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A purchase of own shares takes place when a company purchases shares in itself from an existing shareholder. A company may decide to purchase shares from a shareholder when there is no other buyer available.

It is worth noting that a company can purchase redeemable shares. Where the company purchases redeemable shares, that does not amount to a redemption of those shares where the purchase is not carried out on the terms for redemption set out either in the articles or determined by the directors prior to the allotment of such shares. A public, listed company with listed redeemable shares may choose to purchase them rather than redeem them if they are trading at a discount, as this would be cheaper than redemption.

There are three sources for a company to finance a purchase of its own shares:

1. out of profits;
2. out of the proceeds of a fresh issue of shares; and
3. out of capital either in compliance with Chapter 5 CA 2006 or using the De Minimis provisions set out in s.692(1ZA) without following the requirements of Chapter 5.

Before examining these methods of a company financing a purchase of its own shares, we must consider a further distinction made by CA 2006 between two sources of authority for a company to make a purchase of shares, namely ‘off-market’ and ‘market’.

Authority for making a purchase of own shares:

The two possible ways in which a company can obtain authority to make a purchase of its own shares are by making:

• an ‘off-market’ purchase; or
• a ‘market’ purchase.

Off-market purchase of own shares

The definition is set out in s.693(2) CA 2006. This is when a purchase of own shares takes place otherwise than on a ‘recognised investment exchange’ (for example, the London Stock Exchange). (The same term also covers a purchase made on a recognised investment exchange of shares not subject to a ‘marketing arrangement’ on the exchange. Section 693(3) CA 2006 sets out when a company’s shares are subject to a marketing arrangement.

The conditions that need to be fulfilled to make a valid off-market purchase are set out in s.694 CA 2006:

• a contract to purchase own shares is required (s.694(1) CA 2006); and
• the terms of the contract need to be approved by ordinary resolution (s.694(2) CA 2006). The contract may be entered into with the purchaser conditional on the ordinary resolution being passed. The shareholder whose shares are being redeemed can vote on the resolution at a general meeting but the resolution will be ineffective if his votes in respect of the shares being redeemed carry the resolution (s.695(3) CA 2006). Therefore that shareholder should be advised to abstain – unless some, but not all, of his shares are to be purchased, in which case he may safely vote on a poll in respect of the shares that he is keeping. If the resolution is passed as a written resolution that shareholder is disenfranchised for that vote (s.695(2) CA 2006).
• There are separate requirements if the off-market purchase is made pursuant to an employees’ share scheme.

The disclosure requirements for an off-market purchase are as follows:

• Where an ordinary resolution to approve an own share purchase is proposed at a general meeting, the contract must be available for inspection at the company’s registered office for a period of 15 days before the general meeting and also at the general meeting. Where such a resolution is proposed as a written resolution, a copy of the contract must be sent together with the copy of any written resolution (s.696(2) CA 2006).
• Within 28 days of the date on which the shares that are bought back are delivered to the company, the company must send a return to Companies House under s.707(1) CA 2006 and a notice of cancellation under s.708(1) CA 2006 together with a statement of capital (s.708(2) CA 2006).

Market purchase of own shares

The definition is set out in s.693(4) CA 2006. This is when the purchase of own shares by a company does take place on a recognised investment exchange (such as the Main Market of the London Stock Exchange).
Section 701(1) CA 2006 specifies that an ordinary resolution of the company is required to approve the market purchase of own shares (although in practice, shareholders of listed companies may ask for a special resolution). A return must be filed with the Registrar of Companies (s.707(1) CA 2006) and a notice of cancellation of the shares (s.708(1) CA 2006) together with a statement of capital (s.708(2) CA 2006) within 28 days of the date on which the shares that are bought back are delivered to the company.

Purchase out of profits or the proceeds of a fresh issue of shares

When a company is purchasing its shares from the selling shareholder, the company must first use any money it has available to it either in the form of distributable profits (unless the De Minimis provisions apply) or it may use money raised from a fresh issue of shares to fund the purchase. In both of these cases the procedural requirements are very straightforward because the capital of the company is not reduced. Where distributable profits are being used wholly or partly to finance the purchase of shares, the amount of distributable profits available should be verified by the company’s accountants.

When new shares (i.e. a fresh issue) are issued by a company to a shareholder (new or existing), the subscribing shareholder pays the company for these shares. The proceeds of such fresh issue of shares which is made for the purpose of the purchase or redemption can then be used by the company to fund the purchase of its own shares.

A company may purchase its shares out of distributable profits or the proceeds of a fresh issue of shares for the purpose of the purchase if the following conditions are met:

• the purchase of own shares by a limited company, whether public or private, is not restricted or prohibited in its articles (s.690(1)(b) CA 2006);
• the shares being purchased by the company are fully paid up (s.691(1) CA 2006); and
• following the purchase, the company must continue to have issued shares other than redeemable and treasury shares. This is because if the company purchased shares leaving only redeemable and treasury shares in issue, the company could potentially be left with no issued share capital / no shareholders.

The requirements for an off market purchase of shares apply to a purchase out of distributable profits or a fresh issue of shares. Accordingly, a contract will be needed for such a purchase, and it will need to be approved by ordinary resolution.

Reduced procedure for private companies making de minimis purchases of shares (the ‘De Minimis Procedure’)

The De Minimis Procedure (s.692(1ZA) CA 2006) allows private companies to purchase shares using capital without complying with Chapter 5 CA. The amount of the shares that can be bought back under this procedure is capped at an aggregate amount in a financial year not exceeding the lower of:

• £15,000, or
• the value of 5% of its share capital.

This provision effectively allows private companies to make small amounts of share purchases out of capital each year without following the procedures set out in ss.709-723 CA 06. Private companies can therefore purchase their own shares under the De Minimis Procedure without having any distributable profits.

Guidance issued by BIS has clarified that the purchase price of the shares under the De Minimis Procedure can be at more than the nominal value (so at a premium) or less than the nominal value.

Note that a company’s articles must authorise it to follow this procedure so that, where the articles are silent, a special resolution will be required to be able to rely on this provision. In addition, the requirements for an off-market purchase apply to a De Minimis Procedure. Accordingly, a contract will be needed for a De Minimis Procedure, and it will need to be approved by ordinary resolution.

Purchase of own shares out of capital in compliance with Chapter 5 CA 2006

Only private companies are permitted to fund a purchase of their own shares out of capital (s.692(1) CA 2006).

