The Game Group Plc v The Electronic Boutique Incorporated & Anor

This appeal raises a short but difficult issue on the construction of one clause in a Services Agreement, made between the Claimant (“EBUK”) and the First Defendant (“EBI”), dated 13^th October 1995. (I use the abbreviations adopted by the judge.)

EBUK is a public company limited by shares incorporated in England and Wales. EBI is a corporation incorporated under the laws of the Commonwealth of Pennsylvania, USA. They are and were both involved in the business of retailing computer video games and related products. The Second Defendant (“EBS”) is a limited liability partnership formed in January 1997 pursuant to a limited liability partnership agreement under the laws of Pennsylvania, USA.

In early 1995, EBUK was experiencing trading and financial difficulties. Mr James Kim, the owner of EBI, decided to invest in EBUK. Accordingly he procured, in April 1995, that EBI subscribe for 25.2 million shares in EBUK representing 17.9% of its issued share capital, being the shares not taken up in a rights issue made by EBUK. As the judge found, EBUK “was at that stage wholly dependent on Mr Kim…” Mr Kim also gave other financial assistance, including a £5m on loan from EBI to EBUK.

By the time of the Services Agreement EBI had acquired a further 17 million shares in EBUK, and had a total of 25.1% of EBUK. EBI thus became the largest shareholder in EBUK. It also had significant board representation, having three out of seven directors before the Services Agreement and four out of nine after the Services Agreement. This non-majority status was a Stock Exchange requirement.

The Judge made the following findings as to the ownership of EBI at the time of the services agreement:

“(9.) As at 13^th October 1995 EBI was authorised to issue 5,000 shares of Class A $0.10 voting common stock, 25,000 Class B non-voting $0.10 common stock and 200,000 share of $100 Preferred Stock. The issued share capital of EBI was $2,290 divided into 1,900 voting Class A shares of $0.10 each and 21,000 non-voting Class B shares of $0.10 each, all of which were owned by the Kim family.

(10.) EBI’s directors at the time were Mr Kim, his wife Agnes Kim, and his daughter Susan Kim. The officers of EBI were Mr Firestone, Jeff Griffiths and John Panichello (Mr Kim’s son-in-law). As at 13^th October 1995 EBI was wholly owned and controlled by Mr Kim and his family interests.”

The structure of EBI at the time of the agreement is shown in diagrammatic form in a chart (“Structure Chart II”), which was agreed by the parties and is appended to this judgment.

The Services Agreement, according to the preamble, was intended to set out the terms on which EBI were to provide “certain management and other services” to EBUK, in connection with what were called Future Zone Stores. The services were set out in a schedule. They included the provision of such things as advice and assistance in the design of retail outlets, the training of staff, advertising and so on. There was an initial period from 1^st July 1995 to 31^st January 1996, following which the agreement was to continue for a period which at the earliest would end on 31^st January 2006. The nature of the services and the terms of the agreement generally are not material. It appears that whatever services were provided in the earlier stages, EBUK’s position, as the Judge found, is that “it would wish to rid itself of the services now if it could do so, as it has outgrown the need for such services.” During the course of the agreement payments have been made by EBUK in excess of £16m.

The issue before us relates solely to the construction of certain parts of Clause 14, which provides for termination. The relevant parts are as follows:

“14.

Termination

This Agreement may be terminated:-

14.1

at any time by EBI by written notice if:-

….

(d)

control of Rhino passes from the persons who at the date hereof exercise such control provided that for the purposes of this Clause control shall mean either ownership of more than fifty percent of the issued share capital of Rhino or any holding company of Rhino or the right to direct the policies and affairs of Rhino whether by statute, contract, governmental decree or regulation, ownership of voting capital or otherwise; or

……

14.2

at any time by Rhino by written notice if:-

…

(b)

any analogous events to those described at 14.1 above occur under the law of the United States of America or any relevant State thereof in relation to EBI;…”.

The Judge heard evidence and made certain findings about the thinking of the respective parties in relation to this clause. However, he concluded that this evidence was of doubtful relevance as a matter of law, and of little assistance in any event in construing the clause. I agree.

