Board diversity as a corporate governance tool

On November 20, the European Parliament approved the European Commission’s legislative proposal to improve the gender balance in company boards. The proposed directive sets a minimum threshold of 40% of the under-represented sex in non-executive board-member positions in listed companies and a “flexi quota” (self-imposed targets) for executive directors, to be met by 2020. If the proposal becomes law, publicly listed companies with less than 40% of women among their non-executive board members will be required to adopt a selection procedure for board members, which gives priority to qualified female candidates. Small and medium-sized enterprises, while not bound by this requirement, will be encouraged to improve the gender balance at all levels of management and on boards.

Corporate board diversity (mostly in the form of gender diversity) has been a very dynamic area of corporate governance in Europe over the past decade. Norway is the frontrunner in the reforms promoting gender diversity, with a 40% quota of women on boards imposed on publicly listed companies since 2003. Several other European countries, including Spain, France, Belgium and Netherlands, have passed laws imposing quotas of women representation on board.

UK regulators preferred a soft law approach. The UK Corporate Governance Code recommends that board members be appointed “on merit, against objective criteria and with due regard for the benefits of diversity on the board, including gender” (principle B.2). In 2010, the UK Government commissioned Lord Davies to investigate the barriers preventing women from reaching senior decision-making roles in corporations. Davies’ report of 2011, with follow-ups in 2012 and 2013, maintained the soft law approach by recommending a voluntary, disclosure-based, strategy aimed to create a culture of diversity from within corporations.

Board diversity is, unsurprisingly, a very hot topic in academic research as well (for recent examples see Ferreira 2010; Broome et al., 2011; Dobbin & Jung, 2011). From a corporate governance perspective, however, the concrete ways in which board diversity contributes to better corporate governance and increased firm value are not altogether clear. The evidence drawn from empirical research is mixed and inconclusive. While academics may be suspected of being disconnected from the practical aspects of everyday life, business practitioners, it seems, are none the wiser. A recent study has shown that, despite showing an almost universal assent to the value of diversity in abstracto, corporate directors and officers have difficulty providing specific concrete examples of instances or ways in which diversity adds value to their boards (Broome et al., 2011).

The studies on the relation between board diversity and corporate performance have identified several main benefits and costs of diversity. On the benefits side, the positive business effects of board diversity include:

  • improved access to information, increased creativity and more effective problem-solving
  • better understanding of the marketplace, customers and suppliers
  • improved relations with employees, by signalling that the company values diversity and offers mentoring and advancement opportunities for all groups of employees
  • improved public image, by conforming to societal expectations

On the costs side, the potential downsides of diversity include:

  • decreased cohesion in the board, resulting in distrust, lack of cooperation and breakdown in communication
  • a lengthier and more costly decision-making process
  • decrease of quality of decisions, due to insufficient business expertise of directors chosen on diversity criteria
  • enhanced conflicts of interest by directors aiming to promote agendas or ideologies

From a corporate governance perspective, some of the most promising arguments in support of diversity are those linking diversity with directors’ improved ability to discharge their main duties. The first duty that comes to mind is the duty of care, skill and diligence (s. 174 of Companies Act 2006). The improved access to information, the diversity of viewpoints, and the greater scope for debates could increase the quality of business judgment and the outcomes of board deliberations.

Another example is directors’ duty to take into account the interests of relevant stakeholders, while promoting the success of the company as a whole (s. 172 of Companies Act 2006). Board diversity may help directors weigh more accurately the relevant considerations by helping to correct some of their prejudices and biases (Langevoort 2011). The different traits or characteristics associated with a certain ethnicity or gender create cognitive and behavioural diversity in the boardroom, which in turn may lead to a more balanced weighting of relevant considerations for each decision. Another way in which diversity could improve compliance with this duty is the difference between male and female directors in terms of self- and other- orientation: it has been argued that women directors have a greater “other-orientation” (Langevoort 2011), and hence are more committed to the development of stakeholder relationships and the long-term firm value.

Board diversity may also assist non-executive directors in discharging their oversight duty, requiring them to scrutinise the executive directors’ performance and the company’s system of financial controls and risk management (UK Corporate Governance Code, Principle A.4). A diversified board increases non-executives’ independence by reducing the probability of “groupthink”. Groupthink is a feature of homogenous groups, manifested in loss of individual creativity and independent thinking due to loyalty to group norms and desire for harmony (Janis 1972). Diverse boards undermine the homogeneity required by groupthink and reduce the likelihood of uncritical rubber-stamping of management’s decisions.

These avenues of research could bring important insights into the value of diversity as a corporate governance tool. In all advanced societies of today it is unacceptable to doubt the value of diversity, and rightfully so. In the context of corporate governance, the attempt to find a more concrete causal links between board diversity and good corporate governance does not call into question the intrinsic value of diversity within the firm. On the contrary, this exercise will provide contextual evidence to support diversity as an overarching value.

 

Bibliography:

Lisa L. Broome, John M. Conley and Kimberly D. Krawiec, “Dangerous Categories: Narratives of Corporate Board Diversity” (2011) 89 North Carolina Law Review 759

Frank Dobbin and Jiwook Jung, “Corporate Board Gender Diversity and Stock Performance: The Competence Gap or Institutional Investor Bias” (2011) 89 North Carolina Law Review 809

Lisa M. Fairfax, “The Bottom Line on Board Diversity: A Cost-Benefit Analysis of the Business Rationales for Diversity on Corporate Boards” (2005) Wisconsin Law Review 796

Daniel Ferreira, “Board Diversity” in H. Kent Baker and Ronald Anderson, eds., Corporate Governance: A Synthesis of Theory, Research, and Practice (Hobioken, N.J: Wiley, 2010) 225-243

Irving L. Janis, Victims of Groupthink: A Psychological Study of Foreign-Policy Decisions and Fiascoes (Boston: Houghton Mifflin, 1972)

Donald C. Langevoort, “Puzzles about Corporate Boards and Board Diversity” (2011) 89 North Carolina Law Review 841.

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Transatlantic Comparisons in Contract Law at Edinburgh Law School

From 30 August to 1 September a contract law conference took place at Edinburgh Law School. Entitled “Transatlantic Perspectives on Commercial Contract Law II”, this was the second such conference on this theme, the first having resulted in a book of the same name (available here: http://www.cambridge.org/es/academic/subjects/law/contract-law/commercial-contract-law-transatlantic-perspectives)

The editors Martin Hogg (University of Edinburgh) and Larry Di Matteo (University of Florida) had invited guest speakers from the US and the UK. Speakers were grouped into twos, and were encouraged to take a comparative approach, commenting on their partner’s legal system in addition to their own. This allowed many of the speakers to make interesting observations on the approach of their counterparts: we don’t “do” law in the same way. An obvious difference lay in the use of case law. The US speakers noted how useful it was for UK lawyers to identify one or two high level authoritative cases. This was more difficult to do in a US context. The sheer number of cases on a given issue at State level was also a challenge for US lawyers. By contrast, many of the Scots lawyers lamented the lack of decided case law in their own system, looking with admiring eyes at some of the useful and interesting US cases. The conference also provided the opportunity for the all contributors to find out more about the UK’s European context, the Common European Sales Law being a significant point of reference.

Many excellent papers were given, not all of which can be commented on here. One of the interesting themes which emerged was the role of consent in a modern context. This was explored in several thought-provoking papers including “The Death of Consent?” by Peter Alces (The College of William and Mary School of Law) and “Offer and acceptance in modern contract law: a needless concept?” Shawn Bayern (FloridaStateUniversity of Law).

A particular highlight for this blogger was the way in which certain speakers took a classic case from the other legal system and provided their own “foreign” perspective. This was the approach of Mark Gergen (Berkley Law School, University of California) who analysed the Scottish case, White and Carter (Councils) Ltd v McGregor ([1962] AC 413). Interestingly, it seems likely that this case would have been decided in the same way in the US. Mark’s analysis of the “legitimate interest” and “not wholly unreasonable” tests was particularly thought-provoking, providing food for thought for the UK lawyers who have tended to criticise the outcome in this case.

