When is a subsidiary company not a subsidiary company?

Introduction

A recent Court of Appeal decision has the effect that in some circumstances a company which a holding company considers to be its subsidiary may not in fact be its subsidiary.

Statutory background

Section 736 of the Companies Act 1985 (1985 Act) states that a company is a “subsidiary” of another company (its “holding company”) if that other company:

• holds a majority of the voting rights in it
• is a member of it and has the right to appoint or remove a majority of its board of directors
• is a member of it and controls, alone, pursuant to an agreement with other members, a majority of the voting rights in it,

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

A key clause in the relevant documentation considered in the case defined a company as being an “affiliate” of another company if both companies are subsidiaries of the same holding company. The clause referred to the definition of “subsidiary” in the 1985 Act. The substance of the relevant provisions of the 1985 Act is reproduced in the new Companies Act 2006 (2006 Act) so the decision applies equally to the definition of “subsidiary” in the 2006 Act.

Factual background

Enviroco Ltd (Enviroco) was an affiliate of Asco UK Ltd (Asco UK) by virtue of having the same holding company (Asco plc). Farstad Supply A/S (Farstad) chartered a ship to Asco UK. Enviroco was engaged to carry out maintenance work on the ship.

Asco plc “pledged” its shares in Enviroco to a bank by a Scottish law “deed of pledge”. Pursuant to this pledge, Asco plc’s shares in Enviroco were registered in the name of the bank’s nominee. The deed of pledge made it clear that the registration of the bank’s nominee as the holder of the shares was for the purpose of security only, and the voting rights remained with Asco plc.

A fire then occurred, causing damage and the death of an Enviroco employee. Farstad brought proceedings against Enviroco, who tried to protect itself against the claim by using an indemnity clause in the charter-party agreement. The indemnity clause only applied to Asco UK’s “affiliates” so the High Court had to decide as a preliminary issue whether, as a result of the share pledge and the registration of the bank’s nominee as the holder of the Enviroco shares, Asco plc had ceased to be a holding company of Enviroco (and therefore whether or not Asco UK and Enviroco had ceased to be affiliates of one another).

High Court decision

The High Court held that “as a matter of commercial common sense” the registration of the shares in the name of the bank’s nominee was only for the purpose of giving effect to the bank’s security. Asco plc had therefore retained control of Enviroco, meaning that Enviroco was a subsidiary of Asco Plc (and an affiliate of Asco UK) and could benefit from the indemnity.

Court of Appeal decision

Farstad appealed to the Court of Appeal, which overturned the decision of the High Court. Its rationale was that, although it did not necessarily make sense to decide that Enviroco had ceased to be a subsidiary of Asco plc, the Court was limited in the extent to which it could correct errors in the 1985 Act (or any other Act of Parliament).  In the circumstances of this case, section 736 of the 1985 Act had to be interpreted to mean that Enviroco had ceased to be a subsidiary of Asco plc (and an affiliate of Asco UK) and therefore Enviroco could not benefit from the indemnity.

Comment

Until such time as the law is clarified by the Supreme Court when it hears Enviroco’s appeal against the Court of Appeal decision, English companies should be wary of granting legal mortgages over shares and instead grant security over shares by way of equitable charge (as tends to be the usual practice anyway).

The definitions of “subsidiary” and “affiliate” in contracts and finance documents commonly cross-refer to the definitions in the 1985 Act (or the restated definitions in the 2006 Act). Group companies should therefore check their contracts and finance documents and, if the statutory definitions are referred to, seek advice as to whether or not the case impacts on their activities.

Enviroco Ltd v Farstad Supply A/S [2009] EWCA Civ 1399