The Enviroco case will be of interest to banks' in-house lawyers, credit policy teams and credit documenters dealing with security issues. The case looked at the holding company/subsidiary relationship and the impact on that relationship of the holding company granting security over shares in the subsidiary. Specifically, the case considered whether a particular company was a "subsidiary" that fell within the scope of an indemnity. In considering that, it held that the transfer of legal title to the company's shares by way of security to a bank (which became the registered holder of the shares in the company's share register) caused the company to lose its status as a Companies Act subsidiary.

The problem arose because the holding company in the case did not hold more than 50% of the voting rights in the subsidiary. It was a subsidiary because it instead controlled voting rights through an agreement with other shareholders but, in order for this to give rise to a holding company/subsidiary relationship, the holding company had to be a "member" of the subsidiary: section 736(1)(c) Companies Act 1985. Because the holding company had transferred legal title to the shares by way of security to the bank, it was no longer a "member"; the bank was. The Court of Appeal's decision meant that the "subsidiary" could not claim the benefit of the indemnity. This article looks at the case in more detail and reflects on the implications for banks taking security over shares in such cases.

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The Enviroco case will be of interest to banks' in-house lawyers, credit policy teams and credit documenters dealing with security issues. The case looked at the holding company/subsidiary relationship and the impact on that relationship of the holding company granting security over shares in the subsidiary. Specifically, the case considered whether a particular company was a "subsidiary" that fell within the scope of an indemnity. In considering that, it held that the transfer of legal title to the company's shares by way of security to a bank (which became the registered holder of the shares in the company's share register) caused the company to lose its status as a Companies Act subsidiary.

The problem arose because the holding company in the case did not hold more than 50% of the voting rights in the subsidiary. It was a subsidiary because it instead controlled voting rights through an agreement with other shareholders but, in order for this to give rise to a holding company/subsidiary relationship, the holding company had to be a "member" of the subsidiary: section 736(1)(c) Companies Act 1985. Because the holding company had transferred legal title to the shares by way of security to the bank, it was no longer a "member"; the bank was. The Court of Appeal's decision meant that the "subsidiary" could not claim the benefit of the indemnity. This article looks at the case in more detail and reflects on the implications for banks taking security over shares in such cases.

The facts of the case were these. Farstad granted an indemnity in favour of Asco UK and its "Affiliates".

Enviroco sought to rely on that indemnity and claimed it was an "Affiliate" of Asco UK.

"Affiliate" included any subsidiary of Asco UK and any company that was a subsidiary of another company of which Asco UK was also a subsidiary (i.e. a sister company of a common parent).

"Subsidiary" had the meaning assigned to it in section 736 of the Companies Act 1985 (CA 1985). Section 736 reads as follows:

"A company is a "subsidiary" of another company, its "holding company", if that other company:

(a) holds a majority of the voting rights in it, or

(b) is a member of it and has the right to appoint or remove a majority of its board of directors, or

(c) is a member of it and controls alone, pursuant to an agreement with other shareholders or members, a majority of the voting rights in it, or if it is a subsidiary of a company which is itself a subsidiary of that other company".

Asco UK and Enviroco were subsidiaries of Asco plc, the "holding company", on the basis of paragraph (c) above. Asco plc then pledged its shares in Enviroco to the bank under a Scottish law deed of pledge, which required the shares to be registered in the bank's name, which was done.

Farstad argued that, as a result of the bank's registration, Asco plc ceased to be a "member" of Enviroco and no longer satisfied the first requirement in paragraph (c) above. Asco plc, on the other hand, relied on section 736A(7) CA 1985, which reads as follows:

"(7) Rights attached to shares held by way of security shall be treated as held by the person providing the security:

(a) where apart from the right to exercise them for the purpose of preserving the value of the security, or of realising it, the rights are exercisable only in accordance with his instructions;

(b) where the shares are held in connection with the granting of loans as part of normal business activities and apart from the right to exercise them for the purpose of preserving the value of the security, or of realising it, the rights are exercisable only in his interests".

Asco plc pointed to clause 4 of the deed of pledge which clearly satisfied section 736A(7), and argued that "membership" of the company was one of the rights described in section 736 and so subsection (7) ought to operate to treat that right as continuing to be vested in Asco plc notwithstanding the security transfer.

The Court of Appeal did not agree. Membership was not a right described in section 736, nor indeed was it a "right" as such at all. It was "a status derived from the entry of the shareholder's name in the register of members". On that basis, Asco plc was no longer a "member" of Enviroco. As a result of the deed of pledge and the bank's registration, the bank was the member.

As a result, Farstad did not have to indemnify Enviroco. That company was not an "Affiliate" of Asco UK, because it was not a "subsidiary" of Asco plc under section 736 CA 1985.

It is clear that the result in the case would have been different if Asco plc had owned more than 50% of the shares in Enviroco. Then it could have relied on paragraph (a) of section 736(1) because it held "a majority of the voting rights" in Enviroco. Paragraph (a) has no "membership" requirement. So the fact that the bank had become the registered owner of the Enviroco shares would have been irrelevant, provided that the deed of pledge contained a clause - which it did - giving Asco plc the right to exercise the voting rights attached to the shares prior to an enforcement. Unfortunately, Asco plc never at any stage held more than 50% of Enviroco's shares. The holding company/subsidiary relationship therefore depended on "membership" of the subsidiary.

Legal documents often use the Companies Act definitions of "subsidiary" and "holding company" (and sometimes "subsidiary undertaking" and "parent undertaking" which are similar) to capture a shifting population of group companies. In most cases, the intra-group relationships will be based on majority shareholdings, but where, as in this case, the holding company/subsidiary relationship depends on "membership" of the subsidiary, the case might warn against allowing registration of shares held by way of security.

The decision also gives an opportunity to a holding company to manipulate a corporate structure to its advantage (and so perhaps avoid entities falling within a "Group" definition in a facility agreement, for example) where it owns 50% or less of the shares in its subsidiary, and vests legal title to the shares in a nominee. In that case, it is no longer a "member".

Although section 736 CA 1985 has now been repealed, the substance of that section has been reproduced in section 1159 of the Companies Act 2006. The decision in Enviroco will therefore apply to the interpretation of that section. Where the Companies Act definitions are used going forward, consideration should be given to extending the definitions so that transferring legal title to the shares by way of security to a bank or its nominee or to the holding company's own nominee does not destroy the holding company/subsidiary relationship for the purpose of any agreements or covenants that might have been entered into unless expressly agreed to the contrary.

It is worth pointing out that the case does not put banks at greater risk of being grouped with the relevant subsidiary for accounting or tax purposes, even if they become the registered "member". Provided the security document contains a clause which provides that, prior to enforcement, exercise of the rights attached to the shares will be subject to the chargor's instructions and interests, those rights will be deemed under the Companies Act definitions to remain with the chargor.

Further reading

Enviroco Ltd v Farstad Supply A/S [2009] EWCA Civ 1399 (http://tinyurl.com/yakzt3l)

This article was written for Law-Now, CMS Cameron McKenna's free online information service. To register for Law-Now, please go to www.law-now.com/law-now/mondaq

Law-Now information is for general purposes and guidance only. The information and opinions expressed in all Law-Now articles are not necessarily comprehensive and do not purport to give professional or legal advice. All Law-Now information relates to circumstances prevailing at the date of its original publication and may not have been updated to reflect subsequent developments.

The original publication date for this article was 08/01/2010.