Catherine Mitchell (HullLawSchool) and Blake Morant (Wake Forest University School of Law) provided excellent papers on interpretation of commercial contracts, Blake focussing his attention on the impact on the small business industry. The themes which emerged following discussion of these two papers were taken up later in the conference, when the participants were addressed by the Right Honourable Lord Hodge, UK Supreme Court. Lord Hodge provided his own thoughts on the reasons for continuing to exclude both prior communings and post-formation conduct in the interpretative exercise. It was clear that he was highly sensitive to one of the main criticisms levelled at the contextual approach, i.e. the increase in costs, identifying ways in which Scottish court procedure operated to help keep costs to a minimum. Almost every participant took up the opportunity to question Lord Hodge, both at the event and later over dinner.

Professors Hogg and DiMatteo are to be congratulated on their well-organised conference. The method adopted, of pairing contributors, worked well. Not only did participants learn about the “foreign” legal system, but also had cause to reflect on the merits and demerits of their own. Discussions were intensive, and much was achieved over the two days. The conference book which will finally emerge will undoubtedly be as valuable as the previous one.

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Uncertainty in Commercial Contracts

Whilst it is understandable that parties may wish to conclude a contract leaving certain issues to be agreed at a later date, this might introduce the risk that the contract becomes void from uncertainty.  This important issue was considered by the Court of Appeal earlier this year in MRI Trading AG v Erdenet Mining Corporation LLC ([2013] EWCA Civ 156).

Facts
Essentially the dispute involved a sale of copper concentrates, in terms of which EMC, a Mongolian mining company, was the seller and MRI, a Swiss trading company, the buyer.  Disputes arose between the parties, and in 2009 they entered into arbitration.  The arbitration was terminated when they entered into a Settlement Agreement.  That Settlement Agreement bound both parties to enter into new contracts of sale.  One of those contracts of sale, the 2010 agreement, was the subject of the dispute eventually heard by the Court of Appeal.  Three clauses of this sale contract, clauses 6.1, 9.1, and 9.2 were, so EMC argued, so uncertain as to be agreements to agree, rendering the entire contract void.  In effect these clauses stipulated that the shipping schedule, and two deductions, the Treatment charge and the Refining Charge, were to be agreed during negotiations which normally took place between the parties annually.  The parties had entered into to arbitration to resolve this dispute.  Lord Justice Tomlinson, with whom Lords Justice Pill and McCombe agreed, found that the uncertainty in these clauses did not have this effect, and the contract was binding on the parties, thus overturning the arbitral award.

Court of Appeal Decision – Statement of the Law
Early in his judgment, Lord Justice Tomlinson referred the leading case Walford v Miles in which Lord Ackner confirmed that agreements to agree imposed no binding obligation ([1992] 2 AC 128).  Having thus set the scene he examined the terms of the arbitral award, in particular a quote from Lewison’s The Interpretation of Contracts which the Tribunal indicated was worth noting (quoted by Lord Justice Tomlinson at para 15):

“The effect of uncertainty may be that no contract comes into existence; or it may be that one provision in an otherwise binding contract is unenforceable.  Which of these two possibilities is likelier depends on the importance of the term which is uncertain.  The more important the term, the more likely it is that the contract as a whole is unenforceable.”

The arbitrators then considered two leading cases on uncertainty in commercial contracts, Mamidoil-Jetoil Greek Petroleum Company SA v Okta Crude Oil Refinery AD ([2001] 2 Lloyd’s Rep 76) and BJ Aviation Ltd v Pool Aviation Ltd ([2002] 2 P & Cr 25).  In the former, Mamidoil, Rix LJ had summarised the law in a number of principles ([2001] 2 Lloyd’s Rep 76, para 69):

“ i) Each case must be decided on its own facts and on the construction of its own agreement.  Subject to that,
ii) Where no contract exists, the use of an expression such as “to be agreed” in relation to an essential term is likely to prevent any contract coming into existence, on the ground of uncertainty.  This may be summed up by the principle that “you cannot agree to agree.”

iii) Similarly, where no contract exists, the absence of agreement on essential terms of the agreement may prevent any contract coming into existence, again on the ground of uncertainty.

iv) However, particularly in commercial dealings between parties who are familiar with the trade in question, and particularly where the parties have acted in the belief that they had a binding contract, the courts are willing to imply terms, where that is possible, to enable the contract to be carried out. 

v) Where a contract has once come into existence, even the expression “to be agreed” in relation to future executor obligations is not necessarily fatal to its continued existence.

vi) Particularly in the case of contracts for future performance over a period, where the parties may desire or need to leave matters to be adjusted in the working out of their contract, the courts will assist the parties to do so, so as to preserve rather than destroy bargains, on the basis that what can be made certain is itself certain.  Certum est quod certum redid potest [translated in A.G.M. Duncan (ed) Trayner’s Latin Maxims, 4th edn, 1993, p. 76 as “That is certain which can be made certain].

vii) This is particularly the case where one party has either already had the advantage of some performance which reflects the parties’ agreement on a long term relationship, or has had to make an investment premised on that agreement.

viii) For these purposes, an express stipulation for a reasonable or fair measure or price will be a sufficient criterion for the courts to act on.  But even in the absence of express language, the courts are prepared to imply an obligation in terms of what is reasonable.   

x) The presence of an arbitration clause may assist the courts to hold a contract to be sufficiently certain or to be capable of being rendered so, presumably as indicating a commercial and contractual mechanism, which can be operated with the assistance of experts in the field, by which the parties, in the absence of agreement, may resolve their dispute.”

Chadwick LJ also summarised the law into a number of principles in BJ Aviation.  Worthy of note are his suggestion that if “the parties must be taken to have intended to leave some essential matter, such as price or rent, to be agreed between them in the future…there is no bargain which the courts can enforce” ([2002] 2 P & CR 25, para 21).  If, however, the court is satisfied that the parties intended their bargain to be enforceable, it may imply a term that the price will be “fair”, “market” or “reasonable” ([2002] 2 P & CR 25, para 23). 

Court of Appeal – application of the law to the facts.
The arbitrators had erred in concluding that there had been no part performance in this case.  They had failed to take into account the overall commercial context, i.e. the Settlement Agreement and the fact that the parties had a long-term relationship (para 18).  Both parties had derived benefits from performing this contract for over a year.  The language of the Settlement Agreement also placed it beyond doubt that the parties intended their agreement to be legally binding.  It was certainly not indicative of a mere agreement to agree.  Lord Justice Tomlinson approved the approach of the judge at first instance where he identified the binding language used in the Settlement Agreement.  In particular use of the word “shall” was a “strong indicator that the parties did not intend that a failure to agree should destroy their bargain” (para 21).  Lord Justice Tomlinson also approved the approach of the judge at first instance where he carefully analysed Mamidoil, identifying the ways in which this particular case showed some factual similarities.  Given that both parties were familiar with the trade and had acted in a manner (objectively construed) that suggested they had a binding contract, (para 22). The contract should be upheld. This was particularly so given that EMC, the party arguing that the contract was not binding, had already received benefits from MRI’s performance (para 22).   Finally, the presence of an arbitration clause (para 22):

“…should have supported the conclusion that the agreement was sufficiently certain or capable of being rendered so, since it provided a commercial and contractual mechanism, which could be operated with the assistance of experts in the field, by which the parties, in the absence of agreement, could resolve a dispute about a reasonable TC/RC or shipping schedule.”

In general, the arbitrators were subject to stringent criticism for the decision they reached, having failed to ask themselves what the parties’ intention was if agreement was not reached on the points in the clauses in question (para 24).

Analysis
This case illustrates the extent to which a court will strive to give effect to a contract between commercial parties which is not only fully executed but has also been acted upon by both parties.  Such a contract can be valid notwithstanding the lack of agreement on specific terms.

