UK: Court Of Appeal Decision On The Meaning Of ‘Subsidiary’ Generates Uncertainty Over The Giving Of Security In Group Structures

Last Updated: 2 February 2010
Article by Matthew Dumbrell

A recent decision of the Court of Appeal in a case regarding an indemnity clause in a charterparty has provided an interpretation of the meaning of "subsidiary" in the Companies Acts (both 1985 and 2006) that could have significant implications for any corporate group structures or financial transactions where the shares in a group company or subsidiary are transferred to a security holder.  In Enviroco Ltd v Farstad Supply A/S [2009] EWCA Civ 1399, the Court of Appeal held that as a result of a parent company's pledge to its bank of shares in its subsidiary, and the registration of the shares in the name of the bank's nominee, the subsidiary ceased to be a subsidiary of the parent company for the purposes of sections 736 and 736A of the Companies Act 1985.  The decision has the potential to affect any contractual or financial relationship where there is a transfer to a security holder of shares in a company that is part of a group of companies -- such a transfer could now trigger, for example, change of control and breach of covenant provisions.  The case could also provide significant opportunities to holding companies for potential mischief with their group structures -- shares in a subsidiary could be vested in a nominee to place the subsidiary outside of its "group" for the purposes of, for example, facility agreements, VAT group structures or obtaining shareholder approvals.  As sections 736 and 736A of the 1985 Act have since been essentially replicated in section 1159 the Companies Act 2006, the decision will equally apply to the interpretation of the term "subsidiary" in the 2006 Act.

The Facts Of The Case

The case arose out of the circumstances of a tragic ship fire at Peterhead docks in 2002.  Enviroco Limited, the claimaint, had been instructed to clean the tanks of an oil rig supply vessel, the MV Far Service. The MV Far Service was owned by the appellant, Farstad Supply A/S, but was chartered to Asco UK Limited under a charterparty.  During cleaning by Enviroco, oil removed from the MV Far Service's tanks ignited, causing a fire in the ship's engine room, killing one of Enviroco's employees and causing substantial damage to the vessel. 

Farstad brought proceedings in Scotland against Enviroco for damages (which were heard in London under the charterparty's choice of law clause).  The basis of Enviroco's claim was that, as both it and Asco UK were subsidiaries of Asco plc, Enviroco was for the purposes of the charterparty an "affiliate" of Asco UK and therefore able to rely on the series of indemnities by Farstad in favour of Asco UK and its "affiliates" contained therein, including one in respect of all claims and liabilities resulting from loss and damage to the chartered vessel.

Farstad responded that Enviroco was not entitled to rely on the indemnity in favour of Asco UK as an "affiliate" of Asco UK, as Asco plc had ceased to be a member of Enviroco when Asco plc charged its shares in Enviroco to the Bank of Scotland under a deed of pledge.  The pledge contained, as a term of the security, a requirement for the Enviroco shares to be registered in the name of the bank or its nominee.  The deed of pledge also provided that until the security became enforceable "the full voting and other rights and powers in respect of the Shares" would be exercised by Asco plc as the bank's proxy, subject to a proviso that these powers should not be exercised in a manner which would adversely affect the value of the security or result in the shares being registered in the name of anyone but the bank.

As such, the case hinged on whether Enviroco remained an "affiliate" of Asco UK on the true construction of the charterparty when the shares in Enviroco held by Asco plc were registered in the name of the Bank of Scotland. 

The High Court's Conventional Approach

The definition of "affiliate" in the charterparty incorporated, by reference, the definition of "subsidiary" contained in section 736 of the Companies Act 1985.  Prior to the decision of the Court of Appeal, the High Court had held that the effect of the reference to section 736 in definition of "affiliate" was to treat section 736 as being set out in the charterparty, including the reference in section 736(1)(c) to one company being a subsidiary of another if the other company "is a member of it and controls, alone, pursuant to an agreement with other members a majority of the voting rights in it".  On this construction, the High Court held that, despite the bank's nominee being registered as the member in Enviroco's register of members, Asco plc retained the voting rights in respect of its shares in Enviroco and hence Enviroco remained a subsidiary of Asco plc.  As such, Enviroco remained an "affiliate" of Asco UK entitled to the benefit of the indemnity in the charterparty.

The Court Of Appeal Decision

The Court of Appeal overturned the decision of the High Court.  In doing so, the Court of Appeal reviewed section 736A of the 1985 Act, which explains the expressions used in the definition of "subsidiary" contained in section 736.  In particular, the Court of Appeal held that the rights attached to shares held by way of security as set out in section 736A(6) and (7) of the 1985 Act did not explicitly refer to the right of a security holder to be registered as a member of a subsidiary company.  The Court of Appeal declined to read the reference to "rights" in section 736A(6) and (7) as a reference to anything other than the rights described in section 736 and, as membership of a company was not one of the rights described in section 736, membership of a company was not a right as such at all.  Indeed, the Court of Appeal noted that membership of a company was only ever a status derived from entry of the shareholder's name in the register of members.  On this construction of section 736, Asco plc was not a member of Enviroco and Enviroco was therefore unable to rely on the indemnity in the charterparty.  (Note that the result would have been different if Asco plc had owned more than 50% of the shares in Enviroco, and as such would have owned a majority of voting rights under section 736(1)(c)).

"Uncommercial Results" And The Implications Of The Decision

The Court of Appeal's direct criticism of the High Court sets the stage for the commercial consequences of the Enviroco case.  The Court of Appeal criticised the High Court for "[starting] from the proposition that it would be absurd if the giving of a charge by a parent company under which the chargee become the registered shareholder in the subsidiary meant that the statutory definition in s.736 ceased to apply to the parent chargor. ... [T]he court is not given the power to revise the provisions of a statute simply because it takes the view that their operation may produce uncommercial results in some cases."

So what are these "uncommercial" results?  The Enviroco decision has significant implications for the transfer to a security holder of shares in a company that is part of a group of companies.  These effects will be most particularly pronounced in financial and banking arrangements where the Companies Acts definitions of "subsidiary" and "holding company", etc. are used to define and corral groups of companies which may change over time.  The drafting of such arrangements should now consider extending these definitions so that transferring shares in a subsidiary by way of security to bank, nominee or other security holder does not negate the relationship between the subsidiary and its holding company/member for the purpose of other agreements, covenants etc. to which the subsidiary might be a party. 

The decision also appears to provide holding companies with the potential for mischief with their group structures.  By vesting shares in a subsidiary in a nominee, a holding company may be able to place that subsidiary outside of its "group" for the purposes of, for example, facility agreements, VAT group structures or obtaining shareholder approvals for transactions with directors.  The decision will also affect, inter alia, contracts containing change of control provisions, provisions granting rights between group companies (e.g. to assign contracts, or to perform services, or, as in Enviroco, to grant indemnities), and provisions triggering intra- or parent- company guarantees.  All such provisions should now be reviewed to determine the extent to which they rely on the Companies Acts definition of "subsidiary".

Despite agreeing with the leading judgment of Lord Justice Patten, Lord Justice Longmore noted in his short concurrence his concern at "the apparent ease with which it might be possible ... for a company to conceal the fact that it has a subsidiary behind the fact that it has mortgaged, charged or pledged its shares to a lender."  His Lordship reluctantly observed, however that there was "no escape" from the true construction of sections 736 and 737A.  Perhaps the Supreme Court will find such an escape: Enviroco has, at the time of writing, requested leave to appeal the Court of Appeal's decision.

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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