Agile Software Development

Agile Software Development - A Legal Perspective

Agile Software Development came to the fore as a concept in 2001 with the bringing together of seventeen software developers in Snowbird, Utah. All with a shared vision of how software development could be improved for supplier and customer alike. They distilled their views in The Manifesto for Agile Software Development. Among other values it called for “customer collaboration over contract negotiations”. While a potentially wince inducing statement for the conventional lawyer, Agile Software Development has nonetheless proved popular (it is not to be forgotten, however, that such alternative management styles had been experimented with since the 1950s – most notably in Project Mercury, the first human spaceflight programme).

Software development is often a creative and exciting moment for any business. Sadly (but importantly), it is the job of the lawyer to bring things down to earth and so whilst Agile Software Development may well be the best model to use for the platform that you want built, it is important to understand the process and its risks.

Waterfall method

In order to understand the conceptual basis for Agile Software Development, it is useful to know what it opposes. The first formal description of the waterfall model is often cited as the 1970’s article, Managing the Development of Large Software Systems by Winston W. Royce, although the term ‘waterfall’ was not explicitly used. The waterfall model was presented as a flawed, non-working model. It is the waterfall model to which Agile Software Development is opposed.

Here is how the waterfall method usually pans out:

Specification requirements – Design – Coding – Testing and Error Detection – Integration – Deployment – Maintenance.

This is how a product is usually made for a customer i.e. the customer specifies what it would like, the supplier creates the product, the product is tested. Once the product passes the tests it is then integrated in the customer’s system, tested again then goes live. Having gone live the supplier usually then provides support and maintenance services to fix any defects in the software.

Agile Software Development - Flexibility

Potential disadvantages of the waterfall method include the difficulty for customers to define their requirements clearly at the outset and that in many cases it does not easily accommodate changes to these requirements made throughout the project. By contrast to the waterfall method, an Agile Software Development project does not have detailed demands for the end product at the outset, although overall project scope and goals are agreed. Flexibility is the core to agile projects as they acknowledge that a customer’s demands and priorates may change from time to time during the course of the project.

Agile Software Development -Method

Typical features of the agile method include:

  • The goal is to deliver functionality and business value to the customer. This means that the solution to business goals and needs cannot necessarily be defined from the outset. It is only the goals and needs that are themselves initially important.
  • The project is divided into a number of sprints, each has its own set of priorities and goals. At the end of each sprint is an approval process assessed by the customer.
  • Planning and review meetings occur at the start and end of each sprint meaning close communication is maintained between the two parties.
  • The customer will reprioritise its needs from time to time, based on its ongoing assessment, and communicate this to the supplier. This may mean that some of the original requirements may become redundant over time.

Terminology

Although Agile Software Development projects can run on their own terms, there is generally a set of positions and relevant terminology used:

  • Product owner – customer’s representative who acts as the first point of communication with the supplier. Key functions include understanding the business needs and organising the development tasks. They must be present at sprint planning and review meetings.
  • Development team – typically supplier personnel. They are responsible for enacting the development sprints.
  • ScrumMaster – focuses on the development team, its progress, removal of obstacles and quality assurance. Typically a member of the supplier’s personnel.
  • Stakeholders – representatives of the customer’s management.
  • Product vision – an explanation of what needs to be developed, focusing on business goals and targeted benefits, rather than technical solutions.
  • Product backlog – a prioritised list of the customer’s business requirements that are to be developed during the project term. These can be reset at any time with new ones added and old ones deleted.

Importance of the product backlog

Maintenance of the product backlog (described above) is a key part of the agile process. The business requirements contained in it and the priorities accorded to them steer the development of the software and testing/approval procedures. These needs are generally described in the form of user stories. Customers should therefore ensure that any mandatory data protection law principles or cybersecurity obligations are contained within the product backlog.

Agile Software Development Scrum

The software development term ‘scrum’ was first used in a 1986 paper titled The New New Product Development Game. The term is borrowed from rugby, where a scrum is a formation of players and is illustrative of teamwork. Scrum is an agile framework used for complex projects (sometimes called extreme programming). Here are its key components:

  • Sprint – a timeboxed effort in which development takes place.
  • Sprint planning – establishes sprint goals.
  • Daily scrum – each day during a sprint, the team holds a daily scrum, preferably at the same place and time, and not longer than fifteen minutes. The scrum is concerned with what each player is contributing to a present/future sprint and has contributed to previous ones.
  • Sprint review and retrospective – demonstrates the work from the current sprint and improve processes respectively.
  • As another sprint begins, the product owner and development team select further items from the product backlog and begin work again.

Legal remedies for a dissatisfied customer

In a waterfall-type agreement the customer can rely upon damages, termination or remedial work in the case of defects or delays. In the case of Agile Software Development it can be difficult to determine whether there is actually any delay or defect because the flexibility of the system means that either can be easily buried behind prioritisation or vague notions of acceptability. Meaning that a delay could be deemed unprioritised by a product backlog and therefore not really a delay or the lack of an accepted definition of acceptance could allow a supplier to argue that no defect exists. The informality of decision-making can also make it difficult to gather the relevant evidence in case of a perceived breach of contract.

Time limits

Time, whilst fluid under an Agile Software Development process, is also bound to sprints and usually given a deadline. In a standard arrangement the customer would estimate the project duration and the number of sprints. It is, however, the discretion of the supplier/customer as to whether or not to formally agree to such estimates. This will need to be negotiated before an agreement is reached. Whilst setting time limits may be tempting, it may also be the undoing of the whole purpose of an agile agreement, in that flexibility will seem undervalued. On the other hand, having some framework in place to ensure contractual remedies is by no means discouraged.

Liability

Here are a some risk areas to be aware of:

  • Not meeting specific requirements within the original timeframe may not necessarily be seen as a breach of the agreement (as they may be re-arranged in the backlog).
  • Acceptance criteria of a sprint – if the agile software development contract is unclear around acceptance criteria the parties can be left arguing over whether an element of the build is completed or not. Acceptance criteria should be described in detail in any agreement so that there is no reliance on less formal descriptions that may be contained in user stories.
  • It is common for agile software development projects to go over budget. Leaving aside delays or quality issues that ramp up costs, if a customer walks into a project not really sure about what they want then it can often happen that their eyes will light up when the developer says “hey, do you want the product to do this cool thing”.
  • Everyone needs to be involved. Developing software using agile methodology is quite an intense process, depending on the project. As it is a collaborative process the parties need each other to be on focused on the project and communicating with each other the whole time. If a key member of the team suddenly goes AWOL then the project may grind to a halt.

Agile Software Development in practice

Agile Software Development as a methodology has the potential to produce creativity and customer/supplier satisfaction  on paper and in practice. It is important, however, to be aware of the potential legal pitfalls from the outset so that each party feels satisfied with the contents of an agreement before moving forward. It is also significant to note that agile methods require both parties to commit to a significant level of time and resources. If either party is remotely located or overburdened with other responsibilities (and so unable to focus on the agile project) the chances of success will be limited.

EM law specialises in technology and contract law. Get in touch if you need advice on Agile Software Development agreements or have any questions on the above.


EMI Share Option Schemes

EMI Share Option Schemes: A Quick Guide

Enterprise Management Incentives (EMI) Share Option Schemes are a type of employee incentive scheme that can enjoy very favourable tax treatment if introduced and operated correctly. They are the most popular HMRC tax favoured scheme used by businesses in the UK. EMI Share Option Schemes are specifically designed for small companies and they are a great way for businesses to attract or retain talented staff who may not be able to afford the high salaries that such staff could command elsewhere. Nowadays, many highly qualified staff, in particular in the tech sector, are expecting to be offered shares as part of their remuneration.

Essentially, EMI Share Option Schemes reward employees (usually key employees) with equity participation in a company. An overview of the qualification criteria for operating a scheme is set out below but please note this is subject to change. In the Spring 2020 Budget (paragraph 2.200), the government announced that it will review the EMI legislation to see how effectively it meets the objective of enabling smaller companies to recruit and retain staff. This may lead to a relaxation of the qualification criteria to enable more companies to benefit.

Which companies can operate EMI Share Option Schemes?

In summary, for a company to qualify to grant EMI options, the following conditions must be met:

  • The company must be independent (i.e. not a 51% subsidiary of any other company or under the control of another company / another company and a person connected with it and there are no arrangements in place under which these conditions would not be met).
  • If the company has any subsidiaries they are “qualifying” subsidiaries (i.e. the company owns at least 51% of the subsidiary, the subsidiary is not under the control of someone else and there are no arrangements in place under which these conditions would not be met). Additional requirements apply to property managing subsidiaries.
  • The company’s gross assets are no more than £30 million at the time of grant.
  • The company must have fewer than the equivalent of 250 full-time employees.
  • The company must be a trading company, or the parent company of a trading group with a qualifying trade which does not involve an excluded trading activity.
  • The company must have a UK permanent establishment.