Although the court did not specifically say so, the quotation with approval of the passage from Lewison’s The Interpretation of Contracts suggests that the court did not consider the factors on which agreement had not been reached, namely the shipping schedule, and two deductions, the Treatment charge and the Refining Charge, so significant as to constitute “essential terms” the lack of agreement of which rendered the contract void.  Both Rix LJ in Mamidoil and Chadwick LJ in BJ Aviation referred to the concept of such “essential terms.”  Exactly what constitutes an essential term may differ depending upon the particular commercial context.  This point can be illustrated by reference to older Scottish case law.  In R & J Dempster v Motherwell Bridge Engineering (1964 SC 308, per Lord President Clyde at 326) the Inner House did not consider lack of agreement over the price fatal to the conclusion of a binding contract.  In that case the commercial background, which involved shortages and quota systems in the industry, explained why agreement of the price could be delayed.  Thus the particular commercial circumstances may explain why the parties have failed to agree a price and need not completely rule out a finding that a binding contract has been concluded.  Lord President Clyde also considered it significant in that case that the parties had acted for over a year as though they had a binding contract (1964 SC 308 at 327).

The court treated the language of the document as significant: in fact, it carried out a very close analysis of the words used in order to reach the conclusion that the document was binding. 
Also worth noting is the availability of implied terms to resolve uncertainty in contract.  That solution was not applied here but is referred to in Rix LJ’s summary in Mamidoil.   As we have already heard today, the bar remains high in the implication of terms.  The term must be “necessary” in one of the senses expressed by Lord Hoffmann in the Belize case. 

Significantly this case reaffirms the proposition that it is possible for the parties to leave issues to be agreed in the future.  As stated by Rix LJ in Mamidoil, the courts “preserve rather than destroy bargains” ([2001] Lloyd’s Rep 76, para 69).   This is likely to be economically efficient: it may suit both parties to delay agreement of a specific issue to a later date.  It also upholds the parties’ intentions: if they intend to agree something later, there is no reason why the courts should prevent them from doing so. 

Also interesting is the effect of the arbitration clause.  By including such a clause the parties had provided a mechanism to deal with the consequences should they be unable to agree.  Thus the clause acts as an indicator that the parties intend to be legally bound. 

 

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Of trusts and patrimonies

Patrimony and trust are paradoxical private law concepts. Fundamental in civil law and, respectively, common law traditions, they are shrouded in a dense fog of controversy. Combine them, and you get the perfect comparative private law symposium. The experiment, "a first in the history of the world" as our colleague Ken put it, took place last Friday, 3 May, under the auspices of the Edinburgh Centre for Private Law. It brought together a lively assortment of academics, practitioners and doctoral students, from Aberdeen, to Brisbane, to Montreal. The workshop explored the various ways in which the concept of patrimony has been used, or could be used, to create a civilian trust that is the functional equivalent of the common law trust.

The workshop featured five papers and a presentation, with a commentator assigned for each two-paper panel. Dr Peter Turner of St Catharine's College, Cambridge, started the day with a sobering question: what are we trying to achieve with a comparative trust analysis? Peter drew attention to the potential limits to the understanding of the trust that one may derive from a comparative analysis. Two important limitations stand out. First, different scholars may have different purposes when comparing trusts, and they may hold different views of what matters about comparative trust analysis. Second, trust is necessarily examined and discussed on different levels of abstraction, ranging from particular effects to their irreducible core. These are, indeed, potential obstacles in a meaningful dialogue between comparative lawyers, but they are just that: obstacles that could be avoided, rather than inherent limitations.

The next speaker, Professor Paul Matthews of King's College, London, flagged up another potential problem in associating the trust and patrimony concepts: how useful is it for the common lawyer to explain and understand the trust idea using the concept of patrimony? In other words, why adopt a patrimonial approach to trusts? Professor Matthews explained why a patrimonial approach to the common law trust would not work. First, the belief that the patrimony concept is necessary to explain the segregation of the trust fund from the trustee's own assets and liabilities is a mistake. Regarding the assets side, a trustee has no prima facie duty to segregate trust assets from his personal assets, or the assets of another trust of which he is trustee. On the liabilities side, there is no clear segregation either: in dealing with third parties, the trustee assumes liability personally. Many consequences flow from this, which cast doubt on the utility of patrimony as an explanatory tool for the common law trust, as it currently exists. Nevertheless, Professor Matthews conceded, patrimony may be brought into discussion as an organising concept de lege ferenda, if it could be used to bring about desirable changes to the existing rules.

Next, the discussion shifted north of the border. Dr Dan Carr of Edinburgh Law School, investigated the aims of the patrimonial theory in Scots law: is it a silver bullet, capable of explaining all the facets of the Scottish trust, or is it simply "the law of the instrument", i.e. a theory likely to be adopted by courts or the Scottish Law Commission because it is the established, dominant view? Dan made a startling revelation in his talk: there is no general theory of patrimony in the Scots private law. Therefore, even if the patrimonial theory is thought to be best available approach, more work must be done to explain this concept at general and specific levels. The underlying message of Dan's paper is that the patrimonial theory is only one of the potential explanations of the Scottish trust, and the nature of the trust in Scotland is far from being a closed matter.

The next paper brought about a change of tone. Ms Magdalena Raczynska from Anglia Ruskin University argued that the common law bare trust could be translated into a civilian special patrimony. Several similarities exist between the two concepts. Beneficiary's potential liability for trust debts is one of them. A key feature of the bare trust is that the trustee has no active duties to perform, except that of transferring the trust property at the beneficiary's direction. Since the beneficiary has the right to direct the bare trustee, the former may become liable towards the latter or a third party, based on a principal-agent relationship. In other words, the beneficial owner of trust property held in a bare trust could be liable with all his assets for claims incurred in relation to the trust property. This resembles the civil law scenario where the creditor of a person holding a special patrimony may be paid not only with the assets from the special patrimony but also with assets from that person's general patrimony (e.g. the general and special patrimonies that spouses hold). The civilian concept of special patrimony, however, is heterogeneous, and this may raise obstacles for a comparative lawyer.

Related to the notion of special patrimony, the concept of patrimony by appropriation is another example of a trust-patrimony overlap. Ms Alexandra Popovici, from McGill University and Université Laval, explained how the Quebec trust has been reconceptualised from a sui generis form of ownership, under the reign of the Civil Code of Lower Canada (1866) to a patrimony by appropriation, under the Civil Code of Quebec (1994). Under the latter code, the Quebec trust is conceived as an ownerless patrimony, in which the rights are appropriated to a purpose rather than held by a person. Rights, in other words, are now understood in two different manners: either they are subjective, that is exercised in their holders' own interest, or they are without holder and exercised by a person assigned for that purpose, the trustee. De-coupling rights from holders may have wide-ranging effects. Obligations, for instance, could be understood not as personal relationships but as patrimonial relationships in which the persons involved are just administrators. More importantly, by depersonalising rights and obligations the Civil Code may have stripped the traditional French notion of patrimony from its very essence, turning it into a mere legal universality.

The final presentation of the workshop showed that, despite its difficulties, patrimony may be the future of civilian trusts. Mr Emile Schmieman of the Ministry of Security and Justice of Netherlands discussed the legal, practical and political challenges of introducing a trust in the Netherlands. On the legal side, Emile argued that a trust could be fitted into the existing Dutch legal system by using the model of multiple patrimonies. This model may be the solution for a smooth integration of the trust, since Dutch law already recognizes instances of multiple patrimonies (e.g. in bankruptcy, partnerships or statutory administration of assets).

The workshop raised more questions than it answered. Patrimony may not be the silver bullet after all, and we may be mistaken in trusting patrimonies. But the day was a success for other, more important reasons. First, it showed that there is a vast scholarly appetite for discussing comparative trusts. Second, it drew attention to the fact that more debate is needed to fine-tune the civilian trusts conceptualized as patrimonies. And perhaps more importantly, it brought together lawyers from various walks of life, sharing a passion for the trust. 

