Legal Briefing

Enviroco: what now for the meaning of subsidiaries?

The In-House Lawyer Logo

Finance | 01 April 2010

The recent decision in Enviroco Ltd v Farstad Supply A/S [2009] has prompted debate and consideration of how corporate structure has, and should be, defined going forward, and the potential impact this may have on group companies’ financial and commercial dealings.

Background

Enviroco centred on the following facts. Asco UK Ltd (the charterer) entered into a charter party with Farstad Supply A/S (Farstad) in respect of a vessel, the Farstad (the charter party). The charterer subsequently engaged Enviroco Ltd (Enviroco) to clean the vessel. Enviroco and the charterer were both subsidiaries of Asco plc (the holding company). During the cleaning, there was an explosion, killing a worker and causing significant damage to the vessel. As a result, Farstad brought proceedings against Enviroco, which in turn sought to rely on an indemnity provision in the charter party that applied to the charterer’s affiliates. The definition of ‘affiliate’ expressly referred to the definition of ‘subsidiary’ in s736 of the Companies Act 1985 (the 1985 Act).

However, subsequent to the charter party, the holding company entered into financing arrangements that were secured in part by a Scottish law deed of pledge over the holding company’s shares in Enviroco. The terms of this deed of pledge required the chargee bank or its nominee to become the registered holder of the pledged shares. The deed of pledge also stated that the registration of such bank or its nominee in Enviroco’s register of members was solely for the purposes of security and that the holding company would retain its voting rights in relation to the pledged shares.

Farstad argued that, as a result of the pledge (and the subsequent entry of the chargee bank’s, or its nominee’s, name into Enviroco’s register of members), the holding company was no longer a member of Enviroco and as such Enviroco was no longer an affiliate of the charterer, thus losing its ability to rely on the indemnity in the charter party.

As a preliminary issue, the High Court was asked to consider whether Enviroco was an affiliate of the charterer on the true construction of the charter party, or whether, because of the pledge, the holding company had indeed ceased to be a member of Enviroco from the time its shares in Enviroco were registered in the name of the chargee bank.

Section 736

Under s736 of the 1985 Act, company A is a subsidiary of company B if company B:

  1. holds a majority of the voting rights in company A;
  2. is a member of company A and has the right to appoint or remove a majority of company A’s board of directors; or
  3. is a member of company A and controls, alone, or pursuant to an agreement with another member, a majority of the voting rights in company A.

As the holding company did not own a majority of the shares in Enviroco (holding them instead in conjunction with another shareholder), Enviroco had to argue that it was a subsidiary by virtue of s736(1)(c).

However, Enviroco also had to meet the test of being a member for the purposes of this section, set out in s22 of the 1985 Act, which states that a ‘member’ is anyone whose name is entered in the company’s register of members. Once the share pledge was taken, the name in the registered members in Enviroco was the chargee bank, not the holding company. As such, Asco plc was not a member for the purposes of s736(1)(c).

Enviroco sought to rely on s736A(7) of the 1985 Act, which states that where shares are held under normal forms of security arrangements, the rights in those shares, such as voting rights, should be deemed to be held by the chargor, rather than the chargee. The question for the High Court was whether this was sufficient to render the holding company a member for the purposes of s736(1)(c) and thus classify Enviroco as a subsidiary.

Decision

The High Court’s view was that it was sufficient. The reference to s736 had to be construed in the context of the charter party. Enviroco was an affiliate of the charterer despite the fact that the holding company had pledged Enviroco’s shares as security and the chargee was registered as a member in Enviroco’s register of members. Consequently, Enviroco was entitled to the benefit of the indemnity.

Farstad appealed the decision. The Court of Appeal, allowing the appeal, held that the statutory meaning of s736 would apply to the charter party. By cross-referring to the statutory definition in the charter party, the parties had provided an ‘unequivocal direction’ (judgment of Patten LJ) that the statutory definition should be applied, and not ‘some alternative meaning of the same words’. While the legislation might produce a result that did not sit well from a commercial point of view, the wording was clear and it was not for the Court of Appeal to correct it to produce what might have been a more logical result.

Furthermore, there was nothing to suggest that the share pledge was in the contemplation of the parties at the time when they entered into the charter party. The Court of Appeal had to proceed on the basis that a change of shareholder was unforeseen. The Court was unwilling to imply that membership was achieved for one party where shares were registered in the name of another party for the purposes of security only.

What does this mean for companies?

The definition in s736 of the 1985 Act is reproduced in s1159 of the Companies Act 2006 (the 2006 Act) so Enviroco remains relevant. While the security in Envirocowas governed by Scottish law and on the facts (in particular, that the holding company did not, on its own, control Enviroco) its application is likely to be limited, the decision should nonetheless prompt English companies to think carefullyabout the terms of financing arrangements to which they are party, and the terms of any supporting security.

In finance documents, parties should consider how the ‘detachment’ of a subsidiary may affect provisions, such as financial covenants, change of control covenants, representations, undertakings and triggers for events of default. It may also be wise to consider adding language to clarify that where the definition of subsidiary is used (for instance, with financial covenants) this would be deemed to include those entities that would qualify as subsidiaries under ss1159(1)(b) and (c) of the 2006 Act, but for any legal mortgages granted over their shares.

From a company law perspective, a change in how a subsidiary is classified may affect 2006 Act provisions, such as the prohibition on financial assistance for the acquisition of shares in a public company (s678, 2006 Act), the prohibition on a subsidiary being a member of its holding company (s136, 2006 Act) and more broadly, the interpretation of the many provisions in the 2006 Act that include references to subsidiaries. Concerns may also arise with regards to tax (such as the effect of degrouping on VAT and stamp taxes), and on the rules of employee share and pension schemes.

However, in the area of security, Enviroco may not be as concerning as it first appears. The taking of security over shares in the form of a legal mortgage (by registering them in the name of the chargee at the date when the security is taken, rather than exercising this right on default), is not all that common. What may be of more concern is that a chargee could find itself holding shares in an entity that is no longer a member of the relevant borrower group. Lenders may therefore see an equitable mortgage as a more attractive option (though as this is the more common approach in any event, little may change in practice).

Enviroco has applied for leave to appeal the decision. At the time of writing no hearing date has been set, but pending the outcome of any appeal, companies would be advised to keep the above considerations in mind.