The following conditions must be fulfilled, in addition to those set out in above:

• check the articles of the company – an own share purchase from capital must not be restricted or prohibited by the articles;
• see if the company has any distributable profits available to fund the purchase – if it does, those distributable profits (or funds from a fresh issue of shares for the purpose) must first be used to fund the own share purchase before capital can be used (s.710 CA 2006). The company’s capital (the ‘permissible capital payment’) may only be used if that company’s distributable profits are insufficient to fund the total cost of the purchase; and
• check that the accounts used to determine the distributable profits were prepared to a date no more than three months before the date of the directors’ statement given under s.714 CA 2006 (s.712(7) CA 2006).

Where distributable profits are being used wholly or partly to finance the purchase of shares, the amount of distributable profits available should be verified by the company’s accountants. Likewise, if the directors conclude that a payment should be made out of capital, this view should be verified by the accountants.

Provided that the above conditions have been fulfilled, the further documentation required to effect the payment out of capital is set out in s.713 CA 2006 and is as follows:

• a contract stating the terms of the purchase, including the price to be paid. An ordinary resolution to approve the contract is required (s.694(2) CA 2006);
• a written statement of solvency made by the directors of the company. By making this statement, the directors of the company are stating that they believe that the company is able to pay its debts as they fall due from the date immediately after the payment out of capital is made and that it will continue to be able to do so for a period of 12 months (s.714(3) CA 2006);
• an auditors’ report, which is annexed to the written statement of solvency (s.714(6) CA 2006); and
• a special resolution to approve payment out of capital, to be passed on (or within a week after) the same day as the directors sign the written statement of solvency (s.716(1),(2) CA 2006).

The procedure and timing for use of capital to fund an own share purchase is:

• A board meeting of the company purchasing its own shares must be held to call a general meeting on at least 14 clear days; notice (unless either the short notice or written resolution procedure is used). The contract to purchase must be made available for inspection by shareholders both (i) at the company’s registered office for at least 15 days ending with the date of the general meeting and (ii) at the general meeting (s.696(2)(b) CA 2006). This means that the general meeting cannot be held on notice which is shorter than 15 days. Where a written resolution is used, the 15-day requirement does not apply. Instead, a copy of the contract must be sent to each member at the same time as, or before, the written resolution is sent (s.696(2)(a) CA 2006).
• The directors’ statement and auditors’ report must be finalised on the day of (or within 7 days prior to) the general meeting (s.716(2) CA 2006).
• A general meeting must be held (unless the resolutions are to be passed as written resolutions), at which two resolutions are passed: one ordinary resolution to approve the contract and one special resolution to approve the use of capital. The selling shareholder can vote on the resolutions at a general meeting but if his votes in respect of the shares
  being sold carries either of the resolutions, it will be ineffective (ss. 695(3), 717(3) CA 2006). Therefore that shareholder should be advised to abstain – unless some, but not all, of his shares are to be purchased, in which case he may safely vote on a poll in respect of the shares that he is keeping. If the resolutions are passed as written resolutions that shareholder is disenfranchised for that vote (ss. 695(2), 717(2) CA 2006).
• Under s.719 CA 2006, the company must publish a notice in the Gazette within the week immediately following the date of the special resolution approving the payment out of capital. The notice must state:
  • that the company has approved a payment out of capital for the purpose of purchasing its own shares;
  • where the directors’ statement and auditors’ report are available for inspection; and
  • that any creditor of the company may, at any time within the five weeks immediately following the date of the resolution, apply to the court under s.721 CA 2006 for an order preventing the payment.

  Within the week immediately following the date of the special resolution, the company must also publish a notice in the same form as the Gazette notice in an appropriate national newspaper, or give notice in writing to that effect to each of its creditors (s.719(2) CA 2006).

  The company must (i) deliver a copy of the directors’ statement and auditor’s report to Companies House on or before the day its first notice is published and (ii) make those documents available to any shareholder or creditor of the company for inspection, without charge, from the day its first notice is published until five weeks have passed since the special resolution approving the payment out of capital (ss.719 and 720 CA 2006).

• The share purchase can take place no earlier than five weeks, and no later than seven weeks, after the date of the special resolution (s.723 CA 2006). This period cannot be reduced even if the special resolution is passed unanimously – the five week delay is designed to enable shareholders and/or creditors of the company to object to the payment out of capital by lodging an application at court for cancellation of the resolution (s.721 CA 2006). Shareholders who vote in favour of the resolution cannot object and so if the resolution is passed unanimously there can be no objection by the shareholders (although creditors can still object). The seven week longstop period is intended to ensure that the view formed by the directors in their statutory declaration as to the solvency of the company is still likely to be accurate at the time the share purchase is made.
• Within 28 days of the date on which the shares that are bought back are delivered to the company, the company must send a return to Companies House under s.707(1) CA 2006 and a notice of cancellation under s.708(1) CA 2006, together with a statement of capital (s.708(2) CA 2006).

NB: the requirements of s.714, s.716 and s.719 CA 2006 do not apply where a company wishes to finance an own share purchase for the purposes of or pursuant to an employees’ share scheme out of capital, as it can do so by special resolution together with a written statement of solvency made by the directors (s.713(2) and s.720A CA 2006). In other words, no auditors’ report is required and the special resolution must be passed within 15 days of the written statement of solvency.

No deferred payment after purchase of own shares

When the shares are purchased by the company, there is no ability to defer the payment of consideration on an own share purchase (s.691(2) CA 2006) (except where the purchase is for the purpose of or pursuant to an employees’ share scheme (s.691(3) CA 2006)). This is different to the position when redeemable shares are being redeemed.

General

Redeemable shares give the holder temporary membership in the company. They are issued as redeemable shares – they are to be redeemed on the occurrence of certain circumstances (for example by providing for redemption on a fixed date and at a fixed price) or may be redeemed at the option of the issuing company or the shareholder. All details of the redemption, including date of redemption and the price to be paid at that date, will either be in the articles or determined by the directors.

As a result, a contract is not required to redeem shares, irrespective of the source of funding used. This is because the terms of the redemption have already been set out in the company’s articles of association (or determined by the directors) prior to the shares being allotted.

Redemption out of profits or the proceeds of a fresh issue of shares

A company’s redeemable shares may be redeemed out of profits or the proceeds of a fresh issue of shares for the purpose of the redemption, if the following conditions are met:

• The articles of association of a private company may exclude or restrict the issue of redeemable shares (s 684(2) CA 2006).
• Under s.684(3) CA 2006 public companies are required to have an express authority in their articles to issue redeemable shares.
• The company must also have non-redeemable shares in issue at the time it issues redeemable shares (s.684(4) CA 2006). This is because if it did not, and the redeemable class of shares were redeemed by the company, the company would be left with no issued share capital.
• The shares to be redeemed must be fully paid up (s.686(1) CA 2006).
• The terms of the redemption must be set out in the articles (s. 684(4) CA 2006). The exception to this is that the articles, or an ordinary resolution, may provide that the directors can determine the redemption rights attaching to such shares (s. 685(1) CA 2006). If the directors determine the redemption rights, they must do so before the shares are allotted (s.685(3) CA 2006).
• No shareholder resolution is required under CA 2006.
• The redeemed shares are treated as cancelled (s.688 CA 2006).
• Notification must be sent to Companies House within one month of redemption together with a statement of capital (ss. 689(1), 689(2) and 685(3)(b) CA 2006).