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Socially responsible investment at the University of Edinburgh

The University's approach to socially responsible investment was the object of a debate organized on the 3rd of April by EUSA and People & Planet. The discussion focused on the legality and feasibility of disinvesting from companies that are involved in unethical businesses, such as manufacturing of components for military drones, genetically modified foods, or fossil fuel companies. The panellists included Mr Julian Parrot, partner at Ethical Futures (a financial advisers firm specialising in ethical investments), Mrs Catherine Gilfedder, corporate social responsibility advocate at Reprieve (a London-based human rights organisation) and myself. The discussion was chaired by Mr Peter McColl, University Rector.

This debate is part of an ongoing campaign carried by People & Planet in conjunction with EUSA, aiming to steer the University towards a more ethical and sustainable investment strategy. The proposals advanced by the two organisations include the creation of an independent committee that would allow stakeholders throughout the University community to challenge investment decisions, and the right to have an elected student representative who will participate to the investment decision meetings. The campaign has also launched a petition calling for a review of the University's investment strategy. This movement is not without precedent in the University's recent history. In 2004 the University accepted a proposal of disinvestment from the tobacco industry, given the University's role as a major centre of medical research.

Two underlying themes emerged from this debate. On the one hand, there is the students' enthusiastic endorsement of the socially responsible investment / corporate social responsibility movement. There was a strong consensus among the participating students that the University should consider divesting from harmful companies and place its funds in companies involved in socially and environmentally beneficial activities. On the other hand, there are the legal restrictions, which raise difficult questions concerning the compatibility between trustees' duties and socially responsible investment strategies.

Institutional investors are dominant players in today's investor landscape. Their holdings amount to about 80% of the shares of listed UK companies. When organised as registered companies (such as insurance companies), institutional investors have free hand in considering ethical, governance and social (ESG) factors when deciding their investment strategy. Company directors have a duty to consider such factors when deciding how to promote the success of the company for the benefit of its members (s. 172 Companies Act 2006). The case of institutions organised as trusts (such as pension funds or mutual funds), however, is more ambiguous when it comes to ESG considerations. In the (in)famous case of Cowan v. Scargill [1985] Ch 270 at 286 Megarry VC argued that in a trust set up to provide financial benefits for the beneficiaries, the best interests of the beneficiaries are their best financial interests. Trustees of charities may exclude certain investments of questionable ethical nature, if such investments are contrary to the objects of the charity. Nevertheless, trustees must ensure that such exclusion would not create a risk of significant financial detriment (Harries v. Church Commissioners for England [1992] 1 WLR 1241 at 1247, per Nicholls VC).

The effect of screening out tainted investments is the crux of the problem for trustees of institutional investors. The standard investment criteria governing trustees' powers of investment require the creation of a diversified portfolio, with assets whose values fluctuate independently of one another. Screening out non-ethical fields, such as alcohol, tobacco, gambling, or weapons may leave trustees with insufficiently diversified portfolios, or may simply be bad business decisions. After all, ‘sin stocks' such as tobacco or weapons have been among the UK stock market's best performers in the early 2000s. Such stocks tend to generate stable and predictable cash flows and are considered safe investments in declining markets.

Recent developments in the law of fiduciary duties, however, may be a first step towards clarifying the extent of trustees' powers of investment. Following the recommendations of the Kay Review on UK Equity Markets and Long Term Decision Making the Law Commission undertook a review of the fiduciary duties of pension trustees, investment managers and other financial intermediaries with respect to investment decision-making. The terms of reference for this project mandate the Commission to evaluate the extent to which fiduciary duties permit or require such persons to consider, when developing or discharging an investment strategy, the following factors:

(a) factors relevant to long-term investment performance which might not have an immediate financial impact, including questions of sustainability or environmental and social impact;

(b) interests beyond the maximisation of financial return;

(c) generally prevailing ethical standards, and / or the ethical views of their beneficiaries, even where this may not be in the immediate financial interest of those beneficiaries.

The Commission's report, which is due in July 2014, will hopefully bring much needed clarifications for the socially responsible investment movement. Unfortunately, the Commission was empowered to draft a report with recommendations to the Government, but no draft bill adressing directly trustees' right to take into account ESG considerations when deciding on their investment strategy.

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Business Valuation and the Delaware Court of Chancery

Last month we had the pleasure to welcome Moin Yahya as visiting scholar at our law school. Moin is Associate Professor at the University of Alberta Faculty of Law and former Commissioner at the Alberta Utilities Commission. With this occasion, Moin delivered a talk at the Edinburgh Centre for Commercial Law. His talk, entitled "The Law and Economics of the Equity Risk Premium: The Delaware Approach" provided fascinating insights into the process and methods used by the Delaware Court of Chancery in determining the fair value of a company.

The talk outlined recent developments on the appropriate measure of the equity risk premium (ERP), a concept that is central to the valuation of shares. More specifically, Moin discussed the recent case of Global GT LP and Global GT Ltd v. Golden Telecom, Inc., 993 A.2d 497 (Del. Ch. 2010), aff'd, 11 A.3d 214 (Del. 2010), in which the Delaware Court of Chancery replaced the historical market returns method of determining the ERP with the supply-side ERP.

The case concerns an appraisal proceeding under Section 262 of the Delaware General Corporation Law. Section 262 (h) provides that in the event of a merger, a stockholder of a Delaware corporation is entitled to an independent appraisal proceeding regarding the fair value of its outstanding shares. In December 2007, Vimpel-Communications (Vimpel), a major Russian provider of mobile telephone services, acquired Golden Telecom, Inc. (Golden), a Russian-based telecommunications company listed on the NASDAQ, at a price of $105 per share. Global GT LP, a minority shareholder in Golden, filed an appraisal rights claim with the Delaware Court of Chancery, believing that Golden was undervalued in the merger. Vimpel's expert claimed that Golden's value was $139 per share, while Golden's expert valued the company at $88 per share. The court carried an independent determination, and estimated the fair value at $125 per share.

Before commencing its own valuation process, the court had to address whether the merger price itself was an adequate statement of fair value. The court found that it was not, due mainly to the fact that the transaction was not carried at arm's-length. Vimpel's two largest stockholders were also the largest stockholders in Golden. Golden made relevant efforts to ensure that the merger price was fair: it appointed a special committee of independent directors to assess the merger; it obtained a fairness opinion from Credit Suisse stating that the $105 price was fair; it secured the unanimous approval of Golden's board of directors. Nevertheless, the court rejected the view that the merger reflected a market-tested price. 

The Delaware Supreme Court affirmed this view, arguing that "[s]ection 262(h) unambiguously calls upon the Court of Chancery to perform an independent evaluation of ‘fair value' at the time of the transaction" and that "[r]equiring the Court of Chancery to defer -conclusively or presumptively- to the merger price, even in the face of a pristine, unchallenged transactional process, would contravene the unambiguous language of the statute and the reasoned holdings of our precedent."

In the second half of his decision, Vice Chancellor Strine applied the discounted cash flow (DCF) valuation method to determine the value of Golden, the same method used by both parties' experts. Although they used the same method, the experts disagreed on the value of several variables used in calculating a discount rate, including the equity risk premium (ERP), hence the different share values. The Court sided with the Global financial expert on this issue. After surveying the academic debate regarding the most accurate calculation of the ERP, the court refused to adopt "historic ERP", which had been the more commonly used ERP estimate up to that point, and noted that there is solid academic and professional support for the adoption of the "supply-side ERP".

For a non-US lawyer, Vice Chancellor Strine's decision looks like a chapter from a finance textbook, rather than a court decision. Valuation methods appear to be not a matter of law but one of commercial judgment, which courts should be reluctant to review or second-guess. When a court is confronted with issues of valuation, one would expect that the court rely on expert witnesses, drawn from the accountancy profession, rather than carry on its own, independent valuation.

The Delaware Court of Chancery, however, is no ordinary court. It is widely recognized as the US leading business court in terms of volume of business related cases. Its chancellors and vice chancellors have developed substantial expertise in corporate finance, including an ability to assess an expert's methodology and calculations. This explains why the Court of Chancery enjoys great flexibility, and is entitled to great deference, in conducting its independent appraisal of the fair value of a company.

