No fault corporate divorce?

No fault corporate divorce?

Bree Taylor warns departing company directors of the problems they might face in protecting their investments

All is fair in corporate divorce.

In Phoenix Office Supplies Ltd & Anor v Larvin [2002] EWCA Civ 1740, the Court of Appeal made surprising findings about the rights of shareholders and directors in private companies once they have expressed a desire to exit.

In 1989, Jonathan Parish and Brian Ogden incorporated a stationery and office supply business.

A couple of years later, Shaun Larvin joined the company to build the computer side of the business.

That side of the business flourished and Mr Larvin became a director and one-third shareholder in the company.

The three of them discussed formalising their arrangements as to capital but never got round to it.

By 2000, for his own reasons, Mr Larvin wanted the leave but had no means of escape.

There were no formal arrangements dealing with the unlocking of any of the shareholders' investment in the company.

The two sides had different views about what was fair play in the negotiations that ensued.

Mr Parish and Mr Ogden wanted to buy Mr Larvin's shareholding at a discount (as is the usual practice when buying a minority holding in a private company).

Mr Larvin took the view that he had been responsible for a large part of the company's value and did not see why he should have to accept a discounted price for his shares.

Mr Larvin applied to the High Court for a 'corporate divorce' under section 459 of the Companies Act 1985.

This section provides that any shareholder who has suffered unfair prejudice may apply to the court for relief.

The particular form of relief sought by Mr Larvin was an order compelling Mr Parish and Mr Ogden to buy him out for one-third of the value of the company, without a discount for his minority holding.

In the High Court, Mr Justice Blackburne found that the company was akin to a partnership because the relationship between the investors was such that it attracted implied obligations of mutual trust and confidence.

While not documented, the underlying agreement between the investors/directors gave each of them the right to participation in the management of the business.

Mr Parish and Mr Ogden wrongly excluded Mr Larvin from the management of the business after he expressed a desire to sell his shareholding.

They held him to a resignation that was only intended to be a resignation from his role as an employee, not as a director.

They refused him access to financial records to which he should have been entitled as of right in his capacity as a director of the company.

They applied various forms of pressure designed to persuade Mr Larvin to take a discounted price for his shares and go.

As such, Mr Parish and Mr Ogden had acted in a way that was unfairly prejudicial to Mr Larvin's interests as a shareholder.

The court ordered Mr Parish and Mr Ogden to buy Mr Larvin's shares without any discount for the minority holding.

Mr Parish and Mr Ogden appealed.

The Court of Appeal judges took a different view to that of Mr Justice Blackburne.

They were less concerned about the exclusion of Mr Larvin from the management of the company, finding that he really wanted nothing to do with the company, save as was necessary to get hold of financial information to ascertain the value of his shares.

Section 459 does not provide a right to exit at will.

It is necessary to show 'unfair prejudice' to qualify for relief.

One of Mr Larvin's main complaints was that he was treated as having resigned as a director when he had not done so.

But section 459 is for the protection of shareholders and it is in that capacity that they must seek relief - not as directors or employees.

Mr Parish and Mr Ogden were within their rights in trying to force Mr Larvin to sell for a discounted price - and there was therefore no unfair prejudice entitling Mr Larvin to relief.

The Court of Appeal's decision leaves outgoing director/ shareholders who are also negotiating the sale of their shares with a dilemma over the point at which to resign.

If they resign too early, they forgo automatic rights of access to the books and records that will enable them to protect their investment, and will provide crucial information about the value of the company for negotiation purposes.

If they resign too late, they continue, in the meantime, to incur the risks and responsibilities associated with being a company director (for example, the risk of personal liability arising from trading while insolvent).

These will obviously not be concerns if the exit is amicable and the shareholders or 'partners' act reasonably.

However, it is rare that the breakdown of a small business venture or partnership is entirely harmonious.

Whether or not the parties are fair and reasonable generally, the parting of ways in a business venture is often the result of a difference of opinion about the running of the business or its future - and negotiations can be tough.

As noted by Lord Justice Auld in Larvin: '...it is usually a waste of time to investigate who caused the breakdown.

Such breakdowns often occur...

without either side having done anything seriously wrong or unfair.'

The court's task, when dealing with a section 459 petition, is to determine the quality of the parties' conduct in a 'breakdown' situation.

Bearing this in mind, it is surprising that the Court of Appeal in Larvin seems to be saying that if the outgoing shareholder remains a director while negotiating a sale of his shares, he can properly be subjected to exclusion, pressure and unfair play, provided his rights as a shareholder are not prejudiced.

It is difficult to understand what this envisages.

Where a company is closely held, the lines between director and shareholder are not as clear as in larger companies with formal constitutions.

In the Hight Court, Mr Justice Blackburne treated Mr Larvin's rights as a director as part and parcel of his rights as a shareholder.

If an outgoing director's rights are denied or he is the object of unfair forms of pressure, it probably makes no difference to him whether that conduct is aimed at his rights as a director or as a shareholder.

The point is that such conduct is ultimately designed to make him accept less for his shares than he might otherwise.

Such tactics can bring about unfair prejudice to the rights of shareholders by targeting director or employee rights.

The lesson for investors in private companies, whether they are to be involved in the management or not, is to insist, before investing, on a tailored set of articles of association or a shareholders' agreement that expressly provides timing and procedure for the exit of shareholders in a fair and orderly fashion.

- Mr Larvin has sought permission to appeal to the House of Lords.

Bree Taylor is an associate in the dispute resolution department at City-based law firm Baker & McKenzie