Please note that detailed statutory rules determine whether a company is able to satisfy these requirements, and specialist advice on this is recommended before setting up an EMI scheme. Companies can also seek clearance from HMRC that they meet these requirements.

What shares can EMI options be granted over?

EMI options can be satisfied by newly issued shares or by the transfer of existing shares from a shareholder, including an employee benefit trust (EBT). The shares must meet certain requirements, including that the shares must be fully paid up, non-redeemable ordinary shares.

Who can be granted EMI options?

To be eligible to be granted an EMI option, an employee must work for the company for at least 25 hours per week, or if less, 75% of their working time. Employees cannot be granted EMI options if they (or their "associates") have a "material interest" in the company whose shares are used for the scheme, or in certain related companies.

Setting the exercise price and valuing the shares in EMI Share Options Schemes

The exercise price of an EMI option can potentially be set at any level (including nil). Options are usually granted at a price equal to the market value at the time the options are granted in order to prevent any income tax or national insurance contributions charges arising on exercise. HMRC will agree share valuations in advance of the grant of EMI Share Options and will usually agree a valuation window of 90 days during which the option may be granted (although it is currently offering windows of 120 days during the COVID pandemic).

Limits on EMI options

An employee can hold unexercised EMI options over shares worth up to the current EMI individual limit (£250,000). A company cannot have granted outstanding EMI options over more than £3 million worth of shares at any one time.

When can an EMI option be exercised?

The EMI code requires that EMI options must be capable of being exercised within ten years of the date of grant, and options can only be exercised within a period of 12 months after the option holder's death. Otherwise, there are few restrictions on the exercise provisions that can apply to EMI options, and this flexibility means that they can be used for exit-only arrangements (where an option can only be exercised on an exit event, such as a share sale or listing), as well as for options exercisable at the end of a performance or vesting period.

When do EMI options lapse?

Apart from the legislative requirements for the exercise of EMI options referred to above, there are no restrictions on when EMI options can be exercised or will lapse. However, it is best practice for EMI option agreements to specify exactly when options will lapse, particularly at the end of a window period for exercise. Often, the EMI option agreement will provide that options will lapse on leaving employment, although early exercise may be permitted in certain circumstances.

The EMI option agreement will generally also provide that options lapse if the option holder becomes bankrupt, and it must also prohibit an option holder from assigning the options or using them as security.

Tax treatment for the company

A corporation tax deduction may be available when EMI options are exercised (under Part 12 of the Corporation Tax Act 2009). Relief is given in the accounting year in which the options are exercised and should be claimed by the option holder's employer company (not the company whose shares are acquired, if different). The deduction is equal to the gain the employee makes.

Tax treatment for the employee

The EMI option plan must be registered with HMRC who will allocate a unique scheme reference number about a week later. In order for an EMI option to qualify for favourable tax treatment, the grant of each option must also be notified to HMRC within 92 days of the grant date, using the ERS Online Service.

In practice, it is not possible to notify the grant until HMRC has allocated a scheme reference number, so it is important to do this well before the 92 day period expires. If the option remains a qualifying EMI option (no disqualifying event has taken place before exercise), the tax treatment for an employee holding an EMI option is as follows:

  • On grant - there is no income tax liability on the grant of the option.
  • On exercise - there is no income tax liability on exercise if the exercise price was at least equal to the market value of the shares at grant. If the exercise price was less than the market value of the shares at grant, then income tax is due on the difference between the exercise price and the market value at grant.
  • On disposal - on a sale of the option shares, capital gains tax(CGT) may be payable on any gain over the market value at grant (that is, the difference between the sales proceeds and the market value of the shares at grant). Importantly, provided that at least 2 years have passed since the option was granted and all other statutory requirements are met, CGT business asset disposal relief (previously referred to as entrepreneurs’ relief) will be available.

Disqualifying Events Under EMI Share Option Schemes

The EMI rules refer to certain “disqualifying events” which, if they occur, can impact on the tax treatment of the EMI option affected.

Disqualifying events include:

  • the company ceasing to satisfy the independence test;
  • the company ceasing to meet the trading activities test;
  • the employee ceasing to be an eligible employee because:
    • they cease to work for the relevant company or within the group; or
    • they cease to satisfy the working time commitment;
  • certain alterations to the option:
  • certain alterations to the share capital of the company; and
  • the grant of options under a CSOP which would (when added to unexercised EMI options) take the aggregate market value of the shares subject to such options (measured at the date of grant) to over £250,000.

EMI Share Option Schemes - National Insurance Contributions

Broadly, the NICs treatment of EMI options follows the income tax treatment:

  • There will be no NICs if no income tax is due.
  • There will be NICs if income tax is payable and the shares are readily convertible assets.

The employer and the employee may enter into arrangements under which the employer NICs liability is transferred to the employee

EMI Share Option Schemes – traps for the unwary

Although EMI Share Option Schemes can be set up fairly quickly and for some companies it will simply be a question of following a set process, we see many examples of schemes gone wrong.

In particular, the EMI option agreement must be drafted with care in order to comply with all current HMRC requirements, including the detailed information that must be given to the option holder and the declarations that must be provided by them.

In circumstances where the scheme was not set up properly (for example because documents are not compliant or notifications weren’t made on time or full disclosure was not made to HMRC when agreeing share valuations) this will lead to unexpected income tax charges arising on exercise of the grant and other reliefs being lost. This can leave the employer with very disgruntled employees who will want to be compensated for the additional tax they are having to pay. It can also be a problem if the owners of the business intend to sell it and the errors are spotted by the lawyers acting for the buyer. Those lawyers will be advising the buyer that they should be reducing the purchase price for the business to cover the fallout.

Here to help

If you have any questions on EMI Share Option Schemes or need help putting such a scheme in place please contact Suzy Giele our expert EMI lawyer.


UK GDPR

UK GDPR - Data Protection After The Transition Period

UK GDPR, EU GDPR, DPA 2018, DP Regulations. Confused? Hopefully this blog will help you understand what is happening with data protection laws in the UK now that the Brexit transition period has ended.

The UK data protection authority, the Information Commissioner’s Office (ICO), is telling us that at the end of the Brexit transition period, data protection compliance should continue as usual. The key principles, rights and obligations remain the same. What then is the consequence of the Brexit transition period ending on data protection in the UK?

Most importantly, following the end of the transition period, the EU and the UK will be operating under different, albeit very similar, data protection regimes. This means that any transfer of data between the two regimes will be considered as such – i.e. between two independent data protection legal systems.

The Legislation – UK GDPR and the DP Brexit Regulations

A confusing aspect of the UK’s new data protection regime is its reference to legislation. There is mention of the ‘UK GDPR’ and ‘DP Brexit Regulations’. In order to clear up any misunderstanding it is useful to consider how data protection legislation operated before Brexit

Before Brexit data protection was mainly governed by two pieces of legislation: the General Data Protection Regulation ((EU) 2016/679) and the Data Protection Act 2018. The first being EU law and the second being the mechanism by which it was implemented into UK law.

With the coming of Brexit came a concern with what the UK government should do with all its EU law. The European Union (Withdrawal) Act 2018 sought to retain EU law already implemented in the UK, including GDPR. Simply put, retained EU Law is copied and amended before becoming UK law. The EU data protection law GDPR, in its retained form, is now known as the UK GDPR. This is in contrast to data protection law in the EU now known (in the UK) as the EU GDPR.

The Data Protection Act 2018 (DPA), although already being UK law, was also defined as retained EU law for the purposes of the European Union (Withdrawal) Act 2018 and therefore at the end of the transition period it will continue to be a main source of data protection law in the UK.

In order for the retained EU data protection law to work in the UK after the transition period it needs to be amended. The Data Protection, Privacy and Electronic Communications (Amendments etc) (EU Exit) Regulations 2019 (referred to here as the DP Brexit Regulations) is the legislation by which this will be achieved. The amendments made to the UK GDPR and the DPA by the DP Brexit Regulations will therefore merge to form the core of the UK’s data protection law. Organisations will need to consider two legal texts after the transition period: the UK GDPR and the DPA.

Changes made by the DP Brexit Regulations

The purpose of the DP Brexit Regulations is first and foremost to integrate EU data protection law, as it stands, into UK law after the transition period. Therefore most of the changes are relatively predictable. Here are a few:

  • The Information Commissioner (UK data protection authority) is no longer a party to EU GDPR co-operation, consistency mechanisms and will not have a seat on the European Data Protection Board (EDPB).
  • Amendments are made throughout the UK GDPR to change references to EU institutions, member states and decisions.
  • European Commission powers are transferred to the Information Commissioner or the Secretary of State. For example the Information Commissioner has the power to issue Standard Contractual Clauses (a mechanism by which data is transferred internationally).
  • Section 4 of the DPA is amended to make clear that it applies to personal data to which the UK GDPR applies and that it supplements and must be read with the UK GDPR.
  • A new section 17A in the DPA covers transfers based on adequacy regulations (a mechanism by which data is transferred internationally). The Secretary of State has the power to make “adequacy regulations” to specify that a third country, territory, sector or international organisation ensures an adequate level of data protection.

