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Company law

Alan Dignam John Lowry

2009

LLB 2650021

This subject guide was prepared for the University of London External System by:
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A. Dignam, BA, (TCD), PhD (DCU), Professor of Corporate Law, Queen Mary, University of London

and
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J. Lowry, LLB, LLM, Professor of Law and Vice Dean, Faculty of Laws, University College London, University of London

This is one of a series of subject guides published by the University. We regret that owing to pressure of work the authors are unable to enter into any correspondence relating to, or arising from, the guide. If you have any comments on this subject guide, favourable or unfavourable, please use the form at the end of this guide.

Publications Office The External System University of London Stewart House 32 Russell Square London WC1B 5DN United Kingdom www.londonexternal.ac.uk Published by the University of London Press University of London 2009. Reformatted and reprinted 2010 Printed by Central Printing Service, University of London All rights reserved. No part of this work may be reproduced in any form, or by any means, without permission in writing from the publisher.

Company Law

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Contents
1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 1.1 1.2 1.3 Company law . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 Approaching your study . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 The examination . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6

2 Forms of business organisation . . . . . . . . . . . . . . . . . . . . . . 9


Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10 2.1 The sole trader . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11 2.2 The partnership . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11 2.3 The company . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12 15 2.4 Some general problems with the corporate form . . . . . . . . . . . . . .

Reflect and review . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20

3 The nature of legal personality . . . . . . . . . . . . . . . . . . . . . 21


Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22 3.1 Corporate personality . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23 3.2 Salomon v Salomon & Co . . . . . . . . . . . . . . . . . . . . . . . . . . . 23 3.3 Other cases illustrating the Salomon principle . . . . . . . . . . . . . . . . 24 3.4 Limited liability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25 Reflect and review . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27

4 Lifting the veil of incorporation . . . . . . . . . . . . . . . . . . . . . 29


Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30 4.1 Legislative intervention . . . . . . . . . . . . . . . . . . . . . . . . . . . 31 4.2 Judicial veil lifting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32 4.3 Veil lifting and tort . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34 Reflect and review . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37

5 Company formation, promoters and pre-incorporation contracts . . . . . . . . . . . . . . . . . . . . . . . 39


Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40 5.1 Determining who is a promoter . . . . . . . . . . . . . . . . . . . . . . . 41 5.2 The fiduciary position of promoters . . . . . . . . . . . . . . . . . . . . . 41 5.3 Duties and liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42 5.4 5.5 Pre-incorporation contracts . . . . . . . . . . . . . . . . . . . . . . . . . 43 Freedom of establishment . . . . . . . . . . . . . . . . . . . . . . . . . . 44

Reflect and review . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47

6 Raising capital: equity . . . . . . . . . . . . . . . . . . . . . . . . . . 49


Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50 6.1 Private and public companies . . . . . . . . . . . . . . . . . . . . . . . . 51 6.2 Raising money from the public . . . . . . . . . . . . . . . . . . . . . . . . 52 6.3 Insider dealing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54 6.4 Regulating takeovers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56 Reflect and review . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59

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University of London External System

7 Raising capital: debentures . . . . . . . . . . . . . . . . . . . . . . . 61


Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62 7.1 Debentures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63 67 69 7.2 Company charges . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63 7.3 Priority . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7.5 Reform . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7.4 Avoidance of floating charges . . . . . . . . . . . . . . . . . . . . . . . . 68 Reflect and review . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73

8 Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 76 8.1 Overview the maintenance of capital doctrine . . . . . . . . . . . . . . . 77 8.2 Raising capital: shares may not be issued at a discount . . . . . . . . . . . . 77 8.3 Returning funds to shareholders . . . . . . . . . . . . . . . . . . . . . . 8.4 Prohibition on public companies assisting in the acquisition of their own shares . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78 83

Reflect and review . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 87

9 Dealing with insiders: the articles of association and shareholders agreements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 89


Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9.1 The operation of the articles of association . . . . . . . . . . . . . . . . . 9.3 9.4 9.5 90 91

9.2 The articles of association . . . . . . . . . . . . . . . . . . . . . . . . . . 91 The contract of membership . . . . . . . . . . . . . . . . . . . . . . . . . 93 Shareholders agreements . . . . . . . . . . . . . . . . . . . . . . . . . . 96 Altering the articles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96

Reflect and review . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99

10 Class rights . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101


Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 102 10.1 Shares and class rights . . . . . . . . . . . . . . . . . . . . . . . . . . . 103 10.2 Classes of shares . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 104 10.3 Variation of class rights . . . . . . . . . . . . . . . . . . . . . . . . . . 105 Reflect and review . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 108

