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.


Initial Coin Offering

Initial Coin Offering - Legal Aspects

An Initial Coin Offering (ICO) is a low-cost and time-efficient type of crowdfunding which is facilitated through the use of distributed ledger technology. For more information on distributed ledger technology and its most common form, blockchain, read our blog on the topic.

What is an Initial Coin Offering?

In much the same way that an initial public offering involves the issue of shares to investors in exchange for fiat currency, an initial coin offering involves the issue of transferable tokens to investors typically in exchange for cryptocurrency such as Bitcoin or Ether. Some tokens may resemble traditional securities such as shares or debt securities, while others may represent a right to access or receive future services. It is the legal status of such tokens and the cryptocurrency used to purchase them which needs to be explored.

Advantages and disadvantages of an Initial Coin Offering

The rights attaching to tokens vary widely. Some tokens may resemble traditional securities such as shares or debt securities, while others may represent a right to access or receive future services. A key appeal of ICOs is that tokens are easily tradeable. This means that investors can, assuming sufficient liquidity, buy and sell tokens on cryptocurrency exchanges, unlike more traditional venture capital investments, which may not be easily traded.

Other benefits of ICOs compared to more traditional fundraising models are seen to include:

  • The ease and speed with which tokens can be issued and funds raised, in many cases without the use of intermediaries.
  • Low transaction and settlement costs.
  • A perceived lack of regulatory barriers.
  • For many issuers, the formation or augmentation of a wide and motivated user base of the underlying product or service.

Commonly cited disadvantages of initial coin offerings when compared to traditional fundraising models include:

  • The price volatility of the most popular cryptocurrencies. ICO issuers will commonly seek to exchange cryptocurrencies subscribed by investors into fiat currency following the ICO, therefore incurring substantial exchange rate risk. It may be prohibitively expensive or difficult to mitigate this risk effectively.
  • A lack of clarity regarding numerous legal issues relating to the underlying distributed ledger technology, including the enforceability of code-based smart contracts.As you can see in our blog such uncertainty in the UK, although untested in court, is likely to be overcome.
  • An uncertain and evolving regulatory position globally. Combined with the absence of any industry standardisation, this increases the advisory costs and slows the speed at which a compliant ICO may be carried out.
  • Cyber security risks, compounded by the irreversibility of many cryptocurrency transactions.

What ICOs are being used for?

The earliest ICOs were used to launch new cryptocurrencies but increasingly they have been used by early stage companies to fund the development of other projects or services and, in particular, the development of decentralised software applications that run on existing blockchain platforms, such as Ethereum.

However, an ICO can be executed by any company looking to issue tradeable rights to investors in exchange for capital, regardless of the sector in which it operates or the product that it wishes to develop. In September 2017, Kik, an established social media platform, raised approximately $98 million through an ICO of “Kin” tokens to support the development of its existing messaging ecosystem. It remains to be seen whether other non-blockchain centric businesses will use ICOs as a means of raising funds.

How do you launch an ICO?

To launch an initial coin offering, an issuer will generally produce a white paper, which is analogous to the prospectus that a company is required to produce in connection with the admission of securities to trading on the Main Market of the London Stock Exchange. A subscriber will subscribe for tokens by transferring consideration to a specified account, and in doing so it is deemed to have accepted the terms and conditions applicable to that ICO. The tokens themselves are typically created, allocated and distributed through a pre-existing blockchain platform, such as Ethereum, in each case without requiring an intermediary.

Regulation of Initial Coin Offerings

A lack of regulatory barriers is seen by some participants as one of the primary attractions of carrying out ICOs. However, while there is no regulatory framework in the UK which is specific to ICOs, or which refers to the specific technology or terminology used in ICOs, it is a common misconception to say that all ICOs are unregulated. Issuers and their advisers must therefore consider carefully the applicability and effect of the full range of relevant legislation.

Regulatory perimeter

An initial coin offering may or may not fall within the Financial Conduct Authority’s (FCA) regulatory perimeter depending on the nature of the tokens (the terms used by the FCA to denote different types of cryptoassets) issued, and the legal and regulatory position of each ICO proposition must be assessed on a case by case basis.

Although many ICOs will fall outside the regulated space (depending on how they are structured, such as exchange and utility tokens), some ICOs (such as security tokens) may involve regulated investments, and firms involved in an ICO may be conducting regulated activities (such as arranging, dealing or advising on regulated financial investments).

