A recent Court of Appeal decision1 has raised concerns on the incorporation by cross reference of the statutory definition of “subsidiary” in section 736 of the Companies Act 1985 (now reproduced in section 1159 of the Companies Act 2006) in contracts, in particular in relation to sections 736(1)(b) and (c).

In the case in question, the Court of Appeal considered whether a company remained a subsidiary within the meaning of section 736(1)(c), after the parent (Asco) charged its shares in the subsidiary (Enviroco) as security to a bank. The relevant part of the legislation states that a company will be a subsidiary of another if it “is a member of it and controls, alone, pursuant to an agreement with other members, a majority of the voting rights in it.”

The Court of Appeal held that as a result of the registration of the bank as holder of the shares, Enviroco was no longer a subsidiary of Asco within the meaning of sections 736 and 736A. In particular, the case largely turned on the fact that Asco was not entered on Enviroco’s register of members (as required by section 22 of the 1985 Act), although it still retained the control required by section 736.

It was acknowledged by the Court that the outcome created a “surprising” and “absurd” result, but the Court had no power to construe the statute in a way that was inconsistent with its drafting even if that led to an uncommercial result. An argument by Enviroco that the definition should be considered in the context of a commercial construction of the contract also failed.

While this decision will have an impact where companies have granted security over shares in subsidiaries, it should be noted that the ruling does not affect the interpretation of section 736(1)(a) of the 1985 Act (or its 2006 Act equivalent section at 1159(1)(a)) which states that a company is a subsidiary if the parent holds a majority of the voting rights in it. In most cases, the parent-subsidiary relationship will fall into the section 736(1)(a) category. It is only a small proportion of cases where either party will need to consider whether an entity whose shares have been charged as security remains a subsidiary for the purpose of the contract.

Enviroco has applied to the Supreme Court for leave to appeal the Court of Appeal’s decision, but in the meantime large corporate groups may want to consider the impact of the ruling on current and future agreements involving subsidiaries. Businesses may also want to review definitions of “subsidiary” or “group” in any standard terms in light of the issues raised by the case.