Lessons for investors when starting out with a joint venture

In the excitement of starting a joint venture or deciding to invest in a new company, don’t overlook the importance of turning any verbal agreement into a written contract. Not only that, but advice should be taken on the terms of that contract. 

The Court of Appeal has just issued its judgment in Broadcasting Investment Group Ltd v Smith [2021] EWCA Civ 91 which highlights the perils of not putting a contract into writing. It also touches on areas of law that business people may not be aware of, such as the Contracts (Rights of Third Parties) Act 1999 (Third Party Rights Act or TPRA) which operates to give third parties rights under the contract (even if they are not parties to it). The case also highlights the so-called “rule in Prudential” which means that a shareholder cannot recover for a drop in the value of his or her shares if that loss merely reflects loss suffered by the company.

What happened in this case?

The claimants in this case, Broadcasting Investment Group Ltd (BIG) and its majority indirect shareholder Mr Burgess (B), brought claims against Mr Smith (S) for both damages and specific performance of an alleged verbal joint venture agreement. Under the verbal agreement, S incorporated a new holding company, JVCo, in which BIG agreed to subscribe for shares (together with S and other external investors), and S agreed to transfer the share capital of two companies with existing businesses (OpCos) to JVCo. S failed to transfer the shares of OpCos, as promised.

Who could bring a claim? BIG sought to enforce the agreement on the basis that failure to transfer the OpCos to JVCo reduced JVCo’s value, thus causing BIG to suffer loss due to the diminution in value of its shareholding and loss of dividends. B brought equivalent claims in his capacity as ultimate beneficial owner of BIG. JVCo also had a right to enforce the agreement, under section 1 of the Third Party Rights Act because, in providing that the OpCos should be transferred to it once incorporated, the agreement conferred a benefit on JVCo.

So JVCo had rights under a verbal agreement, even though it was not party to it?

Yes. Broadly, the Third Party Rights Act (which can be excluded in a written contract) gives rights to third parties to enforce the terms of the contract if that contract purports to confer a benefit on it.  Here, JVCo was entitled to the benefit of the promise by S to procure the transfer of the shares in the two OpCos to JVCo. The judge held at first instance that JVCo was entitled to enforce the agreement under the Third Party Rights Act, even though it had not signed a written contract. 

Judgment in the High Court

Having held that JVCo had rights under the TPRA, the court next considered the Prudential rule, as most recently explained by the Supreme Court in Marex Financial LTd v Sevilleja [2019] QB 173, and analysed its interplay with the Third Party Rights Act. The Prudential rule bars a shareholder from recovering loss in respect of the value of its shares where that loss is simply reflective of the company’s loss.  In the High Court, BIG (as a direct shareholder in JVCo) was prevented from bringing its claim because the court held that it fell within the scope of the Prudential rule. However, B, BIG’s majority indirect shareholder, did not have his claim barred because the court held (following the Supreme Court in Marex) that the Prudential reflective loss principle only applies to a direct shareholder.

Judgment in the Court of Appeal

The Court of Appeal overturned the High Court decision for the following reasons:

• On the interplay between JVCo’s rights and BIG being a promisee under the agreement (thus having rights to sue for damages / specific performance based on breach of contract) the proper interpretation of the TPRA was that the acquisition of enforcement rights by JVCo could not extinguish BIG’s right to enforce the agreement as promisee
• Section 4 of the TPRA provides that a right conferred on a third party under section 1 of that Act “does not affect any right of the promisee to enforce any term of the contract”. So the rights conferred on third parties under section 1 of the TPRA were in addition to the right of BIG to enforce the contract
• It disagreed with the view of the High Court that section 4 was subject to “generally applicable legal principles including (where applicable) the rule in Prudential”. In the Court of Appeal’s view, such an approach was contrary to section 4 and would defeat the purpose of that section. BIG’s claims under the contract were not barred by the rule in Prudential; in fact the correct approach was to recognise that they were expressly protected by section 4 of the TPRA

Comment

While complex areas of law such as the Prudential rule against reflective loss may keep lawyers busy, they are not something that you would wish to bump into inadvertently. Nor is it a good idea to reach an agreement without considering the TPRA, because you may inadvertently give someone rights to enforce a term of your contract even though they are not a party. The parties in this case might have avoided the costs of litigation by:

• Making sure that their agreement was recorded in writing. A verbal contract is enforceable, but there will be inevitable uncertainty about what the terms of that contract are
• Discussing the application of the TPRA and whether to exclude it in a written contract. It was made clear by Mr Simmonds QC (sitting as a deputy High Court judge at first instance) that JVCo was entitled to enforce a term of the oral joint venture agreement by virtue of the TPRA, and he observed that the word “contract” was not defined in the TPRA and so included both written and oral contracts
• Being clear as to which companies and individuals were intended to have rights, and what happens if they have rights to recover in respect of the same damage. Where a company suffers a loss and has the right to sue for damages to recover that loss under a contract, the rule in Prudential may prevent one or more shareholders from making a claim to recover their losses if those losses are simply reflective of the company’s loss

If you are a current or prospective shareholder and are contemplating a joint venture investment scenario, or you need advice on claims you may have in relation to a current investment, please contact Jenny Robertson.