International transfers

At the end of the transition period, the UK would have been a third country under the EU GDPR, meaning that EU controllers and processors would need to ensure that an adequacy mechanism was in place to protect transfers i.e. Standard Contractual Clauses or Binding Corporate Rules.

However, on 24 December 2020, the UK and EU reached a trade and co-operation agreement addressing the arrangements following the end of the Brexit transition period on 31 December 2020 (as implemented by the European Union (Future Relationship) Act 2020).

Most significantly the agreement has introduced at least a four month period (extended another two months unless one of the parties objects) in which data can flow between the regimes without additional safeguards. The aim of the agreement is to give organisations breathing space while the Commission continues its assessment of adequacy for the UK. If the UK is granted an adequacy decision then data will continue to flow freely between the regimes after this period.

Data processed or obtained before the end of the transition period

From the end of the transition period the UK is required to continue applying “EU law on the protection of personal data” to the processing of EU personal data where the personal data was processed before the end of the transition period. It will therefore be helpful for organisations to know what data has been processed in the EU before the end of the transition period so that, should the regimes diverge, that data continues to have EU law applied to it. By contrast, personal data about UK data subjects processed in the UK before the end of the transition period will fall under the UK GDPR and DPA.

More to come - UK GDPR and EU GDPR to diverge?

The big next development in data protection and Brexit will be whether or not the commission grants the UK an adequacy decision. Organisations should have a clear idea of how they are going to confront the possibility that no adequacy decision is reached. This will mean reviewing data flows and the contracts that enable them.

The ICO is right to say that the data protection principles before Brexit will largely remain the same in the UK. The UK GDPR and DPA as a new legislative framework are more than anything else a replica of what has come before. But with an adequacy decision pending and the EU’s draft E-Privacy Regulation still being finalised and therefore without a hope of being applied in the UK, the two data protection regimes could split in significant ways in a relatively short amount of time.

If you have any questions on Brexit and data protection, data protection law more generally or on any of the issues raised in this article please get in touch with one of our data protection lawyers.


Heads Of Terms

Heads Of Terms For Buying A Company

Heads of terms in private M&A (also known as letters of intent, memoranda of understanding and heads of agreement) are generally contained in a relatively short document that outlines the main terms that the parties have agreed. Heads of terms evidence serious intent, and may have moral force, but are not automatically legally binding. This will depend on the contents of the heads of terms, the parties' intention and whatever particular circumstances can be taken into account in accordance with the rules for contract formation.

Heads of Terms Purpose

It should not always be assumed that heads of terms will be useful in the context of negotiating a transaction and they may be of more use to one party than the other, but heads of terms can help to avoid misunderstandings and provide a useful map of the steps to be taken on the way to signing the formal agreement. If, however, negotiation of the heads of terms stalls over points of unnecessary detail (which in reality should properly be addressed at a later stage in the process) this can delay preparation of the definitive documents and increase the length and cost of the negotiations.

Heads of terms are used for a number of purposes:

  • As written confirmation of the main terms agreed in principle.
  • To outline the timetable and obligations of the parties during the negotiations.
  • As a framework for certain preliminary legally binding clauses, such as an exclusivity (or lock-out) agreement.

Heads of terms are commonly entered into at the beginning of a transaction, once preliminary terms have been agreed and before commencement of detailed due diligence and the drafting of definitive agreements (which is where the parties will begin to incur significant legal costs). The parties may enter into a series of heads of terms throughout the negotiations, particularly when negotiations are prolonged.

What goes in Heads of Terms?

As a general rule, the heads of terms should cover the commercial deal points, rather than legal drafting ones, and important deal points rather than routine ones. Inevitably, the distinctions blur, but it is in the interests of both sides not to turn the negotiation of the heads into a full dress rehearsal for the final agreement. Time spent negotiating the heads of terms should be confined to discussing the commercial deal in principle. Arguments over the fine print should be reserved for negotiating the final agreements.

Below are some examples of suggested principles to be applied to heads of terms:

  • State the exception and defer the rule - If it is fundamental that, for example, certain sellers will not join in the giving of warranties and indemnities, or that only very limited warranties will be given, the heads should say so. If not, it should be sufficient to indicate that the final agreement is expected to include warranties, indemnities (and limitations on them) appropriate to a transaction of this type.
  • State the principle and defer the detail - Unless an issue is very complicated or unusual, the heads of terms should state the principle underlying the issue and leave the detail for the formal agreement. For example, if there is to be a post-completion audit and balancing payment based on net asset value, that is probably all that needs to be said in the heads of terms. Timing, agreed adjustments to the accounts and accountants that prepare the initial version can be dealt with later. If, however, the parties have agreed a specific unusual formula for calculating the net asset value this may need to be set out in the heads of terms to avoid any later disagreement.
  • Consider carefully, and take professional advice, before making significant concessions - If one side wants the agreement to be governed by foreign law, the other party should understand how this may affect its rights before making this concession. Similarly, both parties should take advice on the tax consequences of the basic deal structure. Such issues highlight the importance of taking appropriate advice or at least including reservations to the extent this has not yet been possible.

Are Heads of Terms legally binding?

Heads of terms may be fully binding or partly binding or not binding at all. Typically, however, they are not legally binding apart from sections dealing with confidentiality (where the parties agree to keep their discussions confidential) and exclusivity (where the seller agrees not to talk with any other potential buyer for an agreed period while the buyer carries out due diligence and hopefully concludes the purchase). Where the heads of terms include provisions that are intended to be binding, these must be clearly identified and the legal requirements for creation of a valid contract must be satisfied. Among other things, under English law:

  • The terms must be sufficiently certain to be enforceable. An "agreement" to continue negotiations in good faith, for example, is nothing more than an "agreement to agree" and normally unenforceable (Walford v Miles). Much depends on the facts however.
  • Unless the heads of terms are executed as a deed, there must be consideration moving from the party benefiting from the agreement to the other party, either in the form of a promise in return, or a payment, action or forbearance. Where there is no actual consideration, however, and execution as a deed alone is relied upon, specific performance is unlikely to be available. For more information on the specific formalities relating to the execution of deed by a company, see section 46 Companies Act 2006.

Third parties

Regard should also be had to the implications of the Contracts (Rights of Third Parties) Act 1999. If a term expressly provides that a third party has the right to enforce that term, or if the term purports to confer a benefit on a third party, then that term may give the third party directly enforceable rights. For example, a parent company, or another group subsidiary of a party to the heads of terms may wish to benefit from the confidentiality provisions. Where there is more than one prospective buyer, the seller may intend the successful buyer to have the benefit of confidentiality undertakings given by the others. On the other hand, if there is a risk that a term may be enforceable by a third party and the parties do not wish to create any third party rights, then an express exclusion should be included to that effect.

Reasons for using Heads of Terms

Whether or not the parties draw up heads of terms is purely a matter of choice: there are both advantages and disadvantages. The perceived advantages of using heads of terms are:

  • Moral commitment. Heads of terms are usually considered to confirm a moral commitment on both sides to observe the terms agreed (which can be an advantage or disadvantage depending on the circumstances).
  • Complex transactions. Where a transaction is complex, heads of terms can help focus the negotiations, bring out any misunderstandings and, by highlighting major issues at an early stage, prevent the parties wasting time and money if those issues cannot be resolved at this stage.
  • Framework for binding commitments. Heads of terms frequently contain a binding exclusivity agreement, a confidentiality agreement and, in some cases, provide for payment of costs and break fees in the event of negotiations breaking down. Obtaining exclusivity for a limited period, and some protection against wasted costs, should enable the buyer to proceed with more confidence.
  • Third parties. Where a deal has to be explained and sold in advance to persons not directly involved in the negotiations, the heads of terms can provide a useful statement of the key terms of the proposed deal.
  • Basis for clearance submissions. Heads of terms can provide the basis of a joint submission for clearance or guidance from the relevant competition authorities and might assist in the preparation of tax clearance applications.
  • Basis for instructing advisers. Draft heads of terms can sometimes be a helpful tool for the parties to instruct their respective advisers.
  • Provide seller with a tactical advantage. Because heads of terms are normally prepared early in the transaction process, before the buyer has commenced detailed due diligence, the seller will know considerably more about the business being sold than the buyer.

