Summary and implications
In Enviroco Limited v Farstad Supply A/S, the Court of Appeal considered the definition of a subsidiary in accordance with the Companies Act 1985. It was held that where a holding company has granted a legal mortgage over its shares and they are registered in the name of the lender or its nominee, the holding company is no longer deemed to be a “member” of the subsidiary.
The implications are that where the holding company does not hold a majority of the voting rights in the subsidiary, the subsidiary ceases to be a “subsidiary” of that holding company within the meaning of section 736 of the Companies Act 1985 (now section 1159 of the Companies Act 2006 (“CA 2006”).
Therefore the case is of limited application as:
- it is unusual for lenders to take legal mortgages (where the shares are registered in the name of the lender or its nominee). Equitable mortgages are more common (where the lender holds the share certificate(s) and a blank, executed stock transfer form in respect of the charged shares and the shares are only registered in the name of the lender or its nominee on enforcement of the security);
- where the mortgagor holds more than 50 per cent of the voting rights in the subsidiary, the subsidiary relationship still exists pursuant to section 1159(1)(a) CA 2006 which does not require a company to be a member of its subsidiary; and
- under the CA 2006 and for the purposes of its definition of a subsidiary, voting rights and rights that give control of the board are treated as held by the person providing the security rather than the security holder.
- Equitable v legal mortgage – the case confirms that the more common approach of taking an equitable mortgage over shares by lenders is the safer option
- Drafting note – when drafting the definition of “subsidiary” in facility agreements, for the purposes of the change of control/covenant provisions, it would be prudent to refer to the CA 2006 definition with the added proviso that this included companies which had granted legal mortgages over their shares.
- Acquisition of a new subsidiary? – Just because a lender has been granted a legal mortgage over shares does not necessarily mean it has acquired a subsidiary under the Companies Act definition while it may be deemed to be a member of the company. Under sections 1159(1)(b) and (c) it must also have acquired the right to control the board or control the majority rights of the voting rights for it to have acquired a subsidiary. For the purposes of the definition under CA 2006, such voting rights and the right to control the board are still treated as held by the mortgagor.
- Further assurance – If lenders find themselves in the rare circumstance where they have taken a legal mortgage over shares in a company which is no longer deemed to be a subsidiary of the borrower group, they may wish to relinquish this in favour of an equitable mortgage by using the further assurance clause in the security document.
What are the concerns?
Where lenders do find themselves in circumstances as in this case, it is worth noting the potential consequences they could have:
- finance agreements –change of control provisions, financial covenants and other representations and warranties which are linked to the structure of the borrower group, cross default provisions etc.; and
- tax – where any grouping for tax purposes is determined by reference to the Companies Act definitions of subsidiary.
Facts of Enviroco
Farstad Supply A/S (Farstad) chartered a vessel to Asco UK Limited (Asco). Enviroco Limited (Enviroco) was appointed to clean the oil tanks in the vessel. Asco and Enviroco were both subsidiaries of Asco.
Considerable damage was caused to the vessel after a fire broke out while the tanks were being cleaned which led Farstad to bring proceedings against Enviroco. Enviroco sought to rely on the benefit of an indemnity which had been given by Farstad in favour of Asco and its affiliates. The definition of “affiliate” referred to the definition of “subsidiary” under section 736 CA 1985. The granting of a legal mortgage does not mean automatic de-grouping of a subsidiary from its holding company.
Asco plc had pledged its shares (the security was governed by Scottish law) in Enviroco to a bank and the shares were registered in the name of the bank's nominee. The question for the Court was: in light of the circumstances, did Enviroco still qualify as a subsidiary of Asco plc and therefore an affiliate of Asco?
Farstad's argument: Asco plc was no longer a “member” of Enviroco.
As Asco plc did not hold a majority of Enviroco's shares (on its own), Enviroco was forced to rely on section 736(1)(c) CA 1985 to establish it was a subsidiary of Asco plc. This limb, amongst other things, requires the parent to be a member of its subsidiary. Farstad argued as a result of the share pledge and the transfer to the bank's nominee, Asco plc was no longer a member of
Enviroco and therefore Enviroco no longer a subsidiary.
Enviroco's argument: Asco plc's membership derived from section 736A(7) CA 1985 Enviroco argued that under the above section, which states that rights attached to shares should be treated as being held by the person providing the security (in certain circumstances), Asco plc still had the right to be a registered member.
The “rights” in section 736A(7) did not include the right to be registered as a member
The Court of Appeal took a strict approach to the wording of section 736 CA 1985 and was unwilling to imply membership of Asco plc under it even if the judges considered that it produced an uncommercial result.
Enviroco has applied for leave to appeal the decision but at the date of this briefing no hearing date has been set.