Redemption out of capital

Only private companies are permitted to fund a redemption of their own shares out of capital (s.687(1) CA 2006).

The following conditions must be fulfilled in order for a redemption to be funded out of capital:

• check the articles of the company – a redemption from capital must not be restricted or prohibited by the articles (s.709(1) CA 2006);
• see if the company has any distributable profits available to fund the purchase – if it does, those distributable profits (or funds from a fresh issue of shares for the purpose) must first be used to fund the own share purchase before capital can be used (s.710 CA 2006). The ‘permissible capital payment’ (s. 710(2)) may only be used if that company’s distributable profits are insufficient to fund the total cost of the purchase; and
• check that the accounts used to determine the distributable profits were prepared to a date no more than three months before the date of the directors’ statement given under s.714 CA 2006 (see below) (s.712(7) CA 2006).

Where distributable profits are being used wholly or partly to finance the redemption of shares, the amount of distributable profits available should be verified by the company’s accountants. Likewise, if the directors conclude that a payment should be made out of capital, this view should be verified by the accountants.

Provided that the above conditions have been fulfilled, the further documentation required to effect the payment out of capital is set out in s.713 CA 2006 and is as follows:

• a written statement of solvency made by the directors of the company. By making this statement, the directors of the company are stating that they believe that the company is able to pay its debts as they fall due from the date immediately after the payment out of capital is made and that it will continue to be able to do so for a period of 12 months (s.714(3) CA 2006);
• an auditors’ report, which is annexed to the written statement of solvency (s.714(6) CA 2006); and
• a special resolution to approve payment out of capital – to be passed on (or within a week after) the same day as the directors sign the written statement of solvency (s.716(1),(2) CA 2006).

The procedure and timing for use of capital to fund a redemption of redeemable shares is as follows:

• A board meeting of the company must be held to call a general meeting on at least 14 clear days’ notice (unless either the short notice or written resolution procedure is used).
• The directors’ statement and auditors’ report must be finalised and signed on the day of (or within 7 days prior to) the general meeting (s.716(2) CA 2006).
• A general meeting must be held (unless the resolution is to be passed as a written resolution), at which a special resolution to approve the payment out of capital is to be passed. The shareholder whose shares are being redeemed can vote on the resolution at a general meeting but the resolution will be ineffective if his votes in respect of the shares being redeemed carry the resolution (s.717(3) CA 2006). Therefore that shareholder should be advised to abstain – unless some, but not all, of his shares are to be redeemed, in which case he may safely vote on a poll in respect of the shares that he is keeping. If the resolution is passed as a written resolution that shareholder is disenfranchised for that vote (s.717(2) CA 2006).
• Under s.719(1) CA 2006, the company must publish a notice in the Gazette within the week immediately following the date of the special resolution approving the payment out of capital. The notice must state:
• • that the company has approved a payment out of capital for the purpose of redeeming its own redeemable shares;
  • where the directors’ statement and auditors’ report are available for inspection;
  • that any creditor of the company may, at any time within the five weeks immediately following the date of the resolution, apply to the court under s.721 CA 2006 for an order preventing the payment.

Within the week immediately following the date of the special resolution, the company must also publish a notice in the same form as the Gazette notice in an appropriate national newspaper, or give notice in writing to that effect to each of its creditors (s.719(2) CA 2006).

The company must (i) deliver a copy of the directors’ statement and auditor’s report to Companies House on or before the day its first notice is published and (ii) make those documents available to any shareholder or creditor of the company for inspection, without charge, from the day its first notice is published until five weeks have passed since the special resolution approving the payment out of capital (ss.719 and 720 CA 2006).

• The redemption can take place no earlier than five weeks, and no later than seven weeks, after the date of the special resolution (s.723 CA 2006). This period cannot be reduced even if the special resolution is passed unanimously – the five week delay is designed to enable shareholders (who did not approve the resolution) and/or creditors of the company to object to the payment out of capital by lodging an application at court for cancellation of the resolution (s.721 CA 2006).

Shareholders who vote in favour of the resolution cannot object and so if the resolution is passed unanimously there can be no objection by the shareholders (although creditors can still object). The seven week longstop period is intended to ensure that the view formed by the directors in their statutory declaration as to the solvency of the company is still likely to be accurate at the time the redemption is made.

• The redeemed shares are treated as cancelled (s.688 CA 2006).
• Notification must be sent to Companies House within one month of redemption together with a statement of capital (ss. 689(1), 689(2) and 685(3)(b) CA 2006).

Deferred payment for redemption

When redeemable shares are redeemed by the company, the company must pay the selling shareholder for their shares at that time. Only if the terms of the redemption so specify may the shareholder agree with the company to be paid on a date later than the redemption date (s.686(2) CA 2006).

(Sections 684-723, 733-737 CA 2006)

There are two types of situation when a company can effectively buy its own shares:

• redemption of redeemable shares; and
• purchase of own shares.

One reason a company may wish to do this is that (in a private company) a shareholder may want to leave and cannot find a buyer for their shares. Shareholders in private companies are prohibited from offering their shares to the public. In order to prevent a shareholder being locked into the company with no way to sell his shares, the company can purchase or redeem the shares. However, because of the principle of the maintenance of share capital, there are very strict controls on the purchase or redemption of a company’s shares. Both private and public companies may purchase their own shares or redeem redeemable shares provided they comply with the provisions of CA 2006. Only private companies can use capital to fund a purchase of its own shares or a redemption of redeemable shares.

A company can raise funds for a redemption of redeemable shares or a purchase of its own shares in one of three ways:

1. distributable profits (s.687(2)(a), 692(2)(a)(i) CA 2006);
2. a fresh issue of shares for the purpose of the redemption or the purchase (s.687(2)(b), 692(2)(a)(ii) CA 2006) – but note that there are limits on using these funds to finance repayment of the premium; or
3. capital (s.687(1), 692(1) CA 2006).

