The High Court had to decide whether the valuation of shares under a call option should take into account restrictions that would apply to the company's business if the option were exercised.
If the option were exercised, the company would come under the control of a regulated entity for the purposes of U.S. regulations. In that scenario, the company would not be able to pursue an expansion of its existing business lines into the United States.
The judge found that, based on the wording of the contract, these regulatory restrictions needed to be disregarded when valuing the company (and, therefore, the shares under the call option) for the purposes of the option price.
What happened?
J.P. Morgan International Finance Ltd v WEREALIZE.COM Ltd [2024] EWHC 1437 (Comm) concerned a company – Viva – whose business was to provide financial and payment system solutions.
51.49% of the shares in Viva were held by WEREALIZE.COM (WRL) and the remaining 48.51% were held by JP Morgan (JPM).
WRL and JPM had entered into a shareholders' agreement which contained (among other things) call option arrangements. Broadly speaking, under those arrangements:
- JPM had the option, over a four-year period, to acquire WRL's shares in Viva (and so acquire complete ownership and control of Viva); and
- if JPM did not exercise its option within that four-year period, WRL had the option to acquire JPM's shares in Viva (and so, similarly, acquire complete ownership and control of Viva).
In both cases, the price payable under the option was to be based on a valuation of Viva. The contract specified that the same valuation mechanism and principles would apply both to an acquisition by JPM of WRL's shares in Viva and to an acquisition by WRL of JPM's shares in Viva.
Among other things, the contract contained the following stipulations for valuing Viva for the purposes of the options.
- Viva was to be valued "on a going concern basis for an arm's length sale between a willing buyer and a willing seller and on the assumption that the [shares] are being sold in an open market".
- The valuation was to be based on "[Viva']s current and reasonably expected operational capabilities under the ownership of WRL and JPM".
- The valuation was to "[make] no allowances for and [disregard] any financial impact ... as a result of ... exercising any Call Option (or otherwise acquiring the [shares]) in accordance with the terms of this Agreement".
- The valuation was also to "[make] no allowances for and [disregard] any financial impact or any financial synergy that may be expected to be realised or derived as a result of JPM acquiring a majority stake in [Viva]".
JPM was classified as an "Edge Corporation" for the purposes of a piece of U.S. legislation known commonly as "Regulation K". Under Regulation K, Edge Corporations may only engage in certain specific activities within the United States, and they may not engage in certain specified activities outside the United States.
There was a concern that, if JPM exercised its option and became the sole shareholder of Viva, Viva would come within the scope of Regulation K. This could, in turn, potentially limit Viva's activities, including any future expansion of its business into the United States and, hence, produce a lower value for the shares in Viva.
Indeed, JPM contended that Viva's current business was already subject to Regulation K, and that any valuation needed to reflect this.
The question for the court was whether, if JPM exercised its option, the valuation of the shares should take into account, or alternatively disregard, any restrictions arising from the current or potential application of Regulation K to Viva.
This required the court to carry out contractual interpretation of the shareholders' agreement (see box "How will the courts interpret a contract?" for more information).
How will the courts interpret a contract?
The approach the courts will take to interpreting (in legal terms, "construing") a contract has now been effectively codified in a series of three cases (Arnold v Britton [2013] EWCA Civ 902; Rainy Sky SA v Kookmin Bank [2011] UKSC 50; Wood v Capita Insurance Services Ltd [2017] UKSC 24).
If the wording of a contract is clear and unambiguous, the court will assume that it reflects the parties' intentions and apply that wording literally. This is the case even if the wording produces an uncommercial or unlikely result, provided the result is not completely absurd. In this case, the court has no power to enquire into the meaning behind the contract words.
If a contract contains unclear or ambiguous wording, the court will embark on the process of interpreting it. It will attempt to identify what the parties intended by the wording in question.
In doing so, the court will apply an objective test. It will consider the ordinary meaning of the words in the contract to establish what a reasonable person with all the relevant background available to the parties would have understood by them.
To achieve this, the court will consider different, "rival" interpretations of the language used (the "iterative process"), testing them against the language elsewhere in the contract ("textual analysis") and the factual circumstances surrounding the making of the contract ("contextual analysis").
The court will consider the commercial consequences of each rival interpretation and ultimately adopt the interpretation that most closely accords with what the evidence suggests was the parties' intentions. Often, this will align with the interpretation that makes most sense commercially, but the court will not discount the possibility that parties intended to conclude an uncommercial bargain.
What did the court say?
The court held that the contract required the valuation to ignore any restrictions arising from Regulation K.
The judge reached this conclusion based on various factors, including the following.