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2nd Edinburgh International Willem C Vis Arbitration Pre-Moot

Over the weekend of 23-24 February 2013 Edinburgh Law School welcomed five guest teams from across the world to a Pre-Moot event in preparation for the prestigious Willem C. Vis International Commercial Arbitration Moot, which will take place in Vienna 22nd-28th March 2013.  This will be the third time Edinburgh Law School has entered the competition, which is now in its 20th year (and the 10th in Hong Kong) and aims to foster practical legal education in international commercial arbitration and international sales law.  Edinburgh is one of 13 UK law schools and the only Scottish one to enter a team this year.

The Pre-Moo saw teams from universities in New Zealand, Sweden, France and Germany join a multinational team of eight Edinburgh LLM students for a weekend of events to practice their performances ahead of the March competition.

The key aim of the Pre-Moot was to provide students with feedback from the profession in an international setting.  Eminent QCs, arbitrators, advocates, solicitors and academics responded to the call to act as Moot arbitrators, as did former Moot participants.  All kindly gave freely of their time and expertise to support the students, some travelling from afar to join in the Edinburgh Pre-Moot.  The list of moot arbitrators comprises many distinguished practitioners; a full list of moot arbitrators is available on the website of the 2nd Edinburgh Pre-Moot at http://www.law.ed.ac.uk/edinburghvismoot/edinburghpremoot201213.aspx.

The high level of participation from the arbitration and legal communities was noted by participants and coaches and helps distinguish the Edinburgh Pre-Moot from competing events.  It is also one of the few ‘Common Law’ Pre-Moots, with many more such events being held in Civil Law countries.

The Pre-Moot was based on the problem for the 20th Vis Moot and consists of arbitration proceedings in a dispute between parties to a contract for the sale of polo shirts governed by the UN Convention on the International Sale of Goods.  The main issue was whether the use of child labour by the seller (but not in the manufacture of the actual shirts in question) constituted a fundamental breach of contract justifying the buyer’s avoidance of the contract.  A secondary issue concerned liquidated damages for alleged late delivery of the shirts which in turn related to an issue as to whether the sale contract had been modified orally.  There was also a conflict of laws issue and an evidentiary one, the latter concerning the admissibility of a witness statement given by an absentee witness.

The Pre-Moot was formally opened by Professor Emeritus Sir David Edward QC (Honorary President, Scottish Arbitration Centre), who welcomed all participants and encouraged students with guidance and advice.  After an induction for arbitrators into the Moot philosophy and practice by Hew Dundas, students pleaded against each other in front of panels of three arbitrators.  After each performance teams received extensive feedback, to enable them to firmly build upon the experience gained.

The atmosphere over the mooting weekend was charged with excitement, enthusiasm and team spirit on all parts and it was rewarding to see how students assimilated the feedback obtained.  Alongside intensive work, arbitrators and teams had time to meet and mingle, whether at the Moot venue, during the Saturday reception at the Playfair Library in Old College, at dinner, or over informal meetings at the Library Bar. 
 
The event was only possible due to the generous support of colleagues throughout the profession.  Our gratitude goes to all Pre-Moot arbitrators for enabling this event and for making it such an outstanding success.  Particular thanks are also due to Hew Dundas for his hands-on support with this event and throughout the years.  We are also very grateful to our sponsors Hogan Lovells International LLP, Terra Firma Chambers, The Scottish Arbitration Centre and Skyscanner.

The date for next year’s Edinburgh Pre-Moot is set for 15th/16th March 2014.   Please save the date. 

Arbitration practitioners or academics with interest in international commercial arbitration and/or international sales law and who would like to be informed/involved in future events and are not yet on our mailing list are encouraged to contact the Edinburgh Vis Moot Organisers.

For further information, including a full list or arbitrators please visit the Edinburgh Vis Moot website http://www.law.ed.ac.uk/edinburghvismoot, or contact Dr Simone Lamont-Black (Simone.Lamont-Black@ed.ac.uk) or Neil Dowers (N.A.Dowers@sms.ed.ac.uk).

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Group companies and agency: The Harbro Group v MHA Auchlochan

The Harbro Group Limited v MHA Auchlochan [2013] CSOH 8, decided earlier this month, provides evidence (if any were needed) of the challenges which the group company structure poses in litigation.  I am grateful to my colleague Dr Dan Carr for bringing this case to my attention. 

The dispute concerned commercial missives to purchase two areas of ground near Lesmahagow.  The purchasers intended to construct a new factory there from which to operate their business, the manufacture, sale and distribution of animal food products.  The sellers of the land were the trustees for the Auchlochan Trust.  The Trust had transferred their assets and liabilities to the defenders.   Certain obligations under the missives were not timeously performed by the Auchlochan Trust, including the dismantling of overhead mains and making up of the access road.  This delayed entry for the pursuers, requiring the pursuers to extend their existing lease and eventually resulting in the cessation of some of their manufacturing.  The action was therefore one of damages for breach of missives, the pursuers seeking to recover both costs related to the extension of the lease and loss of profit through the cessation of manufacturing work. 

So far, so straightforward, except that the lease of the existing premises was held, not by the pursuers, but by a different company, Strathclyde Nutrition Ltd (SNL), a wholly owned subsidiary of the pursuers.  Indeed the manufacturing business seemed to be carried out by SNL too, and SNL earned the profit.  This raised the question of whether the pursuers (the holding company) had actually suffered a loss. 

The pursuers made what seem to this blogger to be confusing averments on the law of agency.  They answered the defenders averments on agency by suggesting that SNL (and another company in the group, HB, who manufactured feed blocks and feed buckets) were acting as agents for the pursuers (para [10]).  However, counsel for the pursuers explained that they were not suggesting that a contract of agency existed (para [23]).  Rather, they used agency averments to “reinforce the de facto control by the pursuers of all the group activities” (para [23]).  The essence of the pursuers' case appeared to be that a holding company can raise an action for losses suffered by its subsidiaries. 

Lord Boyd dealt swiftly with the agency point: “Either the subsidiaries are agents for the pursuers, or they are not” (para [29]).  Not surprisingly he considered the defender’s averments on agency to be irrelevant. 

Lord Boyd allowed the parties a proof before answer.  The defenders had relied on Lord Clyde’s speech in Alfred McAlpine Construction Ltd v Panatown Ltd (2001) A.C. 518 as authority to the effect that one could not sue for another’s losses.  That case is a highly complex one in which the judges took differing approaches.  Lord Boyd hinted at this: “Yet the discussion of the possible exception in building contract cases where there is a group structure in the speeches of their Lordships, seems relevant to the issues in this case, as is the debate on the application of any principles arising in Scotland (see e.g. the article by Professor Joe Thomson, Restitutionary and Performance Damages 2001 SLT 71 and Sheriff J A Taylor in Clark Contracts Ltd v Burrell Company (Construction Management) No 2 Ltd 2003 SLT (Sh Ct) 73)” (para [34]).   

This case report is as interesting for what it doesn’t say as for what it does.  Even though counsel for the pursuers was not seeking to establish agency between the pursuers and SNL, the case provides the opportunity to recap on the principles of creation of agency.  Agency does not require to be formed by a written contract, but rather can arise as an express oral contract or as an implication from the facts.  Where the latter applies, agency is an implied contract between principal and agent.  Relevant averments of fact require to be made to establish this implied contract.  Those averments might describe acts the agent has performed on the principal’s behalf, most obviously the negotiation of a contract but also other commercial activities.  Whatever the activities, they have to create a picture of representative activity on the part of the agent.  The simple connection between a holding and a subsidiary company is not sufficient to create agency.  Indeed, counsel for the defenders cited both Bowstead & Reynolds on Agency, pages 4-18 and Peterson Farms Inc v C & M Farming Ltd ((2004) 1 Lloyd’s Rep 603 per Langley J at para 60) as English authority suggesting that the courts do not look favourably on the existence of a relationship of agency that would circumvent their separate legal personalities (para [20]).  Counsel for the defenders also stated, “like any contract, the existence or otherwise of a contract of agency is not purely a matter of fact, but of fact and law” (para [20]).  