Note that, the option of using capital is only available to private companies (ss.687(1), 692(1) and 709(1) CA 2006). A public company can never use capital to purchase its own shares. Also any redemption or purchase out of capital must comply with the restrictions in Chapter 5 of Part 18 CA 2006, i.e. ss 709 – 723 CA 2006 inclusive unless it is a purchase which falls within the scope of the de minimis provisions set out in s.692(1ZA) (which are available only for smaller share purchases and not for redemption.

Basic principles

Once a shareholder has invested in a company by the purchase of shares, that investment cannot normally be returned to him, i.e. a company is not usually permitted to return capital to its shareholders. Any payment to shareholders (including dividends) must normally be made out of profits.

The shareholders’ investment in a company is recorded in the accounts in the bottom half of the balance sheet. Generally speaking a company cannot release the sums represented in the equity account and the share premium account to return value to shareholders. The money represented in these accounts may be used to carry on the business of the company as working capital but generally it cannot be returned to the shareholders while the company is a going concern. This is known as the doctrine of maintenance of share capital.

Until any winding up of the company takes place, the only return that shareholders are usually entitled to from the company are dividends out of distributable profits (or the redemption/purchase amount on a redemption or purchase of own shares by the company, where permitted).

Because of the doctrine of maintenance of share capital, if a shareholder wants a capital return on his investment, his only recourse is to sell his shares to another individual. This sale will not affect the total shareholding of the company as the same number of shares are still in issue.

However, there are some limited exceptions to this doctrine.

Reasons for the doctrine

During the life of a company its capital (expressed as equity in the balance sheet) is a liability owed to its shareholders.

In accordance with the common law rule set out in Trevor v Whitworth (1887) 12 App Cases 409, the share capital of a company is seen as a permanent fund available to its creditors. Those creditors are entitled to assume that the full nominal value of the shares (and any premium on the shares) in the company has been paid up and that no capital of the company will be dissipated otherwise than in the ordinary course of the company’s business.

The obligation on a company to maintain its share capital mirrors the fact that the liability of its members (on a winding up) is generally limited to the amount unpaid on their shares (s.74 Insolvency Act 1986).

The common law principles established in Trevor v Whitworth have been enshrined in s.658 CA 2006. There are various statutory exceptions to s.658 which are set out in s.659. In addition, the rule in s.658 is stated to be subject to an acquisition by the company in accordance with Part 18 of CA 2006. Part 18 includes the provisions dealing with a company purchasing and redeeming its own shares.

Directors must bear in mind their statutory duties under ss.171–178 CA 2006 when considering an own share purchase or a redemption of redeemable shares by the company and in particular their duty to promote the success of the company for the benefit of the members as a whole.

In summary, the doctrine of maintenance of share capital exists for the protection of creditors.

Dividends

In keeping with this doctrine of maintenance of share capital, under s.830(1) CA 2006, a company may not make a distribution of assets (including cash) to shareholders except out of realised profit that is available for distribution.

Part 23 of CA 2006 sets out various additional provisions which stipulate how ‘profits’ (for the purposes of the law restricting the return of value to shareholders) should be determined. A company paying a dividend will have to ensure that it complies with these sections. In addition, it will also have to comply with any rules in relation to dividends set out in the company’s articles of association.

Articles typically provide (and Article 30 MA does provide) that the company can declare a dividend by ordinary resolution of the shareholders. The amount of the dividend cannot exceed the amount recommended by the directors, although the shareholders can decide on a smaller amount. In practice, therefore, the directors recommend a dividend in a board meeting and then the shareholders vote on it at a general meeting by ordinary resolution, or, if it is a private limited company, they can vote on it by using the written resolution procedure. This is commonly known as a final dividend and is typically paid after looking at the company’s financial results for the year.

Articles also usually provide that directors can decide by board resolution to pay interim dividends (e.g. Article 30 MA). ‘Interim dividend’ is basically the name given for any dividend that the directors pay without asking the shareholders for approval in a general meeting. It is usually a portion of the profits for the year and is effectively an estimate, as it is calculated before the company’s annual earnings have been determined. The final dividend can then add an appropriate amount in addition to the interim dividend to ensure that the final dividend is reasonable for the year.

Declaring and paying dividends

When considering the payment of a dividend, a company’s articles and any shareholders’ agreement should always be checked. Articles usually contain express provisions regarding the declaration and payment of dividends (although, where the articles are silent, common law gives companies an implied power to distribute profits to shareholders).

It is possible that the articles could include a restriction or prohibition on paying dividends. Alternatively the articles (or a shareholders’ agreement) could contain a mechanism requiring the payment of dividends where legally permissible. In this scenario the mechanism would usually work on the basis of a percentage of distributable profits.

Dividends do not carry interest against the company unless otherwise provided by the rights attached to the shares (see for example Article 32 of MA).

The shareholders entitled to a dividend will be those on the register of members at the time of the declaration. For some companies the articles may provide for a record date to be set to establish which shareholders are entitled to receive the dividend. This would be the case for a company where there are significant numbers of shareholders that change frequently, for example, in listed companies.

Articles will typically state that dividends are declared and paid according to the amounts paid up on the relevant shares. In the absence of such an article, the amount paid to each member would be calculated on the nominal value of each relevant share (and thus not take account of different amounts paid up on shares).

Company directors need to consider their statutory duties (in particular the duty to promote the success of the company for the benefit of the members as a whole) and the company’s future financial requirements before recommending a final dividend or resolving to pay an interim dividend. They can also set aside part of the profits as a reserve, for example, to fund dividends in any future low profit years.

Preference shares and cumulative dividends

Preference shares entitle the holder to preferred rights of some sort, usually a first fixed dividend which is often stated as a percentage of the amount paid up on the shares. The right to receive a fixed dividend is a right to be paid in priority to ordinary shareholders in any year in which the company has sufficient distributable profits.

Cumulative preference shares entitle the holder to accumulate the right to dividends where they are expressed to be payable in a year but are not then paid. The dividend accumulates as a debt owed to the cumulative preference shareholder until it is paid, unless there are provisions in the articles or shareholders’ agreement to the contrary.

Bear in mind that in practice, the above types of shares may not have the exact same names but will still function as described above.

Bonus issues of shares (also called a capitalisation issue or a scrip issue) and scrip dividends

Companies may issue shares to shareholders as an alternative to cash in respect of dividend payments. A bonus issue (otherwise known as a capitalisation issue or scrip issue) is an issue of new shares to all the existing shareholders in proportion to their existing shareholdings. The respective percentages of the shareholders therefore stay the same. A bonus issue is not usually treated as a distribution by the company for tax purposes. Shareholders benefit because they receive shares in the company without having to pay dealing costs or stamp duty.

