LLM Company Law CW3
Liam, John and Ming are directors of Sunny Ltd. They hold 30%, 30% and 40% of the shares respectively. Sunny Ltd recently rejects a contract of sale of flour with Flour Ltd as John and Ming say the price of the flour is not suitable for Sunny Ltd. However, Liam finds out that John and Ming later make a profit by entering into the contract of sale of flour with Flour Ltd in their own names. John and Ming have not informed Sunny Ltd regarding their conduct of contracting with Flour Ltd.
Sunny Ltd. is now in compulsory liquidation and its assets amount to £13,200. The creditors have submitted the proofs of debts. The cost of winding up is £10,000 and the interests on all the debts are £6,000. Three employees of Sunny Ltd. are claiming for their unpaid salaries for the last 5 months, each person in total seeks to claim £6,000 respectively. And there are three unsecured creditors who are claiming £1,000, £3,000 and 4,000 respectively.
Liam is not happy with the conduct of John and Ming and he comes to you for advice. He would like you to:
1. advise Liam whether John and Ming have breached any of the statutory directors’ duties;
2. advise the liquidator regarding payments of the claims listed above.
COMPANY LAW MODULE GUIDE 2014/2015
SESSION ONE
Business Structures, Incorporation and Lifting the Corporate Veil
Required Reading
Textbooks:
• Wild & Weinstein (2013), Chapters 1, 2 & 3
• Hannigan, Chapter 1 & 3
• Boyle & Birds, Chapters 1 &3
• Gower & Davies, Chapter 8
• Dignam & Lowry, Chapters 2 and 3
• Hicks & Goo Pages 33 -53, 91-94.
Articles:
• Mohanty, S & Bhandari, V The evolution of the separate legal personality doctrine and its exceptions: a comparative analysis (2011) Company Lawyer, volume 37, issue 7, pages 194-205.
• Griffin, ‘Limited Liability: A necessary revolution’ (2004) 25 Company Lawyer 99.
• Nakajima, ‘Lifting the Veil’ (1996) 17 Co Law 187
• Lowry, ‘Lifting the Corporate Veil’ (1993) JBL 41
• Rixon, ‘Lifting the veil between holding and subsidiary companies’ (1986) 102 LQR 415
• Ottolenghi, ‘From peeping behind the corporate veil to ignoring it completely’ (1990) 53 MLR 338 [Note: this pre-dates Adams v Cape]
• Scanlan, ‘The Salomon Principle’ Company Lawyer (2004), volume 25, issue 7, 196.
• Kahn-Freund, ‘Some reflections on Company Law Reform’ (1944)7 MLR 54. [Especially pages 54-59. Please note that whilst the article is dated and the proposals to the reform of legislation are not relevant, some good criticisms of the Salomon decision are offered].
• Moore, ‘A temple built on faulty foundations: Piercing the corporate veil and the legacy of Salomon v Salomon’ [2006] JBL180-203.
• Linklater, ‘Piercing the Corporation Veil – The never ending story’ Company Lawyer (2006), Volume 27, Issue 3, 65-66.
• Tham, ‘Piercing the corporate veil: searching for appropriate choice of law rules’ Lloyds Maritime and Commercial Law Quarterly (2007), pp 22-43.
• Walters, ‘Corporate Veil’ (1998) 19 Comp. Law 226.
• Pickering, ‘The company as a separate legal entity’ (1968) MLR 481
• Sealy, ‘The disclosure philosophy and company law reform’ (1981) 2 Co Law 51
• Griffin, ‘Holding companies and Subsidiaries – The Corporate Veil’ (1991) 12 Co Law 16
• Clarkson, ‘Kicking corporate bodies and damning their souls’ (1996) 59 MLR 557
• Wickins & Ong, ‘Confusion worse confounded: the end of the directing mind theory’ [1997] JBL 524
• Hawke, ‘Corporate Liability: Smoke and Mirrors’ (2003) 14 ICCLR 75
• Gratham, ‘Corporate Knowledge: Identification or Attribution’ (1996) 59 MLR 732
Recent cases on lifting the corporate veil:
• Chandler v Cape Plc [2012] 3 All ER 640
• VTB Capital plc v. Nutritek International Corp & Others [2013] 2 WLR 398
• Prest v Petrodel Resources Limited [2013] UKSC 34
Outline of the Session
In this session we will have an overview of the recent company law reform and explore the doctrine of the separate corporate personality and the law in relation to lifting of corporate veil.
Introduction
The UK was one of the first nations to establish rules of the operation of companies. Company legislation has roots back into the mid-nineteenth century with inter alia the Joint Stock Companies Act 1844 and the Limited Liability Act 1855. The Companies Act 1985 consolidated different strands of company law under one Act. Company Law is also a common law subject and accordingly, there is a wide body of case law. The Companies Act 1985 is replaced and superseded by a brand new piece of legislation: the Companies Act 2006 (the ‘CA2006’) which received Royal Assent on 8th November 2006.
1. Company Law Reform
In 1998, the then Department of Trade and Industry (now “The Department for Business Regulatory and Reform”) commissioned the Company Law Review. An independent group of experts, practitioners and business people was set up to take an extensive look at our system of company law. This review group published two white papers (in 2002 and 2005). In the 2005 white paper, a draft Bill was enclosed. This draft Bill went to the House of Lords in November 2005 and then to the House of Commons in May 2006. However, the path in between these visits has been tortuous and some commentators have called it a fiasco:
“Labour was accused of leaving a wide-ranging review of company law in “disarray” yesterday because it failed to muster enough MPs to allow the scheduled detailed scrutiny of the bill to go ahead.” (John Eaglesham, The Financial Times 16th June 2006 Labour accused of Company Law Fiasco)
The CA 2006 seeks to make alterations to a number of key areas, including
– Shareholder engagement with the company
– Improved use of electronic communication
– Codifies directors duties
– Codification of the derivative action
A list of company law review reports is available at http://www.berr.gov.uk/bbf/co-act-2006/clr-review/page22794.html .
The CA 2006 has 47 parts, 1300 sections and 16 schedules and seeks to make the company law legislation more palatable for smaller companies and to make the legislation fit better in the context of companies today. The main objectives of the new Act are to ensure that it is accessible to all those who use it, that it does not contain unnecessary burden, it remains flexible, it responds to the business needs of today and provides flexibility for the needs of the future. It is designed to modernise and simplify company law under the key-phrase “Think small first”. In general, approximately a third of the provisions in the Companies Act 1985 are repealed, a third amended and the remaining third untouched.
2. The approach of the CA 2006
There are four main aims behind the new legislation:
– A ‘Think Small First’ approach
– Enhancing Shareholder Engagement
– Making it easier to establish a company
– Providing flexibility for the future.
The CA 2006 intends to be a break from the past and tries to fit in more comfortably with the company context within the 21st century. Therefore, it focuses more on small companies (a small company is a company with a turnover of less than £5.6m, a balance sheet less than £2.8m and less than 50 employees. This is compared to a medium-sized company, which can have a turnover up to £22.8m, a balance sheet of £11.4m and up to 250 employees. It seeks to improve accessibility with clear and simple language, and provide more comprehensive guidance, particularly for smaller companies. New model articles are introduced and the decision making processes are relaxed, for example, the requirement to hold an AGM are abolished for smaller companies and written resolutions can be passed with a 75% majority.
Lord Sainsbury (the then DTI Under- Secretary of State) stated that:
“Better regulation is at the heart of the Bill. As it stands, our company law was originally deigned for larger companies with numerous public investors, but over 90% of companies have five shareholders or fewer. We have lifted from private companies the burden of unnecessary provisions, and have drafted the provisions they use most often in a more accessible way.”
There are five main changes which are intended to be of assistance to smaller companies:
1. Abolition of the requirement to appoint a company secretary
2. Abolition of financial assistance provisions for small companies to purchase their own shares
3. New procedures for capital reduction
4. Abolition for small companies to hold Annual General Meetings
5. New default Articles of Association.
Annex A in the White Paper (2005) stated: “The Government’s overall objective is to produce clearer law, without unnecessary burdens, and which responds to today’s business needs and provides flexibility for the future.”
The Act introduces some major changes, which we shall be examining during the course of this module. Of specific interest are the changes to the derivative actions and the codification of directors’ duties. The DTI suggest that the new Act will save business around £250m/year, and approximately £100m of that will benefit smaller companies. Alan Wells’ article in the Business Law Review (2006) provides a good overview of the breakdown of the Act.
3. Classification of Registered Companies
There are two main types of company:
PUBLIC (Public Limited Company or ‘Plc’)
• Defined by s4(2) Companies Act 2006 as “…a company limited by shares or limited by guarantee and having share capital, being a company (a) the memorandum of which states that it is to be a public company…[and]…the requirements of the Act…as to registration…as a public company have been complied with”
• A Plc must have at least two directors.
• A public company must have the words ‘public limited company’ or ‘Plc’ at the end of its name (for instance Halifax/ Bank of Scotland or HBOS Plc)
• A public company must have £50,000 of authorized capital before they can start trading (s763).
• A public company has an unrestricted right to offer shares to the public and these shares may be floated on the stock market.
PRIVATE (Limited or ‘Ltd’)
• S4(1) Companies Act 2006 simply states that a private company is “…a company that is not a public company”.
• A private company can have just one member.
• A private company must have the word ‘Limited’ or ‘Ltd’ at the end of its name. (Ltd refers to the liability of the shareholders, as opposed to the actions of the company. We shall discuss this further into the course). An example would be Manchester United Football Club Limited.
• A private company has no minimum capital requirement.
• A private company cannot offer shares publicly and does not float its shares on the stock market.
This course will focus primarily on private limited companies. We shall refer, at times, to public companies, but try to focus your research on private companies.
There are other types of business associations alongside public and private companies. One of the more widely found associations is that of a partnership. These are much more informal than incorporation as a company and provided partners do nothing illegal the law places very few requirements on a partnership. Perhaps the key difference between a partnership and a company is that of liability. In a partnership, the partners could be held liable for acts of the firm, whereas the liability of a member of a company is limited by shares.
There are approaching two million companies within the United Kingdom, so what is the incentive for people to incorporate?
4. The advantages and disadvantages of incorporation (Companies v partnerships)
ADVANTAGES
DISADVANTAGES
• Limited liability (this protects members from personal insolvency).
• The assets are in the name of the company Mauara v Northern Assurance Co. (1925) AC 619
• It is the company that sues or is sued as in Williams v Natural Life Health Foods (1998) 1 BCLC 689
• Members obtain shares and receive dividends.
• Perpetual succession. (i.e. the existence of the company remains, even if original members die or are otherwise removed).
• Increased methods of raising finance.
• Possible tax advantages? • Public inspection of accounts and loss of privacy for the business.
• There are various administrative costs, for instance filing fees for documents.
• Cost of a compulsory audit.
• There is less flexibility and more formality after incorporation.
It is generally considered that the advantages to incorporation outweigh the disadvantages. Hicks and Goo (2004, page 81) state:
“In contrast to a partnership a company is a corporate body…a separate legal entity with corporate capacity to hold property, to sue and be sued in its own name. As a separate legal entity it also contracts in its own name. Its members are not liable for its debts, and enjoy limited liability.”
5. The Doctrine of Separate Corporate Personality
The principles set out in the case of Salomon v Salomon [1897] AC 22 have been commended by Mayson, French and Ryan as a “cornerstone” of Company Law. The House of Lords held that a company is – at law – a distinct and separate person from the people who set the company up. Any fully paid-up shareholders could not be required to pay anymore. Once an association has incorporated the company was an independent entity, separate from those who had set it up.
This doctrine has been confirmed by the courts in various different contexts, for instance the company can inter alia:
• Own the property within a company: Macaura v Northern Assurance [1925] AC 619.
• Sue for defamation – South Hetton Coal co. Ltd v North-Eastern News Association Ltd [1894] 1QB133.
• Employ members and outside individuals – Lee v Lee’s Air Farming [1961] AC 12.
• Sue directors who steal from them – A-G’s Reference (no. 2 of 1982) [1984] 2 All ER 216.
• Continue without its original shareholders/directors – Re Noel Tedman Holdings Pty Ltd [1967] QdR 561 (Australian case).
6. Lifting the veil of incorporation
The corporate veil is a metaphor used to describe the effect of the legal principles of separate legal personality and limited liability. The effect of the Salomon decision was to create a veil in front of the shareholders of a company. The company itself is liable for its own debts.
As a separate legal entity, the courts to a very large extent allow companies to operate as they see fit within the boundaries of the law. The courts are very protective of the Salomon decision and the corporate form. Without it, company law would virtually collapse as limited liability would no longer be available; the consequence being the grinding to a halt of the corporate-capitalist machine.
However, on some occasions the courts and the legislature have found it necessary to lift the corporate veil, or to remove the protection (in the form of limited liability) that is afforded shareholders. This means that the courts or statutes will lift the veil of incorporation to reveal the people who stand behind the company. They will look to make those people responsible for the actions of the company.
Circumstances when the veil is lifted are haphazard and difficult to categorize. However, what is clear is that on occasions the Salomon decision has caused problems and the courts have had to remove the veil of incorporation to enable them to see the commercial reality behind the corporate personality. It is, however, important to bear in mind that there are only a few examples of the courts removing the veil of incorporation. The overriding concern is to protect the corporate form; there is a great reluctance by the courts to depart from the Salomon principle. Indeed, Hicks and Goo state that: (at page 88):
“Despite the lifting-of-the-veil cases this [Salomon] principle remains extremely strong and almost without exception.”
Yet it is clear that the courts will remove the veil of incorporation in cases where the incorporator is trying to avoid an obligation or achieve an unfair advantage, in other words, where there is an abuse of the corporate form. There are some occasions where the courts will not lift the veil to impose financial liability on shareholders or to benefit shareholders who discover that trading as a company is a disadvantage. Hicks and Goo provide an insightful quotation by Professor Sealy (1994) (at page 89):
“…one will search the reports in vain for a single English case where the principle of limited liability, as distinct from that of corporate personality, has not been respected – statute apart. This is true of cases brought against directors and dominant shareholders alike. Those cases where the corporate veil has been pierced on the basis that the company was a façade or sham, or was the agent of its controllers, turn out on examination to have been concerned with the evasion of statutory provision or a contractual obligation, or some similar issue, and not with imposing personal liability on the directors or shareholders for the company’s debts.”
There are some occasions where it is clear that the courts will remove the veil, yet the important thing to remember is that this list is not exhaustive and it is not known where the boundary lies between a court removing a veil of incorporation and leaving it in tact.
7. Examples of removing the veil of incorporation (In no particular order)
Please bear in mind that the law does not always fit discretely into neat compartments, many of the cases cover more than one category of veil lifting.
• Fraud, sham or façade
For a removal of the corporate veil under this heading, it must be shown that the company was incorporated for an illegitimate and improper purpose. An example will be where the underlying motive for incorporation was to escape liability for a debt to a third party. Accordingly, the motive behind incorporation is relevant.
For instance, in Gilford Motor Co. v Horne [1933] Ch 935, Mr Horne was employed by the plaintiff and in his contract it was stated that should he leave their employment he could not solicit customers of Gilford. However, on leaving the company, Mr Horne set up a second company and attempted to entice Gilford’s customers to his new company. The court held that this company was a sham, a simple attempt to avoid a contractual liability (a restraint of trade clause). Accordingly, the veil of incorporation was pierced. The company was still recognised as incorporated, but the veil was pierced to recognise Mr Horne’s liability for a breach of contract.
Consider the following cases:
– Jones v Lipman [1962] 1 WLR 832
– Trustor AB v Smallbone [2001] 1 WLR 1177
Please note however, that simply because a company was set-up for an improper motive, it does not necessarily follow that it was for a fraudulent purpose, which could render a piercing of the corporate veil.
In the leading case – Adams v Cape (1990) Ch 433, although it was acknowledged that the fraud, sham, façade exception did exist, it did not apply on the facts. The court held instead that the principle that a company could be set up to avoid future liability was “inherent” in our company law. It seems that to justify lifting the veil under this head there must also be some form of impropriety.
• Statute
Parliament has the power to make or unmake any law. It can lift the veil when it chooses. There are numerous examples of the veil being lifted due to statutory provisions. Most pertinent within the context of this course are S.214 Insolvency Act 1986 and also S.24 Companies Act 1985, for example, the courts can remove the corporate veil if the company goes bankrupt under the Insolvency Act 1986 or if the (public) company falls below two members (s24, CA 1985).
The courts will however take care that the particular statute does indeed give the power to lift the veil:
“…one would expect that any Parliamentary intention to pierce the corporate veil would be expressed in clear and unequivocal language.”
Dimbleby & Sons Ltd v National Union of Journalists [1984] 1 WLR (per Lord Diplock)
• State of national emergency
If the country is at war or there is another national emergency, the court can dislodge the corporate veil, if it would be in the country’s interests to do so. Clearly, this only has limited application, but consider the case of Daimler v Continental Tyre and Rubber Co. [1916] 2 AC 307.
• Agency & The Single Economic Unit Agreement
In some cases, there may be an agency relationship between two or more ‘companies’. This could occur in a group company set-up, where the dominant company is, in essence, the principal and the lesser company is merely an agent. The veil could be removed to reveal a single economic entity. In order to use this heading to remove the corporate veil, evidence must point to an agency relationship and not merely that there could be only one economic entity within the group structure.
Consider the following cases:
– Re Southard & Co. Ltd [1979] 3 All ER 556
– Woolfson v Strathclyde Regional Council (1978) SLT 159
– Adams v Cape Industries [1990] Ch 433
Under ordinary principles of agency law, it is possible that one company can in fact be the agent of its shareholders. This was argued in Salomon itself and succeeded at first instance. Under agency law the principal (the shareholder) will be liable for the debts of the agent (the company). Clearly if a creditor of an insolvent company could prove that an agency relationship exists between the shareholders and the company, the corporate veil could be ignored and the shareholders will be liable. An express agency is theoretically possible but very unlikely (as it would defeat the object of incorporation and limited liability. It is also very unlikely that the courts will consider that there is an implied agency relationship.
The following two cases are exceptions to the general rule:
Smith, Stone & Knight v Birmingham Corporation [1939] 4 All ER 116
Re FG (Films) Ltd [1953] 1 WLR 483
Lord Denning and the Single Economic Unit
Lord Denning in several cases attempted to introduce a new exception essentially derived from that of agency. This exception related to the fact that the in the modern corporate world there are groups of companies. (For example – the Virgin Group.) All the companies in these groups may have been separately incorporated and registered, but to all intents and purposes they behaved as if economically they were the same company.
In some cases, there may be an agency relationship between two or more ‘companies’. This could occur in a group company set-up, where the dominant company is, in essence, the principal and the lesser company is merely an agent. The veil could be removed to reveal a single economic entity. In order to use this heading to remove the corporate veil, evidence must point to an agency relationship and not merely that there could be only one economic entity within the group structure.
The following case is probably the high water point of Lord Denning’s rather cavalier attitude to the Salomon principle.
DHN Food Distributors Ltd v London Borough of Tower Hamlets (1976) 1 WLR 852
DHN is almost certainly no longer good law (although it has not been expressly overruled). The following cases adopt a much more restrictive approach.
– Woolfson v Strathclyde Regional Council (1978) SLT 159
– Adams v Cape Industries [1990] Ch 433
The main reason given for the rejection of the SEU exception was given by Lord Goff in Bank of Tokyo v Karoon [1987] AC 45:
“Counsel suggested beguilingly that it would be technical for us to distinguish between parent and subsidiary company in this context; economically, he said, they were one. But we are concerned not with economics but with law. The distinction between the two is, in law, fundamental and cannot be bridged.”
This was followed by Slade LJ in Adams v Cape.