What is (thankfully) missing from the case is any reference to ad hoc agency.  This is an idea which was created by Lord Drummond Young in three cases: Whitbread Group plc v Goldapple Ltd (No 2) (2005 SLT 281); Laurence McIntosh Ltd v Balfour Beatty Group Ltd and the Trustees of the National Library of Scotland ([2006] CSOH 197); and John Stirling t/a M & S Contracts v Westminster Properties Scotland Limited ([2007] CSOH 117).  In these cases, Lord Drummond Young used agency to avoid the consequences of the separate legal personality of companies to reach what he saw as commercially useful results.  Lord Drummond Young offered up his concept for use in group company situations.  He stated in McIntosh (para 16): 

“Within groups of companies, it is relatively common to find one company performing tasks for another company within the group.  This may take many different forms; for present purposes, an example that is relevant is that one company may perform debt collection functions on behalf of other companies within the group.  In such a case, the debts do not become due to the debt-collecting company; they remain due to the original contracting party, but the debt-collecting company acts as an agent for the payment of debts into a bank account in the name of the debt-collecting company; the latter company’s function is merely that of an agent, and the underlying contractual structures are not affected.”

This blogger, in an article published with Niall Whitty, criticised ad hoc agency (‘Payment of another’s debt, unjustified enrichment and ad hoc agency’ (2011) Edin L R 57.  Not only does the concept subvert the separate legal personality of companies, it ignores the rules of creation of agency summarised above.  In the three cases decided by Lord Drummond Young, there was almost no evidence of representative activity on the party of the so-called agent.  Equally, in this case, presumably once again there was no representative activity by the pursuers on behalf of SNL and that may be why the pursuers’ legal team did not seek to establish agency.  Whatever their reasons, it is heartening to see that ad hoc agency is not taking hold. 

We can look forward to the further stages of this case.  The problems caused where loss and the right to sue are split between different entities are very difficult ones.  As such they are also of interest.  Scottish judicial analysis of the concepts discussed by the judges in McAlpine would make interesting reading.  This may provide something for us to look forward to in these dark January days (apart from the Supreme Court decision in Lloyds TSB Foundation for Scotland v Lloyds Banking Group plc). 

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The commercial agent’s duty of good faith: short-changed by the Court of Appeal?

A commercial agent falling within the Commercial Agents (Council Directive) Regulations 1993 owes both a fiduciary duty towards his principal at common law and a duty to act in good faith towards that principal under reg 3(1).  There has been little case law in the UK on the meaning of the statutory duty.  Although, by contrast,  there is a large body of case law on the agent’s fiduciary duty at common law, that duty is often expressed using broad abstract language, making it difficult to apply to concrete situations.  The English Court of Appeal case Crocs Europe BV v Craig Lee Anderson & Anor t/a Spectrum Agencies [2012] EWCA Civ 1400, presented an opportunity to shed light on the meaning of both duties and the effect the agent’s breach has on the agency contract. 

Facts
The dispute centred around a practical joke taken too far.  Employees of the agent were frustrated with the alleged poor service offered by the principal, the manufacturer of the famous crocs shoes.  The agent’s employees created a “Crawl”, i.e. a posting on a website poking fun at this lack of service.  The Crawl was in the form of rolling credits, a spoof of the format used in the Star Wars films.  Unfortunately, the principal did not see the funny side.  Describing the Crawl as “highly derogatory,” the principal treated it as repudiatory conduct on the part of the agent and rescinded the agency contract.  Where the principal has terminated the agency contract because of a default attributable to the agent which would justify immediate termination, no indemnity or compensation is payable to the agent (reg 18, read in conjunction with reg 16).  The agent, not surprisingly, argued that the principal’s identification of the Crawl as repudiatory conduct was nothing other than a veiled attempt to escape from an agency contract which was no longer attractive at the same time avoiding payment of compensation to the agent.  Compensation is, after all, the agent’s entitlement under reg 17.     

Decision at first instance
At first instance judgment was entered by Sir Raymond Jack for the agent, with damages due to be assessed.  Only one point was appealed by the principal, namely that the principal had not been entitled to terminate the contract on the grounds of a repudiatory breach.  The trial judge concluded that a reasonable person would not have concluded that the Crawl showed an intention on the part of the agent not to fulfil the contract (para 42).

Court of Appeal – Defendants’ Submissions
On appeal, the defendants (the principal) argued that reg 3 implied a “condition” into the agency contract.  This is to use the word “condition” as it is understood in English contract law, i.e. as an important contract term, breach of which results in the right to terminate.  It can be contrasted with a warranty, breach of which results only in damages.  This distinction is not part of Scots law where a material breach results in a right to rescind, with non-material breaches resulting in a right to damages only. Scots law has no hierarchy of the importance of contract terms.  The English classification is more complex than has been presented here: innominate terms also exist, but thankfully that class, and indeed the English approach as a whole, need not be analysed here.  If the principal was correct in its assertion that the duty of good faith is a condition, any breach of that duty would result in the principal’s  right to terminate.

The defendant drew interesting analogies in their appeal (the defendant was represented by Fergus Randolph, one of the two authors of the leading English text on commercial agency, The European Law of Commercial Agency, the other author being Jonathan Davey).  The first was with contracts of marine insurance, where they argued that an agency contract was, like a contract of marine insurance, a contract of utmost good faith.  The second was with the duty of trust and confidence which lies at the heart of the employment relationship.  This analogy was supported by the fact that it would be productive of commercial uncertainty if a principal was forced to accept a disloyal agent. 

Court of Appeal – Lord Justice Mummery 
Lord Justice Mummery reviewed the relevant provisions of the Regulations and, in particular, reg 3 which contains the agent’s duty of good faith towards the principal.  He noted that the Regulations did not specify the consequences which flowed from breach of the duty of good faith (para 18).  Rather, reg 6 provides that the law applicable to the contract governs the consequences of breach of the rights and obligations under regs 3 and 4.  Thus, the correct approach is to apply English contract law relating to termination for breach. 

The principal appealed on the basis of both the agent’s duty of good faith under the regulations and the common law fiduciary duty.  Lord Justice Mummery indicated that these duties “co-exist” (para 22).  He noted that, according to Bowstead and Reynolds on Agency, not all breaches of fiduciary duty go to the root of the contract (para 23, referring to this book at para 7-049).  From this he concluded that whether or not a breach was repudiatory “depends, in general, on an objective assessment of all the surrounding circumstances” (para 23).  And, indeed, not all of the agent’s duties are fiduciary in nature (para 24).     

Lord Justice Mummery had no hesitation in rejecting the defendant’s “condition” argument, describing it as suffering from “insuperable difficulties” (para 44).  Reg 3 was not expressed in a way that would suggest an intention to create a condition (para 45).  He emphasised his earlier observations that not all agency duties are fiduciary in nature, and not all breaches of fiduciary duties give rise to a right to rescind.  He indicated that the remedial consequences of breach of fiduciary duty depend “…not only on the nature of the duty owed but also on the factual circumstances in which the particular breach occurred and the intentions of the parties, as expressed or inferred, in relation to the contract” (para 48). 

The analogy with the employee’s duties did not, in Lord Justice Mummery’s opinion, assist the defendant.  He identified a line of employment law cases in which an isolated act of misconduct did not justify termination of the contract (para 49). 

