Good faith and unfair prejudice: Faulkner v Vollin Holdings

In Faulkner & Ors v Vollin Holdings Limited & Ors [2021] EWHC 787 (Ch), Adam Johnson J found that minority shareholders had been unfairly prejudiced by the actions of the majority shareholder investors, who had, amongst other things, excluded two founding directors from the management of the company.

Background

Mr Faulkner (the First Petitioner) and Dr Sachs (the Second Petitioner) were founding directors (and former chairman and CEO respectively) of Compound Photonics Group Limited ("CPGL"). CPGL’s business was to harness technology developed by Dr Sachs to revolutionise the market in projectors. The remaining petitioners were individual investors in CPGL who had been introduced by Mr Faulkner (the “Petitioners”). The Respondents were the majority shareholders in CPGL (the “Investors”).

The Petitioners claimed that they were unfairly prejudiced because, contrary to the terms of the shareholders' agreement relating to CPGL (the "Agreement"), Dr Sachs and Mr Faulkner had been excluded from the management of CPGL. Further, they claimed that the Investors’ nominee directors had acted in breach of CPGL’s articles of association (the "Articles"), the Agreement, and their duties under the Companies Act 2006 (by, for example, permitting the sale of a property at undervalue), resulting in them being unfairly prejudiced.

The Investors claimed, by contrast, that they had invested in CPGL in order to support Dr Sachs’s vision but that after long delays and failures, they had entirely reasonably asked Dr Sachs to resign, which he agreed to do. Mr Faulkner’s removal from the business was, they claimed, as a result of his acting in an erratic and unpredictable manner which was damaging to CPGL. The Investors claimed to have acted in good faith at all times, and not to have acted in breach of the Agreement or, in the case of the directors, in breach of CPGL’s articles or their duties under the Companies Act 2006.

Key clauses in CPGL’s constitution

Adam Johnson J examined the Agreement and the Articles, agreed in 2010 and then updated in 2013. He focussed in particular on the following aspects:

• “…resolutions arising at any meeting of the Directors shall be decided by a majority of votes provided that both of the Founder Director and the CEO must at all times form part of that majority”¹; 
• “The Board shall not be able to pass a resolution to remove the CEO as a director or the Founder Director as a director and nor shall those individuals vacate the office of director if they make any arrangement or composition with their creditors generally”²;
• “Each Shareholder undertakes to the other Shareholders and the Company that it will at all times act in good faith in all dealings with the other Shareholders and with the Company in relation to the matters contained in this Agreement" ³;
• Further requirements in the 2013 Agreement obliging the parties to: (1) cooperate with the CPGL's Board in respect of the conduct of CPGL and any group companies' business; (2) ensure that CPGL's business was conducted in accordance with good business practice and on sound commercial and profit making principles; (3) ensure that CPGL and any group companies' business was conducted in a proper and efficient manner and on arm’s length terms and for their own benefit; and (4) keep shareholders informed regarding all CPGL and any group companies' material financial and business affairs.

The Petitioners argued that, read together, CPGL’s constitutional documents gave rise to a “contractual quasi-partnership”. Mr Faulkner and Dr Sachs were, it was argued, “entrenched” in the management of CPGL and the Investors were prevented from obtaining control of CPGL's Board.

By contrast, the Investors asserted that: (1) there was nothing in CPGL’s constitution preventing them, as majority shareholders, from removing Mr Faulkner and Dr Sachs as directors pursuant to section 168 of the Companies Act 2006; and (2) without prejudice to this contention, at most, the good faith provisions in the Agreement obliged them to exercise this power honestly and in a commercially justified manner, which they contended was the case.

The scope of good faith clauses

In considering the parties’ arguments, Adam Johnson J focussed on the effect of the good faith requirement in CPGL’s constitution. While the entire agreement clause in the Agreement precluded analysis of the parties’ pre-contractual negotiations, he examined the factual matrix at the time the constitutional documents were entered into in order to establish the ambit of the provision.

Overall, Adam Johnson J concluded that the structure agreed by the parties was a compromise designed to “maintain an acceptable balance of power between the existing and new shareholders”. This was manifested by, amongst other things, the protections which had been agreed to ensure that the minority's position was protected against the Investors' otherwise unrestricted ability to control CPGL. These protections provided in particular that:

• Mr Faulkner and Dr Sachs' positions were specifically protected in line with the minority's expectation that they would deliver on their investments;
• The Board would conduct itself in accordance with the Agreement and the Articles, free from interference from the Investors;
• Dr Sachs and Mr Faulkner retained a controlling role in CPGL's Board's decision making and were subject to restrictions on their removal.

Within that structure, the good faith obligation was intended to act as a contractual restriction on the “otherwise untrammelled” rights of the Investors to exercise their majority power as they saw fit. Part of the good faith obligation meant, Adam Johnson J held, “respecting the balance of power achieved by means of the overall constitutional settlement”.

Adam Johnson J found that the Investors had instigated processes by which both Dr Sachs and Mr Faulkner were removed from the management of CPGL in breach of their contractual obligation of good faith. In particular, the Investors' failure to deal with matters openly and fairly and to take account of minority interests represented such a breach; the Agreement and the Articles were specifically designed to prevent just such actions from being valid.

This was unfairly prejudicial to the minority for two reasons: i) it deprived the minority of the benefit of the technical expertise which they had invested in; and ii) it deprived the minority of the protection which their presence on the Board had been designed to achieve.

Furthermore, in supporting the Investors' conduct in this regard the Investors' directors were in breach of various fiduciary duties pursuant to the Companies Act 2006.

Adam Johnson J also identified other examples of unfairly prejudicial conduct, (which also constituted breaches of the Agreement and the Articles, and breaches by the Investors' directors of various fiduciary duties pursuant to the Companies Act 2006) including withholding information concerning CPGL’s affairs in the period after Dr Sachs' and latterly Mr Faulkner's removal from the Board.

Analysis

Although the Petitioners had argued that CPGL was a “quasi-contractual partnership”, this was not a case in which the parties relied upon an equitable entitlement or agreement as established in Ebrahimi v Westbourne Galleries [1973] AC 360⁴. Here, Adam Johnson J focussed on the contractual bargain to which the parties had agreed and the extent to which that bargain had been breached. In particular, he focussed on the good faith obligation, which he preferred to analyse as: “the obligation to deal fairly and openly, the need to take into account the interests of the other party as well as one's own interests, and the fact that the duty may be breached where an otherwise justifiable result is achieved in procedurally non-compliant way.”

Although the Investors had the power to remove Dr Sachs and Mr Faulkner under the Companies Act 2006, the inclusion of a requirement to act in good faith meant that in exercising their statutory rights, the Investors were susceptible to a claim by the minority for unfair prejudice if their exercise of this right was in breach of contract.

This case serves to highlight the significant effect the inclusion of express good faith obligations can have on the outcome of shareholder disputes and the way in which such obligations can assist parties contemplating unfair prejudice petitions. However, it should be borne in mind that, the extent of the impact in this regard will, of course, depend on the formulation of the relevant obligations applicable in each case, and the extent to which it can be said that they have been properly respected.