Although it is still possible for groups of companies to be in an agency relationship – this will now no longer be simply inferred from the fact that a group of companies are acting “economically” as one unit.
A final postscript to the Single Economic Unit – there is another way in which a parent company can be found liable for its subsidiary – by imposing a tortuous liability derived under the Hedley Byrne principle. This was successful in the following cases:
Connelly v RTZ Corp Plc [1998] AC 854 HL
Lubbe v Cape Plc [2000] 1 WLR 352 HL
• Justice?
The idea of piercing the veil in pursuit of justice was championed by Lord Denning. He often displayed a cavalier approach to piercing the corporate veil. In Wallesteiner v Moir [1974] 3 All ER 217 Lord Denning (in a very entertaining judgement) was of the view that the companies managed by Mr Wallersteiner were merely his ‘puppets’. Accordingly, Denning was of the view that the courts should have unfettered discretion when it came to piercing the corporate veil, and instead of taking the rigid view that once all the requirements of the Companies Act have been met, a company can consider itself incorporated, the courts should look at the motive of the incorporator.
Lord Denning’s belief was continued in the case of DHN Food Distributors Ltd v London Borough of Tower Hamlets (1976) 1 WLR 852 in which he held that a group of companies were in reality a single company, thus allowing compensation for a compulsory purchase of some land.
The House of Lords decision in Woolfson v Strathclyde Regional Council (1978) SLT 159 muddied the water somewhat by saying that the courts should only pierce the veil in special circumstances, but failed to define exactly what these circumstances were. However, this approach was followed in the Canadian case of Transamerica Life Insurance Co. of Canada v Canada Life Assurance Co. (1996) 28 OR (3d) 423, Sharp J stated:
“The cases and authorities already cited indicate that it will be difficult to define precisely when the corporate veil is to be lifted, but that lack of a precise test does not mean that a court is free to act as it pleases on some loosely defined ‘just and equitable’ standard.” (at page 433).
This followed that decision in Adams v Cape Industries (1990) Ch 433. Hicks and Goo (citing Professor Gower) called this a “mammoth judgment” (at page 98). This reviewed the issues surrounding the lifting of the corporate veil. First, the court held that the veil could not be lifted merely in pursuit of ‘justice’. Slade LJ stated:
“If a company chooses to arrange the affairs of its group in such a way that the business carried on in a particular foreign country is the business of its subsidiary and not its own, it is, in our judgment, entitled to do so. Neither in this class nor in any other class of case is open to this court to disregard the principle of Salomon v Salomon & Co Ltd [1897] AC 22 merely because it considers it just to do so.” (at page 513).
Therefore, the necessity to protect the rule in Salomon is a greater concern to the courts than any abstract notion of ‘justice’. Second, the courts should only lift the veil in circumstances where a fraud, sham or façade is present, or third whether there is an agency relationship. Although the veil can be lifted in cases where there is a fraud, sham or façade, these terms have not been defined; the judgment merely gave examples based on fraud and agency. The courts therefore proceed on a case by case basis in deciding whether to pierce the veil of incorporation. Consider:
– Creasey v Breachwood Motors Ltd (1992) BCC 639
– Re Poly Peck International Plc (In Administration) (No. 3) (1996) 2 All ER 433
– Customs and Excise Commissioners v Hare (1996) 2 All ER 391
– Ord v Belhaven Pubs Ltd (1998) 2 BCLC 447
– Kensington International Ltd v Congo (2005) All ER (D) 30
• Important update – The Supreme Court’s Judgment in Prest v Petrodel Resources Limited [2013] UKSC 34
Background to the Appeal:
This appeal arises out of proceedings for financial remedies following a divorce between Michael and Yasmin Prest. The appeal concerns the position of a number of companies belonging to the Petrodel Group which were wholly owned and controlled by Michael Prest, the husband. One of the companies was the legal owner of five residential properties in the UK and another was the legal owner of two more. The question on this appeal is whether the court has power to order the transfer of these seven properties to the wife given that they legally belong not to the husband but to his companies.
JUDGMENT
The Supreme Court unanimously allows the appeal by Yasmin Prest and declares that the seven disputed properties vested in the companies are held on trust for the husband on the ground (which was not considered by the courts below) that, in the particular circumstances of the case, the properties were held by the husband’s companies on a resulting trust for the husband, and were accordingly “property to which the [husband] is entitled, either in possession or reversion”.
SESSION ONE
Questions for consideration
1. What are the advantages and disadvantages of incorporation compared with sole-traders and partnerships?
2. The decision in Salomon v Salomon was described by Kahn Freud as being ‘calamitous’.
In the light of modern company law, do you agree?
3. ‘There are no doubt situations … where on the established facts a company is so utterly subservient or subordinate to the will and the wishes of some other person (whether an individual or a parent company) that compliance with that other person’s demands can be regarded as assured. Each case must depend upon its own facts and also upon the nature, degree and context of the control it is sought to exercise.’
(Shaw LJ, Lonrho Ltd v Shell Petroleum Co Ltd)
Discuss.
4. ‘It is clearly right to maintain the separate personality of a company except in wholly exceptional cases involving fraud or conduct very close to fraud. Businessmen are entitled to form companies and expect the advantages of incorporation without having to worry about some court ‘lifting the veil’, possibly to their disadvantage, at some future date.’
Discuss.
Learning Outcomes:
By the end of the session you should be able to:
• Demonstrate a high level of knowledge of and critically evaluate the main theoretical elements of corporate personality and apply the relevant law to complex problem/essay style questions.
• Demonstrate a high level of knowledge of and critically evaluate the notion of separation of ownership and control within a company and apply the relevant law to complex problem/essay style questions.
• Identify accurately issues which require research with limited guidance.
• Demonstrate an ability to inter-relate corporate personality with other aspects of company law.
SESSION TWO
Company’s Constitution
Required Reading
Textbooks:
• Wild & Weinstein (2013), Chapters 5, 6 &7.
• Hannigan, Chapter 4.
• Boyle & Birds, Chapter 5.
• Mayson, French & Ryan, Chapter 3.
• Hicks & Goo, chapters 5 & 6.
• Dignam & Lowry, Chapter 8.
Articles:
• Hannigan, B., ‘Altering the article to allow for compulsory transfer – dragging minority shareholders to a reluctant exit’ (2007) JBL471.
• Williams, R., ‘Bona Fide in the Interest of Certainty’ (2007) 3 CLJ 498
• Rixon, F. G., ‘Competing interests and conflicting principle: an examination of the power of alteration of articles of association’ (1986) 49 MLR 446.
• Ferran, ‘The decision of the House of Lords in Russell v Northern Bank Development Corporation Limited’ [1994] CLJ 343
• Goldberg, ‘The enforcement of outsider rights under the section 20 contract’, (1972) 35 MLR 362; (1985) 48 MLR 121
• Goldberg, ‘The controversy on the section 20 contract revisited’, (1985) 48 MLR 158
• Gregory, ‘The section 20 contract’ (1981) 44 MLR 526
• Drury, ‘The relative nature of a shareholder‘s right to enforce the company contract’ (1986) CLJ 219
• Prentice, ‘The enforcement of ‘outsider rights’ (1980) 1 Co Law 179
• Sealy, ‘Shareholders Agreements: An Endorsement and a Warning’ [1992] CLJ 437
• Davenport, ‘What did Russell v Northern Bank Development Corporation Ltd Decide?’ (1993) 109 LQR 553.
• Griffin, ‘The limited contractual nature of s.14 of the Companies Act 1985’ (1993) Company Lawyer, Volume 14, Issue 11, pages 217-218.
• Riley, ‘Vetoes and Voting Agreements: Some problems of consent and knowledge’, (1993) 44 NILQ 34
• Wedderburn, ‘Shareholders’ rights and the rule in Foss v Harbottle’ (1957) CLJ 193
• Fang Ma, “Removal of Directors: Lord Morris in Bushell v Faith [1970] A.C. 1099” in Geach & Monaghan (ed), Dissenting Judgments: With a Foreword by Lord Nicholls of Birkenhead, (Wildy, Simmonds and Hill, 2011)
Outline of Session
In this session, we will examine the constitution of a company, in particular, the articles of association and how they are to be enforced and altered. We will also look at the distinction between insider and outsider rights as well as the importance of shareholders’ agreements.
1. What is a company’s constitution?
Prior to the CA 2006, the constitution of every registered company was embodied in both its memorandum of association and articles of association. The memorandum of association had to state the company’s name, the situation of the registered office and its objects, as well as further items where the company is limited either by share capital or by guarantee.
Under the CA 2006, the memorandum is only a basic document and no longer be a central feature of the company’s constitution. Most of the information that had to be included in the memorandum under the CA 1985 now has to be given in the company’s registration documents (ss 9-13). For companies formed before the CA 2006, with regard to provisions contained in the memorandum which can no longer be included there, such provisions are treated as provisions of articles of associations instead (s.28, CA 2008).
Section 17 of the CA 2006 states that the company’s constitution includes its articles of association, as well as any resolutions and agreements which affect a company’s constitution. The latter are defined in s.29, CA 2006, including any special resolutions. This broad approach towards a company’s constitution is to reflect the constitutional importance of many such documents.
As a company registers its constitutional documents at Companies House, making them a matter of public record, anybody dealing with a company has constructive notice of the contents of that company’s memorandum and articles – per Lord Wensleydale in Ernest v Nicholls [1857] 6 HL Cas 401.
2. Articles of Association
The reforms in the CA 2006 mean that the Articles of Association are now the most important constitutional document. (S.17 CA 2006)
1) The content of the articles of association
The Articles of Association provide the rules for a company’s internal management. They will provide detailed instructions as to how the company is to work. In other words, they provide an ‘instruction book’ or ‘rule book’ which outlines the way in which various activities should be undertaken within a company – the internal management structure – and so provide the answer to the question as to whether the members or the directors are permitted to undertake some proposed act. They outline procedures such as the appointment of directors, transfers of shares and voting rights.
Under the CA 1985, every company was required to include its memorandum of association a statement of its objects (‘the objects clause’). This requirement has been removed so that a company’s objects are not restricted.
2) Model articles
Under the 1985 Act, the standard form of articles was found in Table A. The 2006 Act seeks to provide greater flexibility (remember ‘the think small first’ approach?) and intends to provide a number of different forms of Table A (or equivalent) so that the terms found within are more applicable to each type of company.
The current power is in S.19, CA 2006 – Power of secretary of state to prescribe model articles. These model articles are very useful – particularly for small businesses who wish to incorporate quickly without going to the time and expense of drafting their own set of articles.
The new default articles for private and public companies are due to come into force in October 2009 (available at http://www.opsi.gov.uk/si/si2008/uksi_20083229_en_1 ).There are different forms of model articles of association for public companies, private companies and companies limited by guarantee. They will apply by default for any company formed and registered on or after 1 October 2009, to the extent they are not modified or excluded by that company’s articles of association.
The model articles for private companies are designed to reflect the concerns of small owner-managed businesses and are more user-friendly than the Table A. We will be referring to both the new Model articles for private companies limited by shares and Table A throughout the course as a large number of existing companies were established before October 2009 and still use Table A. Although this may seem rather confusing – it will be more useful for you in your future careers to have knowledge of both systems.
3) Entrenched provisions
Under the CA 2006, it is possible to ‘entrench’ certain provisions of the article, making it more difficult to amend or remove them; for example, this may be appropriate to give a particular shareholder the right to appoint a director irrespective of the strength of his shareholding. Articles can only be entrenched where this is done at the time of formation, or where the articles are amended with the agreement of all the members of the company.
As articles of association can normally be amended by special resolution, the entrenched provisions will be subject to more restrictive conditions or a more restrictive procedure. Thus, it is possible to set a higher majority, or even impose a requirement of unanimity of all shareholders, in order to amend the articles.
However, these restrictions can be overridden if all the members of the company agree to an alternation, or by an order by a court or other authority having such power, to amend the articles.
4) Alteration of articles
S.21 of the CA 2006 provides that the articles of a company may, subject to certain restrictions applicable to charities, be altered by special resolution. The power to alter articles is subject to any class rights which may be attached to particular shares.
However, it should be noted that the alterations to the articles must not conflict with any statutory provisions. In addition, the power of alteration must be exercised ‘bona fide for the benefit of the company as a whole’ as was held in Allen v Gold Reefs of West Africa Ltd [1900] 1 Ch 154.
S.25 of the CA 2006: No alternation of the articles of association after a person becomes a member can bind him either to take up more shares than he held at the date when the alternation was made, or in any way increase his liability to contribute to the share capital, or to pay money to the company, unless he agrees in writing.
Copy of the amendments made to the company’s articles must be sent to the Registrar within 15 days of the amendment taking effect (s.26, CA 2006).
3. Enforcement
Section 33(1), CA 2006, ‘statutory contract’
“The provisions of a company’s constitution bind the company and its members to the same extent as if there were covenants on the part of the company and of each member to observe those provisions.”
The effect of s 33(1) is to create an obligation binding alike on the members in their dealings with the company, on the company in its dealings with the members as members, and on the members in their dealings with one another as members.
1) A contract between the company and the members
Hickman v Kent or Romney Marsh Sheepbreeders Association, [1915] 1 Ch 881
The issue is whether an article of association which allowed for arbitration proceedings where there was a dispute between the members and the company. Astbury J considered that ‘articles regulating the rights and obligations of the members generally as such do create rights and obligations between them and the company respectively’. The article was, therefore contractually binding between the members and the company.
2) A contract between members
Does s 33(1) bind the members ‘inter se’? Does each member have a binding enforceable contract with every other?
The question as to the enforceability of the contract between members has caused some difficulty and there has been much judicial debate as to whether a member can enforce a right contained in the articles directly against another member or whether the company is the proper claimant in such action.
Towceser Racecourse Co. Ltd v The Racecourse Association Ltd [2003] 1 BCLC 260.
Eley v Positive Life Association, [1876] 1 Ex D 88
Browne v La Trinidad [1877] 37 Ch D 1
Wood v Odessa Waterworks Co Ltd [1889] 42 Ch 639
Quin & Axtens v Salmon, [1909] 1 Ch 311, [1909 AC 442
3) Insider and outsider rights
While there is deemed to be a binding contract between the members and the company, that contract only binds the members in their capacity as members. Where outsider rights are at issue s.33 contract does not apply.
In Eley v Positive Government Security Life Assurance Co (1876) the articles contained a clause which ensured that a particular member of the company was appointed as the company’s solicitor. The member was not appointed as the company’s solicitor and sued for breach of contract. The court held that he could not rely on breach of that clause in the articles as the cause of his action as there was no contractual relationship between the member as ‘solicitor’ and the company.
Hickman v Kent or Romney Marsh Sheep-breeders’ Association, [1915] 1 Ch 881
Astbury J stated:
‘this much is clear, first, that no article can constitute a contract between a company and a third person; secondly, that no right merely purporting to be given by an article to a person, whether a member or not, in a capacity other than as a member, as for instance, solicitor, promoter, director, can be enforced against the company; and thirdly, that articles regulating the rights and obligations of the members generally as such do create rights and obligations between them and the company respectively.’
The same appraoch is taken in Globallink Telecommunications Ltd v Wilmbury Ltd (2003), where the court considered the validity of a directors‘ indemnity provision that had been placed in the comapny’s articles. The court found that such a provision would not be binding because the articles do not consititute a contract betweem the company and its officers. It will only bind the comapny if the provision is contained in a separate contract between the company and the officer.
In Beattie v E & F Beattie Ltd, [1938] 3 All ER 214, the Court of Appeal heavily relied on the Hickman decision but chose to ingore the House of Lords‘ decision in Salmon v Quin & Axtens Ltd (1909).
In Samlon , the House of Lords accpeted a general perosnal right of members to sue to enforce the articles by allowing a member to obtain an injunction to stop the completin of the transactions entered into in breach of articles. The court viewed the issue in terms of enforcing a member right which tangentially affects his right as a director rathter than in teh Beattie case where they viewed it as a director right which has a tangential effect on membership.
• Academic debate: Gower; Wedderburn; Goldberg
Wedderburn, ‘Shareholder’ Rights and The Rule in Foss v Harbottle’ [1957] CLJ 193, [1958]CLJ 93.
Prentice “Enforcement of outsider rights” (1980)1 Co Law 179
Goldberg, “The enforcement of outsider rights under s. 20(1) of CA 1948” (1972)35 MLR 362;
Goldberg, “The Controversy on the section 20 contract revisited” (1985) 48 MLR 158.
Drury, ‘The Relative Nature of a Shareholders Right to Enforce the Company Contract’ [1986]CLJ 219
Exceptions
The following two examples would appear to fall within the category of outsider rights and, as such, prove to be unenforceable under the s 33 contract. However, they are in fact exceptions to this rule. The reason (which some of you will find unsatisfactory) will be examined later.
– Weighted voting in certain circumstances (Bushell v Faith [1970] 1 All ER 53) and
– Rights attached to a percentage/proportion of shares (Cumbrian Newspapers Group Ltd v Cumberland & Westmoreland Herald Newspapers Ltd [1986] 2 All ER 816)
The Hickman test (filter), which is frequently (and misleadingly) quoted as focusing on insider and outsider rights, actually makes mention of membership and non-membership rights. Consequently, over the years, exceptions have developed – mainly as a result of attaching non-membership related rights to shares or proportions of shares.
Therefore, strictly speaking, both exceptions outlined above are membership rights as they are class rights – rights attached to a particular class of shares. Such rights may only be exercised by a member and, as such, must fall within the acceptable scope of membership rights mentioned in the Hickman test.
Removal of directors:
– Articles of association: It is common for the Articles of Association to contain terms upon which they may be removed from office.
– Companies Act 2006:
Section 168 provides that notwithstanding any contrary provision in a company’s Articles or in any agreement between the company and a director, a director may be removed from office by the passage of an ordinary resolution.
It is possible for a director to circumvent the effect of s168 by way of attaching ‘weighted votes’ to the shares that he holds. See
Bushell v Faith [1970] 1 All ER 53
Cumbrian Newspapers Group v Cumberland [1986] 2 All ER 816
– Contractual restraints: where the director has a service contract then it is possible that removal of the director will amount to a breach of contract by the company, as in Southern Foundries v Shirlaw [1940] AC 701 and Shindler v Northern Raincoat Co Ltd [1960] 2 All ER 239.
The potential use of shareholders agreements should also be borne in mind, especially in terms of their use with statutory remedies such as s994 or perhaps the new statutory derivative actions in ss.260-262.
4. Shareholders’ Agreements
Agreements between shareholders have become an increasingly common feature of company law. Shareholders’ agreements are agreements between shareholders themselves (all the shareholders or just between some of them) or between the company and the shareholders (all of them or just some of them).
Compared with the articles of association, shareholders’ agreements are relatively easier to achieve and enforce. The disadvantage of a shareholder agreement is that it does not bind the new owner of the shares. Once a party to a shareholders’ agreement sells them on, the new owner has no obligations under the shareholders’ agreements.
The courts have been willing to enforce shareholder agreements purely between shareholders. However, such agreements can only attempt to regulate the rights and obligations belonging to those shareholders.
If a company is a party to the agreement, the subject matter of the agreement which affects a statutory obligation of the company may not be enforceable. In Punt v Symons & Co Ltd (1903) the court held that a company could not contract out of the right to alter its articles (where the law allowed the company to alter its articles by special resolution).
As regards the ability of the company to contract out of statutory provisions, the courts have not taken entirely consistent approach. In Bushell v Faith (1970) the articles contained a provision whereby in the event of a resolution to remove a director that director’s shares in the company would be multiplied by three. This in effect entrenched the director on the board of directors as the other shareholders could never outvote him. In effect, the article attempted to remove the ability of the members conferred by s. 168 of the Companies Act 2006 to remove a director for any reason whatsoever. The House of Lords held that the article in question was not inconsistent with the statutory power.