The circumstances on which EBUK now rely to justify terminating the agreement under this clause began with changes in the structure of Mr Kim’s organisations made in 1997, apparently as part of a tax-saving scheme. This involved the formation of a limited liability partnership under Pennsylvania law. There was an agreed statement between Pennsylvania law experts as to the effect of these arrangements under that legal system. The new entity, as well as being a limited liability partnership, had characteristics similar to those of a limited partnership under English law. The Judge described the effect of the agreed statement as follows:

“(46.)…. The partnership in question is a limited liability partnership. That means that a limited partner is not liable solely by reason of being a limited partner for liabilities of any kind or for acts of any partner, agent or employee of the limited partnership. In contrast, a general partner in a limited partnership usually has the same rights and powers and is subject to the same liabilities as a partner in a General Partnership, which makes him liable for all obligations of the partnership incurred in the ordinary course of his business. However, a limited liability partnership reduces the general partner’s exposure to liability for debts and obligations of the partnership that arise from negligent or wrongful acts of misconduct in which the general partner was not involved.”

In this case the new entity, referred to in the judgment as “EBS”, was formed in January 1997 under a limited liability partnership agreement. The parties to that agreement were the general partner (“EBS Corp”) and various trustees of Kim family trusts as limited partners. 99% of the new entity was owned by the limited partners and 1% by the general partner. The sole shareholder of the general partner was and is Mr Kim. By an agreement dated 1^st February 1997 between EBI and EBS, EBI assigned to EBS the rights and obligations under a number of contracts including the service agreement in this case. The prior consent of EBUK was obtained to that assignment, and at the same time EBUK obtained a guarantee from EBI in respect of EBS’s obligations. It was common ground that, under English law, the effect of the assignment was a novation of the Services Agreement, so as to take effect as a new agreement between EBUK and EBS, but otherwise subject to the same incidents.

There were further stages of re-organisation on the EBI side. The Judge summarised them as follows:

“(42.) By an agreement to consent to assignment and an assumption of partnership interest dated 13 July 1998 (‘the EBS Assignment’), the ownership of EBS was re-organised in the following way. First, the Kim Trusts transferred their limited partner interests to EBHC and those limited partner interests were subsequently transferred to EB Investments Corp (‘EB Invest’) and finally to Electronic Boutiques of America Inc (‘EBOA’). Second, the General Partner transferred 99% of its 1% General Partner interest also to EBHC and that interest was subsequently also transferred to EB Invest and EBOA.

(43.) Third, pursuant to the express terms of Section 9.3 of the LLP Agreement, EBHC did not become a general partner in connection with its acquisition of the 99% of the General Partner interest of the General Partner. Instead, the interest thereby acquired was transformed into a limited partner interest. Currently, EBS is owned as to 0.01% by the General Partner, and as to 99.99% by its sole limited partner, EBOA

(44.) In 1998, 1999 and 2001, EBHC conducted a series of public offerings of its stock which resulted in the ownership interest of the Kim family in EBHC being reduced from 100% to 46.1%. I note that the last transaction which took the holding below 50% was that in August 2001.”

The new structure following these changes was set out in Structure Chart 2, reproduced at the end of this judgment.

For present purposes, it is enough to note that, whereas at the time of the 1997 novation, the Kim family owned effectively the whole of the beneficial interest in EBS, after the re-structuring it had fallen to below 50%. Mr Kim, however, by virtue of his ownership of the general partner, retained “the right to direct the policies and affairs” of EBS. The short question is whether this change triggers the right of EBUK to terminate the agreement under clause 14.2. Mr Crane, for the claimants says yes, because it is sufficient if either of the events comprised in the definition of “control” occurs. Mr Briggs, for the defendants says no, because the Kims retain control within the second part of the definition.

The Judge agreed with the defendants. He started by considering the application of the clause to EBUK:

“(68.) The starting point is therefore Clause 14.1(d). It is designed as I have said to provide a mechanism when change of control occurs. It follows from that for the clause to operate there must be controller A and subsequent events which means that controller A is no longer the controller but B is.