Reasons against using heads of terms

  • Limit room for manoeuvre. Heads of terms carry strong force, so they can limit room for manoeuvre in the subsequent negotiations. They should therefore be approached with caution, especially on the part of a buyer, who at this stage normally has much less information than the other side. If the buyer is required to sign heads of terms, then consideration should be given to inserting into the document the key assumptions on which the buyer is relying. This was illustrated by the ill-fated acquisition of PRB by Astra Holdings PLC in 1989. PRB went into liquidation a year after the acquisition and the Department of Trade and Industry (now BEIS) launched an investigation into the matter. In their report, the inspectors mentioned the fact that Astra had, before taking legal advice, entered into heads of terms which included certain unfavourable terms (the acquisition agreement was to be drafted by the seller's lawyers, governed by Belgian law and was to contain only limited warranties). Although it was not legally binding, it severely tied Astra's hands in the subsequent negotiations. It was the seller's "firm view that the [heads of terms] had set the agreed goal posts, and they did not want them moved".
  • Create legal relations inadvertently. In some jurisdictions, heads of terms can create a legally binding agreement between the parties unless an express term is included to the effect that there is no intent to create legal relations.
  • Accelerate need for public announcement of deal. Where either party is a listed company, an AIM company or otherwise has financial instruments that bring the company within the Market Abuse Regulation (596/2014/EU) it will need to consider whether one effect of negotiating and signing heads of terms may be to precipitate an early announcement of the deal.
  • Adverse tax consequences. In the UK, the heads of terms can be evidence of an "arrangement" which restricts the ability of the parties subsequently to take advantage of certain tax reliefs.
  • Increase in workload. The time taken to agree heads of terms may be disproportionate to the benefit. Care needs to be taken to avoid effectively negotiating the main agreement twice.

Here to help

Drafting heads of terms can be an exciting moment in pursuit of a deal. It is crucial to have an insight into how best to play your hand and what the legal consequences will be of your commercial strategy. The most significant legal question will be whether or not any of the terms are binding.

A document will usually be enforceable when it is adopted into a parent contract and is subsequently agreed upon. Until that point, a heads of terms will not usually be legally binding (Fletcher Challenge Energy Ltd v Electricity Corp of New Zealand Ltd [2002]). However, such documents can be legally binding if the agreement document contains terms or language which explicitly indicates a binding intention. Equally, a letter which contains no expression of whether its terms were intended to be binding can be found to be binding due to language used. (RTS Flexible Systems Ltd v Molkerei Alois Müller GmbH & Co KG [2008]) This is also dependent on the circumstances of the transaction and includes the conduct of the parties themselves.

If you have any questions on heads of terms or need help drafting such a document please contact Neil Williamson.


Due Diligence When Buying A Business

Due Diligence When Buying A Business

This blog considers the purpose, scope and practical aspects of due diligence when buying a business. In the past, studies have shown that, for a number of reasons, a large number of acquisitions fail to meet expected targets and some high-profile disasters have brought the question of acquisition planning and management sharply into focus. It is therefore crucial that there is good management of the acquisition process and, in particular, the due diligence exercise.

Purpose of due diligence when buying a business

On any significant acquisition, the prospective buyer will want to be sure that the seller and (in the case of a share purchase) the target company have good title to the assets being bought and to know the full extent of any liabilities it will assume. For acquisitions subject to English law, the principle of caveat emptor, or buyer beware, will apply. It is therefore essential that the buyer carries out its own investigation of the target business at the negotiating stage through a due diligence review.

The primary purpose of carrying out due diligence when buying a business is to obtain sufficient information about the target's business to enable the buyer (or other parties with an interest in the transaction) to decide whether the proposed acquisition represents a sound commercial investment. Due diligence is effectively an audit of the target's affairs - legal, business and financial. It is therefore a crucial bargaining tool for the buyer.

Business due diligence when buying a business

Business due diligence looks at broader issues such as the market in which the business operates, competitors, the business' strengths and weaknesses, production, sales and marketing, and research and development. Obviously, some of the results of this part of the due diligence review will be relevant to the legal investigation which focuses on the full extent of any liabilities the buyer will assume.

Financial due diligence when buying a business

As part of the due diligence process, the buyer may instruct accountants to prepare a report on the financial aspects of the target business. This financial due diligence is not the equivalent of an audit, and accountants' reports will usually make this clear. However, financial due diligence should focus on those areas of the target's financial affairs that are material to the buyer's decision so that the buyer can assess the financial risks and opportunities of the deal and whether, given these risks and opportunities, the target business will fit well into the buyer's strategy.

Legal due diligence when buying a business

The legal due diligence exercise will focus on a number of core areas mainly to establish the ownership structure in the target, the target’s position under its key customer and supplier contracts, whether any litigation is ongoing and the extent to which the target is behaving in a legally compliant way.

On the basis of this information, the buyer can determine whether it is appropriate to:

  • Proceed with the transaction on terms that have been negotiated.
  • Seek to renegotiate the terms of the acquisition to reflect any issues or liabilities identified during the due diligence process.
  • Withdraw from the transaction.

In addition to identifying any issues that may affect the buyer's decision to enter into the transaction (or the terms on which it is prepared to proceed), the information revealed during the legal due diligence exercise will assist the buyer and its solicitors in:

  • Determining the scope of the warranties that should be included in the share purchase agreement (SPA).
  • Identifying any areas of risk that should be subject to specific indemnities.

Who carries out due diligence when buying a business?

It is essential that the acquisition team is made up of appropriate people under clear leadership and with good reporting structures. The team carrying out the due diligence must involve the buyer's own personnel as well as its legal and financial advisers and accountants. Only the buyer's own personnel will be able to make effective judgements as to the commercial importance and potential risk brought to light by the information uncovered.

Due Diligence Questionnaire

The cornerstone of any due diligence exercise is the questionnaire or information request which sets out the areas of investigation and a list of questions and enquiries to be put to the seller. These questions will usually be supplemented by further requests as the negotiations proceed and as the buyer learns more about the target.

Confidentiality and data protection

Although a seller will typically require prospective buyers to enter into a confidentiality agreement, these are difficult to enforce in practice. Where the buyer is a competitor or potential competitor, a seller may be particularly reluctant to disclose sensitive information about the target business until it can be sure that the sale will go through. The knowledge that a business is for sale can also be unsettling for employees, customers and suppliers. At worst, it can lead to a permanent loss of customers; even at best it may involve loss of sales and possibly key staff during the course of the sale process. In some cases, the seller will wish to keep confidential from all but the most senior management its intention to sell the target. Of necessity, this will limit the scope of the information available for a full due diligence enquiry.

The seller will want to ensure that no approaches are made to its customers, suppliers, management or employees either with a view to poaching them or obtaining more information. On an auction sale particularly, although confidentiality undertakings are required as a matter of practice, it is more difficult to maintain confidentiality because of the number of parties involved. The seller may be reluctant to risk the consequences of a breach of security during the information-gathering process or may be concerned that the only purpose of obtaining more information is to renegotiate the price. Bridging the gap in expectations between the seller, who is concerned to restrict the release of information, and the buyer, who will want to gather as much information as possible, is a crucial element of the initial stages of any transaction.

The due diligence report

Once the enquiry is complete, the information will be summarised in the due diligence report, which should cover the business, financial, legal and other specialist areas of the investigation. For certain transactions, this may be a fairly informal report focusing only on matters material to the transaction. For others, it will comprise a complete audit of the target's business including an in-depth summary of the target's material contracts. Some clients may wish to have a board presentation in addition to a written report. In any event, the due diligence report should be easy to read and have an index. It should be written in a clear and concise manner and should be free of legal jargon, bearing in mind that it will be read by non-lawyers. The executive summary - the part of the report that everyone will read - should summarise all of the key findings of the due diligence review

International transactions

International transactions, by their very nature, throw up a number of added risks and challenges. These fall broadly into three categories:

  • On a practical level, there may be difficulties relating to language, the added number of people involved, time differences, and so on.
  • Buyers should carefully assess the impact of a foreign country's law on a transaction.
  • In some jurisdictions, investigations of the level which have now become invariable practice in the UK or US may be seen as damaging the spirit of mutual trust between seller and buyer or even as a sign of mistrust or bad faith on the part of the buyer.

Here to help

This blog is only an introduction to due diligence when buying a business. If you have any questions about due diligence more specifically or if you need help undertaking such an investigation please contact our specialist corporate lawyers.


National Security And Investment Bill

National Security and Investment Bill

On 11 November 2020, the National Security and Investment Bill 2019-21 was introduced to the House of Commons and given its first reading. The Bill will establish a new statutory regime for government scrutiny of, and intervention in, investments for the purposes of protecting national security and follows the government's 2017 and 2018 Green and White Papers on the national security and infrastructure investment review.