A scrip dividend is similar to a bonus issue, however, there is a key difference. Where a scrip dividend is offered to the shareholders of the company, those existing shareholders have a choice as to whether they wish to receive their dividend wholly or partly in the form of additional shares or in cash (as is usual). The shareholders who elect to receive the additional shares are receiving a scrip dividend. The shareholders who do not elect to receive the scrip dividend and who receive their dividend in the form of cash will be diluted by the shareholders who do elect to receive the scrip dividend.

There are some aspects of shareholders’ agreements which are particularly relevant to minority shareholders and which are therefore mentioned here.

Right of action/enforceability

A shareholders’ agreement provides a right of action which enables one member to enforce the provisions of the shareholders’ agreement directly against another, whereas under the articles this right of action may not arise. Because of the difficulties shareholders can encounter in enforcing the provisions of the articles under s.33 CA 2006, a shareholders’ agreement can be used in order to ensure the enforceability of provisions that would not be regarded as membership rights, such as the right to be appointed as the company’s solicitor or the right to approve certain transactions.

If a term of a shareholders’ agreement is breached it can be enforced in the usual way under general contract law principles. A shareholder will be able to claim for breach of contract, or alternatively could apply to the court for an injunction to prevent a breach of the terms of the agreement. A shareholders’ agreement can also prevent the need for s.994 petitions, although it obviously cannot stop a disgruntled shareholder from bringing such a petition.

Reserved matters in shareholders’ agreements

As mentioned above, certain matters can be reserved in a shareholders’ agreement as matters requiring the consent of all shareholders or certain individual shareholders. This is an additional way in which minority shareholder rights can be protected. The type of matters reserved to shareholders under a shareholders’ agreement may include amendments to the articles of association, the issue of new shares, or the appointment or removal of a director.

For example, in order for a company to remove a director from office an ordinary resolution requiring a simple majority is required under s.168 CA 2006 (and s.281(3) CA 2006). A minority shareholder owning 5% of the shares in a company will therefore not be in a position to influence the outcome of a vote on this matter (unless he or she is able to join forces with other shareholders to make up the relevant majority).

A shareholders’ agreement may provide, however, that the unanimous consent of all shareholders is required in order for a resolution to remove a director to be passed. It is important to note that such a provision does not remove the statutory right of the majority shareholders to remove a director under s.168 CA 2006, as a company is bound to accept the vote of a shareholder even if this is in breach of the provisions of the shareholders’ agreement.

In a situation where a resolution is passed without the required unanimity and therefore contrary to the terms of a shareholders’ agreement, provided a simple majority voted in favour (in accordance with CA 2006), the resolution would still be valid and the director would be removed from office. The director would then have a claim against the other shareholders for breach of the shareholders’ agreement. This may give the impression that a minority shareholder has only minimal influence. However, in reality the threat of a breach of contract claim effectively means that the minority shareholder is able to influence whether or not the resolution is passed, despite his or her minority shareholding. To this end a shareholders’ agreement minimises the effect of the principle of majority rule. Such provisions are sometimes known as veto provisions.

Amendments to shareholders’ agreements

A further reason why parties may enter into shareholders’ agreements is that amendments to a company’s articles of association can be made by passing a special resolution requiring 75% approval. Changes to a shareholders’ agreement in contrast will require the unanimous approval of all parties to the agreement. This would consequently give a minority party a right of veto.

Minority shareholders also have one other right arising from IA 1986 and various rights under the CA 2006 which enable them to take action in certain circumstances (provided that the relevant shareholding thresholds are met).

Just and equitable winding up – IA 1986

The right for a disgruntled shareholder to apply for the company to be wound up on the grounds that it is just and equitable to do so arises under s.122(1)(g) IA 1986.

When a company is wound up its life is effectively brought to an end so this is rather a drastic solution for a disgruntled shareholder. In such cases the court has discretion to decide whether it is just and equitable for winding up to take place. As there is a degree of overlap between the sections, it is common for a s.122 IA 1986 and a s.994 CA 2006 petition to be made at the same time.

Other CA 2006 provisions benefiting minority shareholders

S.303 as amended by The Companies (Shareholders’ Rights) Regulations 2009

Shareholders together holding not less than 5% of the paid up voting share capital of the company can require a general meeting, by serving a request on the company.

S.314

Shareholders together holding 5% of the total voting rights or not less than 100 members holding shares in the company with the right to vote on which there has been paid up an
average sum per member of not less than £100 can require the circulation of statements regarding proposed resolutions to be considered at a general meeting.

S.338

Shareholders together holding 5% of the total voting rights or not less than 100 members holding shares in the company with the right to vote on which there has been paid up an
average sum per member of not less than £100 can force resolutions onto the agenda of an AGM for public companies only.

S.527

Shareholders together holding 5% of the total voting rights or not less than 100 members holding shares in the company with the right to vote on which there has been paid up an
average sum per member of not less than £100 can require website publication of audit concerns for quoted companies only.

s.721

Any shareholder, other than one who voted in favour of the resolution, can apply to the court for the cancellation of a special resolution approving any payment out of capital for the redemption or purchase by a private company of its shares.

In June 2007, a retired solicitor and 100 other shareholders of Tesco forced an item onto Tesco’s AGM agenda (under CA 1985) in respect of the alleged meagre wages it paid workers in the developing world to supply its supermarkets (see http://theguardian.com/business/2007/jun/29/supermarkets.tesco1). Shareholders did not pass the resolution.

Section 994 allows a member to bring an action on the grounds that the company is being run in such a way that he or she has suffered unfair prejudice. This is a long established provision which is preserved under CA 2006. Examples of conduct that may be held to be unfairly prejudicial to the interests of members include the granting of excessive remuneration to directors, directors’ dealing with associated persons, or non-payment of dividends.

Note that under s.260 CA 2006 the shareholder sues on behalf of the company in respect of the company’s loss, whereas under s.994 the shareholder sues for himself.

The statutory right

Section 994(1) CA 2006 provides: “A member of a company may apply to the court by petition for an order….on the ground

1. that the company’s affairs are being or have been conducted in a manner that is unfairly prejudicial to the interests of members generally or of some part of its members (including at least himself), or
2. that an actual or proposed act or omission of the company (including an act or omission on its behalf) is or would be so prejudicial.”

If the shareholder can show that the company’s affairs are being conducted in a manner unfairly prejudicial to his or her interests, or that some act or omission of the company has unfairly prejudiced him or her (in terms of the reasonable bystander (objective) test – see Re Guidezone Limited [2000] 2 BCLC 310), the court will decide what remedy is appropriate in the circumstances.