- The reference to an "arm's length sale" required the valuation to assume a sale between "unconnected parties" at an "open market" value. This meant disregarding any matters that were relevant only to particular purchasers, such as restrictions arising from Regulation K.
- The contract explicitly required the valuation to ignore any impact resulting from JPM exercising its option. Any restrictions arising from Regulation K would apply because of the transfer under JPM's call option and, therefore, had to be disregarded.
- The contract also explicitly required the valuation to ignore any impact of JPM acquiring a majority stake in Viva. Again, the restrictions arising from Regulation K would arise from JPM acquiring control over Viva and, therefore, had to be disregarded.
The judge also rejected the argument that any valuation should be based on the business Viva was carrying out at the time of the valuation, and not any potential future business. He gave the following reasons.
- The term "going concern" did not suggest that Viva should be valued based on its business as at the date the option was exercised (i.e. with no presence in or intention to enter the U.S. market). Rather, it merely meant that Viva had to be valued on the basis it was not expected to liquidate or curtail its operations.
- The phrase "current and reasonably expected operational capabilities" did not require the valuation to be based only on Viva's actual or current business. The words "reasonably expected" allowed the valuation to take into account future operational capabilities, including potential expansion into the United States.
- It was commercial common sense that a potential purchaser of shares in Viva would assess the company's value not only based on its current business, but also on future prospects. If Viva were operating under regulatory constraints arising directly from having a particular shareholder, but those constraints would not apply following a sale to a new purchaser, it was appropriate to disregard them.
In reaching its conclusions, the court explicitly recognised that the shareholders' agreement that was a sophisticated and complex contract that had been negotiated and prepared with the assistance of skilled professionals. It therefore gave less weight to the factual background leading to the contract and more weight to the objective meaning of the wording of the contract.
What does this mean for me?
Valuation mechanisms can be notoriously difficult to draft perfectly (if, indeed, this is possible at all).
Parties will naturally want to strike a sensible balance between including sufficient detail to provide clarity on the parameters and basis of the valuation, while at the same time ensuring their contract remains succinct and avoids reams of pages of specific valuation principles and assumptions.
Indeed, it is sometimes better in a commercial contract to include less detail on valuation methodology and leave a greater degree of discretion to the valuer. This can allow the valuer to flex or take into account considerations which the parties may not have considered relevant when drafting the contract but which are, in fact, pertinent to the valuation (although this can put more pressure on the parties to agree who the valuer will be).
However, there are a number of important matters to consider when building a contractual valuation mechanism.
- Identity of the parties. Should the valuation
take into account the identity of the purchaser? In this case, the
mechanism required the valuation to disregard any restrictions or
synergies specific to a given purchaser and instead to generate a
more generic, open-market value. This will normally be sensible or
necessary if the mechanism supports a valuation for a sale to an
unknown third party. Where, however, the valuation supports a sale
to a known party (e.g. under an option, as in this case), it is
possible to adjust the valuation to take into account any
identified factors that may affect that particular party's
assessment of the company's value. This is often a key aspect
of valuation methodology drafting in a joint venture context (as
was the case here).
- Minority and control stakes. Where the shares
to be valued represent a minority stake, it is not uncommon to
apply a discount to reflect the fact that the shareholder carries
less influence. Conversely, if the shares represent a controlling
stake, it is not uncommon to apply a premium. Whether this is
appropriate in a given case depends on a number of factors, which
the contracting parties will need to discuss with their advisers.
But it is certainly a question that can and should be considered up
front when negotiating the valuation mechanism, and will normally
be incorporated specifically into the drafting.
- Market and marketability. Valuing shares in a
publicly traded company is a very different proposition from
valuing unlisted shares, for which there may be no ready market.
Likewise, there may be restrictions on transfers of the shares,
including the categories of person they can be transferred to,
whether they need first to be offered to existing shareholders and
whether they are subject to tag-along rights. Again, these are
factors that can be addressed specifically when drafting the
valuation mechanism.
- Value. A valuation mechanism should always define the basis of value to be used. Candidate bases include market value (which, broadly speaking, adopts a value based on an open market between any hypothetical buyer and seller) and equitable value (previously known as "fair value") (which assumes a sale between pre-identified, knowledgeable parties). Other formulations are often seen, most commonly fair market value, which may or may not have a technical meaning. Whatever the basis of value for the mechanism, it is sensible (where possible) to reference that description to a specific set of valuation methodology, such as the International Valuation Standards Council's bases of valuation.
As is so often the case, the decision in this case was specific to the facts. But it is a helpful example of the consequences that can arise when contracting parties do not see eye to eye on the meaning of the words on the page after the event. It is also a reminder of the importance of clarity and specificity when drafting valuation mechanisms in commercial contracts.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.