National Security and Investment Bill Purpose

The Bill will enable the Secretary of State to "call in" statutorily defined acquisitions of control over qualifying entities and assets (trigger events) to undertake a national security assessment (whether or not they have been notified to the government). Proposed acquirers of shares or voting rights in companies and other entities operating in sensitive sectors of the economy will be required to notify to and obtain approval from the Secretary of State before completing their acquisition. The National Security and Investment Bill also creates, where there is no requirement to notify, a voluntary notification system to encourage notifications from parties who consider that their trigger event may raise national security concerns. It includes five-year retrospective call-in powers, allowing for post-completion review of non-notified transactions, and, where parties fail to notify a trigger event that is subject to mandatory notification, a call-in power at any time.

Trigger Events

The following would trigger a requirement to notify the Secretary of State:

  • The acquisition of more than 25% of the votes or shares in a qualifying entity.
  • The acquisition of more than 50% of the votes or shares in a qualifying entity.
  • The acquisition of 75% or more of the votes and shares in a qualifying entity.
  • The acquisition of voting rights that enable or prevent the passage of any class of resolution governing the affairs of the qualifying entity.
  • The acquisition of material influence over a qualifying entity’s policy.
  • The acquisition of a right or interest in, or in relation to, a qualifying asset providing the ability to:
    • use the asset, or use it to a greater extent than prior to the acquisition; or
    • direct or control how the asset is used, or direct or control how the asset is used to a greater extent than prior to the acquisition.

A qualifying entity is an entity engaged in the sectors referred to below.

National Security and Investment Bill Consultation

The government has published a consultation on proposed draft definitions of 17 sensitive sectors in which it will be mandatory to notify and gain approval for certain types of transactions, covering, for example, energy, telecommunications, artificial intelligence, defence, engineering biology, cryptographic authentication, computing hardware, and military and dual use. It invites comments on these definitions by 6 January 2021.

Policy Intent

The government has also published a Statutory Statement of Policy Intent describing how the Secretary of State expects to use the call-in power, and the three risk factors (target risk, trigger event risk and acquirer risk) that the Secretary of State expects to consider when deciding whether to use it. Once a transaction is notified or called in, assessment should be carried out within a 30-working day review period (which is extendable in certain circumstances).

The National Security and Investment Bill gives the Secretary of State powers to impose remedies to address risks to national security (including the imposition of conditions, prohibition and unwinding) and sanctions for non-compliance with the regime, which include fines of up to 5% of worldwide turnover or £10 million (whichever is the greater) and imprisonment of up to five years. Transactions covered by mandatory notification that take place without clearance will be legally void.

The Bill also sets out provisions for interaction with the Competition and Markets Authority (CMA) and amendment of the Enterprise Act 2002. These include removal of section 23A, which sets out the criteria for a merger to be a "relevant merger situation", thereby qualifying it for investigation by the CMA and repeal of the Enterprise Act 2002 (Share of Supply Test) (Amendment) Order 2018, the Enterprise Act 2002 (Turnover Test) (Amendment) Order 2018, the Enterprise Act 2002 (Share of Supply) (Amendment) Order 2020 and the Enterprise Act 2002 (Turnover Test) (Amendment) Order 2020.

National Security and Investment Bill Specified sectors

The list of specified sectors will be set out in secondary legislation, the definitions of which will be kept under review to reflect any changes in the risks facing the UK.

The government is consulting on proposed draft definitions to set out the parts of the economy in which it will be mandatory to notify and gain approval for certain types of transactions. These cover 17 sectors:

  • Advanced materials.
  • Advanced robotics.
  • Artificial intelligence.
  • Civil nuclear.
  • Communications.
  • Computing hardware.
  • Critical suppliers to the government.
  • Critical suppliers to the emergency services.
  • Cryptographic authentication.
  • Data infrastructure.
  • Defence.
  • Energy.
  • Engineering biology.
  • Military and dual use.
  • Quantum technologies.
  • Satellite and space technologies.
  • Transport.

The consultation document sets out the government's proposed definitions for the types of entity within each sector that could come under the National Security and Investment Bill's mandatory regime. The definitions differ from those in the 2018 and 2020 Enterprise Act merger control amendments, which, as noted, were only ever intended as short-term measures and will be repealed by the Bill.

The deadline for commenting on the proposed definitions is 6 January 2021.

Comment

To date, very few transactions have been reviewed on national security grounds under the current UK framework, most recently Gardner Aerospace/ Northern AerospaceAdvent/ CobhamConnect Bidco/ InmarsatGardner Aerospace / Impcross and Aerostar/ Mettis. The Gardner/Impcross and Aerostar/Mettis transactions were abandoned following government opposition.

Currently, the Secretary of State has the right to intervene and take decisions on mergers only in strictly defined circumstances, where a defined public interest is at stake. National security is one of the grounds set out in the Enterprise Act upon which the Secretary of State can intervene. The government lowered the thresholds for intervention for the development or production of military items and dual-use items, and computing hardware and quantum technology sectors in June 2018 and for the advanced materials, Artificial Intelligence and cryptographic authentication sectors in June 2020.

Competition and Markets Authority

The CMA currently has a role in assessing jurisdictional and competition aspects of such mergers, providing advice to the Secretary of State. Under the National Security and Investment Bill, the CMA will no longer have a role in national security reviews. The Bill separates the national security assessment from the CMA's merger control assessment. However, it also gives the Secretary of State power to overrule the CMA, meaning that, in the event of a conflict, the national security review may take precedence over the merger control assessment.

If you have any questions on the National Security Investment Bill or corporate law more generally please contact our specialist corporate lawyers.


Statement Of Objections To Amazon

EC Sends Statement Of Objections To Amazon - Big Data Law

On 10 November 2020, the European Commission announced that it has sent a statement of objections to Amazon as part of its investigation into whether Amazon's use of sensitive data from independent retailers who sell on its marketplace is in breach of Article 102 of the Treaty on the Functioning of the European Union (TFEU). The Commission has also opened a formal investigation into Amazon's allegedly discriminatory business practices.

What data is amazon collecting?

Amazon has a dual role as a platform:

  • It provides a marketplace where independent sellers can sell products directly to consumers. Amazon is the most important or dominant marketplace in many European countries.
  • It sells products as a retailer on the same marketplace, in competition with those sellers.

As a marketplace service provider, Amazon has access to non-public business data of third party sellers. This data relates to matters such as the number of ordered and shipped units of products, the sellers' revenues on the marketplace, the number of visits to sellers' offers, data relating to shipping, to sellers' past performance, and other consumer claims on products, including the activated guarantees.

Investigation into use of independent sellers’ data

In July 2019, the Commission announced that it had opened a formal investigation to examine whether Amazon's use of competitively sensitive information about marketplace sellers, their products and transactions on the Amazon marketplace constitutes anti-competitive agreements or practices in breach of Article 101 of the Treaty on the Functioning of the European Union (TFEU) and/or an abuse of a dominant position in breach of Article 102 of the TFEU.

Statement of objections to Amazon

The Commission has now sent a statement of objections to Amazon alleging that Amazon has breached Article 102 of the TFEU by abusing its dominant position as a marketplace service provider in Germany and France. Having analysed a data sample covering over 80 million transactions and around 100 million product listings on Amazon's European marketplaces, the Commission is alleging in its statement of objections to Amazon that:

  • Very large quantities of non-public seller data are available to employees of Amazon's retail business and feed into automated systems. Granular, real-time business data relating to third party sellers' listings and transactions on the Amazon platform is systematically feed into the algorithms of Amazon's retail business, which aggregates the data and uses it to calibrate Amazon's retail offers and strategic business decisions (such as which new products to launch, the price of each individual offer, the management of inventories, and the choice of the best supplier for a product).
  • This acts to the detriment of other marketplace sellers as, for example, Amazon can use this data to focus its offers in the best-selling products across product categories and to adjust its offers in light of the non-public data of competing sellers.
  • The use of non-public marketplace seller data, therefore, allows Amazon to avoid the normal risks of retail competition and to leverage its dominance in the market for the provision of marketplace services in France and Germany, which are the biggest markets for Amazon in the EU.

The Commission's concerns are not only about the insights Amazon Retail has into the sensitive business data of one particular seller, but rather about the insights that Amazon Retail has about the accumulated business data of more than 800,000 active sellers in the EU, covering more than a billion different products. Amazon is able to aggregate and combine individual seller data in real time, and to draw precise, targeted conclusions from these data.

The Commission has, therefore, come to the preliminary conclusion that the use of these data allows Amazon to focus on the sale of the best-selling products. This marginalises third party sellers and limits their ability to grow. Amazon now has the opportunity to examine the documents in the Commission's investigation file, reply in writing to the allegations in the statement of objections and request an oral hearing to present its comments on the case.

Investigation into Amazon practices regarding the “Buy Box” and Prime label

The Commission states that, as a result of looking into Amazon's use of data, it identified concerns that Amazon's business practices might artificially favour its own retail offers and offers of marketplace sellers that use Amazon's logistics and delivery services. It has, therefore, now formally initiated proceedings in a separate investigation to examine whether these business practices breach Article 102 of the TFEU.