The issue was reconsidered in the context of a shareholders’ agreement in Russell v Northern Bank Development Corporation Ltd [1992] 1 WLR 588. The House of Lords considered a shareholders’ agreement where the company agreed not to increase the share capital of the company without the agreement of all the parties to the shareholders’ agreement. The company did attempt to increase the share capital of the company and one of the shareholders who was a party to the shareholders’ agreement objected and attempted to enforce the agreement.
The statutory conflict here was between the agreement and s 121 of the CA 1985 which allowed companies to increase their share capital if their articles contain an authority. The article of this company did provide such an authority. The House of Lords found that the company’s agreement not to increase its share capital was contrary to the statutory provisions (s121) and therefore, unenforceable.
This judgement greatly enhances the ability of shareholders’ agreements to contact out of statutory provisions. If shareholders place a provision in the articles that purports to contract out of a statutory provisions it will probably be invalid; however, if they place the same provision outside the articles in a shareholders’ agreement and either all or a majority shareholders, the provision will be effective as it only represents only a private agreement between the shareholders as to how they will exercise their voting rights.
Shareholders’ agreements are not directly mentioned within the CA 2006, accordingly some would argue that the new Act is a ‘missed opportunity’ in this regard. Although others, perhaps somewhat controversially would point to section 29 of the Act that refers to “any resolution or agreement agreed to by all the members” that could affect the company’s constitution.
SESSION TWO
Questions for consideration
1. How far do the Articles of Association form a constitution of the company? What are the characteristics of this constitution? What is (or should be) the contents of the rights and how should they be enforced?
2. ‘The articles form a contract between a company and its members. This contract is, however, an unusual one, limited both in its scope and permanence.’
Discuss.
3. Shareholder agreements are now treated by the law as part of the constitution of the company, arguably equal in status to the memorandum and articles of association. The shareholder agreement has the advantage that the rights it gives are not subject to alteration, unlike the memorandum and articles. There is also the advantage that a shareholder agreement is always enforceable by a shareholder whereas the enforcement of the memorandum and articles is not always certain.
With reference to appropriate case law and academic opinion, critically discuss this statement.
Learning Outcomes:
By the end of the seminar you should be able to:
• Demonstrate a high level of knowledge of and critically evaluate the basic effect of the constitution of a company and the limits on its alteration and apply the relevant law to complex problem/essay style questions.
• Identify accurately issues which require research with limited guidance.
• Demonstrate an ability to inter-relate constitutional concerns/issues with other aspects of company law.
• Demonstrate an ability to evaluate the relationships between theory and practice.
SESSION THREE
Shares and Share Capital
Required Reading:
Text Books:
• Wild & Weinstein (2013), Chapters 9, 10, 13 &14.
• Hannigan, Chapter 19.
• Boyle & Birds, Chapter 8. .
• Hicks & Goo, chapters 9 and 10. .
• Mayson, French & Ryan, Chapter 6.
• Dignam & Lowry, Chapter 9.
Articles:
• Reynolds, ‘Shareholders’ Class Rights: A new approach’ [1996] JBL 554.
• Birds, ‘An odd construction of “class rights”’ Company Lawyer (1986), pages 202-203.
• Armour, ‘Share capital and creditor protection: efficient rules for a modern company law’ (2000) 63 MLR 355.
Outline of the session
This session will explore the nature of shares, classes of shares, class rights, variation or abrogation of class rights, allotment of shares and the maintenance of capital.
1. Nature of shares
S 541 and s. 544 of the CA 2006 describe a share as an item of personal property transferable in the manner provided by the company’s articles. A share is in fact a chose-in-action, one of those property interests which do not give owner the right to possess anything physical. A vivid description is provided by Farwell J in Borland’s Trustee v Steel Bros [1901] 1 Ch 279 (at page 288).
‘A share is the interest of a shareholder in the company, measured by a sum of money for the purpose of liability in the first place and of interest in the second, but also consisting of a series of mutual covenants entered into by all the shareholders inter se in accordance with section [33] of the Companies Act [2006]… A share is not a sum of money… but is an interest measured by a sum of money, and made up of various rights contained in the contract’.
2. Classes of Shares
A company can divide its share capital into different classes, although this would be slightly unusual for a private company. The power to create shares with varying rights is normally contained in the articles.
If a company is authorised by its constitution to issue shares with different class rights, it can divide its share capital into as many different classes as it wishes. The rights attaching to each class should be clearly stated either in the company’s constitution, or in the resolution authorising the share issue as well as in the prospectus because it is a rule of construction that any statement of class rights is presumed to be exhaustive (Re National Telephone Co (1914)). . In other words, there are no limits to the class of shares which can be created, even within a single company. Whatever preference or special rights are intended to be created for a class of shares should be clearly expressed in the articles of association or in the resolution authorising the issue.
1). Ordinary Shares (‘equities’)
An ordinary shareholder is entitled to:
• Receive dividends when declared (subject to any priority as to dividend enjoyed by preference shareholders);
• Have his appropriate proportion of the company’s assets after payment of creditors on a winding-up (subject to any priority as to dividend enjoyed by preference shareholders);
• To exercise one vote for each share that he holds at the GM of the company
The rights to receive a dividend and return of capital include a right to participate in any surplus assets. These rights may be varied by express provision in the articles or terms of issue.
2). Preference Shares.
Preference shares may give a preferential right as to:
• A fixed preferential cumulative dividend ;
• Return of capital on a winding-up in priority to the ordinary shareholders;
• Both dividend and return of capital.
In either case the preferential dividend may be cumulative or it may be payable only out of the profits of each year. A fixed preferential dividend is prima facie cumulative, though this may be rebutted.
Webb v Earle [1875] LR 20
Adair v Old Bushmills Distillery Co [1908] WN 24
Staples v Eastman Photographic Materials Co [1896] 2 Ch 303
Preferential shares sometimes give further rights to participate in profits or assets. If this is the case then they may be known as ‘participating preference shares.’
3). Voting Rights.
The holders of all classes of shares have equal rights of voting unless restrictions are specifically imposed. A provision in the articles that holders of any class of shares shall not have votes or shall have only limited rights of voting in respect of those shares is good; and Resolutions passed by those having voting rights may be binding even when they affect the interests of all classes.
Re Barrow Haematite Steel Co (No. 1) [1888] 39 Ch D 582
Re Mackenzie & Co Ltd [1916] 2 Ch 450
Every shareholder is entitled to vote in accordance with his own interests, although they may appear to be different from those of the company at large. Unless by doing so he infringes the broad principle that members must exercise their voting power in what they bona fide believe to be the interests of the company.
Pender v Lushington [1877] 6 Ch D 70
Burland v Earle [1902] AC 82
3. What are Class Rights?
The CA 2006 offers little guidance on the definition of the term ‘class rights’. If the shares in a company are divided into different classes and they have differing rights in respect of dividend, capital and voting, then the rights specifically conferred in contrast to one or more of the other classes are class rights.
Section 629(1) of the CA 2006 Act states: “For the purposes of the Companies Acts shares are of one class if the rights attached to them are in all respects uniform.”
Scott J in Cumbrian Newspapers Group Ltd v Cumberland [1986] 3 WLR 26 took the view that rights or benefits conferred by a company’s articles of association can be classified into three distinctive categories:
First, the rights or benefits which are annexed to particular shares, for example, dividend rights and rights to participate in surplus assets on a winding up.
Secondly, rights or benefits which, although contained in the articles, are conferred on individuals not qua members or shareholders but, for ulterior reasons, are connected with the administration of the company’s affairs. For example, where the articles included a provision that the claimant should be the company solicitor. Rights or benefits in this category cannot be regarded as class rights.
Thirdly, rights or benefits that, although not attached to any particular shares, are conferred on the beneficiary in his capacity as member or shareholder in the company; for example, where the articles gave a director weighted voting rights on a resolution to remove any director from office (Bushell v Faith [1970] AC 1099 (HL).
4. Variation and Abrogation of Class Rights
Part 17 (Chapter 9: sections 629-640) of the 2006 Act provides the legislative background for class rights. It exists to protect the ‘class rights’ of shareholders, so that they cannot simply be varied, altered or removed by alteration of the documents in which they are contained.
1) What does ‘varying’ or ‘abrogating’ class rights mean? How to determine whether there is variation or abrogation of class rights?
Whether or not a company has varied a shareholder’s class rights is not always immediately apparent. The CA 2006 is far from helpful; however, case law does provide some guidelines.
The courts have generally adopted a restrictive approach and have sought to distinguish corporate conduct which impacts upon the substance of a shareholder’s class right (which amounts to a variation), from conduct which merely affects its exercise or enjoyment.
White v Bristol Aeroplane Co Ltd (1953)
Greenhalgh v Arderne Cinemas Ltd (1946)
A class right is being varied or abrogated when the proposed alteration directly conflicts with or purports to override the particular provision under which the right arises. There are other ways in which variation may take place though.
Greenhalgh v Arderne Cinemas Ltd [1946] 1 All ER 512
White v Bristol Aeroplane Co Ltd [1953] Ch 65 (CA)
Re John Smiths (Tadcaster) Brewery Co Ltd [1953] Ch 305
Re Saltdean Estate Co Ltd [1968] 1 WLR 1844
Re Northern Engineering Industries Plc [1993] BCC 267
2) The statutory procedure for variation of class rights
S630 Variation of class rights: companies having a share capital
S630(2) Rights attached to a class of a company’s shares may only be varied-
(a) in accordance with provision in the company’s articles for the variation of those rights, or
(b) where the company’s articles contain no such provision, if the holders of shares of that class consent to the variation in accordance with this section.
S630(3) This is without prejudice to any other restrictions on the variation of the
rights.
S630(4) The consent required for the purposes of this section on the part of the
holders of a class of a company’s shares is-
(a) consent in writing from the holders of at least three-quarters in nominal value of the issued shares of that class (excluding any shares held as treasury shares), or
(b) a special resolution passed at a separate general meeting of the holders of that class sanctioning the variation.
S630(5) Any amendment of a provision contained in a company’s articles for the
variation of the rights attached to a class of shares, or the insertion of any such provision into the articles, is itself to be treated as a variation of those rights.
S630(6) In this section, and (except where the context otherwise requires) in any
provision in a company’s articles for the variation of the rights attached to a class of shares, references to the variation of those rights include references to their abrogation.
The Common law requirements: the shareholders voting at a class meeting must have regard to the interests of the class as a whole.
British America Nickel Corp v MJ O’Brien Ltd (1927)
Re Holders Investment Trust Ltd [1971] 1 WLR 583
3) Right to object to a variation
Section 633 gives the holders of not less than 15 per cent of the issued shares of the class in question, the right to apply to the court to have the variation cancelled. The application must be made within 21 days after the date on which the consent was given or the resolution was passed (s 633(4)). If such an application is made, the variation has no effect unless and until it is confirmed by the court ( s 633 (3).
The court may, if satisfied having regard to all the circumstance of the case that the variation would unfairly prejudice the shareholders of the class in question disallow the variation, but if not so satisfied, confirm it. The decision of the court in this regard is final. (s.633(5)).
5. Share Capital – Allotment of shares
The capital of a company may typically comprise a mixture of loan capital and share capital. Company law has traditionally paid particular attention to share capital in two particular respects:
– Allotment of shares, where rules exist primarily to protect shareholders;
– Rules that seek to ensure that share capital is properly raised and maintained for the benefits of the company’s creditors.
There are two forms of statutory protection for shareholders against the traditional power of control of the board over the issue of a company’s capital. The first form requires the authority of the shareholders for the allotment of shares; secondly, the CA 2006 confers pre-emptive rights on shareholders in proportion to their holdings of each share.
1) Authority to allot shares.
S 549 (1), CA 2006 restricts the power of directors of a company to allot shares in the company or grant rights to subscribe for, or convert any security into, shares in the company unless they are authorised to do so by the company either in general meeting or by virtue of the articles.
Moreover, private companies with a single class of shares are allowed to allot shares in accordance with procedures set out in S 550: Where a private company has only one class of shares, the directors may exercise any power of the company-
(a) to allot shares of that class, or
(b) to grant rights to subscribe for or to convert any security into such shares,
except to the extent that they are prohibited from doing so by the company’s articles.
In other words, the directors have authority under s550 to allot shares in the company if they are authorised to do so by ordinary resolution or by the articles. Such an authority may be general or specific (that is, it may, for example, be restricted to a specified allotment, an allotment of shares up to a specified value, or an allotment of shares of a particular class). In either case, the authority must state the “maximum amount of relevant securities that may be allotted under it” and the date when the authority will expire, (which must not be more than five years from the date on which the authority is given). The authority may be renewed for further periods not exceeding five years.
The company in GM may renew any authority for successive periods not in excess of 5 years. The resolution must state the amount of shares, which may be allotted and the date of expiry.
One of the major changes of the 2006 Act in relation to share capital is that it also abolishes the concept of authorised share capital (section 542) and a company’s constitution will therefore no longer have to contain a ceiling on the number of shares that the directors are authorised to allot.
2) Pre-emption rights: s. 561
A pre-emption right is ‘a right of first refusal’ on an issuing of shares. The reason for pre-emption rights is that a shareholder should be able to protect his proportion of the total equity of a company by having the opportunity to subscribe for any new issue of equity securities. This may be of relevance to existing shareholders, who have to be offered new shares first, before they are offered to people outside of the company. This right applies to both public and private companies, but private companies may exclude it by a provision in their memorandum or articles.
There is a 21 day period during which the pre-emptive rights may be taken up or refused (s562). During this period, the company may not allot any securities subject to the pre-emptive rights conferred by s561 to any other person.
The pre-emption rights may not apply in certain circumstances (ss 569-573).
When authority under s.551 overrides pre-emptive rights.
Section 570: Where directors of a company are generally authorised for the purposes of s550, they may be given power by the articles or by special resolution to allot equity securities pursuant to their s550 authority as if s561 did not apply to the allotment.
3) Price of allotted shares.
As a general rule, the total consideration received by a company in return for each share allotted must not be less than the nominal amount, or ‘par value’ of the share, that is shares must not be allotted at a discount. (S. 580).
Proper consideration must be obtained for issued shares, though the rule does not go as far as requiring that shares be paid for in cash.
Section 582: Confirms that ‘money’s worth’ is sufficient (e.g. know-how or goodwill).
A new provision is found within s622 which allows a company to redenominate its share capital into another currency, for instance the Euro or Dollar. This puts on a statutory footing the decision in Re Scandinavian Bank plc [1988] Ch 87 and (amongst other reasons) seeks to encourage foreign investors. Redenomination can be achieved by an ordinary resolution and the company can decide on the day of exchange (but must be within 28 days of the resolution). Under s625, Companies House must be notified if a company changes the currency of its shares.
4) Return of allotments: s 555
Whenever a company makes any allotment of its shares, either upon public subscription or otherwise, then it must within one month thereafter lodge with the Registrar for registration the relevant documents.
6. Share Capital – Maintenance of Capital
The term ‘capital’ here means only capital in the narrow sense of money raised by the issue of shares and the assets towards the acquisition of which that money is used. The purpose of the legal rules is primarily to protect the creditors of a company, so that they can be sure that there is something they can look to for payment of debts.
7. Transfer of Shares
Section 544 states that company shares are transferable. Sections 768 to 770, 772 to 779 and 781 to 782 restate the provisions in Part 5 of the 1985 Act (sections 183 to 189) relating to the certification and transfer of shares and other securities. Directors’ power to refuse to register a transfer must be exercised bona fides in the interests of the company.
Re Smith & Fawcett Ltd (1942)
Re Bede Steam Shipping Co Ltd (1917)
A share certificate is prima facie evidence of the fact that the person is indeed a member of the company (s768). The procedure for transfer of shares is laid out in section 771:
Under s776, the company has two months to get the share certificate to the new shareholder.
Section 771 is a new provision which amends the law on the registration of transfers and requires the directors to either register a transfer of shares or debentures or provide the transferee with reasons for their refusal to. In either case, this must be done as soon as practicable, but in any event within two months of the transfer being lodged with the company.
8. The Reorganisation of Capital
A company may reorganise its capital structure in various ways and subject to conditions. This is outlined in s 617:
• It may increase its capital by the allotment of new shares under Part 17 of the CA 2006;
• It may reduce its capital
• It may consolidate its shares and convert its paid-up shares into stock
• It may subdivide its shares
SESSION THREE
Shares and Share Capital
Questions for Consideration
1. What are the purposes of the procedural rules governing the variation of class rights?
Learning Outcomes:
By the end of the seminar you should be able to:
• Demonstrate a high level of knowledge of and critically evaluate the rights of different classes of shares and apply the relevant law to complex problem/essay style questions.
• Demonstrate a high level of knowledge of and critically evaluate the maintenance and protection of a company’s share capital and apply the relevant law to complex problem/essay style questions.
• Identify accurately issues which require research with limited guidance.
• Demonstrate an ability to inter-relate issues relating to share capital with other aspects of company law.
• Demonstrate an ability to evaluate the relationships between theory and practice.
SESSION FOUR
LOAN CAPITAL
Required Reading
Text Books
• Wild & Weinstein (2013), Chapter 24
• Hannigan, Chapter 21
• Gower and Davies, pages 1155 -1210
• Hicks & Goo, pages 506 – 526
Cases
• Agnew v IRC (Re Brumark) [2001] 2 BCLC 188,
• Re Cosslett [2002] 1 BCLC 77.
• Spectrum Plus Ltd (In Liquidation), Re [2005] 2 AC 680
Articles
• Armour, ‘Share Capital and Creditor Protection: Efficient Rules for a Modern Company Law’ (2000) 63 MLR 355.
• Ferran, ‘Corporate Transactions and Financial Assistance: Shifting Policy Perceptions but Static Law’ (2004) CLJ 225.
Loan Capital
One common form of funding for many companies is by obtaining loan capital- borrowing from banks and financial institutions. In order to protect its position in the event of insolvency of the company, the lenders may prefer to seek security on the company’s property and assets.
In this lecture we will consider a company’s loan capital and the means of securing loans by charging the company’s assets. This is a large and complex area of law which covers many topics. It may also overlap with corporate insolvency. All company lawyers need to have a basic understanding of some of the relevant principles involved.
Security Interests
A security interest is defined as follows:
“Every security interest ultimately gives the holder of the security a proprietary claim over assets, normally the debtor’s, to secure payment of the debt“.
Gower & Davies (page 1157)
A security interest is therefore something which a creditor (usually a bank) will be given in exchange for lending money. The purpose of the security interest is to improve the position of the bank in the event of the company becoming insolvent. The security interest enables the bank to be paid before other unsecured creditors. This is highly significant as the company’s assets will not be sufficient to pay all the creditors and the unsecured creditors will receive little or nothing. (Recent changes brought in by the Enterprise Act 2002 have ameliorated the situation for unsecured creditors slightly – however it is still far better to have a security interest.)
The standard methods used by a lender to obtain security are legal mortgages, fixed charges and floating charges.
Debentures
A debenture is defined in s 738 as including ‘debenture stock, bonds and any other securities of a company, whether or not constituting a charge on the assets of the company’. It covers a wide range of instruments in terms of corporate borrowing. It is a document which sets out the charge taken by a lender and acknowledges the debt. It is the most usual form of borrowing by companies and gives a charge on the company’s property.
Types of debentures: secured/unsecured, registered, redeemable/irredeemable, bearer debentures.
Company Charges: Companies Act 2006, Part 25, ss 860-894.
