The Supreme Court case of Enviroco Ltd v Farstad Supply A/S illustrates the importance of ensuring that definitions contained in contracts provide the desired outcome even if they are imported from a dependable source, such as a statute.

Background

The Enviroco appeal case (Enviroco Ltd v Farstad Supply A/S [2011] UKSC 16) caused quite a stir last year when it held that the correct interpretation of the Companies Act definition of "subsidiary" could result in what would otherwise be thought of as a group company not being a subsidiary for the purposes of the Companies Act. Whilst this had obvious connotations in respect of interpreting statutes in connection with group structures (since some statutory provisions that one would expect to apply to certain group companies would not actually apply to them), it had a more practical impact in the case in hand because the group company in question was denied the substantial benefit of an indemnity contained in a contract which relied on the Companies Act definition of "subsidiary". Unsurprisingly, the judgment was appealed. However, in April, the Supreme Court upheld the decision.

The case, therefore, not only illustrates the importance of ensuring that definitions contained in contracts must be checked to ensure that they provide the desired outcome, but also underlines the fact that when relying on a pre-drafted definition, such as one contained in a statute, the wording still needs to be carefully checked because, even if taken from a dependable source, the drafting may not be foolproof.

The case

In the Enviroco case, a group of companies had the benefit of a contractual indemnity. The indemnity was drafted on the basis that it was in favour of the parent company and its affiliates. The term "affiliates" was defined by reference to "subsidiaries", which in turn was defined by reference to section 736 of the Companies Act 1985. Although the case relates to provisions of the Companies Act 1985, as identical provisions have been re-enacted in the Companies Act 2006, the case is relevant to the current statutory regime.

The parent company owned 50% of the shares in Company A, and, under an arrangement with another shareholder, controlled the majority of the voting rights in that company and had the right to appoint a majority of the directors.

Section 736 (now section 1159 of the Companies Act 2006) provides that a company is a subsidiary of another if it:

  • holds a majority of the voting rights in it, or
  •  is a member of it and has the right to control either the board, or, under an agreement with other shareholders, a majority of the voting rights.

Because only 50% of the shares were held, Company A fell to be a subsidiary under the second limb, that is, by virtue of the parent being a member of Company A combined with the arrangements with the other shareholder. Company A was, therefore, also an affiliate for the purposes of the indemnity.

Subsequently, however, the parent charged its shares in Company A by way of a deed of pledge under Scots law. Under Scots law, the only way to grant a fixed security over shares involves transferring legal title to the chargee (akin to a legal charge under English law). As a result, the legal title to the shares was transferred to the chargee's nominee so that its name was written up in the register of members. Notwithstanding that, under the terms of the security, for so long as there was no default (which there never was) the shares were effectively controlled and beneficially owned by the parent, because the term "member" is defined under section 22 of the Companies Act 1985 (now section 112 of the Companies Act 2006) by reference to the persons whose names are entered in the company's register of members, the parent ceased to be a member of Company A and, therefore, Company A ceased to be a subsidiary for the purposes of section 736. It also, therefore, ceased to be an affiliate and lost the benefit of the indemnity.

Practical tips

In this case, the unintended result was due to a combination of fairly unusual factors (a 50% shareholding coupled with security that involved a transfer of legal title), but it illustrates the importance of defining terms clearly even when relying on provisions imported from other sources, even statute. In particular, if importing a definition:

  • check to see if there is a better pre-existing definition - for example, the definition of "subsidiary undertaking" in the Companies Act (1985 and 2006) is drafted more widely than the definition of "subsidiary" and may be more suitable in certain situations
  • do not assume it will be foolproof - read the definition in the context of the agreement and the commercial situation at hand, and adapt it if necessary to make it fit for purpose.