(69.) The clause is designed to operate when there is a ‘passage of control’

(70.) The clause provides its own definition of control and there is no basis for departing from that definition as regards EBUK. Control means either the ownership of all 50% of the issued share capital or of EBUK or any holding company or the right to direct the policies and affairs of EBUK whether by statute, contract, governmental degree or regulation ownership, ownership of voting capital, or otherwise. …

(74.) It seems to me that the purpose of the definition of control is to provide a defined definition of control so as to enable the controller to be found. Once that controller is found, if as a result of an event, the control passes to somebody else who then on the application of those criteria satisfies them, there has been a transfer of control and a triggering.

(75.) This covers all situations, in my judgment. The first question to be asked is whether or not a person holds 50% of the shares. If such a person is found, that person can be the controller. If there is no other relevant factor, that is the end of the enquiry. However, if somebody holds more than 50% of the shares, but there is some other arrangement in place which means that a different person is entitled to direct the affairs of the company, that person is the controller. …”

Turning to the position under clause 14.2, he accepted the expert evidence that the beneficial interest of the limited partners in EBS was analogous to a shareholding in a company. On the other hand, the right to direct EBS, within the meaning of the second part of the definition of control, was vested in the general partner and therefore remained under the control of Mr Kim (paras 96-7). Accordingly, applying the analogy of this construction of clause 14.2(d) he held that control at the time of the novation rested with the general partner and remained there, regardless of the change in beneficial ownership of the interests of the limited partners.

Both sides developed their submissions at impressive length. There was also discussion of how the clause would operate in various hypothetical situations. However, I see the point as a very short one depending on the wording of the clause seen in its context and against the background facts as known to the parties. I do not find it helpful to speculate as to how it might apply in circumstances which are not before the Court. No-one suggests that the clause is a model of draftsmanship; accordingly, the fact that a particular reading may not cater satisfactorily for every hypothetical state of affairs is unsurprising. It tells one very little about how it should apply in the real set of circumstances with which the court is faced.

As to the correct approach to construction, it is particularly appropriate at the present time to quote with great respect the words of Lord Wilberforce in Reardon Smith Line Limited v Yngvar Hansen-Tangen [1976] 1WLR 989.

“No contracts are made in a vacuum: there is always a setting in which they have to be placed. The nature of what is legitimate to have regard to is usually described as “the surrounding circumstances” but this phrase is imprecise: it can be illustrated but hardly defined. In a commercial contract it is certainly right that the court should know the commercial purpose of the contract and this in turn presupposes knowledge of the genesis of the transaction, the background, the context, the market in which the parties are operating.” (pp.995H to 996A)

“…what the court must do must be to place itself in thought in the same factual matrix as that in which the parties were. All of these opinions seem to me implicitly to recognize that, in the search for the relevant background, there may be facts which form part of the circumstances in which the parties contract in which one, or both, may taken no particular interest, their minds being addressed to or concentrated on other facts so that if asked they would assert that they did not have these facts in the forefront of their mind, but that will not prevent those facts from forming part of an objective setting in which the contract is to be construed.” (p.997 C to D).

With that guidance in mind, it seems to me that there are three particular features which deserve comment. First, the clause offers “reciprocity” (as it was put in argument) between the two parties. The provisions applied to EBS are intended apparently to mirror those applicable to EBUK. One would expect therefore to find that the clause is capable of applying to both. This leads on to the second point, which is that in relation to EBUK there is, at first sight, no-one “in control”, within the definition. No single interest group owned 50% of its issued shares, and no-one, other than the general body of shareholders, had the right to direct its policies. Even EBI’s 25% interest in EBUK did not amount to “control” within the definition. In these circumstances, both parties, as I understood them, accepted that one has to read the first part of the definition of control as including ownership by the general body of shareholders.

The third point relates to the dual test for control, one limb of which depends on ownership of more than half the issued capital, without regard to voting rights. Such a dichotomy was a familiar feature of the definition of holding and subsidiary companies under the Companies Act 1985, before the changes made by the Companies Act 1989. Thus section 736 in its original form reads as follows:

“(1)

For the purposes of this Act, a company is deemed to be a subsidiary of another if (but only if)-

(a)

that other either -

(i)

is a member of it and controls the composition of its board of directors, or

(ii)

holds more than half in nominal value of its equity share capital, or

(b)

the first-mentioned company is a subsidiary of any company which is that other’s subsidiary.