There is a considerable amount of recent case law concerning the classification of a fixed and floating charge. The distinction between a fixed and floating charge is explained by Lord Macnaghten in Illingworth v Houldsworth [1904]AC 355:
‘A specific charge… is one that without more fastens on ascertained and definite property or property capable of being ascertained or defined. A floating charge, on the other hand, is ambulatory and shifting in its nature, hovering over and so to speak floating with the property which it is intended to affect until some event occurs or some act is done which causes it to settle and fasten on the subject of the charge within its reach and grasp’.
In determining the categorisation of a charge, neither the intention of the parties nor the terms which they use to refer to describe the transaction are conclusive. In deciding whether a charge is a fixed or floating charge, a two-stage process was established by the Privy Council in Agnew v IRC (also known as Re Brumark) [2001] 2 BCLC 188, and adopted by the House of Lords in Re Cosslett [2002] 1 BCLC 77.
– First, the court must construe the instrument of charge and seek to gather the intention of the parties from the language used in order to ascertain the nature of the rights and obligations which the parties intended to;
– Second, once the above has been decided, it is a matter of law for the courts to determine whether the charge is fixed or floating.
Registration Requirements
All floating charges must be registered (s 860(7)(g)) but fixed charges need only be registered if they are over one of the specified classes of assets in s 860(7). Those listed in s 860(7) include almost all the forms of charges commonly given by companies, except charges on shares.
The purpose of registration is publicity, to warn other creditors that the debtor company has charged its assets. The register of charges is publicly available (s 885(6)).
The particulars and the instrument of charge must be delivered to the registrar of companies within 21 days after its creation. Failure to do so means that the charge is void against the liquidator or administrator and any creditor of the company (s 874(1)). This means that the charge holder will be relegated to the status of unsecured creditor (s 874). It is, however, not void against the chargee, who still has the obligation for repayment.
When the above registration requirement has not been met, a number of options are open to the company and the chargee.
– Application by either party to the court for registration out of time under s 873;
– The chargee may get another charge executed by the company and registered before any third party intervenes.
– The chargee can seek immediate payment of the sum secured (s 874(3)).
What is a fixed (or specific) charge?
A fixed charge is created over a specific asset of a company, eg., its land and buildings and fixed plant. It gives the holder of the charge an immediate proprietary interest in the assets subject to the charge. The charge restricts the debtors ability to deal with the asset- for example the debtor would not be able to sell the asset without the consent of the debenture holders.
What is a floating Charge?
A floating charge is not attached to any particular assets identified when the charge is created. It typically takes over the entire undertaking of the company, including assets such as removable plant and equipment, tool, intellectual property rights, stock-in-trade, work in progress and book debts (which are sums due to the company by its debtors). These are constantly changing in the company’s normal course of business and are therefore not a fixed charge.
The main advantage of a floating charge is that it enables the company who has granted the charge to continue to deal with the charged assets without the need to obtain the consent of the charge holder. This is therefore an extremely flexible device which enables a company to grant a charge and borrow money without tying up its assets in any way.
The characteristics of a floating charge is stated by Romer LJ in Re Yorkshire Woolcombers Association [1903] 2 Ch 284 at 295. A floating charge is
– A charge on a class of assets of a company, present and future;
– That class of assets would be changing from time to time in the ordinary course of the business of the company;
– The company may carry on its business in the ordinary way until some future step is taken.
The name “floating” derives from the fact that the charge is said to float over all the charged assets until some events occurs causing it to crystallise. At this point it becomes a fixed charge which means that the debtor is no longer able to deal with the assets.
Crystallisation of floating charges
A floating charge crystallises:
(1) in the circumstances specified in the debenture or
(2) occurs on the appointment of a receiver under a fixed charge or an administrative receiver under a fixed/floating charge, or
(3) If the company comments to wind up and cease its business.
The Advantages of Fixed Charges over Floating Charge
• As the assets are not fixed, there is always the danger that the assets will be dissipated.
• Floating charge holders rank lower than preferential creditors in a winding up.
• The “top slicing” provisions of the Enterprise Act 2002 mean that a statutory proportion of the assets under a floating charge are reserved for unsecured creditors
• A lender with a floating charge created after October 2003 is no longer able to appoint an administrative receiver. This is a major change in insolvency law and means that lenders much prefer fixed charges.
Charges over Book Debts: fixed or floating?
The nature of a charge over the proceeds of book debts has been subject to a considerable amount of litigation. Book debts are sums due to the company by its debtors and they would ordinarily be entered in the books of the company for accounting purposes. The nature of the charge is determined by who has control of the proceeds of the book debts, as demonstrated by Agnew v IRC (Re Brumark) [2001] 2 BCLC 188 and National Westminster Bank Plc v Spectrum Plus Ltd [2005] 2 BCLC 269 (Re Spectrum Plus Ltd). Neither the intention of the parties nor the terms which they use to describe the charge are conclusive in determining whether a charge is fixed or floating.
A charge over book debts is a floating charge if the company is free to collect the debts and deal with the proceeds without the consent of the holder of the charge. In most cases charges on book debts are floating charges; nevertheless, it is still possible to create a fixed charge over book debts: Re Keenan Bros Ltd [1986] BCLC 242.
The validity of charges
Avoidance of floating charges: IA 1986, s 245
A floating charge shall be invalid if it is created in favour of an unconnected person within 12 months (2 years for a connected person) ending with the onset of insolvency, unless the company was able to pay its debts at the time the charge was created (s 245, IA 1986). A person is connected with the company if he is a director, a shadow director or an associate of such a director or shadow director, or if he is an associate of the company (s 249, IA 1986).
Preferences: IA 1986, s 239
A floating or fixed charge may be avoided under s 239 of the IA 1986 on the basis that the transaction has given one of the company’s creditors an unfair advantage to increase their chances of repayment over the other creditors. The liquidator can apply to the court challenging the alleged preference, if a company has, within 6 months prior to the onset of insolvency (2 years for connected person) given a preference to an unconnected person.
The court may make such order as it thinks fit for restoring the position to what it would have been if the company had not given that preference. It shall not make an order unless the company which gave the preference was influenced in deciding to give it by a desire to put that person in a better position.
Priority of charges and the negative pledge clause
The priority as between charges are determined at common law. The basic rules are that legal interests prevail over equitable, fixed charges over floating charges, and where the equities are equal, the first in time prevails. In the context of corporate insolvency, the fixed charge holder ranks above all other creditors, including the expenses of the liquidation, whilst the floating charge ranks in a lower position, just above the ordinary unsecured creditors.
Under a floating charge, the company can continue to deal with the assets in the ordinary course of business. Thus, a company can create a fixed charge, which will rank in priority over an earlier floating charge. To protect themselves against this risk, it is common for the holder of a floating charge to insert a negative pledge clause in the charge. The effect of such clause is to prohibit the company creating a subsequent charge ranking equally with or in priority to the earlier floating charge. Although registration is held to give constructive notice of the charge, it does not constitute notice of the terms and conditions contained in the charge document. Thus, registration of a floating charge does not by itself give constructive notice of the negative pledge clause: Wilson v Kelland [1910] 2 Ch 306.
When a company becomes insolvent, the issue of priority depends on the order of distribution of assets.
– The fixed charge holder
– The expenses of winding up (s 115, IA 1986)
– Preferential debts (Crown debts) (s 175 and Sch 6, IA 1986), such as employee’s wages or salary. The category of preferential debts was much reduced by the Enterprise Act 2002.
– The floating charge holder
– Unsecured creditors (the pari passu principle- all unsecured creditors participate in the pooled assets in proportion to the size of their claim.)
– Deferred debts (eg., interest on the debts)
SESSION FOUR
Loan Capital
Questions for Consideration
1. Examine the distinctions between a fixed and floating charge by reference to case law.
2. When does crystallisation take place? What is the effect of crystallisation on a floating charge?
Learning Outcomes
• Have developed an understanding of the legal nature of debentures issued by companies.
• Understand the distinction between fixed and floating charges.
• Have an understanding of the registration of charges and the consequences of non-registration or late registration.
• Have read and understood the case of Re Spectrum and fully understand the Insolvency implications for floating charge holders.
• Understand the priority of charges in insolvency and the avoidance of charges under the Insolvency Act 1986.
SESSION FIVE
CORPROATE GOVERNANCE
Required Reading
Wild & Weinstein (2013), Chapter 23.
Hannigan, Chapters 5 and 15.
Gower & Davies, pp 365- 475
Boyle & Birds, Chapter 11.
Dignam & Lowry, pp 262-298, pp 356-396.
Mayson, French & Ryan, Chapters 14 & 15
Hicks & Goo, Chapters 7, 8 and 11
Solomon, Corporate Governance and Accountability, 2nd (John Wiley & Sons Ltd, 2007), Chapter 5 (E-Book).
Further Reading
Mallin, Corporate Governance 2nd (Oxford University Press, 2007), pp 1-149.
Angus Yong, ‘Rethinking the fundamentals of corporate governance: the relevance of culture in the global age’ (2008) 29 Comp. Law 168.
Malin, “Trustees, Institutional Shareholders and Ultimate Beneficiaries” (2004) 12 Corporate Governance 239.
Lysandrou & Stoyanova, “The Anachronism of the Voice-Exit Paradigm: institutional investors and corporate governance in the UK” (2007) 15 Corporate Governance 1070.
Paul Burke, “The Higgs Review” (2003) Company Lawyer 162.
The main documents on corporate governance are available at
www.berr.gov.uk/whatwedo/businesslaw/corp-governance/page15267.html
Outline of the Session
This session examines the corporate structure, its division of powers within a company and the decision-making process. It evaluates the concept of corporate governance and its development in the UK.
1. What is corporate governance?
Corporate governance is traditionally concerned with how the company is directed and the relationship between the board of directors, management and shareholders. The structure of the company is central to corporate governance.
Traditionally, company directors have been regarded effectively as agents who act on behalf of the company in general meeting. In practice, they have been required to act on behalf of the shareholders collectively. This approach has shaped the legal duties of directors. Directors are under a statutory duty to promote the success for the company for the benefit of its members as a whole, and having to regard to broader factors. A new ‘enlightened shareholder value’ approach is also adopted in the CA 2006.
As companies grew in size, the position of directors and managers changed. This led to a delegation of wide powers to the board of directors with the general meeting unable to interfere in the exercise of those powers. This is known as ‘separation of ownership and control’ following the work of Berle and Means in the 1930s.
Berle and Means: The Separation of Ownership and Control
It is often said that the modern subject of corporate governance stems from a work published by Berle and Means in 1932. The essence of this study was the identification of a problem in corporate America. This was the problem caused by the separation of ownership and control.
In order to expand, companies needed capital and therefore issued more and more shares to a diverse and increasing number of shareholders. This led to the effective dilution of shareholder power. Companies are plutocracies rather than democracies. This means that the power will be effectively vested in whoever holds the majority of the shares. Berle and Means discovered that many of the large companies had such widely dispersed share ownership that the shareholders were no longer able to wield any real control over the company. The “control” now effectively rested elsewhere – either in the board, or more likely with professional managers.
The problem with this state of affairs was that there was perceived to be a great danger that managers would be free to run the company for their own benefit, rather than on behalf of the shareholders. In short – it could lead to abuse.
The idea was not completely new in 1932. Adam Smith, the great economist in The Wealth of Nations had stated something very similar in 1776:
“The directors of such companies, however, being managers rather of other people’s money than their own, it cannot be expected that they should watch over it with the same anxious vigilance with which the parties in a private copartnery frequently watch over their own. Like the stewards of a rich man they are apt to consider attention to small matters are not for their master’s honour and very easily give themselves a dispensation from having it. Negligence and profusion, therefore, must always prevail, more or less, in the management of the affairs of such a company.”
The Agency Problem
The problem of separation of ownership and control has been said to cause something called “Agency Problems” for companies. The agency problem relates to the costs involved in controlling managers to ensure that they do not act in their own interest. These costs usually relate to the necessity of having to constantly monitor the performance of the managers.
Although the agency problem could really be said to have been identified by Adam Smith, it was the 1976 Jensen and Meckling article ‘Theory of the firm: managerial behaviour, agency costs and ownership structure’ which has delineated modern thinking in this area.
2. The division of power within a company
Every company regardless of size has two organs: the shareholder general meeting and the board of directors. The board is elected by general meeting and entrusted with the management of the company. There is a considerable difference in practice in the way in which the division of power between these two organs operate in the small private company and the large public company.
1) The Board of directors
The board of directors is the most important decision-making body within the company. S 154 of the CA 2006 requires all public companies to have two directors and private companies one. It leaves the determination of the role of the board very largely to the company’s constitution, which is under the control of shareholders.
The model articles for both public and private companies gives substantial authority to the board: ‘subject to the articles, the directors are responsible for the management of the company’s business, for which purpose they may exercise all the powers of the company’. These model articles may be modified substantially through either the board decisions to delegate authority to management (in public companies) or modifications of the articles in the case of private companies so as to confer decision –making authority on the shareholders.
S168 of the CA 2006 : Directors can be removed by an ordinary resolution of shareholders at any time. This explicitly overrides anything to the contrary in any agreement between the company and the director. For example, if there is a contact of service between the directors and the company, it is possible that shareholders will be able to sack the directors only at the risk of imposing on the company liability to pay damages or a sum fixed by the contract as compensation.
2) Structure and composition of the board
In the UK, the one-tier board is the norm, with managing and supervisory functions being discharged by a single body.
As regards the composition of the board, there are executive and non-executive directors. The debate has focused on the proportion and role of non-executive directors on the board and the regulatory results have shown themselves in the Combine Code on Corporate Governance, rather than legislation.
The Combined Code recommend to listed companies that at least one half of the board as a whole should be non-executive directors, all of whom must be independent directors. It also recommends that the board should have nomination, remuneration and audit committees on which the non-executive directors should be the only or the majority of the members.
It should be noted form the provisions of the Combined Code that the stress on the monitoring role of the independent non-executive directors has the effect of creating the distinction between management and supervision within the single-tier board. There are still concerns that to what extent the independent NED can effectively monitor the strong-minded CEOs.
3) Shareholders’ meetings
As the ordinary business of the company is run by board of directors, the company exercises its control by the votes of a majority at general meetings.
Informal Agreement:
If all the shareholders unanimously give their assent to a proposal, it does not matter that no formal resolution was put to vote. This unanimous consent rule is an alternative to the written resolution and formal resolution procedures (s.281, CA 2006). This applies to both private and public companies.
Resolutions: s 281
Section 281(1): For private companies, a resolution may be passed either as a written resolution or at a meeting. A written resolution has to be agreed by a simple majority or three-quarters majority, depending on whether it is an ordinary or special resolution.
Section 281(2): For a public company, a resolution can be done only at general or class meetings.
Ordinary resolutions: s 282
An ordinary resolution requires a simple majority (50%) of the total voting rights of all members or of the class, whether on a written resolution, a resolution passed on a show of hands, or a poll.
Special resolutions (s 283): A 75% majority is required.
3. The corporate governance committees: the industry response
The Cadbury Committee’s Report (Financial Aspects of Corporate Governance) in 1992 defined corporate governance as ‘the system by which companies are directed and controlled’.
In this relationship, directors monitor the activities of management and then report to he shareholders. Shareholders have the ability to exercise their powers in general meeting, in particular, they have power to appoint or remove the directors from office. However, in large public companies at least, the voting powers of shareholders comprise a limited form of control of management activities.
Despite the existence of the internal, market and legal controls, there are concerns about the inadequacies of these control mechanisms. IN response, the UK has not introduced new statutory provisions; instead, self-regulation has been encouraged as a supplement to existing legislative provisions. A number of Committees have been central to the development of corporate governance.
Since the beginning of the 1990s the corporate governance debate has been shaped to a large degree by the work of the Cadbury Committee, the Greenbury Committee, the Hampel Committee and the Turnbull Committee. The collapse of ENRON and other companies in the US and Western Europe also led to further moves to strengthen the protections afforded by the corporate governance regime.
1) The Cadbury Committee
The Cadbury Committee focused on the control and reporting functions of boards and on the role of auditors. In its Report on the Financial Aspects of Corporate Governance(1992), it concentrated on the tripartite relationship between the board, auditing and the shareholders.
2) The Greenbury Committee
This Committee was established in 1995 in response to public and shareholder concerns about directors’ remuneration. It aimed to identify good practice in determining directors’ remuneration and prepare a code of such practice for use by public companies. The Committee published its Report on Directors’ Remuneration in 1995.
3) The Hampel Committee
The Hampel Committee was established on the initiation of the Financial Reporting Council and published its final Report on Corporate Governance in 1998. It built on the recommendations of the Cadbury and Greenbury Committes and covered the more general aspects of corporate governance.
4. The UK Corporate Governance Code
The Combined Code, embracing the work of the Cadbury, Greenbury and Hampel Committees, was initially produced in 1998. In the wake of the collapse of ENRON in the US, it was revised by the Financial Reporting Council in 2003, incorporating recommendations on non-executive directors and on the role of audit committees. The Combined Code was revised again in 2010
(http://www.frc.org.uk/documents/pagemanager/Corporate_Governance/UK%20Corp%20Gov%20Code%20June%202010.pdf ). It should be noted that the Combined Code is not legally binding. It is only self-regulation.
The Combined Code contains main and supporting principles and provisions of corporate governance. If focuses on directors, remuneration of directors, accountability and audit and relations with shareholders. It aims to allow companies to create and establish their own governance policies in the light of the main and supporting principles set out in the Code.
The Listing Rules require companies to either comply with the Code or explain why they are no complying with the Code. (Known as the ‘company or explain approach’).
The principles established in the Combined Code apply to listed companies but unlisted and private companies are also encouraged to adopt the principles. The flexibility offered by self-regulation and the opportunity it provides for speedy action compared with legislative regulation makes it an attractive form of regulation for corporate governance. However, the principles in the Combined Code have also been subject to considerable criticism. Dignam, for example, stated that the codes are ‘at the very loose end of any regulatory control system’. Directors may take advantage of the flexibility that the Combined Code offers and abuse the system. The effectiveness of the system heavily relies on the disclosure of information and the monitoring of management activity by non-executive directors.
The framework of the corporate governance in the UK has been criticised for its limited and narrow perspective. The definition of corporate governance adopted ‘excludes many activities involved in managing a company which may nevertheless be vital to the success of the business’. It concentrates only on the internal structure of the company. This restrictive approach limits the goal of corporate governance to profit maximisation since it priorities the interests of shareholders.
Opinions differ about the effectiveness of the Combined Code as a Corporate Governance control mechanism. Critics regard it as a purely cosmetic box ticking exercise that the leading companies adhere to in name only rather. They also suggest that corporate governance issues are too important to be left to the code and the “soft” obligations should be replaced by statute. This could be similar to the Sarbanes-Oxley Act in the USA which was introduced in response to the Enron scandal.
On the other hand the flexibility of the “comply or explain” approach is often held to be an advantage and the code could be considered to be less administratively burdensome than hard regulation. The other important factor might be the relative ease with which the Code can be amended. In effect the regime has altered many times since the first Cadbury report in 1992. This stands in stark contrast with the time it took to enact the Companies Act 2006.
5. The corporate governance debate: the Government Response
1) Shareholder or stakeholder debate
In the UK, the position has always been that in law, directors act in the interests of the company. This has traditionally been considered to mean that the directors’ primary goal is to maximise the wealth of the company for the benefit of the shareholders. This position has been called “Shareholder Primacy”.
It has been contended however that a more socially responsible view would be to consider not just the shareholders but also other “stake-holders” in the company. Other stakeholders would include – employees, creditors, the general public, suppliers and customers. There is a school of thought that considers that the stakeholder view of the company would be much more conducive to good corporate governance. This is not a recent idea – it was debated by Dodds and Berle in 1932.
