Case report Shepherds Investments Ltd v Walters - Essex Court ...

CASE REPORTCase reportShepherds Investments Ltd v WaltersEdward Brown: EssexCourt ChambersIn the recent decision inShepherds Investments Ltd vWalters, Etherton J, sitting inthe Chancery division, set outa broad new approach to thepermissibility of employeestaking “preparatory steps” tosetup in competition withtheir employer. EdwardBrown reportsThe factsThe defendants in the case were all former directors orsenior employees of Shepherds, an investment fund thattraded in individual life insurance policies. It made its profit byjudging which policies would accrue earliest (by reason of thebeneficiary deceasing) and assessing their correspondingvalue.As is normal at such a company, Shepherds relied primarilyupon the skills and experience of its traders. As is also thecustom, Shepherds sought to secure its employees’ loyaltywith high salaries and appropriately worded restrictions intheir contracts of employment.Two of the three defendants owed fiduciary duties asdirectors, irrespective of the terms of their contracts ofemployment. In respect of the single defendant who was notformally a director, the judge noted that in appropriatecircumstances, a senior employee could owe fiduciary duties(Nottingham University v Fishel). However, the judge had littledifficulty in finding that this defendant owed equivalentfiduciary duties, having held himself out as a director in fact(Re Hydrodam (Corby) Ltd).Against this background, the defendants, while still inemployment and without authorisation from Shepherds,began discussing the creation of a new investment fund tocompete in the traded life policy market. The new teamdistinguished itself from Shepherds by intending to focus upona slightly different section of the market (the “whole”, ratherthan the “fractionalised” life policy market). These discussionsresulted in a draft business plan, emphasising the new team’sexperience and including significant improvements that, intheir view, could be made to the “Shepherds model”. Thedefendants also developed possible links with banks andauditors for the future transactions and prepared financialpredictions for the first few years of trading. In short, much ofthe groundwork for the future business was in place by thetime some (but not all) of the defendants came to resignformally from Shepherds.Following the resignations of two of the three defendants,the new fund was formally incorporated, and various bankingand auditing formalities concluded. Promotional literaturewas ordered and shortly thereafter the first transactions tookplace. Soon after that, Shepherds itself decided to move intothe whole life policy market and began trading. Upondiscovering the extent of the new team’s activities, Shepherdsbrought claims against its former employees for breach offiduciary duty, and in contract for breach of expresscontractual terms and the implied term of fidelity.“Preparatory steps” to competeIn his decision, Etherton J came down firmly on the side ofthe company, finding the defendants to have breached boththeir fiduciary and contractual duties. He held that the stepstaken crossed the line between legitimate entrepreneurialactivities and illegitimate competition. The significance of thedecision lies in the judge’s assessment as to where that lineshould properly be drawn.The previous authoritiesPreviously, the courts had permitted preliminary steps thatfell short of actual competitive activities. Accordingly, in a lineof cases beginning with Balston v Headline Filters, judicial policyprotected fiduciaries who began setting up a competitorcompany while still in employment, providing it only begantrading post-employment (and post-expiration of anyreasonable and necessary restrictive covenants).Identification of premises and the negotiation of a lease;the purchase of an off-the-shelf company; and tendering forcontracts all constituted permissible steps. Such a dividingline was upheld in the subsequent decisions of FramlingtonGroup v Anderson and Coleman v Oakes, in which Balston wascited and approved.However, the Balston approach sat uneasily withsubsequent decisions regarding the obligation of a fiduciary toreport his own competitive activities to his employer. InBritish Midland Tool Ltd v Midland International Tooling Ltd, Hart Jconsidered it a “simple proposition” that a director shouldreport any “nascent commercial threat” to the company,particularly where he was personally involved.The judge considered this duty to arise both from hisposition as a fiduciary, and by reason of the implied term offidelity (see Hivac Ltd v Park Royal Scientific Instruments Ltd[1946] 1 All ER 350).In Item Software (UK) Ltd v Fassihi, the Court of Appeal heldthat it was incumbent upon a fiduciary to disclose his ownparticipation in the setting up of a rival company as suchactivities did not constitute legitimate entrepreneurialactivities.156ELA Briefing Volume 13 Number 10 December 2006