The FCA outlines perimeter issues relating to ICOs in CP19/3 on perimeter guidance on cryptoassets. It explains that the majority of tokens that are issued through ICOs to the market tend to be marketed as utility tokens (non-regulated). The perimeter guidance being proposed by the FCA will focus on this area to make sure that firms are aware when their tokens may be considered securities, and therefore fall within the FCA’s regulatory perimeter. The FCA explains that it will be paying increasing attention, especially where those preparing ICOs attempt to avoid regulation by marketing securities as utility tokens.

Other points to note about the regulation of ICOs include:

  • The features of some ICOs are parallel with initial public offerings (IPOs), private placement of securities, crowdfunding or even collective investment schemes (CISs) which need to be examined individually in order to comply with regulation.
  • Some tokens may also constitute transferable securities and therefore may fall within the FCA's prospectus regime.
  • Digital currency exchanges that facilitate the exchange of certain tokens should consider whether they need to be authorised by the FCA to be able to deliver their services.

Risks if ICO’s outside regulatory perimeter

  • Unregulated space: Most ICOs are not regulated by the FCA and many are based overseas.
  • No investor protection: You are extremely unlikely to have access to UK regulatory protections like the Financial Services Compensation Scheme or the Financial Ombudsman Service.
  • Price volatility: Like cryptocurrencies in general, the value of a token may be extremely volatile – vulnerable to dramatic changes.
  • Potential for fraud: Some issuers might not have the intention to use the funds raised in the way set out when the project was marketed.
  • Inadequate documentation: Instead of a regulated prospectus, ICOs usually only provide a ‘white paper’. An ICO white paper might be unbalanced, incomplete or misleading. A sophisticated technical understanding is needed to fully understand the tokens’ characteristics and risks.
  • Early stage projects: Typically ICO projects are in a very early stage of development and their business models are experimental. There is a good chance of losing your whole stake.

FMLC paper on ICOs

The Financial Markets Law Committee (FMLC) published a paper outlining issues of legal uncertainty arising from ICOs in July 2019. The FMLC outlines how existing laws apply to ICOs and looks at some of the challenges for regulators, providers and market participants. These challenges include a lack of international and regional harmonisation relating to the categorisation of tokens issued in ICOs, as well as in their regulatory treatment.

FCA consumer warnings on ICOs

The FCA has warned consumers of the risks of ICOs. The FCA warns that ICOs are very high-risk, speculative investments due to, among other things, their price volatility, lack of access to UK regulatory protections such as the Financial Services Compensation Scheme (FSCS) or the Financial Ombudsman Service (FOS), potential for fraud, and the lack of adequate documentation.

Financial crime risks of ICOs

The FCA wrote to CEOs of banks in June 2018 warning of the risk of abuse of cryptoassets, which arises from the potential anonymity and the ability to move money between countries that crypotassets allow. Banks were warned to take reasonable and proportionate measures to lessen the risk that they might facilitate financial crimes that are enabled by cryptoassets.

An often unregulated area

Unregulated initial coin offerings are not considered safe investments by the FCA and should therefore always be treated with caution. On the other hand they offer businesses a quicker and easier way to raise capital. If you are looking to invest in an initial coin offering you should always be aware of such risks. If you are a business looking to raise capital through an ICO then the extent to which you may be regulated needs to be considered.

ICO’s is an area likely to develop alongside the recent increase in legal certainty granted to cryptoassets and smart contracts under English law. As it stands, however, ICO’s are yet to be addressed in such a direct manner.

EM law are experts in technology law. Please contact us if you have any question on the above.


EM Law IR 35

IR35 - New Rules

Despite controversy and calls for the government to reconsider their plans, the changes to IR35 will be implemented in April 2020. But what exactly are the IR35 rules, and what can you do to prepare for these changes? This blog takes a look at the IR35 legislation and aims to answer some of your burning questions. 

What is IR35?

Contractors who work through an intermediary, such as a personal service company, enjoy a certain level of tax efficiency. While they are not entitled to employee benefits such as holiday pay or sick pay, their tax status often enables them to take home more net pay than an employee in the same role. The benefit for an employer of hiring an individual in this way is that they don’t have to organise PAYE or contribute to National Insurance. Brought into law in April 2000, IR35 was designed to crackdown on the use of this corporate structure as a means of avoiding tax. 