Unfairly prejudicial conduct

The meaning of unfairly prejudicial conduct has been developed through case law and you should note the following principles:

• Negligent or inept management of a company – will not amount to unfairly prejudicial conduct unless that conduct amounts to serious and/or repeated mismanagement which puts at risk the value of the minority shareholder’s interest;
• Disagreements as to company policy – (such as a change in direction of the business) will not afford grounds for a petition under s.994;
• Claimant’s conduct – although the conduct of the claimant may be relevant in deciding whether the prejudice was unfair, there is no overriding requirement that the claimant come to court with “clean hands” (see Re London School of Electronics Limited [1985] 1 BCC 99394);
• Breaches of the articles of association – see Lord Hoffmann in O’Neill and another v Philips and others [1999] 2 All ER 961 where he said that “a member of a company will not ordinarily be entitled to complain of unfairness unless there has been some breach of the terms on which he agreed that the affairs of the company should be conducted… [However,] there will be cases in which equitable considerations make it unfair for those conducting the affairs to rely upon their strict legal powers”;
• Bad faith – there is no need to show either bad faith or conscious intent for the conduct to be unfair;
• Excessive remuneration – following Maidment v Attwood and Others [2012] EWCA Civ 998, the courts will take a wide view of the prejudice that may be suffered by a minority shareholder. A minority shareholder argued that he had suffered unfair prejudice on the basis that the sole director of the company had paid himself excessive remuneration prior to the company’s insolvency. The judge at first instance dismissed the petition on the grounds that the remuneration had been disclosed in the company’s accounts. The Court of Appeal found that there was no basis for requiring this level of diligence by a minority shareholder, and that the director had breached his duties by fixing his remuneration by reference to his own interests which amounted to unfairly prejudicial conduct under s. 994; and
• Legitimate expectation – in terms of certain small private companies (which are often referred to as quasi-partnerships (see Ebrahimi v Westbourne Galleries Limited [1973] AC 360)) case law has established that shareholders may have a legitimate expectation that they be involved in the management of the company, and the prevention of such involvement may equate to unfairly prejudicial conduct. For example, in the case of Re a Company No 00477 of 1986 [1986] 2 BCC 99171 the court held that the interests of a member who had risked his capital in the business of a small private company may extend to the legitimate expectation that he will continue to be employed as a director, so that his dismissal will be unfairly prejudicial to his interests as a member.

Section 994 petitions are likely to be expensive, time-consuming and complicated to bring. Since the court has discretion to make such order as it thinks fit, such petitions also bring with them a great deal of uncertainty for the petitioner. Generally, a negotiated settlement will therefore be the preferred option.

Court orders

Under s.996(1) CA 2006 the court has the power to grant such order as it thinks fit to provide relief and, subject to this general power, s.996(2) sets out a list of particular types of order that may be made. These include orders regulating the future conduct of the company’s affairs and requiring the company to do or refrain from doing certain acts. The most commonly made order is to provide for the purchase of the petitioner’s shares by the wrongdoer(s) (only rarely does this result in an order entitling the minority shareholder(s) to purchase the shares of the majority shareholder(s), but see for instance Brenfield Squash Racquets Club Ltd, [1996] 2 BCLC 184). The value at which such shares are to be purchased is a fundamental issue and usually a matter which is argued.

In practice, where one side is willing to buy out the shares held by the other and the dispute centres around the valuation of those shares, the court will encourage the parties to settle out of court by means of a binding third-party valuation of the shares. If the petitioner objects to such an out of court settlement, the court will usually require them to give reasons for their objection.

Therefore, if a shareholder wants to avoid the situation where the court makes an order for the purchase of his or her shares, a petition under s.994 may not be a suitable course of action. Similarly, if the majority shareholder is without funds to purchase the shares, an order for the purchase of shares will not be the most sensible order for the minority shareholder to request.

Valuation Principles

The court has a wide discretion in relation to valuation matters and its aim is to set a fair price. The following principles apply to valuations generally, although the court will look at all the circumstances of the case:

• The courts have traditionally been slow to impose a discount on the value of a minority shareholding in a private company, on the basis that the minority shareholder is being forced to sell his/her shares because of the unfairly prejudicial conduct of the majority shareholder. Therefore in many cases the fact that the shareholding is small and does not confer any control over the running of the company will not be taken into account. This is particularly the case where the company has been controlled and operated by all the shareholders playing major roles (a quasi-partnership). However the court may order a discount to be applied if the shareholding is viewed as an investment or the company is operated along more commercial lines. Shareholders should first attempt to use a valuation mechanism set out in the articles (if any) provided that it is fair. However, if there is no fair method then a court valuation will be necessary.
• The court will try to apply, so far as is possible, a similar mechanism to that provided for in the articles (if any).
• As a general rule the valuation date is that on which the court order was made, unless problems at the company mean that since the court proceedings were commenced there has been a decrease in the value of the shares or the business has changed.
• The behaviour of the claimant may be relevant e.g. if he or she previously rejected a reasonable offer.

For an illustration of the difficulty in bringing a successful claim under s.994 you may wish to read the summary of the case of West Coast Capital (LIOS) Limited Petitioner, [2008] CSOH 72, Outer House, Court of Session (23 June 2008) which can be accessed through Practical Law under the title “Unfair prejudice: Dobbies Garden Centre”.

There are a number of rights and remedies available to minority shareholders:

• “Membership rights” – enforcement under s.33 CA 2006
• Derivative actions:
  • exceptions to the rule in Foss v. Harbottle
  • under s.260 CA 2006
• Unfair prejudice actions under s.994 CA 2006
• Just and equitable winding up under s.122 IA 1986
• Other benefits under CA 2006

These remedies are not necessarily used frequently in practice but their existence and the threat of claims being brought will be ever present in the directors’ minds and may have an impact on their conduct.

“Membership rights” – enforcement under s.33 CA 2006

It has long been the case that the articles of association of a company regulate the relationship between the members and each other and between the members and the company. They act as a contract. This is enshrined in s.33 CA 2006, which provides as follows:

“The provisions of a company’s constitution bind the company and its members to the same extent as if there were covenants on the part of the company and of each member to observe those provisions.”

The effect of this provision is that members can sue under s.33 if their membership rights are infringed. The usual remedy for breach of s.33 is damages.

The meaning of “membership rights” is far from clear and we have to turn to decided case law in order to establish what rights have been considered to be membership rights in the past.

Examples of membership rights that have been enforced under s.33 CA 2006 (or the corresponding section of CA 1985):

• the right to a dividend once it has been lawfully declared;
• the right to share in surplus capital on a winding up;
• the right to vote at meetings; and
• the right to receive notice of GMs and AGMs.