In July 2002 the Governance published its White Paper which contained significant recommendations what are central to the corporate governance debate:
The first was a change in the formulation of directors’ duties to include other constituencies if directors feel so inclined. It should be made clear that the CLRSG rejected the stakeholder (or pluralist view as it called it) in favour of “enlightened shareholder value”.
The second initiative was to introduce a form of corporate constituency reporting, which means that the annual report from the directors should include a section on the impact of the company’s activities on stakeholders.
The stakeholder approach represents a view that company law should recognise interests beyond those of the shareholders. Stakeholder’s interests may include employees, creditors and consumers as well as the wider community.
2) Enlightened shareholder Value
s.172 of the CA 2006 states that a directors of a company must act in the way he considers, in good faith, would be most likely to promote the success of the company for the benefit of its members as a whole, and in doing so have regard (among other matters) to
– the likely consequences of any decision in the long term,
– the interests of the company’s employees,
– the need to foster the company’s business relationships with suppliers, customers and others.
– the impact of company’s operations on the community and the environment
– …..
s.172 reflects the government’s intention to encourage or legitimise directors considering the interests of stakeholders in their decision-making process. It retains the primacy of the shareholders while also compelling directors to consider the company’s stakeholders.
6. Institutional Investors
(1). The arrival of institutional investors
Institutional investors play an important monitoring role in the UK corporate governance. In large companies today, the demography of shareholders has changed dramatically due to one important factor – the institutional investor. When Berle and Means surveyed the corporate landscape in 1932, shares were owned by a large number of individual shareholders. In fact it was this very diversity that caused the problem of separation of ownership and control. The late 20th century however saw the rise of institutional investors – usually pension funds or insurance companies. Such institutions can account for up to 70% of the shareholdings in major companies. Although the problems of corporate governance still exist, one important factor means that the shareholdings in our major companies are no longer so dispersed.
(2). The importance of institutional investors
The potential for good corporate governance through the role of institutional investors is well documented. The agency problem and the problem of the separation of ownership and control could arguably be completely negated by the impact of these powerful groups.
Any group that owns over 50% of the stock in a company can dismiss directors and appoint new management; any group owning 75% of the stock can alter the constitution of the company. As such, shareholders controlling more than 5% of shares can make their voice heard loudly at general meetings.
The importance of institutional investors has been long recognised. The Cadbury report referred to the institutional investors “responsibility as owners”, to bring about change in a company rather than merely selling their shares. This is at the heart of the debate about institutional investors; it is the extent to which institutional investors are prepared to use their “voice” rather than their “exit”.
(3). The Voice or the Exit
The forms of action that institutional investors can take when faced with poor corporate governance are normally categorised in two ways – the voice or the exit. By using the voice, the institutional investor remains with the company and attempts to use his influence to change corporate behaviour. By using the exit, the institutional investor sells his shares and moves on.
Much of the academic literature concerns the encouragement of investors to use their voice. Although shareholder activism is very much on the increase – there are many difficulties facing an institutional investor when considering action. In addition, recent commentators have also expressed the view that the role of institutional investors is not necessarily beneficial to the company.
Advantages of the Voice
• Institutional investors are sophisticated. They are less likely to suffer from the problems of information asymmetry that affect small shareholders. (Information asymmetry refers to the situation where there is an imbalance in the information known by one party compared with another. In other words – small shareholders know comparatively little about the workings of the company. This makes it difficult for them to make informed choices about how they exercise their votes in the general meeting.)
• In theory, the block vote of institutional investor can enforce a change in company policy, dismiss an underperforming board.
• Arguably, there should no longer be a problem of separation of ownership and control.
• Can solve agency problems.
Disadvantages of the Voice
• See literature discussing short-termism – Keynes (in Solomon), Peston’s blog.
• Institutional investors owe fiduciary duties – but to their own shareholders and investors – not to the company. This may mean that they may find it is in the best interests of their own shareholders to exit the company as soon as problems surface.
• It can be difficult, even for institutional shareholders to take action – could be prolonged and expensive. Any action might be controversial and could lead to adverse media interests that bring down the share price.
• The “free rider” problem. Why should other shareholders benefit from the corporate governance monitoring of the institutional investors?
• Although pension fund managers may well be more sophisticated – will they be trained or qualified in corporate governance or financial management? – see Solomon.
• Should institutional investors be interfering in the way a business is run. See Solomon also Hampel report.
Advantages of the “Exit”
• Historically this was very much the preferred option.
• Clearly avoids “free rider” problems.
• An interesting theoretical point – what justification is there in imposing monitoring requirements on an institutional investor?
• Avoids difficulties of publicity – intractable disputes.
• Can it affect corporate governance structure if the management merely knows that the Institutional Investor will sell-up.
• Arguably this could be a powerful corporate governance mechanism – however probably only if seen as a last resort.
Disadvantages of the “Exit”
• For the investor – it can be expensive. Unloading a large number of shares at one time can mean selling them at a premium.
• Clearly the opportunity to change poor corporate governance may be lost.
• If all companies are badly run – where does the investor go to?
(4) Encouraging and compelling institutional activism
One would have thought that the prominence of institutional investors would effectively negate the problem of separation of ownership and control as these institutions potentially have enormous influence. Experience has shown however that this type of investor is often very reluctant to exercise this influence. When bad management is evident in the company – the institutional investors tend to vote with their feet, preferring to sell their shares rather than use their powerful votes to remedy the defects in corporate governance. It has been said that Institutional investors have two options – the voice or the exit.
Monks points out that the institutions could influence managerial behaviour in three important ways in Western capitalist economies:
• they are fiduciaries, subject to the standard of conduct devised by their legal system, and therefore obliged to take any action that is “prudent” to protect and enhance value;
• they are full-time, knowledgeable, sophisticated investors, in close touch with trends, transactions, and markets; and
• they are large enough to make their involvement in monitoring and other corporate governance initiatives meaningful and effective
Self-regulations set out principles relating to the responsibilities of institutional shareholders
– Cadbury, Greenbury, Hampel, and Combined Code.
– The Combined Code on institutional investors has three sets of principles, relating to :
o Dialogue with companies
o Evaluating the corporate governance disclosures by companies
o Shareholder voting
Practical difficulties with shareholder activism
Sheldon Leader and Janet Dine note three factors militate against shareholder control and in favour of management.
• The apathy of shareholders generally and the continued reluctance of large institutional shareholders to be involved in corporate governance issues in the companies in which they invest.
• The system of proxy voting which is heavily weighted in favour of management to the extent that proxies may be solicited by management at the company’s expense.
• The absolute control of information in the hands of management. Apart from financial information required by the accounting provisions, very little information needs to be given to shareholders.
When voiced by minority shareholders, they are often face three problems:
a) Lack sufficient incentive to initiate proceedings;
b) Limit access to information that might reveal a cause of action;
c) Wade through Foss v Harbottle rule to establish that they have standing to sue.
Forbes and Watson suggested, the real problem is not the lack of formal powers of the shareholder but rather of incentives to act and the difficulties in using what powers they have.
The powers over a company is held by the board of directors, not by shareholders – minority shareholders have no right in UK law to interfere with management, even if they succeed in removing an executive director from the board, they cannot also strip the executive of his or her responsibilities since this powers lies solely with the board
‘Collective-action problem’ or the ‘free-rider problem’ – In the absence of an easily enforceable collective arrangement, it is impossible to exclude ‘free riders’ from the benefits arising from improved monitoring by an individual shareholder. Benefit, but not costs, will be shared with other ‘free-riding’ shareholders and, in consequence, the expected benefits accruing to the individual that incurred the full monitoring costs will only be in proportion to his or her equity holding.
Hirschman’s notes that to ‘exit’ rather than use ‘voice’ term indicates several reasons why institutions may adopt such a stance.
• Firstly, in doing so, it may incur the public attention as a “bad news”, resulting in a fall in share price and a reduction in the value of their investment.
• Secondly, because of their intervention, they may become privy to inside information and unable to trade in their shares, potentially increasing their risk.
• Finally, intervention is costly in terms of time and money.
Institutional investors must remain aware that if they become too involved in the affairs of a company and too knowledgeable (i.e. in receipt of information that has not been publicly disclosed), they could become insiders. As insider they would be restricted from dealing the company’s shares under the insider dealing legislation (Criminal Justice Act 1993) or market abuse legislation (Financial Service and Market Act 2000).
Kendall point out, however, the interventions are episodic, for specific reasons and occur on specific occasions, are not putting enough pressure on management to perform. In addition, the institutions lack the necessary expertise for this business approach, nor perhaps do they have the staff and the specialized technical departments, there are no guarantees that intervention will be successful.
Institutional shareholder guidelines
The main guideline on corporate governance and shareholder activism is provided to institutional investors by their various representative bodies, which in the UK include:
• ISC Statement of Principles
• MAPF Corporate Governance Policy
• AB1 guidelines
• ICGN guidelines for members
• The UK Stewardship Code
‘The UK Stewardship Code was published in July 2010. It aims to enhance the quality of engagement between institutional investors and companies to help improve long-term returns to shareholders and the efficient exercise of governance responsibilities by setting out good practice on engagement with investee companies to which the FRC believes institutional investors should aspire.’
See http://www.frc.org.uk/corporate/investorgovernance.cfm
SESSION FIVE
CORPORATE GOVERNANCE
Questions for Consideration:
1. The relationship between the board of directors and the general meeting is such that shareholders do not play an active or influential role in company decision making.
Discuss
2. Critically discuss the meaning of the phrase –“The separation of ownership and control”. Is this problem still the major factor in corporate governance?
3. Critically assess the effectiveness of the UK board system. Reference should be made to appropriate corporate governance regulations, codes and academic opinion.
Learning Outcomes:
By the end of the session you should be able to:
• Demonstrate a high level of knowledge of and critically evaluate the division of power within a company and the role of institutional shareholders in corporate governance.
• Demonstrate a high level of knowledge of and critically evaluate the shareholder activism and critically evaluate the corporate governance system in the UK and apply the relevant law to complex problem/essay style questions.
• Identify accurately issues which require research with limited guidance.
• Demonstrate an ability to inter-relate issues relating to corporate governance with other aspects of company law.
• Demonstrate an ability to evaluate the relationships between theory and practice.
SESSION SIX and Seven
Directors’ Duties
Required Reading
Textbooks:
• Wild & Weinstein (2013), Chapter 21.
• Hannigan, Part 2.
• Dignam & Lowry, Chapter 14.
• Gower & Davies, Chapter 16.
• Hicks & Goo, pp 356-428.
• Boyle & Birds, Chapter 16.
• Mayson, French & Ryan, chapter 16.
Articles:
• Keay, A Good faith and directors’ duty to promote the success of their company Company Lawyer (2011), volume 32, issue 5, pages 138-143.
• Fisher, D The enlightened shareholder – leaving stakeholders in the dark: will section 172(1) of the Companies Act 2006 make directors consider the impact of their decisions on third parties? (2009) International Company and Commercial Law Review, volume 29, issue 1, pages 10-16.
• Alexander, R BP: protection of the environment is now to be taken seriously in company law Company Lawyer (2010), volume 31, issue 9, pages 271-273.
• Lotz, S Directors’ duties wit regard to creditors in German and UK (Core) Company Law International Company and Commercial Law (2011), volume 22, issue 8, pages 264-269.
• Wu, D Managerial behaviour, company law, and the problem of enlightened shareholder value Company Lawyer (2010), volume 31, issue 2, pages 53-61.
• Omar, P In the wake of the Companies Act 2006: an assessment of the potential impact of reforms to company law (2009) International Company and Commercial Lawyer, volume 20, issue 2, pages 44-55.
• Copp, S S172 of the Companies Act 2006 fails people and planet? Company Lawyer (2010), volume 31, issue 12, pages 406-408.
• Pedamon, C Corporate social responsibility: a new approach to promoting integrity and responsibility Company Lawyer (2010), volume 31, issue 6, pages 172-180.
• Keay, Section 172(1) of the Companies Act 2006: An interpretation and Assessment Company Lawyer (2007), volume 28, Issue 4, pages 106-110.
• Keay, ‘The Duty of Directors to Exercise Independent Judgement’ (2008) Company Lawyer 290.
• Riley, ‘The Company Director’s duty of care and skill: the case for an onerous but subjective standard’, (1999) 62 MLR 697
• Worthington, ‘Reforming Directors’ Duties’, (2001) 64 MLR 439
• Li, J The Peso Silver case: an opportunity to soften the rigid approach of the English courts to the problem of corporate opportunity Company Lawyer (2011), volume 32, issue 3, pages 68-75.
• MacDonald, R The Companies Act 2006 and the directors’ duty to disclose International Company and Commercial Law Review (2011), volume 22, issue 3, pages 96-101.
• Singla, The fiduciary duties of resigning directors Company Lawyer (2007), volume 28, Issue 9, pages 275-276.
• Berg, Fiduciary Duties: A director’s duty to disclose his own misconduct (April 2005) Law Quarterly Review, pages 213-220.
• Hemraj, Duty of loyalty: Company Directors’ positive obligation to disclose their own misconduct (2006) Company Lawyer, Volume 27, Issue 6, pages 183-185.
• Finch, ‘Personal accountability and corporate control: The role of directors’ and officers’ liability insurance’, (1994) 57 MLR 880
• L Sealy, “Paycheck Services 3 Ltd: the Supreme Court Reviews the concept of the de facto director”. (2011) Company Law Newsletter 1.
On the meaning of ‘de facto director’ see Supreme Court’s decision in Re Paycheck Services 3 Ltd [2011] 1 BCLC 141.
Outline of the Session
This session starts with the definition of directors, followed by a brief examination of directors’ duties at common law. More importantly, it then focuses on the current law on directors’ duties and the concept of ratification under the CA 2006.
Introduction
The codification of directors’ duties is perhaps one of the key changes in the CA 2006. It has brought in a new statutory statement which has replaced all existing common law and equitable rules.
Directors are first and foremost considered to be in a fiduciary position in relation to the company and all companies must have at least one director (public companies need at least two). Consequently, they must first and foremost act in the best interests of the company and in good faith. This also means that directors should not allow a conflict to develop between their personal interests and their duty to the company in relation to such matters as contracts or other corporate opportunities.
1.The definition of “director”
A director “…includes any person occupying the position of a director, by whatever name called.” A director can appear in several guises:
• De jure directors (as a matter of legal right, i.e. properly appointed)
• De Facto directors (a person ‘doing the things that directors do’)
• Shadow directors (a ‘puppet master’ or someone who provides instructions)
A De jure director can be appointed by an ordinary resolution at the general meeting. When he is successfully appointed his details must be kept at the company’s registered office, and also registered at Companies House.
In Re CEM Connections (2000) BCC 917, the Chancery Division held that a person was not a director of a company as she had not been formally appointed, and had not been in a position to give her informed consent to being a director (even though she was listed as a managing director at Companies House). Even though she had signed important documents on behalf of the company, the court held that she did not adequately know what she was doing as she had been, at important times, either clinically depressed, anorexic and a drug addict.
Furthermore, in Ultraframe (UK) Ltd v Fielding [2005] UKHC 1638, two important points about shadow directors were made:
– First, a person cannot be a director and a shadow director at the same time.
– A shadow director does not generally owe fiduciary duties.
In addition, at paragraph 1254, the judge outlined a clearer definition of a de facto director:
“Persons who undertake the functions of directors, even though not formally appointed as such, are called de facto directors. In Re Hydrodam (Corby) Ltd [1994] BCC 161 Millett J described a de facto director as: “a person who assumes to act as a director. He is held out as a director by the company, claims and purports to be a director, although never actually or validly appointed as such. To establish that a person was a de facto director of a company it is necessary to plead and prove that he undertook functions in relation to the company which could probably be discharged only by a director. It is not sufficient to show that he was concerned in the management of a company’s affairs or undertook tasks in relation to its business which can probably be performed by a manager below board level.””
However, the courts tend to work on a case-by-case basis in deciding whether a person is a de facto director or not and courts will take into account all relevant factors (Re Kaytech International plc [1999]).
Secretary of State v Deverell [2000] BCC 1057 considered the nature of a shadow director and suggested that the definition of a shadow director should be construed in the normal way and should not cover professional advisors. Shadow directors should influence corporate affairs, but not necessarily in all corporate areas. Further, it is difficult to attach liability to shadow directors (although please note, that liability and duties have been extended to shadow directors under the 2006 Act)
2. Directors’ duties at common law
Prior to the CA 2006, directors of a company had five main duties.
1) The First and Main Fiduciary Duty: to act bona fide
The duty to act bona fide in the interests of the company is the first and main duty that must be considered when examining the conduct of any company director – before an analysis is undertaken of any other duty (whether statutory or otherwise).
The reason that one must focus so closely on this particular duty is the fact that there is an overriding qualification that a director must have acted bona fide in the interests of the company before any potential breach of duty may be the subject of ratification (see later in this lecture).
Re Smith & Fawcett [1942] Ch 304
Charterbridge Corporation Ltd v Lloyds Bank [1970] Ch 62
‘The proper test, I think … must be whether an intelligent and honest man in the position of the director concerned, could, in the whole of the existing circumstances, have reasonably believed that the transaction was for the benefit of the company.’
• Attitude of the courts to the question of risk in decision-making or use of their powers.
• Occasionally the courts will look at the motives of the directors (the dominant purpose behind its use).
Howard Smith Ltd v Ampol Petroleum [1974] AC 821
Rolled Steel Products Ltd v British Steel Corporation [1986] Ch 246
Re W & M Roith [1967] 1 All ER 427
• What is meant by the term ‘in the interests of the company’?
• If the company is viewed as a ‘commercial entity’ then this simply includes the present and future shareholders of the company.
• Can a wider view be taken of the company (e.g. including employees, customers and creditors)?
Hutton v West Cork Rly Co [1883] 23 Ch 654
Savoy Hotel Investigation
Re Horsley v Weight Ltd [1982]
2) The duty to act for proper purposes
The main question that needs to be posed is the way in which the term ‘proper purposes’ should be defined. There are two ways in which this may be undertaken:
• Firstly, one could refer to the articles of association which may define the scope of the director’s powers.
• Alternatively, one may define the term with the benefit of ‘hindsight’. Is this latter approach necessarily desirable though?
Howard Smith Ltd v Ampol Petroleum [1974] AC 821
• The proper purposes doctrine applies in all cases where the directors use their powers.
Heron International Ltd v Lord Grade [1983] BCLC 244 (CA)
Lee Panavision Ltd v Lee Lighting Ltd [1992] BCLC 22
• What happens when a problem has been discovered? What is the appropriate procedure?
• This was governed by the rule in Foss v Harbottle.
3) Trusteeship of Company Assets
• Directors are answerable as trustees for any misapplication of the company’s property in which they participated and knew or ought to have known was a misapplication.
• What is covered by the term ‘property’ though?
Selangor United Rubber Estates v Cradock [1968]
4) Conflict of a director’s personal interest with duty to company.
Aberdeen Railway Ltd v Blaikie [1843-60] All ER Rep 249
• This is the underlying basis of the more specific fiduciary duties which follow:
Regal (Hastings) Ltd v Gulliver [1942] 1 All ER 378
Industrial Development Consultants Ltd v Cooley [1972] 2 All ER 162
Cook v Deeks [1916]
Canadian Aero Services v O’Malley [1973] 40 DLR 371
• Circumstances in which a director may retain an opportunity or profit.
Peso Silver Mines Ltd v Cropper [1966] 58 DLR 1
5) The Duty of Care and Skill
The standard of care, together with related issues such as the level of diligence, is determined according to the following:
Re City Equitable Fire Insurance Ltd [1925] Ch 407
Dorchester Finance Co Ltd v Stebbing [1989] BCLC 498
Re D’Jan of London [1994] 1 BCLC 561
Re City Equitable Fire Insurance Co Ltd
‘A director is not bound to give continuous attention to the affairs of the company. His duties are of an intermittent nature to be performed at periodical board meetings, and at meetings of any committee of the board upon which he happens to be placed.’
