Court of Appeal rules on the meaning of subsidiary

January 28, 2010

In the recent case of Enviroco Ltd v Farstad Supply A/S [2009] EWCA Civ 1399, the Court of Appeal decided that, in certain circumstances, a company ceases to be a subsidiary of a holding company for the purposes of the Companies Acts if the holding company mortgages the shares of the subsidiary and, as part of the mortgage, the subsidiary's shares are registered in the name of the mortgagee or its nominee.

Enviroco had been instructed to clean the tanks of a vessel owned by Farstad but chartered to Asco UK Ltd. During the course of cleaning, a serious fire broke out on the vessel which killed one of Enviroco's employees and caused substantial damage to the vessel. Farstad subsequently brought proceedings against Enviroco. The charterparty agreement contained indemnities by Farstad in favour of Asco UK and its "affiliates" including one agreement in respect of all claims and liabilities resulting from loss and damage to the vessel. "Affiliate" was defined in the charterparty by reference to section 736 of the Companies Act 1985 (1985 Act).

Both Enviroco and Asco UK were subsidiaries of Asco plc. Some time after the charterparty had been entered into, Asco plc pledged its shares in Enviroco to a bank by a Scottish law deed of pledge, which required the bank or its nominee to become the registered holder of the pledged shares. The deed made clear that registration of the bank or its nominee in Enviroco’s register of members was for the purpose of security only, and that Asco plc retained its voting powers relating to the shares in Enviroco. Enviroco claimed it was still an affiliate of Asco UK and therefore entitled to rely on the indemnity in answer to Farstad’s claim. The court needed to consider whether Enviroco was an "affiliate" of Asco plc.

Section 736(1) of the 1985 Act provided that:

"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 shareholders or members, a majority of the voting rights in it,

or if it is a subsidiary of a company which is itself a subsidiary of that other company".

In this case the holding company was a 50% shareholder of the subsidiary and could only control all the voting rights through an agreement with the other shareholder. Section 736(1)(a) did not therefore apply and the case concerned the interpretation of section 736(1)(c). The court held that as a result of the registration of the subsidiary’s shares in the bank’s name, the subsidiary was no longer a subsidiary of the holding company within the meaning of section 736(1)(c). The court’s decision turned on the fact that the holding company was no longer a member of the subsidiary by virtue of its shares having been registered in the name of the bank. This decision will be relevant to interpreting the definition of "subsidiary" in the context of both section 736 of the 1985 Act and section 1159 of the Companies Act 2006 (2006 Act), which substantially replicates section 736 of the 1985 Act.

It should be noted that a requirement for a mortgagee to become a registered member is unusual in England. When shares are charged in England, it is more usual for share certificates and executed stock transfer forms to be deposited with the mortgagee. However, the court’s decision will be relevant where there is a requirement for a security holder or its nominee to be registered as a member of a subsidiary whose shares are charged, as well as where a subsidiary’s shares are held by a nominee of its holding company.

The decision may have further implications in a variety of contexts. It is common for a wide variety of contracts to define "subsidiary", "affiliate", "group", "holding company" or similar expressions by reference to the Companies Acts, and if a third party becomes registered as the owner of a subsidiary's shares, relevant contractual provisions may not apply to the subsidiary. This could affect provisions that give a contracting party the right to terminate a contract where there is a change of control of another party, rights to assign a contract to other companies in the same group as one of the parties and indemnities in favour of a party that are also intended to benefit other companies in that party's group. 

There could also be implications for those sections of the Companies Acts to which the statutory definition of "subsidiary" applies, such as those governing the provision of financial assistance for the acquisition of shares, loans to directors and substantial property transactions with directors, which could potentially be evaded if a company is no longer deemed to be a subsidiary as a result of this case. 

The case might also deter companies generally from permitting the registration of shares held as security.

The decision does not apply to a subsidiary relationship arising by virtue of the holding of a majority of the voting rights in that subsidiary. However, companies which, for example, have a subsidiary relationship arising as a result of the right to appoint or remove a majority of the board, or pursuant to an agreement on voting rights, should review their key contracts to ensure that they are not affected by this decision. In particular, finance documents, such as facility agreements and debentures, may need to be reviewed to ensure that the parties' intentions concerning ongoing parent and subsidiary relationships are properly reflected where there is a transfer of ownership of a subsidiary’s shares to a security holder. 

There are also steps which can be taken to counter this decision. Contracts can be amended either to refer to the statutory definition of "subsidiary undertaking" which is wider than the definition of "subsidiary", or to provide that the registration of a security holder as a member shall not mean that a company ceases to be a subsidiary for the purposes of the agreement in question.

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