The recent Enviroco case before the Court of Appeal in England illustrates the unintended consequences that can result from incorporating statutory references into commercial contracts, and indeed from giving a certain type of security over shares.
The effect of the decision should be considered by:-
- groups of companies,
- parties to joint venture company arrangements,
- funders, their advisers and credit documentation teams,
particularly where it's proposed that the title to shares in a subsidiary will be being transferred as part of the security arrangements.
Enviroco (E) sought to rely on an indemnity given by Farstad (F) for the benefit of Asco UK and its Affiliates. In the indemnity agreement the term "Affiliates" incorporated the Companies Act definition of "subsidiary".
The test of being a subsidiary under the Companies Act has three elements. The element which most commonly applies in group situations (being that the parent holds a majority of the voting rights in the subsidiary) did not apply in this case since E's shares were held 50% by Asco plc and 50% by another party. The element that applied here was the one that relied on Asco plc being a member of E and controlling the majority of the voting rights attaching to the shares of E.
Under these arrangements E was initially an Affiliate of Asco for the purpose of the indemnity agreement. However, as part of granting security over its shares in E to its bank, Asco plc subsequently transferred the shares to the bank, which became registered as the "member" of E in place of Asco plc
In its defence against the indemnity claim, F argued that since Asco plc was no longer a member of E, Asco plc was no longer E's parent company. E was therefore no longer a "subsidiary" or an Affiliate of Asco UK for the purposes of the indemnity agreement.
The court held that was the correct interpretation of the Companies Act and the indemnity agreement. E's claim under the indemnity failed.
At the time of writing (January 2010) E has submitted an application for leave to appeal the Court of Appeal decision to the Supreme Court. However, no hearing date has been set.
Click here (http://tinyurl.com/ybalx7v) for a more detailed explanation of the facts and the court's reasoning.
Points to consider:
- a legal mortgage of shares under English law and a fixed security over shares under Scots law both involve the transfer of the shares to the security holder or its nominee, and their name being entered in the register of members of the company whose shares are being charged;
- in relation to shares in a Scottish registered company, such a transfer of its shares is the only way in which a fixed security can be constituted;
- when such a title transfer share security is being granted consideration should be given as to whether this might effect the "subsidiary" status of the company whose shares are being transferred, either from a statutory or a contractual perspective;
- existing commercial contracts, joint venture agreements, etc. should be reviewed to check the position;
- consideration should also be given to the point when such contracts are being written;
- from the perspective of banks and other funders taking such security over shares, they will not be at risk of the company (whose shares are being charged) being deemed part of their group for accounting or tax purposes provided the security arrangements state that prior to enforcement action being taken under the security, the rights attaching to the shares are exercisable only in accordance with the instructions of the party providing the security;
- standard form and bespoke security documentation should be checked to ensure that is the case.
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.