Below are three cases with wildly different sets of circumstances and equally different outcomes.

Irvine v Irvine 2006

In this case, a widow brought an action against her brother-in-law who ran a successful insurance brokerage business. Together with a related trust, her holding was one share short of 50%.

Although the split of the equity interests of the two brothers had been 50:50 there had apparently been an understanding that the profits would be extracted on the basis of 4/7 and 3/7 respectively. The vast majority of the profits had been habitually extracted each year on this basis.

After the death of the brother, the deceased’s  widow was initially extremely appreciative of the support offered by Ian Irvine, the managing director and her brother-in-law.

Relationships sour

For whatever reason the ingredients in the relationship curdled: one of the claims brought against Ian Irvine by Malcolm’s widow was that he had taken excessive remuneration from the company. In the financial statements for 1999, the share of profits enjoyed by Malcolm’s widow (a combination of salary, pension contribution and benefits) totalled £96,250. Ian's came to £902,063.

The evidence and the judgement

The judge heard evidence from a specialist employment consultant and from a forensic accountant and it was apparent from the evidence that Mr Ian Irvine was both a very hard-working managing director, and also an inspirational leader.

The employment consultant held that the reasonable remuneration for Mr Irvine was between £100,000 and £300,000, the figures produced by the forensic accountant were very considerably greater. The judge decided as follows in respect of Ian’s remuneration, “In my judgment, his appropriate remuneration would have been 40% of the business's net profits … before tax subject to a minimum of £300,000 (for the year 2003) and discounted down…for each preceding year back to 1996.”/p>

Fowler v Gruber 2009

In this case, Mr Gruber operated a company which provided specialist engineering services in respect of the deep sea oil industry. Mr Gruber’s starting salary with the company had been £38,000 plus car. In the financial statements his remuneration was as follows in respect of years ended 30 September.

The expert evidence

The expert for Mr Gruber assumed that his starting remuneration should reasonably have been £87,000 comprising a base salary of £72,000 and a commission based on the turnover of the company. He then assumed that the base salary should have increased at an annual rate of 5% compound. These calculations then demonstrated that he had been underpaid from 2001 to 2004 and had been overpaid thereafter. The aggregate net overpayment was £109,000. The expert for Mr Fowler maintained that the total remuneration package for the year to 30 September 2005 should have been £80,000, increasing to £90,000 and £100,000 in the following two years. 

The view from the Bench

The judge dealt crisply with the proposal that alleged underpayments should be netted against subsequent overpayments. He focused solely on the three years ended 30 September 2007. “I consider that it is necessary to look to any excess in those years, and not to have regard to any alleged under remuneration in previous years.” He accepted the figures put forward by Mr Fowler’s expert in full in respect of the fair remuneration.

Arbuthnott v Bonnyman 2014

This is a case of extremes – a private equity business with the requirement for close alignment of management and ownership for its continuing success. The business model therefore operated on the basis of the shareholders working in the business; virtually all of the profits, which could be extremely sizeable, were then attributed to such shareholders (and senior management) but in the form of bonuses.

Out of alignment

Such a very happy set of circumstances worked well but for the passage of the years. Several of the original ownership team, including Mr Arbuthnott, decided to retire and the ownership and executive control began to drift out of alignment. A management buyout was therefore planned for consideration of just over £15m. Mr Arbuthnott objected to this transaction. He also maintained that dividends should be paid to the retired shareholders rather than profits being almost entirely absorbed by bonuses.

The written decision sets out the difficulty faced by Mr Arbuthnott in maintaining this stance. “In cross-examination, Mr Arbuthnott accepted that he had agreed to Mr Bonnyman having sole discretion over all remuneration, that he knew that profits would all be paid out to executives on an annual basis and that he had not complained that no dividends were paid until long after his retirement.”

Decision

The decision is a very interesting one, not least as it is an early precedent for discounted cash flow techniques being used as a preferred methodology in a UK Court. In the special circumstances of this case the Judge decided that the shares held by Mr Arbuthnott should be valued by reference to the model of maximum profit extraction: “I take the same attitude in relation to the calculations in the valuations based upon the assumption that the remuneration model is changed. First, I have already found that Mr Arbuthnott agreed to that model both as a director and as a shareholder and therefore, it seems to me that it is not appropriate to seek to value the Company as if that model does not apply.”

There was therefore no reason to upset the valuation used in the management buy-out and which had been accepted by all other shareholders. Therefore a company which generated extremely significant profits before remuneration to the directors was valued on the basis that the entirety of those profits was paid to those directors.

Andrew Strickland, Consultant, Scrutton Bland Group
Valuation Group, June, 2015