Following recent changes to the professional rules governing accountants, Tamar Halevy warns private companies to put in place alternative share valuation provisions
It is a common scenario: a shareholder, Mr S, in a private company, X Ltd, wishes to sell his shares.
As a result of provisions contained in the articles of X Ltd, Mr S must first offer his shares to the existing shareholders of X Ltd at a price, reflecting market value, to be determined by the auditors of X Ltd, Messrs A. After the shares have been offered to existing shareholders at the price determined by Messrs A, any shares not taken up can be offered to the company itself and, if any are left over after that, to outsiders.
This scenario reflects a common form of pre-emption clause found in the articles of association of many unlisted companies. The purpose of this clause is to give the shareholders an element of control over the membership of the company. The logic behind providing for the auditors to determine the price of the shares is generally that they are already familiar with the financial position of the company and can therefore carry out a valuation relatively quickly and cheaply.
All very straightforward. Or is it? As a result of a recent change in the professional rules governing accountants, there is a risk that this form of pre-emption clause will be unworkable. The Auditing Practices Board has issued new ethical standards for auditors, which came into effect for all accountants on 6 April 2005. Among other things, the ethical standards prohibit auditors from providing valuation services to audit clients where the valuation would involve a high degree of subjectivity, and have a material effect on the financial statements.
There is an exemption for small entities that covers unlisted companies having two or more of the following criteria:
As a result of this new prohibition, auditors will in many cases be obliged to decline to provide valuations to audit clients. How does that affect our scenario? Messrs A may well now decide that the new ethical standards oblige them to decline to carry out the requested valuation of Mr S's shares. If Messrs A do decline, and the articles do not provide an alternative valuation mechanism, there is no procedure for determining the price at which Mr S's shares are to be offered.
The sensible course would be for the parties to agree on a price or on an alternative valuer. However, what happens if the other shareholders do not wish to co-operate in agreeing any variation to the valuation provisions? Under the articles, Mr S is then unable to proceed with offering his shares to outsiders because the articles provide that he cannot do so until the shares have been offered to existing shareholders at a price determined by Messrs A.
In the absence of co-operation between the parties, Mr S is left with the prospect of having to apply to the court for assistance.
However, existing authorities indicate that such a court application would not be straightforward. The House of Lords case of Sudbrook Trading Estate Ltd v Eggleton [1983] 1 AC 444, was concerned with an option to purchase property where the contractual valuation machinery had broken down and the court was asked to substitute alternative valuation machinery. A distinction was made by the Lords between those cases where the mode of ascertaining the price is an essential term of the contract and those cases where the mode of ascertaining the price, though indicated in the contract, is subsidiary and non-essential. It was stated in obiter that where, for example, there is an agreement to sell at a price to be fixed by a valuer who is named, or who, by reason of holding some office such as auditor of a company whose shares are to be valued, will have special knowledge relevant to the question of value, the prescribed mode may well be regarded as essential. In those circumstances, if the machinery breaks down, the court should not substitute other machinery.
In Macro v Thompson (No 3) [1997] 2 BCLC 36, a case of a pre-emption clause in the articles breaking down, Mr Justice Robert Walker referred to the principle established in Sudbrook Trading and said that in the normal case, the valuation of a private company's shares by its auditors is a possible example of contractual machinery that is essential and indispensable. This is because in large private companies where valuations are needed fairly often (either for the operation of pre-emption provisions or for tax purposes) the auditors have drills for producing valuations at short notice and no other expert could perform the task as quickly or as efficiently.
Therefore, it follows that, in the 'normal case', a pre-emption clause that provides for a valuation to be carried out by the company's auditors may well be considered an essential and indispensable provision in the articles, with the result that, if those auditors decline to act, the court would be unlikely to substitute its own alternative valuation machinery.
Where does that leave the parties? This would depend on the wording of the articles and the surrounding circumstances. There is no actual authority on this question but, logically speaking, the following would appear to be possibilities: the shares are untransferable unless a price can be agreed by all shareholders; alternatively, the pre-emption provisions are void and the shareholder may ignore them and sell his shares to an outsider unwanted by the other shareholders.
To break out of this, it may be necessary to apply to the court for an order that: if unfair prejudice can be established under section 459 of the Companies Act 1985, the other shareholders have to buy the shareholder out at a price determined by the court; alternatively, the company has to be wound up (on the ground that it would be just and equitable to do so) in order to release the shareholder's investment.
All those scenarios are commercially undesirable, either creating situations the parties had specifically wished to avoid or involving potentially expensive, lengthy and uncertain court proceedings. While it is to be hoped that, in most cases where an auditor feels that he is obliged to decline to provide a valuation, the parties can resolve the matter amicably, this can never be counted on.
If the problem is spotted quickly, a relatively simple fix can be applied. Companies that have valuation provisions such as those of X Ltd should amend them by providing for an alternative valuation mechanism, for example, for the price to be determined by an experienced valuer appointed by the President of the Institute of Chartered Accountants, in the event that the auditors decline to act. Companies that have valuation provisions such as those of X Ltd and leave them unchanged risk problems every time a shareholder wants to sell his shares.
Tamar Halevy is an associate solicitor in the litigation and dispute resolution department at City-based law firm Lewis Silkin
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