The judge at first instance had, in Lord Justice Mummery’s opinion, used the correct approach which was to judge the seriousness of the agent’s conduct in connection with the Crawl (para 50).  An appeal court could only overturn what was, essentially, an issue of fact if the judge had misdirected himself in law, and there was no evidence to support this conclusion (para 50).  The breach was simply not serious enough to support repudiation: “The Crawl did not in terms disparage the goods to any one (sic).  It referred to the inability of the defendant to meet delivery obligations, a state of affairs that was well known.  The style of the Crawl was obviously jokey, though not everyone might see the joke and though the defendant was not amused.  The circulation of the Crawl was limited and temporary.  The website was soon shut down for other reasons and the Crawl was removed…There was no evidence of harm suffered by the defendant” (para 51).  The breach did not go to the root of the agency, rather it was a “one-off incident that did not involve bad faith on the part of the claimant, was not shown to involve a real risk of harm to the defendant by dissemination to the world at large and did not, when viewed objectively, evince an intention to abandon or to refuse to perform the commercial agency contract” (para 52).  This led him to dismiss the appeal.  

Court of Appeal – Mr Justice Bean
Mr Justice Bean was more persuaded by the analogy with the employee’s duties in the employment contract.  He observed that the agent’s duties were not materially different from the employee’s duties (para 56).  Counsel for the defendant had argued that the agent’s duty was at least as wide as the Malik term.  He referred (at para 56) to the formulation of this implied term in Woods v WM Car Services (Peterborough) Ltd ([1982] ICR 693) and Western Excavating (ECC)Ltd v Sharp ([1978] ICR 221).  This was, in Mr Justice Bean’s opinion, no more than the application to employment contracts of classic principles of general contract law (para 58): “If party A conducts himself in a way which viewed objectively, is likely to destroy or seriously damage the contractual relationship, that amounts to a repudiation of the contract which party B can accept and thus terminate the relationship” (para 58).

The attempts by counsel for the defendant to draw an analogy with shipping law and specifically the obligation to perform timeously were thought to be unhelpful. 

Mr Justice Bean simply agreed with Lord Justice Mummery’s conclusions on the submissions on regulation 3 as a fiduciary duty.        

Although indicating that he thought the breach in question was close to the line between a breach sounding only in damages and one which could be repudiatory in nature, he found no reason to overturn the trial judge’s decision, and dismissed the appeal.  Lord Justice Hughes agreed with both judgments. 

Comment
This is a welcome decision, underlining the fact that not all breaches on the part of the agent necessarily result in termination, and, in the context of commercial agency, the forfeiture by the agent of his rights to either compensation or indemnity.  This must surely be correct.

It is a useful decision for Scots lawyers.  Clearly there are differences in the underlying law of contract in relation to breach in Scotland and England.  Nevertheless, the exercise of examining the breach carried out in the Court of Appeal is highly similar to the one which should be applied in Scotland.  It is a highly factual exercise. 

In other respects one cannot help feeling short-changed by the Court of Appeal’s analysis.  There is no analysis of the meaning of the agent’s fiduciary duty in the context of commercial agency.  There are broad references to “loyalty” but little more. 

There is also a failure to address the manner in which the fiduciary duties at common law interact with the statutory duties of good faith appearing in reg 3.  Randolph and Davey, in The European Law of Commercial Agency (referred to above) concluded that the duties of the commercial agent under reg 3 “essentially mirror the fiduciary duties imposed on the agent by English law” (p. 55).  And yet they later refer to the significant different between the two, i.e. the fact that fiduciary duties require the agent to place the principal’s interests above his own whereas duties of good faith do not impose this very strict requirement (p. 64). It is surely questionable whether there is a mirror-like quality between the two duties.   The need for judicial analysis seems obvious.  They are likely to differ.  In particular, we should understand the duty of good faith imposed by the regulations by reference to the law in other European member states, particularly France and Germany, the acknowledged inspiration for the compensation and indemnity provisions in the Directive.  Where such an exercise of comparison is carried out, the court is more likely to achieve harmonisation, the aim of the Directive.

Finally, I would question Mr Justice Bean’s use of the employment contract as an analogy for the agent’s duty of good faith.  There are sufficient differences between the two types of contract to make such analogies dangerous.  The law is highly protective of employees and rightly so, given that the employee is almost invariably the economically weaker party.  That can be contrasted with the tradition in the UK where agents are economically independent actors.  It is true that the Directive has made a significant inroad into this tradition, extending to agents significant protections on termination of their contracts.  But we are not yet at a stage where an agent can be completely equated with an employee.  Where an employee breaches his duty of trust and confidence, it will indeed be difficult for employer and employee to carry on the employment relationship.  But an agent is in a different position, one step further removed from the principal.  A breach of the fiduciary duty of loyalty is serious, but need not rule out the continuation of the agency contract.  The agent is not in such close proximity to the principal.

Despite these questions, this case is a significant one which should be a point of reference for future cases in Scotland where the question of the commercial agent’s breach of fiduciary or good faith duties arises.       

 

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Illegality in performance of a contract: one of the least satisfactory areas of contract law?

If a contracting party performs an illegal act in the course of performance of a contract, what impact does that conduct have on the availability of remedies for breach of contract?  Can the “innocent” party use that illegality as a defence in order to avoid, for example, payment of damages for breach of contract?  This is the important question considered in the recent English Court of Appeal case, Parkingeye Ltd v Somerfield Stores Ltd [2012] EWCA Civ 1338. 

Facts
The parties had entered into a contract in terms of which P had agreed to provide an automated monitoring and control system for some of the S car parks.  The system read and recorded the vehicle registration numbers and times of entry and departure of vehicles using the car park.  The system was able to determine when a car had overstayed the maximum time permitted for customer use of the car park and therefore when a penalty was due.  P was also responsible for pursuing customers who failed to pay.  This might involve sending out a number of letters to the customer, and in individual cases customers received 4 different letters.  It was the terms of those letters which formed the focus of the dispute.  As further letters were sent to an individual customer, the terms of those letters escalated, becoming more aggressive.  The later letters incorporated a chequered edge in a clear attempt to mimic a police letter and indeed contained falsehoods.  P was entitled to retain the fees levied and so had an incentive to operate the fine system aggressively.  In Sir Robin Jacob’s words, the terms of the later letters were quite “crude and aggressive in fashion” (para 12). 

The contract was to endure for 15 months but was terminated early by S after 5 months.  P raised an action for breach.  S raised the defence of illegality, citing P’s unlawful actions committed in performance of the contract.  At first S alleged that P’s conduct had been both criminal and tortious in nature.  As the case progressed, the allegations of criminal conduct were dropped.  

Decision
First Instance
At first instance the judge indicated that he was not convinced that P intended to perform the contract in an illegal manner.  In fact, he suggested, neither of the individuals managing the two companies had fully appreciated the legal implications of the letters.  The judge awarded P damages of £350,000 for breach of contract by S.  He rejected illegality as a defence although he indicated that he had made a modest discount to the damages to reflect the terms of the third and fourth letters.  On appeal the sole issue before the court was whether S could resist payment of damages on the basis of illegality.     

Court of Appeal – Sir Robin Jacob
In the Court of Appeal Sir Robin Jacob began his substantive analysis by commenting “Illegality and the law of contract is notoriously knotty territory” (para 28).  In his own words he “ducked out of a comprehensive review of the cases” (para 28).  His starting point was two Law Commission papers on the subject, a Consultation Paper from 2009 (No. 189) and a Report from 2010 (No. 230).  A specific point of reference for him in the Law Commission publications was the part on illegality in performance of a contract (paras 3.27 and 3.28 of the Consultation Paper).  Para 3.27 rather depressingly commented that “…the effect of unlawful performance on the parties’ contractual rights is very unclear.”

Counsel for S had argued not only that P had performed the contract in an unlawful way, but also that P had had the intention to perform the contract illegally from the point of formation. As a result, it was argued, the contract was completely unenforceable.  Sir Robin was unconvinced that this was correct, particularly where “the intention was limited to only a partial (and minor on the facts) mode of performance” (para 31). The law is not a “straightjacket” (para 32), in other words not every illegality in performance has this draconian effect.  He rejected too the emphasis on the point of formation as the crucial point at which intention ought to be determined.  To Sir Robin this contract was not intended to be carried out in a wholly illegal manner (para 35), nor was illegal performance an object of the contract or necessary for its performance (para 36). 