Problems with digital platforms

In announcing these developments, EU Commission Vice-President Vestager commented that:

“We must ensure that dual role platforms with market power, such as Amazon, do not distort competition. Data on the activity of third party sellers should not be used to the benefit of Amazon when it acts as a competitor to these sellers. The conditions of competition on the Amazon platform must also be fair. Its rules should not artificially favour Amazon's own retail offers or advantage the offers of retailers using Amazon's logistics and delivery services. With e-commerce booming, and Amazon being the leading e-commerce platform, a fair and undistorted access to consumers online is important for all sellers.”

The report prepared for the Commission by three special advisers on "Competition Policy for the digital era" highlighted possible competition issues in relation to digital platforms. As part of the Digital Services Act package, the Commission is now considering the introduction of ex ante regulation for "gatekeeper" platforms, and consulted on issues related to this in June 2020

Big data regulation

It remains to be seen how these EC investigations will play out and whether the same principles can be applied to smaller online platforms. UK regulators also appear to be ramping up their interest in the overlap between competition law and digital business. Chief Executive of the UK Competition and Markets Authority (CMA), Andrea Coscelli, noted last month that the CMA is increasingly focused on “scrutinising how digital businesses use algorithms and how this could negatively impact competition and consumers” and “will be considering how requirements for auditability and explainability of algorithms might work in practice”.

If you have any questions on the EC’s statement of objections to Amazon, data protection law or on any of the issues raised in this article please get in touch with one of our data protection lawyers.


ICO guidance on AI

ICO Guidance On AI Published - AI And Data Protection

On 30 July 2020, the Information Commissioner’s Office (ICO) published its long-awaited guidance on artificial intelligence (AI) and data protection (ICO guidance on AI), which forms part of its AI auditing framework. However, recognising that AI is still in its early stages and is developing rapidly, the ICO describes the guidance as foundational guidance. The ICO acknowledges that it will need to continue to offer new tools to promote privacy by design in AI and to continue to update the guidance to ensure that it remains relevant.

The need for ICO guidance on AI

Whether it is helping to tackle the coronavirus disease (COVID-19), or managing loan applications, the potential benefits of AI are clear. However, it has long been recognised that it can be difficult to balance the tensions that exist between some of the key characteristics of AI and data protection compliance, particularly under the General Data Protection Regulation (679/2016/EU) (GDPR).

The Information Commissioner Elizabeth Denham’s foreword to the ICO guidance on AI confirms that the underlying data protection questions for even the most complex AI project are much the same as with any new project: is data being used fairly, lawfully and transparently? Do people understand how their data is being used and are they being kept secure?

That said, there is a recognition that AI presents particular challenges when answering these questions and that some aspects of the law require greater thought. Compliance with the data protection principles around data minimisation, for example, can seem particularly challenging given that many AI systems allow machine learning to decide what information is necessary to extract from large data sets.

Scope of the ICO guidance on AI

The guidance forms part of the ICO’s wider AI auditing framework, which also includes auditing tools and procedures for the ICO to use in its audits and investigations and a soon-to-be-released toolkit that is designed to provide further practical support for organisations auditing their own AI use.

It contains recommendations on good practice for organisational and technical measures to mitigate AI risks, whether an organisation is designing its own AI system or procuring one from a third party. It is aimed at those within an organisation who have a compliance focus, such as data protection officers, the legal department, risk managers and senior management, as well as technology specialists, developers and IT risk managers. The ICO’s own auditors will also use it to inform their statutory audit functions.

It is not, however, a statutory code and there is no penalty for failing to adopt the good practice recommendations if an alternative route can be found to comply with the law. It also does not provide ethical or design principles; rather, it corresponds to the data protection principles set out in the GDPR.

Structure of the guidance

The ICO guidance on AI is set out in four parts:

Part 1. This focuses on the AI-specific implications of accountability; namely, responsibility for complying with data protection laws and demonstrating that compliance. The guidance confirms that senior management cannot simply delegate issues to data scientists or engineers, and are responsible for understanding and addressing AI risks. It considers data protection impact assessments (which will be required in the majority of AI use cases involving personal data), setting a meaningful risk appetite, the controller and processor responsibilities, and striking the required balance between the right to data protection and other fundamental rights.

Part 2. This covers lawfulness, fairness and transparency in AI systems, although transparency is addressed in more detail in the ICO’s recent guidance on explaining decisions made with AI (2020 guidance). This section looks at selecting a lawful basis for the different types of processing (for example, consent or performance of a contract), automated decision making, statistical accuracy and how to mitigate potential discrimination to ensure fair processing.

Part 3. This section covers security and data minimisation, and examines the new risks and challenges raised by AI in these areas. For example, AI can increase the potential for loss or misuse of large amounts of personal data that are often required to train AI systems or can introduce software vulnerabilities through new AI-related code. The key message is that organisations should review their risk management practices to ensure that personal data are secure in an AI context.

Part 4. This covers compliance with individual rights, including how individual rights apply to different stages of the AI lifecycle. It also looks at rights relating to solely automated decisions and how to ensure meaningful input or, in the case of solely automated decisions, meaningful review, by humans.

ICO guidance on AI - headline takeaway

According to the Information Commissioner, the headline takeaway from the ICO guidance on AI is that data protection must be considered at an early stage. Mitigation of risk must come at the AI design stage as retrofitting compliance rarely leads to comfortable compliance or practical products.

The guidance also acknowledges that, while it is designed to be integrated into an organisation’s existing risk management processes, AI adoption may require organisations to reassess their governance and risk management practices.

A landscape of guidance

AI is one of the ICO’s top three strategic priorities, and it has been working hard over the last few years to both increase its knowledge and auditing capabilities in this area, as well as to produce practical guidance for organisations.

To develop the guidance, the ICO enlisted technical expertise in the form of Doctor (now Professor) Reuben Binns, who joined the ICO as part of a fellowship scheme. It produced a series of informal consultation blogs in 2019 that were focused on eight AI-specific risk areas. This was followed by a formal consultation draft published in February 2020, the structure of which the guidance largely follows. Despite all this preparatory work, the guidance is still described as foundational.

From a user perspective, practical guidance is good news and the guidance is clear and easy to follow. Multiple layers of guidance can, however, become more difficult to manage. The ICO has already stated that the guidance has been developed to complement its existing resources, including its original Big Data, AI and Machine Learning report (last updated in 2017), and its more recent 2020 guidance.

In addition, there are publications and guidelines from bodies such as the Centre for Data Ethics and the European Commission, and sector-specific regulators such as the Financial Conduct Authority are also working on AI projects. As a result, organisations will need to start considering how to consolidate the different guidance, checklists and principles into their compliance processes.

Opportunities and risks

“The innovation, opportunities and potential value to society of AI will not need emphasising to anyone reading this guidance. Nor is there a need to underline the range of risks involved in the use of technologies that shift processing of personal data to complex computer systems with often opaque approaches and algorithms.” (Opening statement of ICO guidance on AI and data protection.)

If you have any questions on data protection law or on any of the issues raised in the ICO guidance on AI please get in touch with one of our data protection lawyers.


Damages for breach of contract

Damages For Breach Of Contract

The principal (but not the only) remedy in English law for breach of contract is an award of damages. This blog focuses on the law of damages for breach of contract where damages are awarded by a court to compensate for the injured party’s loss. This blog does not cover “liquidated damages”, which are defined by the parties under the terms of the contract as specific amounts payable in the event of a party’s default.

Damages for breach of contract: the general rule for compensation

In English law, the purpose of an award of damages for breach of contract is to compensate the injured party for loss, rather than to punish the wrongdoer. The general rule is that damages should (so far as a monetary award can do it) place the claimant in the same position as if the contract had been performed (Robinson v Harman (1848) 1 Ex 850).

Damages for breach of contract are, therefore, essentially compensatory, measuring the loss caused by the breach. To put it another way, the damages enquiry involves comparing the position the claimant is in fact in, following the breach, and the position the claimant would have been in but for the breach. Accordingly, the awards are often called "expectation damages", because they seek to put the claimant in the position it expected. The net loss is calculated by quantifying all the harms caused by the breach and then deducting or crediting all the benefits caused by the breach.

Damages for monetary loss

The majority of damages for breach of contract award compensation for financial loss. This takes many forms, including costs or liability the claimant has incurred to a third party (but would not have incurred but for the breach), and profits the claimant has foregone (that is, would have earned but for the breach).

