Corporate finance update - April 2011

Deal News

Taylor&Emmet’s Corporate and Commercial Property Teams recently acted for a Sheffield based Trust which acquired the entire issued share capital of a commercial property holding company with assets located in Chesterfield.  The Vendor was a Luxembourg based company.

Peter Crawford explained that “the transaction involved significant corporate, property and funding aspects, meaning that lawyers, accountants, bankers and agents needed to work closely together to get the deal done.  It was very satisfying to complete the transaction, which represents an important acquisition for our clients”.

Briefcase News

Does an entire agreement clause do what it says on the tin?

In Axa Sun Life Services plc v Campbell Martin Ltd and others the Court of Appeal considered whether an entire agreement clause prevented the respondents from bringing claims based on alleged misrepresentations and breach of collateral warranties and/or implied terms.

It is recognised law that an ‘entire agreement statement’ within an entire agreement clause can be effective to exclude claims based on collateral warranties and certain types of implied term, if it is worded appropriately.  However, courts are often asked to consider whether the ‘entire agreement statement’ is enough to also prevent claims in misrepresentation.

In this case, AXA Sun Life Services plc (AXA) had entered into agreements with a number of companies to act as agents to sell AXA’s financial products.  The agreements were on AXA’s standard terms and contained a provision for AXA to claw back commission it had paid to the agents if customers subsequently cancelled their order.  Following termination of the agreements, AXA brought claims against the agents under the claw back clause and for various other sums.

The respondents, in defending the claims, argued that they had been induced to enter into the agreements by negligent and fraudulent misrepresentations and/or collateral warranties, and counterclaimed for consequential loss and damage.  The court at first instance concluded that the agreement’s entire agreement clause did not exclude liability for misrepresentation.  Furthermore the remaining clauses under scrutiny were unenforceable because the respondents had entered into the agreement on the basis of misrepresentations made by AXA; therefore the whole agreement was rendered unenforceable.  AXA subsequently appealed.

The Court of Appeal found that due to AXA’s ‘entire agreement statement’ being in a basic form, it was ineffective to exclude misrepresentations.  Additionally, it was ineffective to exclude an implied term to give the contract business efficacy, but effective enough to exclude collateral warranties and other implied terms.

Whilst the court did not overtly state that an ‘entire agreement statement’ which was constructed to expressly exclude misrepresentation would be effective, this was certainly implied.  Therefore, it is important that in putting together any commercial agreement, the wording of such a clause is examined carefully. 

The court also considered whether the Unfair Contract Terms Act 1977 (UCTA) applied to entire agreement statements.  It held, for the first time, that UCTA does apply to entire agreement statements, as well as to the other elements of an entire agreement clause.

The point of no return

In BNY Corporate Trustee Services Ltd v Eurosail-UK the Court of Appeal had to consider the point at which an ailing company fails the “balance sheet test” and therefore becomes insolvent under the Insolvency Act 1986.

Section 123 of the Insolvency Act 1986 (the Act) forms part of the provisions that give courts the power to issue a winding up order on behalf of a company.  A court has the power to issue such an order if, amongst other things, a company is unable to pay its debts (Section 122(1)(f)).  Under the Act, the circumstances in which this could be the case are either:

• If a company is unable to pay its debts as they fall due (the “cash flow test”, section 123(1)(e)); or
• If the value of the company’s assets is less than the amount of its liabilities (the “balance sheet test”, section 123(2)).

The facts of this case were as follows.  In 2007, Eurosail acquired a portfolio of sub-prime loans secured by mortgages over UK residential properties.  To fund this acquisition Eurosail issued various classes of loan notes to its investors, which were denominated in sterling, euro and US dollars.  BNY Corporate Trustee Services Limited (Trustee) was appointed as the noteholder trustee.  To reduce its exposure to changes in these rates over the life of the notes (which were due to finally mature in 2045), Eurosail entered into currency and interest rate hedges with a Lehman Brothers entity.  The subsequent bankruptcy of Lehman Brothers meant that the hedging contracts were terminated, resulting in a significant deficiency in Eurosail’s net asset position.

All Class A1 noteholders had already been repaid in full. Class A2 noteholders were content that they would be paid in full as and when mortgages were redeemed.  However,the Class A3 noteholders (who held the longer-dated notes) were concerned and wanted to pull out of the transaction early.  They requested that the Trustee serve an enforcement notice based on Eurosail being ‘unable to pay its debts.’  This would bring all the Class A noteholders into one class, ranking them pari passu in any distributions made.

In July 2010 the High Court ruled that Eurosail was not insolvent on the balance sheet test.  It decided that the mismatch between Eurosail’s ongoing receipts under the mortgage loans and its future liabilities under the notes was too uncertain to be given a value, and so these liabilities should not be taken into account in the balance sheet test.   Eight months later, the Court of Appeal upheld this decision, explaining that the balance sheet test cannot be reduced to a one-size-fits-all approach.  The assessment of whether a company is insolvent is one of fact and the company’s audited accounts should only be the starting point.  The test will need to be applied with commercial and common sense.  Indeed, the question a court always needs to ask itself is whether the company ‘has reached the point of no return.’

Applying the blue pencil test to restrictive covenants

In Francotyp-Postalia Ltd v Whitehead and othersthe High Court was asked to consider whether the blue-pencil test was capable of applying to a restrictive covenant in a franchise agreement. 

Restrictive covenants are designed to protect a business, and are particularly common in the contracts of employment of directors who have access to and intimate knowledge of the confidential affairs of a business.  It is an important consideration when drafting restrictive covenants that they must go no further than is reasonably necessary to protect the employer’s legitimate business interests.  If they are excessive they will be held to be unenforceable.

In certain circumstances, an offending restrictive covenant clause can be severed, leaving the rest of the restrictive covenants intact and therefore the contract enforceable.  This is called the blue-pencil test.  In order for the blue-pencil test to be applicable a court will apply a three stage test:

• The enforceable provision must be capable of being severed without the need to add or modify the wording of what remains;
• The  remaining terms continue to be supported by adequate consideration; and
• The severance of the unenforceable provisions must not distort the parties’ bargain so much that it materially changes the contract.

In this case the franchisor (Francotyp-Postalia) and franchisees (Whitehead and others) entered into two agreements that contained restrictive covenants on the franchisee after termination. These restrictions were contained in separate sub-clauses.  The non-solicitation clause prohibited soliciting clients and staff for one year in respect of the Restricted Area; the non-supply clause prohibited supply of competing goods for one year in respect of the Restricted Area; and the non-compete clause prohibited engaging in a competing business in respect of the Restricted Area. The “Restricted Area” was defined only in the non-compete clause, by reference to the franchise territory but also some other surrounding areas. The agreement also contained a severability clause.

On termination the claimant issued proceedings claiming damages for breach of the restrictive covenants.   The defendants denied any breach and argued that, in any event, the restrictions were too wide to be enforceable.  Prior to the hearing the parties had agreed that the non-compete clause was unenforceable in its current form, but would become valid if the definition of “Restricted Area” was “blue-pencilled”. 

The issue at hand for the court to decide was whether the definition of “Restricted Area” could be validly severed under the blue-pencil test.   The court refused to do this on the basis that the offending wording was part of a defined term that was used in other valid covenants.  In fact, the blue-pencil test failed at the first stage.

The advice following this case is to break down your restrictive covenant clauses into as many self-contained sub-clauses as possible, and try to avoid the use of a defined term within a restrictive covenant.  This should go some way to ensuring the severability of unenforceable clauses.