Dorchester Finance v Stebbing
‘They not only failed to exhibit the necessary skill and care in the performance of their duties as directors, but also failed to perform any duty at all as directors.’
6) Penalties for Breach of Duty
– Restoration of property to the company.
Selangor United Rubber Estates v Cradock [1968] 1 WLR 1555
Cook v Deeks [1916] 1 AC 554
– Liability to account for profits.
– Rescission of contracts.
– Damages.
– Remedies for particular shareholders.
– Statutory remedies.
– Removal of the director.
3. A Codification of Directors’ Duties under the CA 2006
The 2006 Companies Act introduces a new approach to directors’ duties in that they are now laid down in statute – there are now seven main duties. They are described as “general duties” and either replace or rewrite the pre-existing duties and are specifically found in part 10 (chapter 2), sections 170-177 (with a few surrounding important sections). Please beware that there are also changes to the ratification procedure.
However, in many cases previous case law authority is still relevant and can be used in the interpretation of the new provisions (s170(4). Also, s170(5) expressly extends the provisions to shadow directors.
During consideration of directors’ duties, it is important to consider, the relative advantages and disadvantages of having a codified system. Disadvantages could be that judicial flexibility is restricted and addition of future duties in the future may be problematic. However, advantages could include the fact that other common law countries, such as Australia, New Zealand and Canada have successful codified directors’ duties and also, having duties laid out in statute will make it easier for both directors and shareholders to see what their rights and responsibilities are.
Section 170: Scope and nature of general duties
As under the old regime (e.g. Re Smith and Fawcett) directors owe their duties to the company. Furthermore, under s170(2) if a director ceases to be a director, he could still be liable in the future for breaches of s175 (conflict of interests) and s176 (duty not to accept benefits from third parties). This will prevent a director from taking advantage of a situation by simply resigning from the company’s board of directors.
a. Section 171: Duty to act within powers
A director of a company must-
(a) act in accordance with the company’s constitution, and
(b) only exercise powers for the purposes for which they are conferred.
This is an unsurprising section and is an over-riding provision. Directors must act in accordance with the company’s constitution, as defined in s257 (including resolutions and decisions and any decision by the members of the company, or a class of members, that is treated by virtue of any enactment or rule of law as equivalent to a decision by the company).
This section also covers the ‘proper purposes’ doctrine. A recent case concerning this doctrine is Dalby v Bodilly [2005] BCC 627, where a director who allocated shares to himself without reference to his co-shareholders was in blatant breach of the proper purposes doctrine.
Also, in Fraser v Oystertec plc [2004] BCC 233, the director of the company entered into an agreement with the company that in the event of insolvency all of the company’s products would pass to the director. The court held that this was a breach on the grounds of both public policy and also a breach of fiduciary duty. As the director had attempted to deprive the company of finding a better price for the goods, this clearly was not in the interests of the company.
b. Section 172: Duty to promote the success of the company
This is arguably the biggest and most controversial section of the new Act. It attracted the most comment during its passage through Parliament. This section links in specifically to the theme of ‘enlightened shareholder value’ and reads as follows:
(1) A director of a company must act in the way he considers, in good faith, would be most likely to promote the success of the company for the benefit of its members as a whole, and in doing so have regard (amongst other matters) to-
(a) the likely consequences of any decision in the long term,
(b) the interests of the company’s employees,
(c) the need to foster the company’s business relationships with suppliers, customers and others,
(d) the impact of the company’s operations on the community and the environment,
(e) the desirability of the company maintaining a reputation for high standards of business
conduct, and
(f) the need to act fairly as between members of the company.
It is suggested that this section will attract a considerable degree of litigation. Although this section seems to adopt (in part) the requirement that directors act bona fide in the interest of the company (the duty to act bona fide still remains and it seems the only alteration is in the language used), it is not yet clear what it means to “…act in the way he considers, in good faith, would be most likely to promote the success of the company for the benefit of the members”. A variety of questions remain…how is success to be defined?what happens if the director believes he is acting in good faith?…can benefit be defined in purely financial terms?
Keay is of the belief that s172 is “pivotal” in that it provides guidance for directors in their activities, in other words, what should a director be aiming towards. Meaning is now provided on acting ‘bona fide in the interests of the company’. Linklater on the other hand, suggests that the section may not be used in litigation a great deal as it will be members who will be required to bring a claim, also the liability of directors seems to have been increased, which could decrease the numbers of people interested in becoming a director.
It is interesting to note that s172(1) gives the directors discretion over whether they are acting in a way that promotes the success of the company. Furthermore, directors only need to ‘have regard’ for the six factors, there appears to be no compulsion. At the same time, however, directors are required to act in good faith, but traditionally in UK law, and this is no exception, the concept is somewhat nebulous.
Under s172, directors have to consider six factors. These are non-exhaustive and it may be that other factors could come into account. The direct effect of these factors is somewhat uncertain: it remains to be seen whether this is simply a statutory adoption of current good practice or whether it is introducing a new set of rules for directors to adhere to. At the outset, it can be said that some of the factors are at best unclear: for instance the likely consequences of the decision in the long-term is a factor that is not very helpful as it leads to a number of possible questions. For instance, what is the long-term of the company? If a third party commences a takeover bid of the company, is that in the long-term best interests of the company. The problem is that the directors and shareholders may have different views on this.
Consideration of the company’s employees is newly stated and arguably introduces a stakeholder theory by the backdoor, as does consideration of the environment and consideration of the company’s suppliers, customers and others. There is also a considerable amount of vagary concerning the maintaining of reputation for high standards of business conduct (what if something is unethical, but not illegal?) and acting fairly between members of the company.
The sets out a number of aspirations, but they are somewhat onerous in nature. The major concern is that more requirements will be placed on directors. What if a director in reaching a particular decision considered all the factors, except that relating to the environment? Would that mean the director was in breach of his duty in promoting the success of the company? There is also a grey area between solvency and insolvency and the question at which stage should the focus of the director’s duties shift from that of the shareholders to the creditors? Although, it could also be argued that as directors continue to owe their duties to the company (as before), provisions relating to the community and environment could well be ignored.
c. Section 173: Duty to exercise independent judgment
(1) A director of a company must exercise independent judgment.
(2) This duty is not infringed by his acting-
(a) in accordance with an agreement duly entered into by the company that restricts the future exercise of discretion by its directors, or
(b) in a way authorised by the company’s constitution.
This could be problematic for nominee shareholders who are appointed to the board by shareholders in the hope that they will follow the instructions of the shareholders. This could also have an effect on directors who obtain advice from external experts, although it seems likely that this will still be allowed provided it does not clash with the constitution of the company.
d. Section 174: Duty to exercise reasonable care, skill and diligence
This section is really a continuation of the position the common law. It reads:
(1) A director of a company must exercise reasonable care, skill and diligence.
(2) This means the care, skill and diligence that would be exercised by a reasonably diligent person with-
(a) the general knowledge, skill and experience that may reasonably be expected of a person carrying out the functions carried out by the director in relation to the company, and
(b) the general knowledge, skill and experience that the director has.
Traditionally, the courts did not require directors to exhibit a greater degree of skill than may reasonably be expected from a person with their knowledge and experience (a subjective test). More recently, the courts have said that the common law standard now mirrors the tests laid down in section 214 of the Insolvency Act 1986, which includes an objective assessment of a director’s conduct. This section is modelled on that section. The case law for this particular duty continues to be relevant, with Re City Equitable [1925] Ch 407 being the foundational starting point for any discussion in this area and in effect states that the duty owed is one of a reasonable person, who does not know the business. Although, more recent case law (for instance Dorchester Finance v Stebbing and Re D’Jan of London [1994] 1BCLC 561) have broadened this approach, and it is this approach that we find in s174.
e. S175: Duty to avoid conflicts of interest
This section preserves the basic principle that directors should avoid conflicts of interest. A conflict may arise where a director uses information obtained through the company for personal benefit (for instance, making a profit). The section reads:
(1) A director of a company must avoid a situation in which he has, or can have, a direct or indirect interest that conflicts, or possibly may conflict, with the interests of the company.
(2) This applies in particular to the exploitation of any property, information or opportunity (and it is immaterial whether the company could take advantage of the property, information or opportunity).
(3) This duty does not apply to a conflict of interest arising in relation to a transaction or arrangement with the company.
(4) This duty is not infringed-
(a) if the situation cannot reasonably be regarded as likely to give rise to a conflict of interest; or
(b) if the matter has been authorised by the directors.
(5) Authorisation may be given by the directors-
(a) where the company is a private company and nothing in the company’s constitution invalidates such authorisation, by the matter being proposed to and authorised by the directors; or
(b) where the company is a public company and its constitution includes provision enabling the directors to authorise the matter, by the matter being proposed to and authorised by them in accordance with the constitution.
(6) The authorisation is effective only if-
(a) any requirement as to the quorum at the meeting at which the matter is considered is met without counting the director in question or any other interested director, and
(b) the matter was agreed to without their voting or would have been agreed to if their votes had not been counted.
(7) Any reference in this section to a conflict of interest includes a conflict of interest and duty and a conflict of duties.
This duty covers all conflicts, actual and potential, between the interests of the director and the interests of the company. This includes conflicts relating to the exploitation of the company’s property, information or opportunity for personal purposes. The only conflicts not covered by this duty, are those relating to transactions or arrangements with the company (interests in transactions or arrangements with the company must be declared under section 177 in the case of proposed transactions or under section 182 in the case of existing transactions unless an exception applies under those sections).
However, it can be seen that there are some considerable changes in relation to disclosure and ratification (also see below), specifically found within s175(4), which allows conflicts to be disclosed to the board of directors (unless the other directors are also conflicting and there is nothing in the constitution to prevent directors from authorising the act – if this is the case, authorisation must be sought from the members). This may be less cumbersome, but may place directors under more pressure to ensure they are acting in the best interests of the company. The rationale behind this change is to ensure that entrepreneurship remains at the forefront of a director’s mind.
f. S176: Duty not to accept benefits from third parties
A director must not accept a benefit (including bribes) from any third party unless; it cannot be reasonably regarded as giving rise to a conflict of interest. However, it is not clear when a situation could give rise to a conflict and when it does not. S176 reads:
(1) A director of a company must not accept a benefit from a third party conferred by reason of-
(a) his being a director, or
(b) his doing (or not doing) anything as director.
(2) A “third party” means a person other than the company, an associated body corporate or a person acting on behalf of the company or an associated body corporate.
(3) Benefits received by a director from a person by whom his services (as a director or otherwise) are provided to the company are not regarded as conferred by a third party.
(4) This duty is not infringed if the acceptance of the benefit cannot reasonably be regarded as likely to give rise to a conflict of interest.
(5) Any reference in this section to a conflict of interest includes a conflict of interest and duty and a conflict of duties.
g. S177: Duty to declare interest in proposed transaction or arrangement
The Duty to Disclose – The Pre-2006 Approach
There were three distinct duties of disclosure.
1. Direct disclosure to the General Meeting (Common Law)
2. Disclosure to the Board of Directors (Section 317, CA 1985):
3. Disclosure to the General Meeting and the public through the company’s accounts (Section 232, CA 1985 )
The Duty to disclose under the 2006 Act
The Disclosure regime under the 2006 is amended and there are (in general) three occasions where a conflict could occur: where there is a conflict relating to information, where the company is not a party (i.e. information), where there is a conflict where the company will be a party and thirdly where there is a conflict where the company is a party. S177 reads:
(1) If a director of a company is in any way, directly or indirectly, interested in a proposed transaction or arrangement with the company, he must declare the nature and extent of that interest to the other directors.
(2) The declaration may (but need not) be made-
(a) at a meeting of the directors, or
(b) by notice to the directors in accordance with-
(i) section 184 (notice in writing), or
(ii) section 185 (general notice).
(3) If a declaration of interest under this section proves to be, or becomes, inaccurate or incomplete, a further declaration must be made.
(4) Any declaration required by this section must be made before the company enters into the transaction or arrangement.
(5) This section does not require a declaration of an interest of which the director is not aware or where the director is not aware of the transaction or arrangement in question.
For this purpose a director is treated as being aware of matters of which he ought reasonably to be aware.
(6) A director need not declare an interest-
(a) if it cannot reasonably be regarded as likely to give rise to a conflict of interest;
(b) if, or to the extent that, the other directors are already aware of it (and for this purpose the other directors are treated as aware of anything of which they ought reasonably to be aware); or
(c) if, or to the extent that, it concerns terms of his service contract that have been or are to be considered-
(i) by a meeting of the directors, or
(ii) by a committee of the directors appointed for the purpose under the company’s constitution.
In short, if a director, in any way, directly or indirectly has an interest in a proposed company transaction or arrangement, he must declare the nature and extent of that interest to the other directors. This declaration must be made in writing and must also be made before the company enters into the transaction or arrangement (this is slightly different to the 1985 Act, which did not require disclosure before the arrangement or transaction and also the director needs to be more specific about the nature of the conflict). S177(6) outlines the occasions when a director need not make a declaration.
Section 182-187 concerns disclosure by a director, which are to be made during an existing transaction or arrangement. A director also has a duty to ‘update’ the disclosure if the circumstances change. Failure to comply is a criminal offence
4. Ratification
1) Prior to CA 2006
Under the CA 1985, if a director committed a breach of duty or exceeded his authority, the act would be voidable, although the company could ratify this act (usually) by an ordinary resolution provided the act was done for the benefit of the company as a whole.
• A breach of duty by a director might often, but not always be cured through the following:
3. Conduct being disclosed to the General Meeting; and
– Conduct then being ratified by the shareholders.
Kaye v Croydon Tramways
• There was no easy dividing line between those breaches of duty which are capable of ratification and those which are not.
• There was though an overriding qualification that the director must have acted bona fide in the interests of the company.
• The following might be potentially ratified:
– Failing to disclose an interest in a contract
– Obtaining a secret profit not involving a misapplication of company property
– Negligence
– Exercising powers for improper purposes
• If a director had acted with a lack of bona fides then the breach might not be ratified.
• Also, an act might not be ratified if it contravenes the Articles.
2) Ratification under the CA 2006 Act
Section 239 of the CA 2006 covers ratification and states:
(1) This section applies to the ratification by a company of conduct by a director amounting to negligence, default, breach of duty or breach of trust in relation to the company.
(2) The decision of the company to ratify such conduct must be made by resolution of the members of the company.
(3) Where the resolution is proposed as a written resolution neither the director (if a member of the company) nor any member connected with him is an eligible member.
(4) Where the resolution is proposed at a meeting, it is passed only if the necessary majority is obtained disregarding votes in favour of the resolution by the director (if a member of the company) and any member connected with him.
This does not prevent the director or any such member from attending, being counted towards the quorum and taking part in the proceedings at any meeting at which the decision is considered.
(5) For the purposes of this section-
(a) “conduct” includes acts and omissions;
(b) “director” includes a former director;
(c) a shadow director is treated as a director; and
(d) in section 252 (meaning of “connected person”), subsection (3) does not apply (exclusion of person who is himself a director).
(6) Nothing in this section affects-
(a) the validity of a decision taken by unanimous consent of the members of the company, or
(b) any power of the directors to agree not to sue, or to settle or release a claim made by them on behalf of the company.
(7) This section does not affect any other enactment or rule of law imposing additional requirements for valid ratification or any rule of law as to acts that are incapable of being ratified by the company.
This section preserves the current law on ratification of acts of directors, but with one significant change. Any decision by a company to ratify conduct by a director amounting to negligence, default, breach of duty or breach of trust in relation to the company must be taken by the members and without reliance on the votes in favour by the director or any connected person. (Although these people may still attend the meeting, but cannot vote). Section 252 defines what is meant by a person being connected with a director. For the purposes of this section it may also include fellow directors (subsection (5)(d)). Also, connected people include parents, adult children and step-children and those with whom the director lives in an “enduring family relationship” (Section 253). It seems likely that this will be another area of potential litigation.
SESSION SIX and Seven
Directors’ Duties
Questions for consideration:
1. ‘It is without doubt that the provisions in s172 will be of assistance to both directors and shareholders and will facilitate the government’s aim of enlightened shareholder engagement within the company.’
Critically discuss this statement.
2. Re City Equitable Fire Insurance Co Ltd (1925) laid down a subjective standard of care for a director (i.e. a variable standard depending on the skill and knowledge of the particular director). To what extent has recent case law and statutory provisions sought to introduce a more objective standard?
3. ‘The no-conflict and no-profit rules at common law are codified in section 175 of the Companies Act 2006. If a director has made a profit by taking advantage of information or an opportunity which belonged to the company, he will be liable to account for it to the company. Whether the company would have obtained the profit or not is irrelevant’.
Critically evaluate the above statement by reference to s 175 of the Companies Act 2006 and the authorisation of directors’ conflicts of interest.
By the end of this session you should be able to:
• Distinguish between the types of duty which directors owe to the company under the Companies Act 2006.
• Understand the concept of disclosure and be able to apply the case law and statutory provisions which provides the rules which regulate it.
• Understand the concept of ratification and be able to apply the case law rules which regulate it.
• Apply these rules and procedures to hypothetical situations.
SESSION EIGHT
Statutory Derivative Action
Required Reading
Textbooks:
• Wild & Weinstein (2013), Chapter 17.
• Hannigan, Chapter 18.
• Gower and Davies, pages 605-627
Articles:
• Gibbs, “Has the statutory derivative claim fulfilled its objectives? A prima facie case and the mandatory bar: Part 1” (2011) 32 Company Lawyer 41.
• Gibbs, “Has the statutory derivative claim fulfilled its objectives? The hypothetical director and CSR: Part 2” (2011) 32 Company Lawyer 76.
• Gray, “The statutory derivative ?claim: an outmoded superfluousness?” (2012) 33 Company Lawyer 295.
• Mujih, “The new statutory derivative ?claim: a delicate balancing act: Part 1” (2012) 33 Company Lawyer 76
• Mujih, “The new statutory derivative ?claim: a paradox of minority shareholder protection: Part 2” (2012) 33 Company Lawyer 99.
• Baxter, ‘The true spirit of Foss v Harbottle’, (1987) 38 NILQ 6
• Boyle, ‘The Prudential, the Court of Appeal and Foss v Harbottle’, (1981) 2 Co Law 264
• Boyle, ‘The new derivative action’, (1997) 18 Co Law 256
• Hirt, H. C. Ratification of breathes of director’s duties: The implications of the reform proposal regarding the availability of derivative actions (2004) Company Lawyer, Volume 25, Issue 7, pages 197-212.
• Prentice, ‘Shareholders’ actions: the rule in Foss v Harbottle’, (1988) 104 LQR 341
• Wedderburn, ‘Shareholders’ remedies and the rule in Foss v Harbottle’, (1957) CLJ 194
Cases
Cinematic Finance Ltd v Ryder [2010] EWHC 3387 (Ch);
Fanmailuk.com Ltd v Cooper [2008] EWHC 2198 (Ch); [2008] B.C.C. 877;
Franbar Holdings Ltd v Patel [2008] EWHC 1534 (Ch); [2008] B.C.C. 885;
Hughes v Weiss [2012] EWHC 2363 (Ch);
Iesini v Westrip Holdings Ltd [2009] EWHC 2526 (Ch); [2010] B.C.C. 420;
Kleanthous v Paphitis [2011] EWHC 2287 (Ch); (2011) 108(36) L.S.G. 19;
Kiani v Cooper [2010] EWHC 577 (Ch); [2010] B.C.C. 463;
Mission Capital Plc v Sinclair [2008] EWHC 1339 (Ch); [2008] B.C.C. 866;
Parry v Bartlett [2011] EWHC 3146 (Ch);
Phillips v Fryer [2012] EWHC 1611 (Ch);
Re Seven Holdings Ltd [2011] EWHC 1893 (Ch);
Stainer v Lee [2010] EWHC 1539 (Ch); [2011] B.C.C. 134;
Stimpson v Southern Landlords Association [2009] EWHC 2072 (Ch); [2010] B.C.C. 387
Introduction:
The rule in Foss v Harbottle (1843) 2 Hare 461 has been a very familiar part of company law for over 150 years. The rule is twofold:
(a) It reinforces the democratic principle of ‘majority rule’. In other words, the rule precludes a minority shareholder from bringing an action to pursue wrongs done to the company; and
(b) It supports the ‘proper claimant’ principle, that where the company has suffered harm, or where there has been a breach of duty owed to the company, then the proper plaintiff in those circumstances is the company itself. In other words, it reinforces the concept that the company is a separate legal entity.