Difference in value or cost of cure

In many cases, even though the defendant has breached the contract, the claimant can pay for a third party to cure or reinstate so as to put the claimant in as good a position as if the defendant had performed. For example, the claimant might pay for repairs to rectify a breach of warranty of quality by a seller of goods, or a partial non-performance by a builder. Where already incurred by the time of trial, such a cost will be recoverable from the defendant providing it was not so unreasonable as to be a failure to mitigate and/or a break in the chain of causation. Where the cost of cure has not been incurred at the date of trial, it will only be recoverable where incurring the cost would be "reasonable" in all the circumstances. This is because a claimant will always have a choice not to cure the problem caused by the breach. A claimant may instead, either simply live with the consequences, or use the market to offload unwanted or defective property and replace it with better property.

The presumption of breaking even and "reliance loss"

In seeking to prove loss, the claimant benefits from a rebuttable presumption that but for the breach the claimant’s venture would have broken even. This means that if the claimant has already incurred costs but not yet had a chance to complete the venture, it is presumed that the breach which halts the venture caused the claimant to lose revenue equal in value to the expenditure already incurred.

This is important in cases where it is impractical for the claimant to prove the profits it would have made from a venture. For example, in Anglia Television v Reed [1972] 1 QB 60, a TV company entered into a contract with an actor to take part in a film, the actor broke the contract and the film could not be made. In that case the claimant was unable to say what the profit would have been had the actor performed the contract, but because of the presumption of breaking even, the claimant was able to recover the wasted expenditure it had incurred.

Damages for breach of contract: Lost management time

A particularly well-established application of the presumption of breaking even is the award of damages for lost management time. If, as a result of the defendant’s breach, the claimant’s staff are diverted from their usual tasks in order to investigate the breach or deal with the consequences of the breach, the claimant can recover its net cost of the staff (that is, their wages). This is not because that cost was itself caused by the breach. (Unless the staff were employed specifically to deal with the breach, their cost would have been incurred even but for the breach.) Rather, it is presumed that the claimant would have earned revenue from the staff at least equal to their cost to the claimant if they had not been diverted from revenue-producing activity but for the breach. In Azzurri Communications Ltd v International Telecommunications Equipment Ltd [2013] EWPCC 17 Birss J observed that: "if the breach can be said to have caused diversion of staff to an extent substantial enough to lead to a significant disruption of the business then it is reasonable to draw the inference of a loss of revenue equal to the cost of employing the staff."

Damages for breach of contract: Loss of profit

A claimant may prove that had the defendant’s breach not occurred, it would have earned greater revenue than its expenditure (that is, done better than broken even, and so has lost profits). Whenever a claimant is successful in a lost profits claim, it is because it proves exactly this. Alternatively, a defendant may prove that a claimant would not have broken even, or indeed that the claimant has suffered no loss because its venture or bargain was a bad one and the claimant would have made a loss but for the breach. For example, in Ampurius Nu Homes Holdings Ltd v Telford Homes (Creekside) Ltd [2012] EWHC 1820 (Ch), the defendant construction company avoided paying substantial damages by showing that the claimant would have suffered a loss from the development if it had gone ahead.

Damages for non-financial loss

The majority of damages for breach of contract provide compensation for financial loss or property damage. Recovery of damages for such losses is restricted by the ordinary rules of remoteness and causation. Non-pecuniary and non-property damage loss falling short of personal injury have traditionally been thought to be subject to a general bar to recovery to which narrow exceptions apply.

This traditional approach was applied by the House of Lords in the surveyor's negligence case of Farley v Skinner [2001] UKHL 49. In that case, the claimant specifically asked the surveyor whether the property he was intending to buy was affected by aircraft noise and the surveyor carelessly reported that it was not. Because "a major or important object of the contract was to give pleasure, relaxation or peace of mind", damages for non-pecuniary loss (of £10,000) were recoverable.

Professional negligence provides a range of examples in which an object of the contract was non-financial. Farley v Skinner is one example in the surveyor context. Solicitors’ negligence cases include that of a solicitor who failed to obtain a non-molestation order, another who failed to protect a mother’s custody of her children and one who mis-handled ancillary relief proceedings.

In contrast, damages for non-pecuniary loss will rarely be awarded in commercial cases. There will be no award where the object of the contract was "simply carrying on a commercial activity with a view to profit" (Hayes v Dodd [1990] 2 All ER 815, Staughton LJ). Similarly, "contract-breaking is treated as an incident of commercial life which players in the game are expected to meet with mental fortitude" (Johnson v Gore Wood & Co [2000] UKHL 65, Lord Bingham).

Personal injury and physical inconvenience

Where the non-pecuniary damage amounts to personal injury (whether physical or psychiatric), such damage is recoverable subject to the ordinary rules of damages. Such cases arise often in such varied contexts as employment, landlord and tenant, defective goods, or defective services (holidays, etc.). Moreover, damages are frequently awarded without reference to any special test in cases of physical inconvenience caused by defective construction, landlord failure to repair, and surveyor negligence, as well as services cases such as those of defective holidays.

Quantifying loss

Generally, there are no rigid rules for the quantification of damages for breach of contract. In the end the assessment of damages is a question of fact. However, there are various principles which delimit the damages that will be awarded. The quantification of damages in litigation is often complicated and requires specialist advice from forensic accountants.

Burden of proof

It is for the claimant to prove its loss. Where the claimant's proof of loss has been made more difficult by the defendant's wrong, there is authority for a rebuttable presumption in favour of the claimant that gives it the benefit of any relevant doubt (see Browning v Brachers [2005] EWCA Civ 753).

Factual causation

At the heart of the damages measure, which seeks to put the claimant in the position it would have been in but for the breach, is the question of factual causation, also known as the "but for" test. In other words, it is necessary to prove both the position the claimant is actually in post-breach, and the hypothetical position the claimant would have been in ‘but for’ the breach, and to compare the two. That is the measure of loss for breach of contract. A claimant cannot, therefore, look to recover losses that it would have sustained in any event (see Tiuta International Ltd (in liquidation) v De Villiers Surveyors Ltd [2017] UKSC 77).

Restrictions on recovery of damages

Not all losses that in fact flow from a breach of contract are recoverable. Just because a loss was in fact caused by the breach (that is, would not have occurred but for the breach) does not mean that the law holds the defendant responsible for it. The rules on mitigation, legal causation, remoteness and contributory negligence may restrict, and in some cases prevent, a damages award.

Damages for breach of contract: Legal causation

The first major principle at play here is that of legal causation. This principle (which is materially the same in contract and tort) holds that, even though some losses were factually caused by the breach (that is, but for the breach they would not have occurred), they are nevertheless treated legally as not having been caused by the breach. The essence of the rather fluid principle of legal causation is that it is not fair to hold the defendant responsible for these particular consequences of its breach. The courts adopt a common sense approach to what intervening acts or events "break the chain of causation" between the breach and the harm. As Lord Bingham explained in Corr v IBC Vehicles Ltd [2008] UKHL 13:

“The rationale of the principle that a novus actus interveniens [Latin for new intervening act] breaks the chain of causation is fairness. It is not fair to hold a [defendant] liable, however gross his breach of duty may be, for damage caused to the claimant not by the [defendant]'s breach of duty but by some independent, supervening cause for which the [defendant] is not responsible.”

Although separate from the principle of remoteness, the foreseeability of an intervening act or event, and whether it was something that the defendant’s duty aimed to protect against, will both be factors that point against a finding that the chain of causation was broken.

Damages for breach of contract: Mitigation

The essence of the principle is that if the claimant unreasonably fails to act to mitigate (avoid or reduce) its loss, or unreasonably acts so as to increase its loss, the law treats those actions as having broken the chain of causation and measures damages as if the claimant had instead acted reasonably. The claimant is said to have a "duty to mitigate" (although this is not a duty enforceable by anyone, rather it is a recognition that if the claimant fails to do so its damages recovery will be affected by that failure). (BPE Solicitors v Hughes-Holland [2017] UKSC 21).

The clearest application of this principle is in the sale of goods context. Thus where a defendant seller fails to deliver goods for which a market substitute is available, the claimant cannot simply claim against the defendant all the losses which result (for example, its lost profit on a sub-sale, or lost profit from the use to which it would have put the goods). This is the case even if it does suffer those losses, because the claimant should have acted reasonably to mitigate its losses by purchasing a replacement on the market.

Remoteness of damage

Remoteness of damage refers to a further important principle by which the law determines which consequences caused (in a factual/but for sense) by the defendant’s breach are within the scope of the defendant’s responsibility and should be brought into account. The traditional test of remoteness, which is in essence a test of foreseeability, is set out in Hadley v Baxendale [1854] EWHC Exch J70.