In response to Counsel for S’s arguments that P’s intention was imbued by moral turpitude, Sir Robin identified unenforceablity as a disproportionate remedy (para 38).  Although the reference to moral turpitude is reminiscent of the Inner House decision in the famous Scottish case of Cuthbertson v Lowes (1870) 8M 1073, it seems unlikely that it inspired counsel.  Sir Robin was careful to indicate that, in making this decision, he was not exercising a judicial discretion (para 39).  Proportionality is something different: “It involves the assessment of how far refusal of the remedy furthers one or more of the specific policies underlying the defence of illegality” (para 39). 

Sir Robin Jacob rejected S’s entitlement to the illegality defence, Lord Justice Laws agreeing both with this conclusion and Sir Robin's reasons.   

Court of Appeal – Lord Justice Toulson
Referring to Sir Robin Jacob’s description of this area of the law as “knotty”, Lord Justice Toulson raised the stakes: “That is a mild way to describe it.  It is one of the least satisfactory parts of the law of contract” (para 43).  The reason why it is so difficult is because it involves questions of public policy (para 44).  He also acknowledged the difficulties inherent in “weighing” the respective illegalities on the part of the contracting parties:

“But where, as in this case, both parties were complicit in the illegality, denial of one party’s claim on that ground will be to give an unjustified benefit to the other.  The rule that where both parties are equally at fault the defendant should prevail may be right in more serious cases (on the ground that the court should, in effect, wash its hands of the dispute), but may be a disproportionately severe response in less serious cases” (para 45). 

Lord Justice Toulson also referred to the Law Commission work in this area, noting their conclusion on the possible creation of a statutory discretion, i.e. that this “…was not the best solution to the problems of illegality in the law of contract, because of the difficulties which close study showed that such a scheme would itself present” (para 48).  He also noted the relatively high standard that the Law Commission suggested ought to be adopted.  In essence, the Law Commission suggested that the court should identify the policies involved and base their decisions “transparently on these policies” (Consultative Report, para 3.140, quoted by Lord Justice Toulson at para 50):
 
“If this approach were adopted, we consider that the illegality defence would succeed in only the most serious of cases.  That is, we believe that the policy issues underlying the defence would have to be overwhelming before it would be a proportionate response to deny the claimant his or her usual contractual rights” (Consultative Report para 3.141, quoted by Lord Justice Toulson at para 50). 

The Law Commission suggested that “…the courts should consider in each case whether the application of the illegality defence can be justified on the basis of the policies that underlie that defence.  These include: (a) furthering the purpose of the rule which the illegal conduct has infringed; (b) consistency; (c) that the claimant should not profit from his or her own wrong; (d) deterrence; and (e) maintaining the integrity of the legal system.” (para 3.142, quoted by Lord Justice Toulson at para 51.)  Those policies could not be looked at in isolation: “Against those policies must be weighted the legitimate expectation of the claimant that his or her legal rights will be protected.” (para 3.142, quoted by Lord Justice Toulson at para 51).  Whilst endorsing this approach Lord Justice Toulson did not see it as a complete substitute for the rules on illegal contracts developed in the case law (para 53), “…rather that those rules are to be developed and applied with the degree of flexibility necessary to give proper effect to the underlying policy factors” (para 53).  He also recognised the unusual nature of cases of this type:

“In some parts of the law of contract it is necessary in the interests of commercial certainty to have fixed rules, sometimes with exceptions.  But in the area of illegality, experience has shown that it is better to recognise that there may be conflicting considerations and that the rules need to be developed and applied in a way which enables the court to balance them fairly” (para 54). 

In applying the law to the facts of the case, Lord Justice Toulson referred to the seminal case on illegality in performance of a contract, namely St John Shipping Corporation v Joseph Rank Ltd ([1957] 1 QB 267).  A distinction drawn in that case which Lord Justice Toulson supported was between, on the one hand, a party who deliberately sets out to break the law in performance of a contract and, on the other, a person who breaks the law without meaning to do so or in a minor way (para 61).  He quoted Devlin J:

“Persons who deliberately set out to break the law cannot expect to be aided in a court of justice, but it is a different matter when the law is unwittingly broken.  To nullify a bargain in such circumstances frequently means that in a case – perhaps of such triviality no authority would have felt it worthwhile to prosecute – a seller, because he cannot enforce his civil rights, may forfeit a sum vastly in excess of any penalty that a criminal court would impose…” ([1957] 1 QB 267 at 288).

He indicated that Lord Devlin’s decision certainly did not suggest that any element of minor illegality in performance would render a contract unenforceable, the position argued by counsel for S (para 63-64). 

Lord Justice Toulson then proceeded to consider the case under the following headings: object and intent of the claimant; centrality of the illegality; and nature of the illegality.  In relation to the first, he noted that the judge at first instance had decided that P did not have a fixed intention to use letter 3, nor did P appreciate its legally objectionable aspects (para 68).  In relation to the second, he referred again to Devlin J’s decision, in which he had suggested that the a contract might be found unenforceable only where what was prohibited was a contract which had at its centre the prohibited act ([1957] 1 QB 267 at 289, quoted by Lord Justice Toulson at para 70).  By contrast the most important part of the service supplied by P was the installation of the system in 17 car parks, a service which was perfectly lawful.  The misrepresentation in letter 3 was “hardly central to the performance of the contract” (para (71).  Finally, in relation to the nature of the illegality, the only form of illegality at issue here was in tort.  Nor was commission of a tort the object of the contract (para 73).  Given that P had no fixed intention of acting unlawfully and that the illegality was incidental to part of the performance of the contract rather than central to it, Lord Justice Toulson concluded that S’s illegality defence ought to be rejected. 

Analysis
This case usefully illustrates the fact that illegality arguments can be raised where the conduct is minor, and not even criminal in nature.  Here the most serious allegations were the commission of a tort.  “Illegality” does not always mean a breach of the criminal law.  Lesser degrees of culpability can, in theory, have an impact on the availability of normal contract remedies.      

It is questionable whether the first instance judge’s approach of applying a “discount” to damages awarded is a useful one.  It is true that the calculation of damages is an art rather than a science and that the court often has access to different methods of calculation (for example a reliance as opposed to an expectation measure).  Nevertheless, this “discounting” approach has little to commend it.  It might involve the courts having to grade degrees of illegal conduct, something courts have tended to avoid in the past. 

The Court of Appeal is to be commended for its close analysis of and adherence to the approach advocated by the Law Commission.  This is as it should be: recommendations were made by the Law Commission after painstaking scrutiny of this area of the law.  It is heartening to see those recommendations being given such weight. Nevertheless, Lord Justice Toulson, having noted the five policies that the Law Commission had suggested underlie the defence, did not seem to apply them to the facts of the case.  Rather, he adopted three different headings (object and intent; centrality of the illegality and nature of the illegality).  Again, confusion reigns.    

Sir Robin Jacob’s “disproportionality” test deserves further comment.  Is it accurate to describe it as such? To recap, he stated “Proportionality…involves the assessment of how far refusal of the remedy furthers one or more of the specific policies underlying the defence of illegality.”  This is surely less about proportionality, and more simply a policy-based approach.  South African law is a good example of a legal system which adopts a policy based approach: only where non-enforcement of the contract furthers an important policy should the court refuse to enforce the contract (see, for example, Jajbhay v Cassim 1939 AD 537).  To create a new proportionality test only populates this already busy area with one more test.

More broadly the Court of Appeal decision is to be welcomed.  It reminds us of the importance of policy in this area.  It moves us father from a “knee-jerk” response which might dictate, as counsel for S appears to have suggested, that any degree of illegality should lead to non-enforcement of the contract.  This is clearly not correct, and certainly not in a case such as this where the conduct involved was relatively minor.  The fact that this case went as far as the Court of Appeal suggests that parties continue to consider it worth trying to use the illegality defence even where the conduct in question is minor in nature.  Perhaps the clear statements made by the judges might act as a disincentive to such an approach in the future.  Finally, the  case reminds us how many factors are potentially relevant in a case of illegality.  In such a “knotty” area, simplification seems unlikely.      
 

                    

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