This rule means that, for good or bad, the decision-making power within a company lies with those in control of more than half of the votes in general meetings or boards of directors. (Though if you refer back to earlier lectures then many resolutions require a special resolution).
Consequently, at common law, if the minority shareholder disagrees with the majority, he has little room to complain. In many instances, the unhappy shareholder in a public limited company is encouraged to use his ‘power of exit’ – in other words to sell his shares on the Stock Market.
However, consider the position of a minority shareholder within a private limited company:
• Where is the available market?
• Is the shareholder able to sell his shares to individuals external to the company? – Consider pre-emption clauses in the articles.
• How will the shares be valued?
The main exception to this restriction on the ability of the minority shareholder to object to the actions of the majority arises in instances where there is a ‘fraud on the minority’. However, even in these circumstances success is not guaranteed.
The obscure nature of the rule in Foss v Harbottle has meant that in the past individuals have been refused a remedy – despite the merits of the case.
However, since October 2007, minority shareholders have been allowed a new statutory derivative action. The two rules in Foss v Harbottle will continue to apply, although the absence of one or the other will no longer be a bar to commence proceedings. Before exploring the new statutory derivative action, it is necessary to provide some context for the rule (and the exceptions to the rule contained in Edwards v Halliwell [1950] 2 All E.R. 1064) in Foss v Harbottle.
Common law rules/matters:
Exceptions to the Rule in Foss v Harbottle:
If a shareholder wishes to resort to litigation, then his first option is to bring an action within one of the exceptions to the rule in Foss v Harbottle.
Wallersteiner v Moir (No 2) [1975] QB 373, 390
It is a fundamental principle of our law that a company is a legal person, with its own corporate identity, separate and distinct from the directors or shareholders, and with its own property rights and interests to which it alone it is entitled. If it is defrauded by a wrongdoer, the company itself is the one person to sue for the damage. Such is the rule in Foss v Harbottle (1843) 2 Hare 461. The rule is easy enough to apply when the company is defrauded by outsiders. The company itself is the only person who can sue… but suppose it is defrauded by insiders who control its affairs – by directors who hold the majority of the shares – who then can sue for damages? Those directors are themselves the wrongdoers. If a board meeting is held, they will not authorise the proceedings to be taken by the company against themselves…yet the company is the one person who is damnified. It is the one person who should sue. In one way or another some means must be found for the company to sue. Otherwise the law would fail in its purpose. Injustice would be done without redress.
There are said to be four exceptions to the rule as identified by Jenkins LJ in Edwards v Halliwell [1950] 2 All ER 1064. These are as follows:
a) Where the act complained of was ultra vires;
b) Where there was a fraud on the minority and the wrongdoers were in control;
c) Where the act complained of was a violation of a requirement in the articles for a special majority; and
d) Where the act complained of was an invasion of members’ personal rights as members.
Pender v Lushington (1877) 6 ChD 70
The main heading that most shareholders will aim to utilize is (b) – fraud on the minority.
If the shareholder is able to bring himself within this exception, then he may bring a derivative claim:
– Where there is ‘fraud on the minority’; and
– The wrongdoers in control of the company prevented it from suing.
It is important to note at this point that the purpose of a derivative action is to obtain a remedy for the Company. The minority shareholder does NOT receive a remedy for himself.
Fraud on the Minority:
The concept of ‘fraud on the minority’ is not an exact one.
Estmanco (Kilner House) Ltd v Greater London Council [1982] 1 All ER 437
Megarry V-C noted that:
” It does not seem to have yet become very clear exactly what the word ‘fraud’ means in this context; but I think it is plainly wider than fraud at common law..”
Burland v Earle [1902] AC 83
A straightforward example is “… where a majority are endeavouring directly or indirectly to appropriate to themselves money, property or advantages which belong to the company”
Pavlides v Jensen [1956] 1 Ch 565
Held that a loss caused to a company through the negligence of its directors who had derived no personal gain through the transaction did not constitute a fraud on the minority.
Daniels v Daniels [1978] Ch 406
Held that a derivative claim arose where a substantial profit was made upon the resale of company land sold to a director.
• Therefore, it should be noted that fraud in this context is not confined to literal or common law fraud.
• It may include:
o Misappropriation of corporate property – (Note the wide scope of this concept);
o Mala fide abuse of power – (Refer to directors duties);
o Discrimination against a section of the membership;
o Errors of judgment from which the directors have benefited.
Wrongdoer Control:
In addition, the shareholder must demonstrate that there was sufficient control exercised by the alleged wrongdoers to enable them to prevent the company from bringing a claim. This is explained as follows:
• As an exception to the ‘proper claimant principle’ the court permits a claim to be brought on behalf of a company by one of its members.
• The member is said to be deriving a right of action from the company, hence the term derivative claim.
• The reason that the shareholder is permitted to undertake this action is because the company is incapable of pursuing the claim due to the influence and control of the wrongdoers. For instance if the wrongdoers control the Board of Directors, then:
o Article 70 Table A;
o The General Meeting delegates powers to the Board of Directors;
o The Board then makes the day-to-day decisions for the company;
o This includes whether or not the company should bring a claim against the wrongdoers.
However, how does a shareholder demonstrate this? In other words, what is the process by which the shareholder establishes locus standi – the right to bring a derivative action on behalf of the company against these alleged wrongdoers in a particular case?
Prudential Assurance Company Ltd v Newman Industries Ltd (No.2) [1982] Ch 204
• If a minority brings a derivative claim on behalf of the company then the defendants may apply for the claim to be struck out on the grounds that the minority does not have locus standi to sue.
• Where this happens, then a full trial of the substantive issues must be avoided.
• Look at the facts of this case.
Smith v Croft (No 2) [1987] 3 All ER 909
• The court can investigate the conduct of the voting and count heads to see what the other shareholders, independent of the plaintiffs and the wrongdoers, think should be done.
• The organ capable of reviewing the matter will usually be the General Meeting.
• Where the majority of independent shareholders would vote against legal proceedings, then no claim in the company’s name should lie.
Other matters:
A derivative action for fraud in the minority is an equitable remedy. Thus, the plaintiff must come with clean hands.
Towers v African Tug Co [1904]
The courts will not allow a derivative action to be brought if the courts are of the opinion that there is an alternative remedy available that is more appropriate in the circumstances.
Barrett v Duckett [1995]
Where a company has gone into liquidation, a derivative action cannot be allowed.
Fargo v Ltd v Godfrey [1986]
A minority shareholder who brings a derivative claim may be entitled to an indemnity for costs from the company.
Wallersteiner v Moir (no.2) (1975)
The statutory derivative action
Unlike the duties, which codified the common law, the statutory derivative claim replaces the common law rules.
The new action is found within Part 11 of the 2006. S260(1) defines a derivative claim as:
(1) This Chapter applies to proceedings in England and Wales or Northern Ireland by a member of a company-
(a) in respect of a cause of action vested in the company, and
(b) seeking relief on behalf of the company.
Accordingly, there are three elements to the derivative claim: the action is brought by a member of the company; the cause of action is vested in the company; and relief is sought on the company’s behalf. (A “member” is defined in section 112. Subsection (5) provides that references to a member in this Chapter include a person who is not a member but to whom shares in the company have been transferred or transmitted by operation of law, for example where a trustee in bankruptcy or personal representative of a deceased member’s estate acquires an interest in a share as a result of the bankruptcy or death of a member).
Section 260(2) states that a derivative claim may only be brought under this section or section 994 (unfairly prejudicial conduct).
Section 260(3) is a key provision in relation to the statutory derivative action and states:
(2) A derivative claim under this Chapter may be brought only in respect of a cause of action arising from an actual or proposed act or omission involving negligence, default, breach of duty or breach of trust by a director of the company.
The cause of action may be against the director or another person (or both).
This section states that the cause of action must be against the director or another person (for instance if a third party dishonestly assisted a director in breaching his fiduciary duties). Therefore, this section gives shareholders – for the first time – a statutory right to sue directors for negligence (in itself a change from pre-existing common law – see Pavlides v Jensen [1956] 1 Ch 565), default, breach of duty (see sessions on directors’ duties, ss170-176) or breach of trust.
The remaining subsections in s260 read:
(3) It is immaterial whether the cause of action arose before or after the person seeking to bring or continue the derivative claim became a member of the company.
(4) For the purposes of this Chapter-
(a) “director” includes a former director;
(b) a shadow director is treated as a director; and
(c) references to a member of a company include a person who is not a member but to whom shares in the company have been transferred or transmitted by operation of law.
However, it is important to realise that members do not have unfettered discretion to bring a derivative action. The member must apply to the court for permission to bring the action. Section 261 states:
(1) A member of a company who brings a derivative claim under this Chapter must apply to the court for permission (in Northern Ireland, leave) to continue it.
(2) If it appears to the court that the application and the evidence filed by the applicant in support of it do not disclose a prima facie case for giving permission (or leave), the court-
(a) must dismiss the application, and
(b) may make any consequential order it considers appropriate.
(3) If the application is not dismissed under subsection (2), the court-
(a) may give directions as to the evidence to be provided by the company, and
(b) may adjourn the proceedings to enable the evidence to be obtained.
(4) On hearing the application, the court may-
(a) give permission (or leave) to continue the claim on such terms as it thinks fit,
(b) refuse permission (or leave) and dismiss the claim, or
(c) adjourn the proceedings on the application and give such directions as it thinks fit.
This clause provides that, once proceedings have been brought, the member is required to apply to the court for permission to continue the claim. This reflects the current procedure in England and Wales under the Civil Procedure Rules. The applicant is required to establish a prima facie case for the grant of permission, and the court will consider the issue on the basis of his evidence alone without requiring evidence to be filed by the defendant. The court must dismiss the application at this stage if what is filed does not show a prima facie case, and it may make any consequential order that it considers appropriate (for example, a costs order or a civil restraint order against the applicant). If the application is not dismissed, the court may direct the company to provide evidence and, on hearing the application, may grant permission, refuse permission and dismiss the claim, or adjourn the proceedings and give such directions as it thinks fit. This will enable the courts to dismiss unmeritorious claims at an early stage without involving the defendants or the company.
Section 262 concerns the alternative scenario of a company commencing an action, only for a member to take it forward as a derivative action. This section is unlikely to be relied upon to a great extent. Under both s261 and s262, the member must demonstrate two points before action can commence. First, the member has sufficient evidence to establish a prima facie case (at this stage the company has no obligation to go to any expense – the impetus is solely on the member) and secondly, the member needs to persuade the court that a derivative action is appropriate. The advantages of this two-stage test are that it will limit frivolous actions and will also minimalise the initial expenditure of the company.
Section 263 outlines the considerations the court must weigh up under an application from after a prima facie case has been established. Under s263(2), a court must refuse permission for a derivative action if:
S263(2) Permission (or leave) must be refused if the court is satisfied-
(a) that a person acting in accordance with section 172 (duty to promote the success of the company) would not seek to continue the claim, or
(b) where the cause of action arises from an act or omission that is yet to occur, that the act or omission has been authorised by the company, or
(c) where the cause of action arises from an act or omission that has already occurred, that the act or omission-
(i) was authorised by the company before it occurred, or
(ii) has been ratified by the company since it occurred.
If any of these three situations are met, then the court must refuse to allow the derivative action to proceed. (Remember, that under part (b) above, the ratification can only be by people not connected to the director – s239).
If the situation the court is presented with does not fall within one or the three situations as list in s263(2), then the court can proceed to consider a number of discretionary factors listed in s263(3), specifically:
S263(3) In considering whether to give permission (or leave) the court must take into account, in particular-
(a) whether the member is acting in good faith in seeking to continue the claim;
(b) the importance that a person acting in accordance with section 172 (duty to promote the success of the company) would attach to continuing it;
(c) where the cause of action results from an act or omission that is yet to occur, whether the act or omission could be, and in the circumstances would be likely to be-
(i) authorised by the company before it occurs, or
(ii) ratified by the company after it occurs;
(d) where the cause of action arises from an act or omission that has already occurred, whether the act or omission could be, and in the circumstances would be likely to be, ratified by the company;
(e) whether the company has decided not to pursue the claim;
(f) whether the act or omission in respect of which the claim is brought gives rise to a cause of action that the member could pursue in his own right rather than on behalf of the company.
The recent case of Airey v Cordell [2006] EWHC 2728 considers the approach courts should take in deciding whether to permit a derivative action, In this case the court decided that Where a shareholder applies to the court for permission to bring a derivative claim he is required to establish both that there is a prima facie case that the company is entitled to the relief sought and that the action falls within the boundaries of one of the exceptions to the rule that a member cannot bring an action on behalf of a company. If no reasonable board would bring proceedings then, even if there is a prima facie case, the court should not sanction proceedings. Where, however, the court is satisfied that a reasonable board of directors could bring the action; the court should not shut out the shareholder on the basis of its own view of what it would do if it were the board.
The remaining sections in s263 read:
(4) In considering whether to give permission (or leave) the court shall have particular regard to any evidence before it as to the views of members of the company who have no personal interest, direct or indirect, in the matter.
(5) The Secretary of State may by regulations-
(a) amend subsection (2) so as to alter or add to the circumstances in which permission (or leave) is to be refused;
(b) amend subsection (3) so as to alter or add to the matters that the court is required to take into account in considering whether to give permission (or leave).
(6) Before making any such regulations the Secretary of State shall consult such persons as he considers appropriate.
(7) Regulations under this section are subject to affirmative resolution procedure.
It is interesting to note that in s263(4), the court must pay particular regard to the views of the (independent) members and there is not merely a requirement to take into account their views. It could be argued that this should be the most prevalent thought in the mind of the judges as they decide whether a derivative action should proceed or not. Further, the Secretary of State has the ability to amend the requirements as he sees fit.
Some tentative analysis
During the early stages of the Companies Bill, there was concern that this new statutory derivative action would open the floodgate to unmeritous litigation claims. However, it seems that the ‘checks’ provided by the court will prevent this. Earlier concerns that the rule (and exceptions) to Foss v Harbottle would be removed are unfounded and it seems that statute has merely established a new derivative procedure.
Early Cases
Thirteen cases have now passed through the High Court in the first six years that are noted above. 5 of these thirteen cases have been allowed (although two only down to disclosure). All 13 cases have survived the initial hurdle of establishing a prima facie case (but see the criticism in Seven Holdings). Three cases have been barred for a mandatory bar s263(2)(a) – Stimpson, Iesini, Seven Holdings
In terms of critical analysis students should consider these cases and the large number of academic material concerning the likely effectiveness (or not) of the new procedure.
SESSION EIGHT
Shareholder Remedies I
Questions for Consideration
1. ‘The rule is, as one would expect, that the proper plaintiff in an action in respect of a wrong alleged to have been done to the company is prima facie the company.’
Analyse this statement in light of the decision in Foss v Harbottle [1843].
2. What are the procedures for shareholders to obtain permission from the court to continue a derivative claim? What factors will the court take into account?
3. “During the early stages of the Companies Bill, there was concern that this new statutory derivative action would open the floodgate. However, it seems that the ‘checks’ provided by the court will prevent this. Earlier concerns that the rule, together with the exceptions to Foss v Harbottle, would be removed are unfounded and it seems that the Companies Act 2006 has merely established a new procedure.”
Wild & Weinstein, Smith & Keenan’s Company Law, (Pearson, 2009), p 264.
Critically evaluate the scope of application and the procedure under the statutory derivative action. Is the statutory derivative action more effective in protecting shareholders’ rights than its predecessor?
By the end of this session you should be able to:
• Demonstrate an up to date knowledge and understanding of the majority rule principle laid down in Foss v Harbottle.
• Demonstrate an up to date knowledge of the procedure of bringing a statutory derivative action.
• Demonstrate an ability to critically analyse the procedure and the factors that the court will consider when granting permission to continue the derivative claim.
• Demonstrate the ability to apply that knowledge to essay questions
• Discuss the topic in legal technical language.
SESSION NINE
Shareholder Remedies II: UNFAIR PREJUDICE REMEDY AND WINDING UP
Required Reading
Textbooks:
• Wild & Weinstein(2013), Chapter 18.
• Hannigan, Chapter 17.
• Gower & Davies, Chapter 20.
• Hicks & Goo, pp 177-207, 429-491.
• Boyle & Birds, Chapter 18.
• Mayson, French & Ryan, chapter 18.
• Dignam & Lowry, Chapter 11.
Articles
• Walters, A ‘Section 459: “shareholder” or “investor” remedy?’ Company Lawyer (2007), Volume 28, Issue 10, page 289.
• Acton, ‘Just and equitable winding up; the strange case of the disappearing jurisdiction’ (2001) 22 Co Law 134
• Chesterman, ‘The just and equitable winding up of small companies’ (1973) 36 MLR 129
• Goddard, ‘Closing the categories of Unfair Prejudice’ (1999) 20 Co Law 333
• Goddard, R Sections 459-461 of the Companies Act (1985): Exeter City AFC Ltd and Fisher v Cadman (2005) Company Lawyer, Volume 26, Issue 8, pages 251-253.
• Hannigan, ‘Section 459 of the Companies Act 1985 – A code of conduct for the quasi-partnership?’ (1988) LMCLQ 60
• Paterson, P A criticism of the contractual approach to unfair prejudice (2006) Company Lawyer, Volume 27, Issue 7, pages 204-215.
• Prentice, ‘Winding up on the just and equitable ground: the partnership analogy’ (1973) 89 LQR 107
• Riley, ‘Contracting out of company law: Section 459 of the Companies Act and the role of the courts’ (1992) 55 MLR 702
• Thomas & Ryan, ‘Section 459, public policy and freedom of contract’ (2001) 22 Co Law 177
• Chiu, I. H. ‘Contextualising shareholders’ disputes – a way to reconceptualise minority shareholder remedies’ [2006] JBL312.
Introduction
This lecture will examine two interrelated statutory remedies. First of all, s994 (ex s459) of the Companies Act 2006, which permits a member (shareholder) of a company to petition on the ground of unfair prejudice. Secondly, s122 (1)(g) of the Insolvency Act 1986, which provides a ‘just and equitable’ ground for a member to petition to have the company wound up.
These statutory remedies, (particularly s994) evolved in response to the undue technicality and doctrinal obscurity of the rule in Foss v Harbottle, aiming to provide a broader and more liberal judicial discretion to the area of shareholder remedies, (see the case of O’Neill v Phillips). However, despite this rather positive development in the law, it should be noted that their beneficial effect is largely restricted to small and/or medium sized private companies. Quite simply, these two remedies are not an appropriate method of dealing with issues such as corporate abuse in public listed companies, (see the case of Re Blue Arrow Plc).
