The recent Court of Appeal decision in Enviroco v Farstad Supply A/A [2009] EWCA Civ 1399 has raised some interesting questions in relation to the interpretation of what constitutes a holding company and subsidiary for the purposes of the Companies Act 1985 (the "1985 Act") in relation to transactions involving a Scots law pledge of shares. The substance of the relevant sections of the 1985 Act is reproduced in the Companies Act 2006 (the "2006 Act") and so the effect of this decision will apply equally to the 2006 Act.

The Case

Enviroco's holding company ("Holdco") granted a Scots law shares pledge (the "Pledge") over its shares in Enviroco in favour of a lender. The Pledge was by way of security and, as is relatively standard with such a document, allowed Holdco to retain the voting and other rights connected to the shares until enforcement.

Unlike the position in England, in order to create effective security over shares in Scotland, the shares must be pledged to the lender and actual transfer of the shares must take place, in the form of registration of the lender in the register of members of the company.

The Scots law form of security is the subject of the Enviroco case but it should be noted that the English equitable charge or the alternative English security, the legal mortgage, may both have the same effect on the subsidiary/holding company relationship where (such as on enforcement) they are perfected so as to register the lender as a member of the company whose shares have been pledged.

In order to rely on an indemnity clause in a supply contract, Enviroco argued that it was a subsidiary of Holdco. Farstad asserted that, as a result of the pledge, Enviroco was no longer a subsidiary of Holdco.

The case turned on the interpretation of sections 736 and 736A of the 1985 Act.

Section 736(1) defines a holding company and, consequentially, a subsidiary in terms of whether or not it:

  • (a) holds the majority of the voting rights in the subsidiary; or
  • (b) is a member of the subsidiary and has the right to appoint or remove a majority of the board of directors; or
  • (c) is a member of the subsidiary and controls a majority of the voting rights pursuant to an agreement with other members)

Section 736A(7) provides, broadly, that for the purposes of s.736 rights attaching to shares should be treated as belonging to the grantor of the security and not the holder of the security where the such rights are only exercisable by the lender on enforcement/realisation.

Effectively, the decision provided that s.736A(7) did not mean that the grantor of a shares pledge remained the "member" of the purported subsidiary and therefore neither s.736(1)(b) nor s.736(1)(c) could be satisfied in situations where the lender was the registered holder of the shares.

Enviroco's submission to the court relied only on s.736(1)(c). However, as the provisions of s.736(1)(b) also require membership of the company, it is likely that the decision will also effect relationships that exist purely by virtue of that section.

It is important to note that the decision does not affect companies who have a holding company-subsidiary relationship by virtue of s.736(1)(a) (holding a majority of the voting rights in the subsidiary), which would include the majority of group company relationships.

It should also be noted that the decision did not result in Enviroco becoming a subsidiary of the lender to whom its shares were pledged. However, in circumstances where a lender is entered in the register of members of a company and controls the rights attaching to the shares prior to enforcement, such an outcome is a possibility.

The Effects

For those groups of companies whose holding company/subsidiary relationship does arise by virtue of s.736(1)(b) or (c) there are several possible implications of the Enviroco decision.

Many contractual provisions will rely on definitions such as "group" "subsidiary" or "affiliate" which are tied into s.736 of the Act. These are typically provisions relating to change of control, rights to assign the contract, provision of services to other group companies, indemnities, VAT clauses, limitation of liability and, of prime importance to funders, provisions relating to parent company guarantees.

Affected companies may no longer be caught by sections of the Companies Acts which rely on the definition of "subsidiary" set out in s.736. As many of these provisions are prohibitive in nature, it is submitted that this may allow the circumvention of certain provisions of the Companies Acts. Substantial property transactions, loans to directors and prohibition on financial assistance for the acquisition of shares in a public company are all areas which, arguably, could be evaded by virtue of the Enviroco decision. The requirement to file accounts of subsidiaries relies on the definition of "subsidiary undertaking" rather than that of "subsidiary" and so should not be evaded by virtue of this decision.

The possible effect on financial covenants, change of control provisions, representations, undertakings and defaults in finance documentation will be of concern to lenders and borrowers alike. Such parties may wish to consider reviewing documentation to clarify any definitions which rely on the s.736 definition of subsidiary.

The case is unlikely to be relevant for tax purposes as the tax legislation generally contains its own definitions of subsidiary. The VAT group rules do rely, however, on the s.736 definition and may therefore be affected. Other possible implications are the effect of the decision on employee share and share option plans and the interpretation of property provisions which determine occupation or business use under the Landlord and Tenant Acts 1954.

It should be noted that Enviroco have sought leave to appeal the decision of the Court of Appeal but no date has been set for the hearing as yet.