CASE REPORT SHEPHERDS INVESTMENTS LTD V WALTERSThe new approachEtherton J’s decision casts significant doubt on thecorrectness of the Balston line of authorities. He held thatwhere a conflict arose between the duty of the director to hiscompany and the policy concern of restraint of trade, therecould be no suggestion that the policy “trumped” thedirector’s duty. Insofar as there was any conflict betweenBalston and British Midland Tools, the judge held that the BritishMidland Tools approach was to be preferred (paragraph 105).The judge further held that whether any particular act waspermissible depended on the facts of the case. Althoughdiscussing an idea with friends and family would be fine,poaching of customers clearly crossed the line. Acts betweenthese two ends of the spectrum were a matter fordetermination by the judge in the case. The crux waswhether an irrevocable intention had been formed by theperformance of a particular act.Significantly, Etherton J also held that the same actsconstituted a breach of the implied term of fidelity (paragraph129). This finding therefore holds mere employees andfiduciaries to the same standard in respect of any preparatoryacts. In most instances, it will be of little relief to a mereemployee that the employer’s remedies would be limited todamages and not an account of profits in such circumstances.Permissible acts post-ShepherdsEtherton J’s analysis and findings of fact suggest that the scopeof permissible acts is remarkably limited. Although heexpressly considered it permissible to formulate an intentionto leave employment at some point in the future and todiscuss potential projects with family and friends, the judgeleft virtually any further act liable to cross the line. Inparticular, the following acts can no longer be considered safein light of the decision:●●●●●●identifying suitable premises for the new business, andnegotiating a lease and signing it (Balston v HeadlineFilters);purchasing an off-the-shelf company (Balston v HeadlineFilters);negotiating and agreeing terms of employment with acompeting business (Framlington Group v Anderson)encouraging (or even failing to act to thwart) therecruitment of employees by a competitor (BritishMidland Tool Ltd v Midland International Tooling Ltd)preparing a company for incorporation (ShepherdsInvestments Ltd v Walters)contacting investment banks for support several monthsprior to the commencement of trading (ShepherdsInvestments Ltd v Walters)● contacting lawyers with details of the proposals(Shepherds Investments Ltd v Walters).Inevitably, the weight given to any one act will be aquestion of fact and degree, depending on the circumstancesof the case. The focus of the court’s attention will be on theextent to which any one act constitutes evidence of a settledintention. Clearly, the existence of several acts will strengthenthe case against an alleged wrongdoer. However, no guidancewas given in Shepherds as to whether any acts might have thestatus of aggravating factors and this may fall to be decided byfuture courts.The specific problem facing legal advisersThe comments made in Shepherds in relation to contact withlawyers are significant. In particular, lawyers should be awarethat their own legal advice may, unwittingly, cause a client tocross the line. Further, it may not be safe for lawyers toassume that any such contact would be covered by legalprofessional privilege.Although the judge did not expand beyond the generalcomment that consulting lawyers may cross the line, adistinction can be drawn between two broad situations:● first, if a client approaches his or her solicitors seekingadvice about the legal implications of a proposed courseof conduct, such a step cannot have been intended toconstitute a breach of duty. It is clearly in the publicinterest that individuals are able to establish the extentof their legal obligations and the implications of anywrongdoing; nothing in Shepherds should be taken assuggesting otherwise. As such, any advice given bysolicitors in this respect would be covered by LPP● secondly, if a client approaches his or her solicitorsseeking assistance in relation to the implementation of aproposal, he or she may, at that stage, have crossed theline. Legal teams are placed in an invidious position whencontacted out of the blue by a client to discuss proposalsthat are sufficiently advanced. By agreeing to a meeting,advisers may unwittingly cause clients to cross the line.Any active participation by lawyers in furthering theclients’ objectives may not necessarily be privileged, onthe ground that privilege cannot be used as a cloak foriniquity. Again, this will depend on the circumstances ofthe case. In any event, even if a client does have adishonest (or even fraudulent) intention, it will notalways follow that the proposed conduct would beregarded as iniquitous by the court. It is likely thereforethat privilege will only be lost in rare cases, if at all.ConclusionThe decision has significant implications for both directorsand employees, and those advising them. The message isELA Briefing Volume 13 Number 10 December 2006 157

CASE REPORT SHEPHERDS INVESTMENTS LTD V WALTERSclear: if a client has formulated an irrevocable intention tocompete and wishes to avoid liability, he or she must usuallybe advised to resign. Obviously, a remedy in damages maysurvive if the employee’s activities are in breach of any postterminationrestrictive covenants. Those acting as legaladvisers must consider their own role as advisers in any suchcompetitive activity, insofar as they assist a client’s wrongfulacts and cause him or her to incur further liability.The decision also does little for the common law’straditional objective of keeping potential restraints of tradewithin reasonable bounds. As Arden LJ commented in ItemSoftware v Fassihi (paragraph 63), an overly intrusive approachto the law would discourage legitimate entrepreneurialactivity and would not be a beneficial outcome. The linedrawn in Shepherds offers scant protection for employeescontemplating the establishment of a competitor company,who fail to resign at an early date. Accordingly,entrepreneurial activities by employees in the same sector astheir existing employment (which may well be the only sectorthey know) are now strongly discouraged.Edward Brown, Essex Court ChambersCases referred to:Shepherds Investments Limited v Walters [2006] EWHC 836 (Ch)Nottingham University v Fishel [2000] IRLR 471Item Software (UK) Ltd v Fassihi [2004] EWCA Civ. 1244; [2005] ICR 450Re Hydrodam (Corby) Ltd [1994] 2 BCLC 180Balston v Headline Filters [1990] FSR 385British Midland Tool Ltd v Midland International Tooling Ltd [2003] EWHC466; [2003] 2 BCLC 523Framlington Group v Anderson (1995) 1 BCLC 475.Coleman v Oakes [2001] 2 BCLC 749.Hivac Ltd v Park Royal Scientific Instruments Ltd [1946] 1 All ER 350158ELA Briefing Volume 13 Number 10 December 2006