1. Section 994, CA 2006 – the unfair prejudice remedy
As noted above, a petition under s994(1) CA 2006 is made on the ground that the company’s affairs are being or have been conducted in a manner which is unfairly prejudicial to the interests of its members generally or of some part of its members (including at least the petitioner) or that any actual or proposed act or omission of the company is or would be so prejudicial.
History of the unfair prejudice remedy
• Originally, s210 of the Companies Act 1948 was intended to provide more flexible remedies free from the restrictions of the rule in Foss v Harbottle and the harshness of s122(1)(g) – (a winding up order).
• The Cohen Committee had recommended this development in the area of minority shareholder protection.
• The new remedy was to be based on the concept of ‘oppression’. In other words, a member could bring an action where the affairs of the company were being conducted in a manner oppressive to some of the members (including the petitioner).
• However, the wording s210 proved to be a problem, resulting in the fact that there were only two successful cases under the section in the UK.
Scottish Co-operative Wholesale Society v Meyer [1959] AC 324
• The Jenkins Committee made a number of recommendations which are now contained in section 459-461 of the Companies Act 1985. (Note that section 210 was repealed).
• The new statutory remedy was based on the concept of ‘unfairly prejudicial conduct’.
The purpose of s.994 is to:
• Provide a remedy
• Where a complaint exists
• Concerning the way in which a company’s affairs are being conducted
• Through the use of, or failure to use, corporate powers
• In relation to the conduct of the company’s affairs
• As provided by the company’s constitution.
Re Legal Costs Negotiator’s Ltd [1999] 2 BCLC 171
Section 994 states:
(1) A member of a company may apply to the court by petition for an order under this Part on the ground-
(a) that the company’s affairs are being or have been conducted in a manner that is unfairly prejudicial to the interests of members generally or of some part of its members (including at least himself), or
(b) that an actual or proposed act or omission of the company (including an act or omission on its behalf) is or would be so prejudicial.
(2) The provisions of this Part apply to a person who is not a member of a company but to whom shares in the company have been transferred or transmitted by operation of law as they apply to a member of a company.
(3) In this section, and so far as applicable for the purposes of this section in the other provisions of this Part, “company” means-
(a) a company within the meaning of this Act, or
(b) a company that is not such a company but is a statutory water company within the meaning of the Statutory Water Companies Act 1991 (c. 58).
The concept of ‘unfairly prejudicial conduct’:
1. The first thing to note is that the tern ‘unfair prejudice’ is wider than the old concept of ‘oppression’ and deliberately so.
Boyle and Birds describe this new concept/term as an elusive one and it can therefore involve many different types of situation and behaviour.
2. Both unfairness and prejudice must be established.
Re Saul D Harrison and Sons plc [1995]
3. It is not necessary to demonstrate that the act complained of is improper or illegal. In fact, the exercise of a legal right may have an unfairly prejudicial effect.
(Refer back to the methods by which the Articles of Association may be amended or Share Capital may be manipulated)
This links in with the fact that it was decided the words ‘unfair prejudice’ should not be defined – and as such restricted.
For instance, in the early days of s994 it was thought that an individual must have unfairly suffered prejudice to an interest as a member only. However, this requirement has since been relaxed so as to take account of various rights, expectations and obligations that may arise within a company other than those strictly classified as membership rights. In this respect, consider:
• Quasi-partnerships
• Legitimate expectations – (e.g involvement in management, valuation of shares)
• Shareholder agreements – (Refer back to your lecture on Articles of Association)
Re A Company (No 00477 of 1986) [1986] BCLC 376
O’Neill v Phillips [1999] 1 WLR 1092
Re Bird Precision Bellows Ltd [1984] 3 All ER 444
Re Blue Arrow Plc [1987] BCLC 585
4. The courts are increasingly prepared to look at any alleged prejudicial conduct from an objective point of view. They are prepared to take into account any relevant circumstances and to give the section its ‘natural meaning’.
• Therefore, it is not necessary for the petitioner to show that the persons have acted as they did in the conscious knowledge that this was unfair to the petitioner or that they were acting in bad faith
Re R.A. Noble & Sons Ltd (Clothing) [1983] and Re Bovey Hotel Ventures Ltd [1981]
• The test asserted in R.A.Noble was whether a reasonable bystander observing the consequences of the conduct would consider that it had unfairly prejudiced the petitioner’s interests.
Scope of the Remedy:
As noted above, the scope of section 994 has increased over time.
O’Neill v Phillips [1999] 2 BCLC 1.
Lord Hoffman stated that unfair prejudice would involve some breach of the terms upon which the member agreed that the affairs of the company would be conducted or a use of these terms “…in a manner which equity would regard as contrary to good faith.”.
He went on to state that:
“In a quasi-partnership company, there will usually be understandings between the members at the time they entered into the association. But there may be later promises, by words or conduct, which it would be unfair to allow a member to ignore. Nor is it necessary that such promises should be independently enforceable as a matter of contract. A promise may be binding as a matter of justice and equity, although for one reason or another…it would not be enforceable in law.”
He confirmed that this approach to the concept of unfair prejudice was parallel to that taken by the House of Lords in Ebrahimi v Westbourne Galleries Ltd [1973] to the concept of ‘just and equitable’ as a ground for the winding up of a company.
Examples of unfairly prejudicial conduct include:
• Exclusion from participation in the management of a quasi-partnership company.
Ebrahimi v Westbourne Galleries Ltd [1973]
• The award to him or herself of excessive financial benefits by the majority shareholder/director.
Re Elgindata Ltd [1991]
• The diversion of business to another company in which the majority shareholder/director holds an interest
Re Cumana Ltd [1986]
Re London School of Electronics Ltd [1986] Ch 211
• In exceptional circumstances, serious mismanagement
Re Macro (Ipswich) Ltd [1994]
• Low payment of dividends may be unfairly prejudicial
Re Sam Weller & Sons Ltd [1990] BCLC 80
Locus standi
• The general position is that a member of the company in question must bring the claim.
• The section also applies to a non-member to whom shares in the company have been transferred or transmitted, but a mere agreement to transfer is insufficient
Re Quickdome Ltd [1988].
• Ownership of a single share is enough to establish locus standi.
Re Garage Door Associates Ltd [1984].
• The petitioner may have joined the company knowing about the conduct complained of.
Bermuda Cabletelevision v Colica Trust Co. Ltd [1988].
• Where persons claim they are being wrongfully excluded from membership an existing member cannot petition on their behalf in this respect as a member of a company has no interest (in the sense of s.994(1))in the recognition of voting rights of other persons claiming to be members.
Jaber v Science an Information Technology Ltd [1992].
• Former members have no locus standi.
Re A Company ex p Holden (1991) BCLC 597
The notion of ‘interest’:
The notion of ‘interest’ has traditionally been limited to the interests of the member as a member of the company as illustrated by the case of Re J.E. Cade and Son Ltd [1992].
• In this instance the petitioner tried to include a claim for possession of land in which he had the freehold title. It was held that that this interest did not fall within s.459(1)).
The position appears to have been somewhat relaxed in O’Neill v Phillips [1999] 2 BCLC 1.
Available Remedies
The Court can make any order it wishes under S.996, 2006 Act, for example:
a) The purchase of the petitioner’s shares by the defendant. This is the most common remedy sought under s.994 and a reasonable offer to buy out the petitioner may defeat the claim of unfair prejudice Guidance on what constitutes a reasonable offer was given by Lord Hoffman in O’Neill v Phillips [1999]. This is aimed at helping parties to avoid costly litigation.
b) The purchase of the petitioner’s shares by a third party Re Little [1995]
c) The sale of the majority shareholder’s shares to the petitioner Re Brenfield Squash Racquets Club Ltd [1996]
d) The amendment of the petition to seek winding up on just and equitable grounds Re Full Cup International Trading Ltd [1995]
2. Winding Up on the just and equitable ground
Where relationships have irretrievably broken down, then a member may petition under s122(1)(g) of the Insolvency Act 1986 for the company to be wound up on the ground that it is just and equitable to do so.
• This was a relatively popular remedy prior to the introduction s994, when the exceptions to the rule in Foss v Harbottle were the only alternative.
• Following the introduction of s994, it was frequently used in conjunction with a plea of unfair prejudice, (though this practice has now been deterred), as an alternative to relief under s994.
The following should be noted:
• Winding up by the court commences on presentation of the petition – s129(2)
• As soon as a application for winding up has been made, the company becomes paralyzed and no transactions relating to the company’s property can be entered into after this point.
Consequently, this is a drastic course of action and as such should be viewed as the last resort for any minority shareholder.
This is reinforced by the fact that the court, under s125(2), may refuse to grant a winding up order if it is of the opinion that:
• Some other remedy is available to the petitioners; and
• The petitioners are acting unreasonably by seeking to have the company wound up instead of pursuing that other remedy.
There are other procedural limitations:
• A ‘contributory’ has standing to make an application to the court with a view to obtaining the winding up of the company (s. 124).
• According to s79, a contributory is any person who is liable to contribute to the assets of a company in the event of its being wound up.
• A fully paid up member who is not liable to contribute has to show that he has a tangible interest in the winding up.
Re Rica Gold Washing Co (1879) 11 ChD 36
• A contributory who has not held shares for the requisite period of time may only petition if:
• The number of members is reduced below two; or
• The shares have devolved on him through the death of a former holder.
• Note that because this in an equitable remedy the petitioner must come with “clean hands”
Ebrahimi v Westbourne Galleries [1973] AC 360
For the winding up to be ordered, the company member who approached the court must establish that the alleged situation falls within the list contained in s. 122(1) IA 1986.
Examples:
The following are instances in which the court considered that it was just and equitable to order the winding up of the company include:
• Cases where the company was promoted fraudulently
Re London and County Coal Co. [1866]
• Cases where there was a “deadlock”- here in the context of a quasi-partnership company.
Ebrahimi v Westbourne Galleries [1973]
• Cases in which the management and conduct of the company are such that it is unfair to require the petitioner to remain a member
Re Five Minute Car wash Service Ltd [1966]
Re Anglo-Greek Steam Co. [1866]
• Cases of oppression
Scottish Co-operative Wholesale Society v Meyer [1959]
Baird v Lees [1924]
• Cases where the company is a quasi-partnership and where there has been a sufficiently serious breach of mutual understanding not expressed on the company constitution.
Virdi v Abbey Leisure Ltd [1990]
• Cases where the substratum of the company has gone.
Court powers – S 125(2) IA 1986:
Re a company (No. 001363 of 1988) [1989]
Cumberland Holdings Ltd v Washington H Soul Pattinson and Co. Ltd [1977]
SESSION EIGHT
Shareholder Remedies II
Questions for consideration
1. According to section 994 CA 2006 and the relevant case-law, discuss how the unfair prejudice remedy applies.
2. “…I think that one useful cross-check in a case like this is to ask whether the exercise of the power in question would be contrary to what the parties, by word or conduct, have actually agreed. Would it conflict with the promises which they appear to have exchanged?…In a quasi-partnership company [these promises] will usually be found in the understandings between the members at the time they entered into association…a promise may be binding as a matter of justice and equity although for one reason or another it would not be enforceable in law.”
In the light of this statement, discuss the inter-relationship between quasi-partnership companies and the remedy available under section 994 of the CA 2006 for ‘unfairly prejudicial’ conduct.
3. ‘The success of unfair prejudice remedies has made derivative claims and winding up remedies redundant’.
Evaluate the above statement with regard to the relationship between the statutory remedies.
By the end of this session you should be able to:
• Demonstrate an up to date knowledge and understanding of unfairly prejudicial remedies.
• Demonstrate an up to date knowledge of the winding up remedies.
• Demonstrate the ability to apply that knowledge to essay questions
• Discuss the topic in legal technical language
SESSION TEN
CORPORATE RESCUE AND INSOLVENCY
Required Reading
Textbooks:
• Wild & Weinstein (2013), Chapters 27 – 29
• Hannigan, Chapter 22-25
• Hicks & Goo, Chapter 20.
• Boyle & Birds, Chapter 21
• Dignam & Lowry, Chapter 17.
• Finch, Corporate Insolvency Law: Perspectives and Principles (2nd edn, CUP, 2009)
Articles
Hunter, ‘The Nature and Functions of a Rescue Culture’ [1999] JBL 491
Cook, ‘Wrongful Trading: Is it a Real Threat to Directors or is it a paper tiger’ (1999) INsolv L 99.
Keay, ‘What Future for Liquidation in Light of the Enterprise Act Reforms’ [2005] JBL 143.
Finch,’ Re-invigorating Corporate Rescue’ [2003] JBL 527.
Introduction
In this session, we will consider the procedures which are designed to rescue the companies in financial difficulties. Two procedures (Administration and Company voluntary arrangement) were introduced by the IA 1986 and aimed at implementing the objective of corporate rescue which was recommended by the Cork Committee (1982).
We will also discuss the procedures of liquidation that brings the company to an end. Receivership which allows secured creditors to recover monies owed is also briefly discussed.
1. Administration
Administration is a rescue procedure where an administrator is appointed to an insolvent but potentially viable company. It is intended to provide a breathing space and enable the administrator to consider whether the business could be rescued or to negotiate with creditors regarding any possible arrangement or compromise of the company’s debts.
The purpose of administration reflects the rescue nature: IA 1986, Sch B1, para 3(1):
‘3 (1) The administrator of a company must perform his functions with the objective of—
(a)rescuing the company as a going concern, or
(b)achieving a better result for the company’s creditors as a whole than would be likely if the company were wound up (without first being in administration), or
(c)realising property in order to make a distribution to one or more secured or preferential creditors.’
(2)Subject to sub-paragraph (4), the administrator of a company must perform his functions in the interests of the company’s creditors as a whole.
A hierarchy as between these objectives is laid down.
‘3(3)The administrator must perform his functions with the objective specified in sub-paragraph (1)(a) unless he thinks either—
(a)that it is not reasonably practicable to achieve that objective, or
(b)that the objective specified in sub-paragraph (1)(b) would achieve a better result for the company’s creditors as a whole.
(4)The administrator may perform his functions with the objective specified in sub-paragraph (1)(c) only if—
(a)he thinks that it is not reasonably practicable to achieve either of the objectives specified in sub-paragraph (1)(a) and (b), and
(b)he does not unnecessarily harm the interests of the creditors of the company as a whole.
4 The administrator of a company must perform his functions as quickly and efficiently as is reasonably practicable.’
The moratorium
The ability to secure a moratorium is one of the most important features of administration. It precludes actions against the company by creditors and others applies (Sch B1, para 44). It ensures that the status quo is preserved regarding the company’s assets. The effect of the moratorium is that owners of property, and charges over property, are disabled from exercising their proprietary rights unless the administrator consents or the court gives permission. Once the company is in administration, the extent of the moratorium is governed by IA 1986, Sche B1, paras 42 and 43.
2. Company voluntary arrangement (CVA)
For a company in financial difficulty, one of the most important options is to make binding arrangements with the creditors of the company. It is another rescue procedure which allows the company to enter into a binding agreement with its creditors.
There are two types of CVA: a CVA under IA 1986, Part 1 or a CVA with a moratorium governed by IA 1986, Sch A1. The latter was introduced by the IA 2000 but less popular due to complex procedure. Most of CVAs are the former.
CVA under IA 1986, Part 1
The procedure:
– proposing an arrangement by directors or administrator or liquidator
– approving an arrangement
– once approved, the arrangement needs to be supervised by administrator or liquidator or a nominee (if the directors made the proposal)
– the nominee must submit a report stating whether the proposed CVA has a reasonable prospect of being approved and implemented and whether or not meetings of the company and its creditors should be convened to consider the proposal.
– Once the proposal is approved, it will bind the company and will be supervised by the nominee.
Administration is more popular than CVA. This is mainly because all administrations come with a moratorium and the procedures for administration are less cumbersome and complex than those relating to proposing and approving a CVA. Director, nevertheless, may prefer CVA to administration because it allows them to remain in control of the company.
3. Receivership
Receivership refers to the procedure where a secured creditor can recover money owed by a company. It usually occurs when a secured creditor appoints a receiver, who then takes control of the charged assets and use them to satisfy the debt of the creditor who appointed him.
4. Liquidation (winding up)
Liquidation refers to the process whereby the assets of the company are collected and realized, its debts and liabilities paid, and the surplus distributed to the members. There are two types of liquidation: voluntary and compulsory.
4.1 Voluntary liquidation
There are two types of voluntary liquidation: a members’ voluntary winding up or a creditors’ voluntary winding up. In both types, the winding up is commenced by the members passing a resolution agreeing that the company is to be wound up voluntarily ( s84(1)(b), IA 1986).
The distinction between them lies on whether a declaration of solvency is made. Where such a declaration is made, it is a members’ winding up; where no declaration is made, it is a creditors’ winding up. A declaration of solvency is made a majority of the directors which states that the directors have made a full enquiry into the affairs of the company and have formed the opinion that the company will be able to pay its debts in full within 12 months from the date of the passing of the resolution for winding up (s 89).
4.2 Compulsory liquidation
In a compulsory winding up, the court orders that the company be wound up following a petition by the company itself, its directors, creditors, an administrator or official receiver and a contributory of the company (s 124(1)). In practice, most petitions are made by creditors of the company.
The grounds for compulsory winding up are set out in s 122, including: that the company has by special resolution resolved that the company be wound up by the court, that the company is unable to pay its debts,or that the court is of the opinion that it is just and equitable that the company should be wound up.
The most common ground is that the company is unable to pay its debts. A company is deemed unable to pay its debts in one of the following four circumstances listed in s 123, IA 1986.
(1) A creditor to whom the company is indebted in a sum exceeding £750 then due has served on the company a written demand requiring the company to pay the sum due; and the company has for three weeks thereafter neglected to pay the sum or to secure or compound for it to the reasonable satisfaction of the creditor;
(2) Execution or other process issued on a judgment, decree or order of any court in favour of a creditor of the company is returned unsatisfied in whole or in part;
(3) It is proved to the satisfaction of the court that the company is unable to pay its debts as they fall due;
(4) it is proved to the satisfaction of the court that the value of the company’s assets is less than the amount of its liabilities, taking into account its contingent and prospective liabilities.
4.3 The functions of a liquidator
In both types of liquidation, a liquidator is appointed to oversee the company’s liquidation. The liquidator’s primary duty is to collect in and realise the assets of the company and then to distribute the proceeds amongst the creditors of the company, and if any surplus remains, to the shareholders (s 143). IA 1986, Sch 4 grants liquidators an extremely wide scope of powers. In particular, the liquidator can obtain a contribution, prevent assets from being removed, and set aside certain transactions or agreements.
Fraudulent trading: IA 1986, s 213
Wrongful trading: IA 1986, s 214
Disqualification of directors: Company Directors Disqualification Act 1986
Transactions at an undervalue: IA 1986, s 238
Preferences: IA 1986, s 239
Avoidance of floating charges: IA 1986,s 245
Extortionate credit transactions: IA 1986, s 244
Misfeasance: IA 1986, s 212
4.4 Distribution of assets
In distributing the assets upon corporate insolvency, the liquidator needs to consider the following issues: have the creditors submitted their proofs of debts?: Are there mutual debts between the company and the creditors which can be set off (the rights of set-off)? What is the order of distribution in relation to the company’s assets?
The order of distribution:
SESSION TEN
Corporate Rescue and Insolvency
Questions for consideration
1. Discuss the objectives that an administrator is appointed to achieve when the company enters into administration.
2. Outline the procedures for a company voluntary arrangement (CVA). Why is CVA less popular than administration?
By the end of this session you should be able to:
– Demonstrate an up to date knowledge and understanding of administration and CVA which are designed to rescue a company.
– Demonstrate an up to date knowledge of the different types of liquidation and the powers of a liquidator.
– Demonstrate the ability to apply that knowledge to essay questions
– Discuss the topic in legal technical language.
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