How does it work?

IR35 effectively determines whether an individual is a bona fide contractor or a ‘disguised employee’ for the purposes of paying tax. If it is concluded that an individual is a ‘disguised employee’, they will be deemed to be inside IR35 and will be subject to National Insurance and Income Tax. If it is concluded that an individual is actually a contractor, then they will be deemed to be outside IR35 and will not be caught by the rules. 

Most of the questions that need to be answered in order to determine whether an arrangement will be caught by the IR35 legislation are relatively straightforward and are set out in the legislation itself. However, one of the key questions that needs to be answered is whether the worker would have been an employee of the client if they had been working directly for it, and this question is less straightforward. HMRC has provided guidance on the factors that it considers to be the most important in determining an individual’s employment status. These factors include whether there is personal service, mutuality of obligation, employee-type benefits and whether the individual provides his or her own equipment. 

What are the IR35 changes?

Extension to private sector

In April 2020, IR35 will be extended to the private sector for large and medium-sized organisations. The 2020 changes will bring IR35 in the private sector into line with the public sector by shifting the liability for defining a worker as employed or self-employed from the individual to the organisation which engages them. The public sector, including major employers such as the NHS, have been responsible for this since April 2017. It will therefore be the private sector end user who will be the subject of any HMRC enquiry and of any demand for tax due. 

Exemption for small companies 

In the public sector, where the IR35 rules already apply, the size of an organisation is irrelevant. However, in the private sector, HMRC has confirmed that small companies will be excluded from the new rules. The government has estimated that, as a result of the exception, 95% of end users will not need to apply the reform. But what is classed as a small company?

In its latest guidance, HMRC has defined a small company as a limited company that meets at least two of the following criteria:

  • An annual turnover of not more than £10.2 million;
  • A Balance Sheet total of not more than £5.1 million; and/or
  • Not more than 50 employees. 

Where a private company satisfies these requirements, the individual will continue to ‘self-assess’ and account for Income Tax and National Insurance where it is concluded that the rules apply. Where a private company does not satisfy these requirements, they will be subject to IR35. Until the draft legislation is published, we cannot say for sure how this exception will be applied to unincorporated entities and limited liability partnerships. 

What can you do to prepare?

The 2020 changes to IR35 are being introduced to make life easier for HMRC. Instead of pursuing thousands of individual workers, HMRC will pursue large employers, at a fraction of the recovery and administration costs. 

Although the changes will not come into force until 2020, organisation is key. Large and medium-sized organisations should consider undertaking a review of their use of contractors, setting out who they are currently contracting with and on what basis. Organisations can also make use of an online tool called CEST, however this should be approached with caution. CEST has come under criticism in the past few months and should not be used as a substitute for a full and proper investigation. 

As part of their review, large and medium-sized organisations should evaluate any contracts that they have in place with individual contractors. In order to limit the risk of IR35 applying, some of the following should be considered:

  • Including a right of substitution clause within the contract. This clause should be drafted so that it is as wide-ranging as possible.
  • Avoiding an obligation to provide and accept work. Including a notice period may point towards a conclusion that there is a mutuality of obligation, so this should be avoided. 
  • Structuring contracts, where possible, by reference to completion of a project or a piece of work, rather than by duration. Similarly, payment should be structured by reference to completion of a project, rather than time worked. 
  • If possible, requiring the individual to provide their own equipment, rather than providing equipment to them. 
  • Integrating the individual into the company no more than is absolutely necessary.
  • Although not determinative, stating in the contract that the relationship is not intended to be one of employment. 

Whilst it is important that contracts are drafted in such a way as to reduce the risk of IR35 applying, it is also important that the practical reality is in accordance with those terms. A carefully drafted contract will not avoid being caught by IR35, unless it also reflects the reality of the situation. IR35 is a complex area of law so speaking to a lawyer or tax specialist early on and before starting your review is recommended.  

Final words

The cases brought against public sector employees have highlighted the fact sensitive nature of the legislation. Currently no easily applicable checklist exists making it difficult for big businesses to apply blanket procedures to ensure adherence to IR35 with multiple contractors. The government promised to improve the employment status tests in the Good Work Plan but is yet to do so. Unfortunately at this time employee status will be best analysed on a case by case basis.