These rights are limited and rights of members which are not membership rights are not enforceable under s.33.

The most commonly referred to case on this matter is Eley v Positive Government Security Life Assurance Co Limited [1876] 1 Ex D 88, CA. In this case the company’s articles contained a provision that the plaintiff would be appointed as the company’s solicitor. He was never appointed as such although he did become a member. The court held that the plaintiff could not sue under the equivalent of s.33 as the right to be appointed as the company’s solicitor was not a membership right.

In order to protect members, it is important, therefore, that any of their rights which are not membership rights are set out in a separate contract (such as a shareholders’ agreement) and not in the articles of association.

It should also be noted that a company’s articles are deemed to be a complete contract and the court will not imply any terms into them whether to create business efficacy or otherwise (see Bratton Seymour Service Co. v Oxborough [1992] BCC 471).

Derivative actions

A derivative action is one where the shareholder’s right of action is not one which is personal to that shareholder but instead it is one which is derived from the company’s right of action, which the company has not exercised.

Since 1 October 2007, the only procedure for bringing a derivative action is under s.260 CA 2006. However, we have included examples of the common law principles established before then as they may still be followed by the court and you may hear them referred to in practice.

In addition, Foss v Harbottle (and associated cases) will continue to be
relevant where shareholders seek to enforce a right which is vested in
themselves rather than the company, since this line of authority will not be
affected by the introduction of s.260 CA 2006.

Exceptions to the rule in Foss v Harbottle

The rule in Foss v Harbottle [1843] 2 Hare 461 has long provided that, in situations where a wrong has been done to a company, the company is the proper claimant (acting through the board or in some circumstances the majority shareholder(s)). In other words, a member would not be the proper claimant. Accordingly, the court will not interfere in the internal management of a company acting within its powers. The effect of this rule is that, in general, under the common law a minority shareholder is not allowed to sue for a wrong committed against a company of which he is a member, even if the company is refusing to take action.

However, over the years the courts recognised that, in order for justice to be done, there needed to be some circumstances in which a shareholder could bring a claim on a company’s behalf if the company would not do so. It was as a result of this recognition by the courts that various exceptions to the rule in Foss v Harbottle established the right of a minority shareholder to bring an action as follows:

• Where the majority exercise their votes in such a way as to defraud minority shareholders. For example, in a situation where there has been a fraud on the minority, the wrongdoers (usually the directors) are in control of the company and the claimant is being improperly prevented by the wrongdoers from bringing an action in the name of the company.
• Where directors who are in control of a company have been guilty of a breach of fiduciary duty, provided that breach of such duty is not ratifiable by the majority. See the cases of Pavlides v Jensen [1956] 2 All ER 518 and Multinational Gas and Petrochemical Co Ltd [1983] 2 All ER 563.
• Where the company (usually as a result of a decision of the board) is proposing to act ultra vires or illegally. See Edwards v Halliwell [1950] 2 All ER 1064 and North-West Transportation Co v Beatty [1887] 12 App Cas 589.
• Where the company has purported to pass an ordinary resolution in circumstances where a special resolution, or some other special procedure is required. These special procedures are in force in order to protect the minority and the rule in Foss v Harbottle is not allowed to defeat this purpose. See Edwards v Halliwell [1950] 2 All ER 1064.
• Where the company proposes to act on the authority of a resolution which is defective because inadequate notice was given. See Kaye v Croydon Tramways [1898] 1 Ch 358.

Derivative claims under s.260 CA 2006

Section 260 was a new provision introduced by CA 2006. It provides an express right to bring a derivative claim in certain circumstances. It is therefore a statutory exception to the rule in Foss v Harbottle.

S.260 CA 2006 allows shareholders to bring a derivative claim where directors have breached their statutory duties. This provides a wider range of circumstances in which a derivative claim may be brought by a shareholder compared with the common law rules described above. This is especially the case since directors’ duties were expanded under CA 2006. The statutory right to bring a derivative claim supports enforcement of the directors’ wider duties.

Definition of derivative claim under s.260 CA 2006

Section 260(1) defines a derivative claim brought under s.260 CA 2006 as one initiated by a member of a company, rather than by the company itself:

1. in respect of a cause of action vested in the company; and
2. seeking relief on behalf of the company.

When a derivative claim may be brought

Section 260(3) provides that a claim: “… may be brought only in respect of a cause of action arising from an actual or proposed act or omission involving negligence, default, breach of duty or breach of trust by a director of the company.”.

Note that a “breach of duty” will also encompass breaches of common law duties not falling within CA 2006.

Importantly, there is no requirement that the director has to have benefited personally from the breach before a derivative claim can be brought. Section 260(5) sets out the definition of director for the purposes of s.260 and includes shadow directors as well as former directors. Note that s.260(3) extends to all statutory duties of directors under ss.170-177 CA 2006 (including, for example, the s.174 duty to exercise reasonable care, skill and diligence).

Against whom the derivative claim may be brought

Under s.260(3) the cause of action may be brought against “the director or another person (or both)”. However a cause of action will only arise in respect of the actions or omissions of a director.

Therefore, provided the cause of action is in respect of a relevant breach by a director, third parties may be defendants to the derivative claim, either in lieu of the director or in addition to the director. According to the Explanatory Notes to CA 2006, derivative claims against third parties are only to be permitted in very narrow circumstances, for example against a third party to a contract entered into in breach of the director’s duties, where that third party knew about the breach. The cause of action against a third party is not set out in CA 2006, but derives from the common law rules relating to the concept of ‘knowing assistance’ in respect of a breach of duty by a director.

Who may bring a derivative claim

Derivative claims brought under s.260 must be brought by a member. However, pursuant to s.260(4) it is immaterial whether the cause of action arose before or after the person bringing the claim became a member of the company.

A member may, therefore, bring a claim in respect of events that occurred before they became a member of the company. This underlines the fact that the cause of action is vested in the company, rather than the member. By contrast, a former member cannot bring a claim even in relation to events which occurred when they were a member.

Requirement for court approval

There are two stages to bringing a derivative claim. The first stage is that the member must obtain the permission of the court to continue a derivative claim (i.e. once the claim form has been issued) – s.261(1). The onus is therefore on the member to make out a prima facie case in order to obtain permission.

There are certain circumstances set out in s.263(2) where permission to continue the claim must be refused by the court. These include where the court is satisfied that a person acting in accordance with s.172 (the duty to promote the success of the company) would not seek to continue the claim.