This test operates as follows:

  • A loss will only be recoverable if it was "in the contemplation of the parties", that is, foreseeable.
  • The loss must be foreseeable not merely as being possible, but as being "not unlikely", which is a more demanding test than in tort (Koufos v C Czarnikow Ltd (The Heron II) [1967] UKHL 4).
  • The loss must be foreseeable at the date of contracting, not the date of breach (Hadley v Baxendale, Jackson and another v Royal Bank of Scotland [2005] UKHL 3, Lord Hope at para 36).
  • It is not the precise circumstances that occur that must be foreseeable, but the type or kind of loss (H Parsons (Livestock) Ltd v Uttley Ingham & Co Ltd [1977] EWCA Civ 13).
  • The knowledge that is taken into account when assessing what is in the contemplation of the parties comes under two limbs: First, is the knowledge of what happens "in the ordinary course of things", which is imputed to the parties whether or not they knew it. Second, there is actual knowledge of special circumstances outside the ordinary course of things and that was communicated to the defendant or otherwise known by the parties.

Contributory negligence (but only in cases of breach of duty of care)

A defendant may seek to argue that the loss suffered by the claimant is partly due to the fault of the claimant. The Law Reform (Contributory Negligence) Act 1945 provides for apportionment of loss where a claimant has suffered loss "as the result partly of his own fault and partly of the fault of any other person" (section 1). "Fault" is defined as "negligence or other act or omission that gives rise to liability in tort or would, apart from this Act, give rise to the defence of contributory negligence" (section 4).

Here to help

Bringing or defending a breach of contract claim can be stressful, time consuming and complex. Unless it is a low value claim it is worth getting solicitors involved as early as possible. If you have any questions about damages for breach of contract or about contract law more generally or if you need help with resolving a dispute please contact Neil Williamson.


best endeavours

Best Endeavours And Other Endeavours Clauses

Best endeavours, reasonable endeavours, all reasonable endeavours - how are these terms used in a legal sense and what do they mean?

Contractual obligations are normally absolute and failure to satisfy an obligation will be a breach of contract. Endeavours clauses are therefore used when a party is only prepared to "try" to fulfil an obligation, rather than commit to it absolutely. For example, in the case Jet2.com v Blackpool Airport the clauses under scrutiny created an obligation for Blackpool Airport to use its “best endeavours to promote Jet2.com’s low cost services” and “all reasonable endeavours to provide a cost base that will facilitate Jet2.com’s low cost pricing”. We refer to this case in more detail below.

Best, reasonable or all reasonable endeavours

It is clear from cases such as Rhodia International Holdings Ltd v Huntsman International LLC [2007] EWHC 292 that there is a spectrum of endeavours clauses, with "best endeavours" being more stringent than "reasonable endeavours". Despite the fact they are widely used, there is some uncertainty as to what efforts each different endeavours clause requires in practice.

Best endeavours

The term best endeavours has received the greatest amount of consideration by the courts and the starting point is that the phrase "means what the words say; they do not mean second-best endeavours" (Sheffield District Railway Co v Great Central Railway Co [1911] 27 TLR 451).

This has been further refined by the Court of Appeal to require the obligor "to take all those steps in their power which are capable of producing the desired results … being steps which a prudent, determined and reasonable obligee, acting in his own interests and desiring to achieve that result, would take" (IBM United Kingdom Ltd v Rockware Glass Ltd [1980] FSR 335). In other words, the obligor must put himself in the shoes of the reasonable obligee.

Reasonable endeavours

Reasonable endeavours are less burdensome. One formulation involves the obligor balancing "the weight of their contractual obligation" to the other party against "all relevant commercial considerations" such as the obligor's relations with third parties, its reputation, and the cost of that course of action (UBH (Mechanical Services) Ltd v Standard Life Assurance Company, The Times, 13 November 1986).

This has been restated as a question of "what would a reasonable and prudent person acting properly in their own commercial interest and applying their minds to their contractual obligation have done to try" to achieve the objective (Minerva (Wandsworth) Ltd v Greenland Ram (London) Ltd [2017] EWHC 1457).

This suggests an objective approach based on the reasonable obligor (not obligee as is the case for best endeavours). However, it appears the assessment should still reflect the circumstances and position of the obligor. Crucially, the obligor is not normally required to sacrifice its own commercial interests and may be entitled to consider the impact on their own profitability (P&O Property Holdings Ltd v Norwich Union Life Insurance Society [1993] EGCS 69). This is one of the major differences between a reasonable and best endeavours obligation.

All reasonable endeavours

The third commonly used endeavours clause is "all reasonable endeavours". It is commonly adopted as a compromise between best and reasonable endeavours. However, it is difficult to decipher its meaning and an analysis of existing case law raises three interlinked questions:

  • Does it mean the same as best endeavours?
  • Is the obligor obliged to sacrifice its commercial interests?
  • Is the assessment based on the obligor's particular circumstances?

The answer seems to be that it depends on the context.

On the first question, the traditional orthodoxy is that all reasonable endeavours sits somewhere between best endeavours and reasonable endeavours. Courts have stated, obiter, that it is "probably a middle position somewhere between the two, implying something more than reasonable endeavours but less than best endeavours" (UBH v Standard Life). This reflects the natural and ordinary reading of the words.

By contrast, in Rhodia, the judge stated, obiter, that an "obligation to use reasonable endeavours to achieve the aim probably only requires a party to take one reasonable course, not all of them, whereas an obligation to use best endeavours probably requires a party to take all the reasonable courses he can. In that context, it may well be that an obligation to use all reasonable endeavours equates with using best endeavours". This passage is sometimes used to argue that all reasonable endeavours equates to best endeavours in all respects.

However, this comment may just relate to the number of courses of action a party needs to take and not to the other distinctions between these obligations, such as the extent to which a party might have to compromise its commercial position. Support for this approach comes from CPC Group Ltd v Qatari Diar Real Estate Investment Company [2010] EWHC 1535, which starts to touch on the second question. In that case, Vos J stated: "It seems to me, therefore, that an obligation to use all reasonable endeavours does not always require the obligor to sacrifice its commercial interests".

The question of whether a party can have regard to his own financial interests is likely to depend on the nature and terms of the contract in question. In Astor Management AG v Atalaya Mining Plc [2017] EWHC 425, Atalaya had to use "all reasonable endeavours" to obtain senior debt facilities, an event which would trigger the payment of substantial deferred consideration to Astor. Atalaya could not raise funds in a different way simply to avoid paying the deferred consideration as that would defeat the purpose of the contract. However, the financial considerations were not irrelevant and Atalaya did not have to raise funds through senior debt facilities if it would make their activities commercially unviable.

Certainty case study

A final factor to consider is whether the endeavours clause is enforceable at all. It is clear that if the underlying objective is unenforceable due to a lack of certainty, an obligation to endeavour to achieve that result will also fail. Similarly, the combination of a less stringent endeavours clause (such as reasonable endeavours) with a poorly defined objective may lead to a very weak obligation.

Jet2.com v Blackpool Airport is a useful example of these principles. Blackpool Airport was under an obligation to use both of the following endeavours obligations:

  • Best endeavours to "promote Jet2.com's low cost services".
  • All reasonable endeavours to "provide a cost base that will facilitate Jet2.com's low cost pricing".

The Court of Appeal found that the former obligation was enforceable there being "a difference between a clause whose content is so uncertain that it is incapable of creating a binding obligation and a clause which gives rise to a binding obligation, the precise limits of which are difficult to define in advance, but which can nonetheless be given practical content". However, the Court of Appeal suggested the latter obligation might not be enforceable. Whilst Jet2.com argued the all reasonable endeavours obligation required Blackpool Airport to help Jet2.com to keep its prices down, Moore-Bick LJ stated the words were "too opaque to enable me to give them that meaning with any confidence".

Practical steps

There is a degree of uncertainty as to what an endeavours clause may actually require in any given case, and these uncertainties are best dealt with expressly in the contract.

A more useful approach is to set out the steps the obligor should take to achieve that particular obligation. The approach will vary from case to case, but parties should have regard to factors such as:

  • Whether the obligor must bear any costs or incur any expenditure and, if so, how much.
  • The period for which the obligor should pursue that objective.
  • Whether the obligor must take legal action or appeal to achieve the objective.
  • Whether the obligor must inform the obligee of its progress in meeting the objective.
  • Whether the obligor must step aside if it is unsuccessful and allow, or even assist, the obligee to solve the problem itself.
  • The extent to which a party is entitled to protect its own interests, is required to act in the interests of the other party, or base its actions on its own particular circumstances. These issues are, in part, determined by the type of endeavours clause used but it may be useful to set them out expressly.
  • Specific steps that the obligor is or is not expected to carry out.

Finally, probably the most decisive factor is whether the obligor does in fact take steps to comply with the endeavours clause. In the majority of cases the debate is not over the nuances in the differing level of obligation imposed by such clauses, but whether any real endeavours were used at all. The prudent obligor will also record evidence of its efforts and inform the obligee should any difficulties arise.

Endeavouring to try our best

Endeavours clauses are a complex and continually debated area in contract law. It is very context dependent and requires those with or willing to impose obligations to think ahead. If you have any questions about endeavours clauses or about contract law more generally please contact Neil Williamson.