The changes to IR35 will throw up all sorts of administrative challenges for large and medium-sized organisations. Those who start planning now will find themselves ahead of the game and ensure that the right level of resource is in place when needed. If you are a business and you think that IR35 may impact upon your operations then do get in touch.


EM Law Contract Lawyers London

You want to sign a contract before your company is incorporated? Think again!

This blog explains the problems with pre-incorporation contracts and sets out what you can do if you find yourself in this situation.

What is incorporation?

A company does not legally exist until it is incorporated. Incorporation is the process by which a new or existing business registers as a company. Once a company is incorporated, it will receive a certificate of incorporation confirming its existence and showing the company number and date of formation. Before a company is incorporated, it cannot enter into commercial contracts. Consequently, nobody can sign a contract for that company as an agent. A contract entered into by a party on behalf of a company, where that company has not yet been formed, is called a pre-incorporation contract.

The law

The
general rule relating to pre-incorporation contracts is set out in section 51
of the Companies Act 2006. The section states that:

“A contract that purports to be made by or on
behalf of a company at a time when the company has not been formed has effect,
subject to any agreement to the contrary, as one made with the person
purporting to act for the company or as agent for it, and he is personally
liable on the contract accordingly.”

This means
that anyone who signs a contract on behalf of a company before that company is
incorporated will be liable as if they were the contracting party. Section 51
also has dual effect, as confirmed in the case of Braymist Ltd v Wise Finance.
As well as having personal liability, the person who signs on behalf of a
company can personally enforce the pre-incorporation contract.

What exactly is an "agreement to the contrary"?

There has
been some disagreement over the years as to the exact meaning of “agreement to
the contrary”. Thankfully, case law has provided some clarity. If you can prove
that there is an “agreement to the contrary” you may be able to negate
liability and get yourself off the hook.

In
Phonogram v Lane, Lord Denning took the phrase “subject to any agreement to the
contrary” to mean that for a person to avoid personal liability the contract would
have to expressly provide for his exclusion.  

In Royal
Mail Estates Ltd v Maples Teesdale, Mr Johnathan Klein took a similar but even
more restrictive approach. Mr Johnathan Klein stated that an “agreement to the
contrary” would only exist if it could be established that, by relevant words
properly construed, the parties intended that the contract would not take
effect as one made with that person. In other words, there was only a contrary
agreement if there was found to be an agreement between the parties by which
they intended to exclude the effect of section 36C(1), which is now section 51
Companies Act 2006.

In the
case the defendant firm of solicitors signed the contract “for and on behalf of
the buyer”. The contract related to the sale and purchase of a property in
London and included a clause which stated that the benefit of the contract was
personal to the buyer. As both parties were unaware that the company in
question had not in fact been incorporated Mr Klein concluded that the contract
was not drafted with section 36C(1) in mind. The terms in question were clearly
intended for a different purpose, which was to prevent or restrict a third
party from becoming a buyer by way of an assignment of sub-sale.

The fact that
the defendants here were a firm of solicitors shows just how easy it is to be
caught out by section 51. Proving that there was “an agreement to the contrary”
is a high hurdle to overcome.

What can I do to avoid liability?

As the
saying goes, prevention is better than cure. As the risk sits with the person
who has signed the contract, it is extremely important for that person to carry
out appropriate checks to confirm that the company in question has been
properly incorporated, and continues its corporate existence, before a contract
is concluded. If you have already signed a pre-incorporation contract on behalf
of a company, and you cannot prove an “agreement to the contrary”, you may
still be able to avoid personal liability as explained below.

  • Novation

A novation
is a three-way agreement that extinguishes one contract and replaces it with
another, in which a third party takes up the rights and obligations of one of
the original parties. In this scenario, the third party taking up those rights
and obligations would be the company. All parties to the original contract, as
well as the company, must consent to a novation for it to be valid. In
addition, consideration must be provided. The various promises between the
parties to the novation are generally regarded as adequate consideration
however some parties may prefer to novate under a deed just to be sure.

  • Ratification

Ratification
is a process by which a party can give retrospective authority to someone who
has entered into an agreement on their behalf. Although some commentators
suggest that ratification may be of assistance in these circumstances, we do
not consider that ratification is possible in the case of pre-incorporation
contracts. There are a number of conditions that must be met for an action to
be capable of being ratified. One of these conditions is that the principal
(here, the company) must be in existence at the time of the contract. As a
company is not legally in existence before it is incorporated, these conditions
will not be satisfied.