If the circumstances are not such as to be an absolute bar to the continuation of the derivative claim, the court must then take in to account the factors listed in s.263(3) in determining whether to allow the claim to continue. These include whether the member is acting in good faith and whether the act or omission which gave rise to the cause of action would be likely to be ratified by the company.

If the application is not dismissed at the first stage then the court will consider the claim at the second stage, when it must consider particular criteria. The court must have “particular regard” to any evidence it has before it as to the views of the members who have no “personal interest, direct or indirect, in the matter” – s.263(4). This provision was introduced to make it harder for a single member to bring proceedings against the wishes of the general body of shareholders and is considered to be an important safeguard against the bringing of tactical litigation by disgruntled shareholders.

The requirement to obtain court permission to continue a derivative claim and the safeguards built into s.263 were designed as a counterbalance to the extension of the rights to make a derivative claim under s.260. It was thought that the new statutory provisions would be easier to use than the exceptions to the rule in Foss v Harbottle and thus lead to more tactical action by minority shareholders. However, the anticipated increase in successful derivative claims has not materialised. The courts have generally adopted a restrictive approach in denying permission to continue derivative claims in a large number of cases (see Stimpson & Ors v Southern Landlords Association [2009] EWHC 2072 (Ch), Mission Capital plc v Sinclair [2008] EWCH 1339 (Ch) and Franbar Holdings Ltd v Patel [2008] EWHC 1534 (Ch)).

The day to day running of a company is carried out by the directors with certain important decisions being reserved to the shareholders, such as changes to the articles of association and authority to allot shares. The decisions reserved to the shareholders are taken following the principle of “majority rule”: a requisite majority of the shareholders must vote in favour of the proposed resolution in order for it to be passed. Significantly, the majority is able to appoint and remove directors from the board, thereby maintaining day to day control over the company.

Bearing this principle in mind there is often little that a minority shareholder can do to influence whether or not a resolution will be carried, or how a company is run day to day, unless he or she can join forces with other shareholders in order to make up or block the majority required. In most cases, therefore, the minority shareholder must simply live with decisions made by the majority.

There are statutory (and certain limited common law) remedies available to disgruntled minority shareholders, but they are far from ideal because they are often costly to pursue and uncertain in terms of the likelihood of success and the remedy likely to be granted by the court. For these and other reasons shareholders may enter into shareholders’ agreements, which aim to minimise the effect of the principle of majority rule by setting out how the company is to be run as between the shareholders and how the shareholders will vote on certain matters.

So, for example, the shareholders of a company with minority shareholders might sign up to an agreement requiring the unanimous consent of all shareholders before certain matters can occur. Such a matter might include the passing of any resolution or doing anything which would lead to a substantial change in the nature of the company’s business. This would prevent the company’s directors taking the company into a different area of business unless all the shareholders gave their consent.

Overview

These regulations are particularly important if you work on acquisitions in the corporate department of a law firm.

The Transfer of Undertakings (Protection of Employment) Regulations 2006 (as amended) (‘TUPE’) protect employees upon the occurrence of a ‘relevant transfer’. There are two types of relevant transfer under TUPE:

• a business transfer – where an ‘undertaking’ (or part of an undertaking) is transferred from one person or company to another. Very generally, an ‘undertaking’ means a business or part of a business referred to as amounting to an ‘economic entity’; and
• where there is a ‘service provision change’ as defined in the TUPE. An example of a service provision change could be where a company outsources its cleaning function to a third party contractor or where it subsequently changes the contractor who provides its office cleaning.

Before TUPE was brought into force, the new owner of a business could either decide not to employ any of the employees, or to employ only some of them on his own terms. This left employees in a very vulnerable position and likely to be made redundant when the business in which they worked changed hands.

Common Law position

It is important to understand the distinction between the sale of a company (involving a share sale) and the sale of a business (i.e. a sale of the assets). The sale of a company involves a sale of shares and a sale of a business generally involves the sale of the assets of the business which allows the new owner to continue to operate the business as a going concern after the transfer of those assets.

Share sale

TUPE does not apply to share sales.

On a share sale, only the shares of the company change hands. The new owner of the shares steps into the shoes of the old shareholder as the new owner of the company. All contracts between the company and the employees remain in place because the identity of the employer and the terms and conditions contained in the contracts of employment remain exactly the same.

Business sale

TUPE applies to business sales.

If a company sells its business, it is likely to sell everything needed to operate its business including e.g. the freehold property, the equipment, stock, computers, work-in–progress, customer lists etc. to a third party.

At common law, the employees’ contracts are with the company and not with the new owner of the business. Under the law of privity, their contracts would not be transferred to the new owner automatically, nor could they be transferred unilaterally by the company. It would require all three parties (the company, the employee and the new owner) to agree to novate the contracts from the company to the new owner.

This position was very unsatisfactory for employees of a business which was being sold (as they could easily lose their jobs) and TUPE was brought into force to reverse the common law rule.

Effect of TUPE

On the sale of a business, the contracts of employment are now, in effect, automatically transferred to the transferee (the new owner) of the business by operation of law, provided that:

1. there is a transfer from one person to another of an undertaking (or part of an undertaking) situated in the UK immediately before the transfer;
2. the transfer is of an economic entity which retains its identity after the transfer; and
3. the relevant employees are employed in the undertaking immediately before the transfer or would have been so employed had they not been unfairly dismissed in the circumstances described below.

TUPE states that those employees employed immediately before the transfer automatically transfer to the transferee. This expressly includes employees dismissed prior to the transfer and because of the transfer where there is no ETO reason entailing a change in the workforce for the dismissal.

Similar protection is afforded to employees in respect of a service provision change

Employees who object to being employed by the transferee will not transfer. The transfer will instead operate to terminate their employment but it will not generally constitute a dismissal.

Any variations to employment terms, where the sole or principal reason for the variation is the transfer itself, will be void, unless the variation is for an ETO reason entailing a change in the workforce and the employer and employee agree to the variation, or the terms of the employment contract permit the variation. This means that the transferee cannot use the transfer as an opportunity to harmonise terms and conditions of employment.

What the transferee acquires

The transferee inherits all accrued rights and liabilities connected with the contracts of employment of the transferred employees, together with all the statutory rights and liabilities connected to that employment with the exception of:

• criminal liabilities; and
• certain rights and liabilities relating to provisions of occupational pension schemes (subject to the requirements of the Pensions Act 2004 and the Transfer of Employment (Pension Protection) Regulations 2005.

It is also worth noting that there is an obligation to ensure that a proper consultation is held with employees as to the fact of, reasons for and consequences of the transaction. A failure to inform or consult can result in large financial penalties for both the transferor and the transferee pursuant to TUPE of up to 13 weeks’ actual pay per employee.