UK: Ceasing To Be A Subsidiary

Last Updated: 28 May 2010
Article by Timothy Parsons

In Enviroco Ltd v Farstad Supply A/S [2009] EWCA Civ 1399, the Court of Appeal concluded that, in certain circumstances, a company which is a subsidiary of a holding company may cease to be a subsidiary following the grant of security over shares in the subsidiary by its holding company to a bank.

The result may seem surprising at first and may cause lenders to be concerned about the risk of the company whose shares are charged becoming a subsidiary of the secured lender. The decision is, however, applicable only to a limited range of circumstances and, as explained below, there should not be a risk for the lender in most situations.

The case concerned the vessel M.V. Far Service which was chartered by Farstad to Asco UK Limited, a subsidiary of ASCO plc. Enviroco was engaged to clean the vessel including its oil tanks. During the operation, oil from the tanks caught fire, resulting in the death of an Enviroco employee and damage to the vessel.

Farstad sued Enviroco. However, Enviroco claimed it was an "affiliate" of Asco UK, by virtue of also being a subsidiary of ASCO plc, and that it was therefore entitled to the benefit of an indemnity from Enviroco in respect of its liability. This indemnity was contained in the charter of the vessel and was expressed to be in favour of Asco UK and its "affiliates".

In the period prior to the incident giving rise to the claim, ASCO plc had entered into a Scottish law "Deed of Pledge" in favour of the Bank of Scotland (the "Bank") in respect of its shares in Enviroco. This document had a similar effect to an English law legal mortgage of the shares (shares being intangible assets incapable of being "pledged" under English law). Pursuant to this security, the Bank had become registered as the holder of the relevant shares.

Prior to the grant of security, it was clear that Enviroco was a subsidiary of ASCO plc since, although it held only a minority of the shares in Enviroco, ASCO plc was also able to control, pursuant to an agreement with another shareholder, the majority of the voting rights in Enviroco in accordance with section 736(1)(c) of the Companies Act 1985 (now section 1159(1)(c) of the Companies Act 2006). The other tests of a "subsidiary" were inapplicable since ASCO plc did not alone hold the majority of voting rights in Enviroco (paragraph (1)(a)), nor did it have the ability to appoint a majority of the directors of Enviroco (paragraph (1)(b)).

The terms of the security were such that, as is usually the case in such situations, the voting rights attaching to them were to be exercised, prior to any default under ASCO plc's banking arrangements, by ASCO plc as proxy for the Bank provided that such exercise did not adversely affect the value of the Bank's security or result in the shares becoming registered in the name of another party.

Section 736A(7) of the Companies Act 1985 (now paragraph 7 of Schedule 6 to the Companies Act 2006) had the effect of treating the voting rights attached to the shares subject to the security as being held by the person providing the security, namely ASCO plc. In order for Enviroco to remain a subsidiary, however, both elements of section 736(1)(c) needed to be satisfied. The deeming provision of section 736(A)(7) (together with the shareholders' agreement in respect of shares in Enviroco) meant that the requirement as to voting rights was satisfied. Was ASCO plc, however, still a "member" of Enviroco once the Bank had been registered as holder of the relevant shares?

At first instance, Gabriel Moss QC sitting as a deputy judge, held that, in the context of the importation of section 736 and section 736A into the charter relating to the vessel, the "rights attached to shares" referred to in section 736A(7) included the right to be registered as a member. The operation of section 736A(7) would therefore also deem ASCO plc to be a "member" of Enviroco even after the Bank had been registered as shareholder by virtue of its security.

The Court of Appeal (Mummery, Longmore and Patten LJJ) disagreed and, in the course of a detailed analysis of the process by which both section 736 and section 736A had been introduced into the Companies Acts, Patten LJ concluded that the "rights attached to shares" referred to in section 736A can only refer to the "rights" detailed in section 736. These "rights" are voting rights in a company and the right to appoint or remove members of a company's board of directors.

The conclusion, therefore, was that Enviroco had ceased to be a subsidiary of ASCO plc upon registration of the Bank as holder of the shares in Enviroco. Enviroco had, therefore, ceased to be an "affiliate" of Asco UK and could not benefit from the indemnity given by Farstad.

Is this result of concern to lenders and borrowers? It is, but only in limited circumstances. At least under English law, it is more common for a lender to take security over shares by way of equitable mortgage or charge. In such a case, the lender will take possession of share certificates and signed stock transfer forms. It will not become registered as shareholder unless there is a default and the lender seeks to enforce its security. The borrower granting the security will, therefore, still be a "member" and that, together with the operation of section 736A(7) (now Schedule 6, paragraph 7) will mean that the holding company/subsidiary relationship will not have been broken.

In the case of a majority or wholly owned subsidiary (assuming the holding company holds the majority of voting rights itself), even the grant of a legal mortgage will not break the holding company/subsidiary relationship since paragraph 1(a) of section 736 (now section 1159(1)(a)) will still be satisfied where, as will usually be the case, the voting rights effectively remain with the holding company as proxy or nominee for the lender.

It is also worth noting that, even in the particular circumstances of this case, there was no suggestion that the Bank would have become the holding company of Enviroco, thus rendering Enviroco a subsidiary of the Bank. The deeming provisions of section 736A(7) would mean that a lender could not satisfy any of the tests in section 736(1) unless, for example, the terms of the security were such as to give a lender completely unfettered control of the exercise of voting rights in respect of the majority of shares in the company in question.

One aspect of this decision that should be considered by lenders and other contracting parties is the possibility that taking security by way of legal mortgage over shares in circumstances similar to this case may result in the company in question ceasing to be one of the companies in a "group" for the purposes of testing covenants, warranties and undertakings in an agreement. Attention to drafting of the definition of "group" and/or "subsidiary" in loan agreements and other documents may therefore be required.

The matter is not finally settled. The Supreme Court has recently granted to Enviroco leave to appeal, with the matter expected to be heard in the autumn.

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.

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