The recent Court of Appeal decision in Enviroco Ltd v Farstad Supply A/S [2009] EWCA Civ 1399 has thrown up an issue with the Companies Act definition of "subsidiary".
What was at stake?
A company called Asco UK Limited (Asco UK) chartered an oil-rig supply vessel from Farstad. The charter document provided that Farstad would indemnify Asco UK and its "affiliates" against various liabilities.
"Affiliate" was defined in the charter document so as to include (a) any subsidiary of Asco UK and (b) any company that was a subsidiary of a company of which Asco UK was also a subsidiary (i.e. a sister company of a common parent), and "subsidiary" was expressly defined as having the meaning given in section 736 of the Companies Act 1985 (CA 1985).
Enviroco considered that it was a relevant "affiliate" of Asco UK for the purposes of the indemnity as both it and Asco UK were subsidiaries of Asco plc.
A fire broke out on the vessel, causing substantial damage to the vessel and the death of an Enviroco employee. Enviroco sought to rely on the indemnity from Farstad.
The Court of Appeal had to decide whether Enviroco had the benefit of the Farstad indemnity, which turned on whether or not Enviroco was a subsidiary of Asco plc for CA 1985 purposes.
The law
Section 736(1) of the CA 1985, which has now been substantially reproduced by section 1159(1) of the Companies Act 2006 (CA 2006), states:
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"A company is a "subsidiary" of another company, its "holding company", if that other company –
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(a) |
holds a majority of the voting rights in it, or
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(b) |
is a member of it and has the right to appoint or remove a majority of its board of directors, or
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(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,
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or if it is a subsidiary of a company which is itself a subsidiary of that other company." |
Asco plc only owned 50% of Enviroco and since Asco plc did not hold "a majority of the voting rights" section 736(1)(a) could not apply. On the facts, section 736(1)(b) did not apply either.
Enviroco could therefore only claim to be a subsidiary of Asco plc within the meaning of section 736(1)(c). In this context, it also had to establish that Asco plc was "a member". Under section 22(2) of the CA 1985 (now reproduced by section 112(2) of the CA 2006), a member of a company is defined as someone "whose name is entered in its register of members".
The issue
It was not disputed that Enviroco was originally a subsidiary of Asco plc on the basis of section 736(1)(c). Although Asco plc only owned 50% of Enviroco's shares, it was agreed that it controlled voting rights through an agreement with other shareholders.
Asco plc had, however, subsequently charged its shares in Enviroco to Bank of Scotland under a Scottish-law Deed of Pledge. While the Deed of Pledge was clear that, until the security became enforceable, "the full voting and other rights and powers" in respect of the shares would still be exercised by Asco plc, the Deed required the shares to be registered in the name of the Bank, with the result that Asco plc was no longer the registered holder of the shares in Enviroco.
Farstad argued that, as a result of the Bank's registration, Asco plc ceased to be a member of Enviroco, so the requirements of section 736(1)(c) of the CA 1985 were no longer met. Enviroco, however, relied on the deeming provision contained in section 736A(7)(b) of the CA 1985 (now entirely restated by paragraph 7(b) of Schedule 6 of the CA 2006) as follows:
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"Rights attached to shares held by way of security shall be treated as held by the person providing the security … where the shares are held in connection with the granting of loans as part of normal business activities and apart from the right to exercise them for the purpose of preserving the value of the security, or of realising it, the rights are exercisable only in his interests." |
Enviroco argued that membership was one of the rights attaching to shares, and so, under section 736A(7)(b) of the CA 1985, the right of membership remained vested in Asco plc, as the provider of the security. On that analysis, Enviroco was still a subsidiary of Asco plc and could enforce the Farstad indemnity.
The decision
The High Court had originally ruled that, as a matter of "commercial reality and business sense", Enviroco should have been considered a subsidiary of Asco plc. The Court reasoned that a parent/subsidiary relationship should not cease to exist simply as a result of pledging shares in the subsidiary as security, even if that security required registration of the shares in the name of the Bank as security holder.
The Court of Appeal, however, overturned this decision and ruled that, at the point that Asco plc pledged its shares in Enviroco to the Bank, Asco plc ceased to be a member of Enviroco and therefore Enviroco ceased to be a subsidiary of Asco plc within the meaning of section 736(1)(c). Section 736A(7)(b) did not assist Enviroco because "membership" is not a right attached to shares: it is simply a status derived from the entry of a shareholder's name into the register of members.
As a result, Enviroco could not enforce the indemnity against Farstad.
The impact
This case should focus the mind on the circumstances in which groups may "lose" subsidiaries unexpectedly, and the risks and implications if this happens.
From a practical perspective, the impact of the case is likely to be reasonably limited, not least because:
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Most parent/subsidiary relationships exist because the parent company holds the majority of the voting rights in the subsidiary (formerly section 736(1)(a) of the CA 1985 and now section 1159(1)(a) of the CA 2006). The result in the Enviroco case would clearly have been different if Asco plc had owned more than 50% of the shares in Enviroco.
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Banks do not often take a legal mortgage over an English company's shares by transferring the shares into their own name for fear of assuming unwanted obligations – e.g. liabilities under pension schemes. Banks usually take an equitable mortgage or charge accompanied by the share certificate and a blank stock transfer form. |
The Court of Appeal judgment did, however, identify a concern that a holding company might be able to conceal a subsidiary through use of share pledges, and so manipulate which companies are/are not subsidiaries to its advantage.
Equally, where there is an impact, the significance could be high. Consider the following for example:
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Commercial contracts – Many contractual provisions turn on the Companies Act definitions of "subsidiary", "affiliate" and "group". Losing a subsidiary could, for example:
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(a) trigger change-of-control provisions;
(b) restrict the ability to assign the benefit of a contract intra group; and/or
(c) cause a breach of financial covenants.
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Employee share schemes – Share and share-option schemes often include rules which define which employees can benefit in the scheme by reference to being employed by a member of a group of companies. An employee may lose its share benefit rights if the employee’s employer company ceases to be a subsidiary of a particular holding company.
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Property matters – In a property context, the definition of "subsidiary" is relevant to provisions that determine occupation or business use under the Landlord and Tenant Act 1954 and could affect, for example, the ability of a tenant under a lease to share occupancy with a "group company".
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VAT groups – The VAT-group rules rely on the CA 2006 definition of "subsidiary". If a company ceases to be a subsidiary for CA 2006 purposes, it may cease to be eligible to be treated as a member of a group for VAT purposes.
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Key points to take away
The Enviroco case serves as a useful reminder that:
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“Boilerplate” definitions always require careful thought.
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If the CA 2006 definitions of "subsidiary" and "holding company" are to be used, these should (where appropriate) be supplemented with wording to ensure that the parent/subsidiary relationship is preserved even if the shares in the subsidiary are registered in the name of (a) a third party in connection with the taking of security or (b) a nominee.
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Security terms can affect the status of companies within a group. In particular, if shares in a subsidiary are used as security, it is important to check whether or not the subsidiary will lose that status as a result. |
If the Court of Appeal's decision is appealed by Enviroco (and application for leave to appeal has been submitted), we shall provide a further update.
Please contact Caroline Copeland if you have any questions or would like to discuss the Enviroco case.
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