…

(2)

For purposes of subsection (1), the composition of a company’s board of directors is deemed to be controlled by another company if (but only if) that other company by the exercise of some power exercisable by it without the consent or concurrence of any other person can appoint or remove the holders of all or a majority of the directorships.”

The 1989 Act varied this by introducing a test related to voting rights. (This accorded with the definitions of “Parent and subsidiary undertakings” in s 258, for the purpose of the new Part VII of the 1985 Act, introduced following the European Seventh Company Law Directive on Company Accounts). The revised version of section 736 provides:

“(1)

A company is a “subsidiary” of another company, its “holding company”, if that other company-

(a)

holds a majority of the voting rights in it, or

(b)

is a member of it and has the right to appoint or remove a majority of its board of directors, or

(c)

is a member of it and controls alone, pursuant to an agreement with other shareholders or members, a majority of the voting rights in it,

or if it is a subsidiary of a company which is itself a subsidiary of that other company.”

Echoes of the old definition linger on in parts of the 1985 Act, for example in the definition of “control” by a director (s 346(5)).

I am not prepared to assume, as was suggested in argument, that the form of the clause was simply the result of the careless downloading of a standard clause from the precedent files of one or other of the distinguished solicitors involved. It is noteworthy that, in the Services Agreement, the 1989 form of definition is in fact adopted by in the definition of “subsidiary undertaking”, following 1985 Act s 258, for example in describing the services to be provided by “EBI and its subsidiary undertakings” (see cl 1.1, and Schedule). However, the reasons for reverting to the 1985 form in clause 14 are not clear.

Against this background one turns to the wording of the clause. Mr Crane’s approach can be illustrated attractively, by simply substituting for the word “control” at the beginning of clause 14.1(d) the words of the definition. Thus, the right to give notice would be triggered where “control” - that is, either ownership of more than 50% of the issued shares, or the right to direct the policies of EBUK - passes from those previously in control. On this footing it is sufficient that the Kims’ shareholding fell below 50% even if they retained effective control in other ways.

In my view, however, this gives insufficient effect to the words “passes from the persons who at the date hereof exercise such control”. Logically the question posed by these words comes first in time, since they describe the state of affairs to be contrasted with that following the “passing”. Furthermore, the use of the definite article “the persons” implies that there is someone at the date of the agreement, who is exercising control in the defined sense.

Thus, I would put the question the other way round. In simple terms, the question is whether the person who was (at the date of the novation) “exercising control” in one or other of the defined ways, was still exercising control after the changes. As I have said, in relation to EBUK, it seems to be common ground that this can only mean the general body of shareholders. They exercise control by virtue of the fact that they own more than 50% of the issued shares, and there is no-one who has a right to direct the policies of EBUK under the second part of the definition. That position has remained unchanged, and it is unnecessary to speculate as to the precise circumstances in which there might be a change.

In relation to EBI the position is also reasonably clear. At the date of the agreement EBI was controlled by the Kim family by virtue of both parts of the definition. That remained the case on the novation in relation to EBS. It remains the position today by virtue of their control of the general partner, even though they no longer retain 51% of the beneficial interest.

Mr Crane said that at the time of the Service Agreement Mr Kim was seen as the creator and financial mainstay of EBI, and that would explain a requirement that he should retain a minimum equity participation in the service provider. The Judge rejected that suggestion (para 26), because there was no reference to financial commitment in clause 14; if that had been at the forefront of EBUK’s thinking, one would have expected to find some protection against the possibility of Mr Kim procuring EBI to dispose of its large shareholding in EBUK Although evidence as to EBUK’s actual thinking is not relevant to the issue of construction, I agree with the Judge that there is nothing in the wording of the clause which suggests that financial protection was the explanation of the ownership criterion.

Accordingly I would uphold the Judge’s conclusion. I am comforted that this also accords with the merits of the position. There seems to be no evidence that EBUK’s position has been prejudiced in any way by the changes on the EBI side. If the contract had been held to give them a right to terminate the payments in the present circumstances, it would have been a windfall not anticipated by either party when the agreement was entered into.

For these reasons I would dismiss this appeal.

I agree.

I also agree.