views and interests of the private equity inves-

tors above those of other shareholders? The wording in the section, that the

duty is not infringed by the director acting ‘in a way authorised by the com-

pany’s constitution’, offers a potential solution here; wording in the articles of

association of the company may protect the investor director by stressing that

he may have due regard to the interests of the investors (or similar wording),

and market practice is heading in this direction. A balance must be struck

when incorporating such a provision, however. Whether the section is broad

enough to enable wording to go into the articles which renders the investor dir-

ector a mere automaton, doing solely what the investors say, is debatable (not

least because not all the duties of a director offer the same exclusion based on

authorisation by the company’s constitution).

6.6 Duty to exercise reasonable care, skill and diligence (section 174)

This duty amounts to a codication of existing case law,

but also closely follows

the provisions in the Insolvency Act 1986 for wrongful trading.

The test here is

both objective and subjective. Exercising care, skill and diligence means:

the care, skill and diligence that would be exercised by a reasonably dili-

gent person with:

(a) the general knowledge, skill and experience that may reasonably be expected

of a person carrying out the functions carried out by the director in relation

to the company; and

(b) the general knowledge, skill and experience that the director has.

45 The authority most often cited was Re City Equitable Fire Insurance Co. Ltd [1925] 1 Ch 407.

46 Section 214 of the Insolvency Act 1986; see further section 6.12(b) below.