Q - When is a subsidiary not a subsidiary?

A – When its parent company has pledged its shares to a third party by way of security.

It has long been accepted that where a holding company ("HC") pledges the shares it owns in a subsidiary company ("SC") to a third party by way of security for some other obligation, unless and until action is taken to enforce that security, SC remains a subsidiary of HC within the meaning of sections 736 and 736A of the Companies Act 1985 (now section 1159 of the Companies Act 2006). Or so we thought....

In Enviroco Ltd v Farstad Supply A/S the Court of Appeal has held that, as a result of a holding company's pledge to a bank of shares in its subsidiary and the registration of the shares in the name of the bank's nominee as security, the subsidiary ceased to be a subsidiary of the holding company within the meaning of sections 736 and 736A of the Companies Act 1985.

Lawyers have been confident in the past when advising clients whose shares are offered as security, that even if those shares are registered in the name of the lender's nominee, all rights attaching to the shares (including the right to be registered as a member of the company) will be treated as being held by HC until such time as the lender enforces the security. This was basis of the decision reached by the High Court in the Enviroco case.

In a surprising turn of events, the Court of Appeal have refused to uphold the High Court's decision, instead stating that the right to be registered as a member of a company is not a right which attaches to the shares themselves but is rather a status derived from entry of ones name in the register of members. Consequently, where the name of the nominee is entered into the register of members (usually for the duration of the loan or facility agreement) SC is no longer deemed to be a subsidiary of HC within the provisions of the Companies Acts.

The impact of this decision may be somewhat tempered by the provisions of section 1159(1)(a) of the Companies Act 2006 (formerly section 736(1)(a) of the Companies Act 1985) which provides that a company will be a subsidiary if the holding company holds "a majority of the voting rights". This connection is not broken by the registration of a nominee as holder of the shares because the nature of the nominee's appointment is such that the voting rights attached to the shares must be exercised in accordance with the holding company's instructions.

The decision does however raise concerns as there are clearly potential circumstances in which a majority of voting rights may not be held. In these circumstances, the validity of contracts to which SC is a party should be considered as the effectiveness and scope of certain clauses may be affected. For example; change of control provisions, rights to assign to other group companies, the right to ask for services to be provided to other group companies, indemnities that benefit group companies, provisions which trigger a grant of a parent company guarantee, VAT clauses which rely on a definition of group, and limitations and exclusions of liability (which limit or exclude liability of group companies).

Not all of the potential effects of the Enviroco decision are negative. Already, a number of potential areas have been identified which could ease the administrative burden imposed on companies by the Companies Act 2006, in particular in relation to substantial property transactions and loans to directors.

For the time being, the situation remains uncertain. Enviroco have lodged an application with the Supreme Court for leave to appeal to the House of Lords. We await the outcome of that application with baited breath!

If you have any concerns or would like any guidance in relation to arrangements that your company has or is considering entering into, please feel free to contact Philip Langford or Tanya Shillingford in the Company department at Goodman Derrick LLP.

This is for general information and interest only and should not be relied upon as providing specific legal advice.