Supreme Court confirms Court of Appeal judgment on the Companies Acts meaning of “subsidiary”
The Supreme Court gave judgment on 6 April 2011 in Farstad Supply A/S v Enviroco Limited [2011] UKSC 16. The judgment is here, the press release is here. For corporate lawyers, the judgment may mean – depending on the facts – that attention needs to be paid to how the terms ”subsidiary” and “holding company” are defined in a contract, because the effect of Enviroco is that a holding /subsidiary company relationship may (probably inadvertently) be broken.
If that relationship is broken:
- a company that was intended to fall within a contractual definition of “subsidiary” or “holding company” may not do so – with adverse consequences on, for example, guarantee provisions, warranty and indemnity clauses, group service provisions, limitations of liability and change of control and assignment clauses; and
- contractual provisions that rely on the Companies Acts definitions of subsidiary and holding company – such as those relating to substantial property transactions or loans to directors – may not have the intended effect.
Background to Enviroco
At the heart of the Enviroco case is the construction of section 1159(1) of the Companies Act 2006 (the Act), which reads as follows:
(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 members, a majority of the voting rights in it…”
The Enviroco case actually concerned section 736 of the Companies Act 1985; but the definition of “subsidiary” in the Act, and its supporting provisions, are the same in the Act and the Companies Act 1985. For practicality, this post discusses the provisions in the Act.
The problem that arose in Enviroco
The facts in Enviroco were unusual. In short, Enviroco attempted to rely on limb (c) of the section 1159(1) definition to show that a subsidiary-holding company relationship existed between a company (S) and its (alleged) holding company (H) . Limb (a) was not available, as H did not hold a majority of the voting rights in S.
Unfortunately for Enviroco, the shares in S had been pledged under a Scottish deed of pledge, which required H’s shares in S to be registered in the name of the lending bank.
A company’s register of members confirms who is a member of the company
Despite Enviroco’s arguments (which largely centred on the supplementary provisions on the meaning of subsidiary contained in Schedule 6 of the Act), the Supreme Court confirmed that membership of a company is determined by entry on the register of members of the company. Section 112 of the Act is unambiguous on this point, and reflects statutory company law as it has developed over the past 150 years.
The lending bank was entered in S’s register of members as a member of S. As a result, H was not a member of S – and so limb (c) of the definition of subsidiary did not apply. (Limb (b) was not applicable on the facts.)
The legal effect of Enviroco
The result of the Enviroco case is that a subsidiary-holding company relationship will not exist between S and H if:
1. Limb (a) of the section 1159(1) definition is not available, because H does not hold a majority of the voting rights in S. (This limb is the provision usually relied on to demonstrate the subsidiary-holding company relationship between S and H, so in the vast majority of corporate structures, Enviroco will not have an impact.)
AND
2. Limbs (b) and (c) are not available, because H is not a member of S in the terms required by section 112 of the Act i.e. H’s name is not entered in S’s register of members.
The practical result of Enviroco
There are two situations where the Enviroco decision may mean that a subsidiary-holding company relationship may not exist, even though one or more of the parties intended that relationship to exist. In each situation, it is necessary for limb (a) of section 1159(1) not to be satisfied.
- Security over S’s shares. Where S’s shares have been taken as security and entered into the name of the lender (or its nominee). This is the situation that arose in Enviroco, because of the requirements of the Scottish law pledge. In English law, it is very unusual for the lending bank to be registered as the legal holder of S’s shares when taking security, so this situation is unlikely to arise under English law banking documentation, although in theory it could if the lender chose to enforce the security and it (or a nominee) became the registered holder of S’s shares.
- Nominee arrangements. Where S’s shares are transferred by H and registered in the name of H’s nominee. This may be for some legitimate purpose, but the Supreme Court noted that the unavoidable result of its judgment would be to confirm the possibility that the statutory requirements for holding-subsidiary company relationship could be evaded by the use of nominees. This might be done, for example, to remove S from the requirements of a guarantee provision, or to take it outside some other provision of the Act which relies on the statutory holding-subsidiary relationship. However, the court also observed that the “loophole” identified by Enviroco has existed for more than 20 years and that there was “no material put forward” during the hearing to suggest that advantage had been taken of the loophole.
The impact on corporate structures and contractual documentation
Given the very particular facts of Enviroco, it will not have an impact on many corporate structures or on many contracts. This is primarily because most holding and subsidiary company relationships exist because of limb (a) of the section 1159(1) definition.
Where there are:
- Particular types of security being granted, which require or may result in the lender or its nominee becoming the registered holder of S’s shares; or
- The use of nominee arrangements may take the corporate structure outside limbs (b) and (c) of the section 1159(1) definition, and
- Limb (a) of the section 1159(1) definition does not apply,
Then the definitions of “holding company” and “subsidiary” used in relevant documentation will need to be considered. Boilerplate definitions of “subsidiary” and “holding” company may need to be amended expressly to state that the membership requirement in subsections 1159(1)(b) and (c) is deemed to be met, even if the shares in the subsidiary are registered instead in the name of (i) another person (or its nominee) for the purposes of taking security, or (ii) the holding company’s nominee.
UPDATE 27 June 2012: This post links to an October 2011 letter from The City of London Law Society to BIS, discussing the problem revealed by Farstad v Enviroco, and suggesting a possible solution
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