Final words

This blog should serve as a timely reminder of the risks of signing documents on behalf of a company; and in particular where a company itself is not in existence. If you have any questions about pre-incorporation contracts or contractual issues more generally please contact Neil Williamson or Joanna McKenzie or you can find out more about our legal services by clicking here.


Warranty Claim Teoco v Aircom EM Law Photo by Kaique Rocha

Share Purchase Agreement Claim Fails Because It Didn’t Follow Contract Procedure - Teoco UK Ltd v Aircom Jersey 4 Ltd & Anor [2018] EWCA Civ 23 (18 January 2018) 

Background

In November 2013 Aicom and Aircom Global (the Respondents) signed a share purchase agreement in which the Respondents sold their shares in two companies that were part of their corporate group to Teoco for £41 million.

In February 2015 Teoco’s lawyers wrote to the Respondents lawyers claiming damages of approximately £3.4 million for breach of warranty or an indemnity in relation to tax said to be owed by two subsidiaries of one of the companies that Teoco had purchased. The letter was stated to constitute “notification in accordance with clause 24 and Schedule 4 of the SPA of the existence of Claims, being either Warranty Claims or Tax Claims, as further detailed below”, and which went on to set out details of the potential tax liabilities of the subsidiaries in Brazil and the Philippines.

In June 2015 Teoco’s lawyers issued a further letter providing more detail around how the level of damages was arrived at.

In August 2015 Teoco issued proceedings in the High Court.

On 18 December 2015 the Respondents applied to the High Court to strike out Teoco’s claim on the basis that it did not follow the procedure for making claims as set out in the share purchase agreement.

On 28 April 2016 the High Court ruled in favour of the Respondents and dismissed Teoco’s claim.

Teoco appealed.

The Appeal Decision

The Court of Appeal dismissed the appeal.

Lord Justice Newey examined the SPA and noted that Clause 10 of the SPA imposed limitations on the Sellers' potential liabilities. It stated:

“The liability of the Sellers under or in respect of any claim for breach of this agreement shall be limited by, and all claims for breach of this agreement shall be dealt with in accordance with, the provisions set out in schedule 4.”

The key provisions of schedule 4 in the SPA read as follows:

“4. Notice of Claims

No Seller shall be liable for any Claim unless the Purchaser has given notice to the Seller of such Claim setting out reasonable details of the Claim (including the grounds on which it is based and the Purchaser's good faith estimate of the amount of the Claim (detailing the Purchaser's calculation of the loss, liability or damage alleged to have been suffered or incurred)).

5. Time limits for Claims

5.1 No Seller shall be liable for any Claim unless the Purchaser has given notice of such Claim in accordance with paragraph 4, as soon as reasonably practicable after the Purchaser Group becomes aware that the Purchaser has such a Claim, and in any event on or before 31 July 2015.”

Judge Newey reviewed the letters that Teoco’s lawyers had sent to the Respondents’ lawyers and concluded that they did not constitute sufficient notice under paragraph 4 of Schedule 4 of the SPA. He found that the letters did not make specific reference to the warranties that the Respondents had allegedly breached or the grounds upon which the tax indemnity was triggered and therefore could not be considered to have been “setting out” the “grounds” of a claim.

Comment

I suspect most non-lawyers would find the decision harsh. In their February and June letters Teoco’s lawyers set out the nature of the claim in detail. Paragraph 4 of Schedule 4 in the SPA did not explicitly state that Teoco would have to make specific reference to the warranties that were breached or how the indemnity in the SPA was triggered in order to bring a claim. Wouldn’t justice be served, you may ask, if the court allowed the claim to be heard and then decided on its merits rather than thrown out on a technicality?

As a lawyer I am not so surprised by the decision (yes, hindsight is a wonderful thing!) because I read court cases all the time. I am used to seeing how somebody not quite getting it right or missing something altogether can lead to a court decision that has serious negative consequences for one of the parties.

Lessons to be learned:

  • don’t let the seller put claims limitation clauses in a share purchase agreement that you, if you are the buyer, are not totally clear on;
  • pay massive attention to detail when you are bringing a claim.

If you are buying or selling a company or need any other help with a share purchase agreement please get in touch.