11 Majority rule . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 109


Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 110 11.1 The rule in Foss v Harbottle the proper claimant rule . . . . . . . . . . . 111 11.2 Forms of action . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 112 11.3 Derivative claims . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 114 11.4 The statutory procedure: Part 11 of the CA 2006 . . . . . . . . . . . . . . 116 11.5. The proceedings, costs and remedies . . . . . . . . . . . . . . . . . . . . 118 Reflect and review . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120

12 Statutory minority protection . . . . . . . . . . . . . . . . . . . . . 121


Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 122 12.1 Winding up on the just and equitable ground . . . . . . . . . . . . . . . 123 12.2 Unfair prejudice s.994 CA 2006 . . . . . . . . . . . . . . . . . . . . . . 125 Reflect and review . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 132

Company Law 13 Dealing with outsiders: ultra vires and other attribution issues . . . . 133
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 134 13.1 The objects clause problem . . . . . . . . . . . . . . . . . . . . . . . . 13.3 Other attribution issues . . . . . . . . . . . . . . . . . . . . . . . . . . 135 139 13.2 Reforming ultra vires . . . . . . . . . . . . . . . . . . . . . . . . . . . . 136 Reflect and review . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 143

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14 The management of the company . . . . . . . . . . . . . . . . . . . 145


Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 146 14.1 Directors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 147 14.2 Categories of director . . . . . . . . . . . . . . . . . . . . . . . . . . . 14.3 Disqualification of directors . . . . . . . . . . . . . . . . . . . . . . . . 150 151

Reflect and review . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 157

15 Directors duties . . . . . . . . . . . . . . . . . . . . . . . . . . . . 159


Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 160 15.1 Directors duties . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 161 15.2 The restatement of directors duties: Part 10 of the CA 2006 . . . . . . . . 163 15.3 Relief from liability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 178 15.4 Specific statutory duties . . . . . . . . . . . . . . . . . . . . . . . . . . 178 Reflect and review . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 183

16 Corporate governance . . . . . . . . . . . . . . . . . . . . . . . . . 185


Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 186 16.1 Introducing corporate governance . . . . . . . . . . . . . . . . . . . . . 187 16.2 The debate in the UK . . . . . . . . . . . . . . . . . . . . . . . . . . . . 189 Reflect and review . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 194

17 Liquidating the company . . . . . . . . . . . . . . . . . . . . . . . . 195


Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 196 17.1 Liquidating the company . . . . . . . . . . . . . . . . . . . . . . . . . . 197 17.2 The liquidator . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 199 17.3 Directors of insolvent companies . . . . . . . . . . . . . . . . . . . . . . 201 17.4 Reform . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 201 Reflect and review . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 203

Feedback to activities . . . . . . . . . . . . . . . . . . . . . . . . . . . 205

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University of London External System

1 Introduction

Contents
1.1 1.2 1.3 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 Company law . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

Approaching your study . . . . . . . . . . . . . . . . . . . . . . . . . . 3 The examination . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6

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University of London External System

Introduction
This subject guide acts as a focal point for the study of Company law on the University of London External System LLB. It is intended to aid your comprehension by taking you carefully through each aspect of the subject. Each chapter also provides an opportunity to digest and review what you have learned by allowing a pause to think and complete activities. At the end of each chapter there are sample examination questions to attempt once you have completed and digested the further reading. Company law requires students to develop their existing understanding of tort, contract, equity, statutory and common law interpretation. It also provides students with new conceptual challenges such as corporate personality. This combination of development and new challenge can initially be a difficult one and the initial learning period will be greatly eased if you understand the everyday context within which company law issues affect businesses. All of the major national newspapers cover company law issues in their business sections. Keeping on top of business and general news developments will help to put your learning into context and aid your comprehension of the subject. It may even stimulate your enjoyment of company law!

Learning outcomes
By the end of this chapter and the relevant reading, you should be able to:
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approach the study of Company law in a systematic way understand what the various elements of the subject guide are designed to do begin your study of Company law with confidence.

Company Law 1 Introduction

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1.1 Company law


Company law is about the formation of companies, their continuing regulation during their life and the procedures for dealing with their assets when they are terminated in a liquidation. The state (the Government) consequently plays a major role in company law. However, self-regulation, as we will see, also plays a significant part in the regulation of larger companies and is widely discussed in the theoretical literature. Company law is one of those subjects that students describe as difficult and lecturers describe as challenging. The difficulty or challenge involved for the student in understanding company law is to overcome the attitude that law is somehow compartmentalised. Most of your previous undergraduate teaching has tended to package subjects neatly tort, contract, equity, etc. While this provides a nice orderly initial learning experience it is unhelpful for students when they come to subjects like company law where tort, contract, and equity all combine. The result can be an initial disorientation which clears over time. As such, it is important that you have a good knowledge of tort, contract and equity, and understand how the common law works, before you tackle this subject.

1.1.1 Reforming company law


Since the election of the Labour government in 1997 there has been an ongoing review of company law which resulted in the Companies Act 2006. It is very important that any student of company law has extensive knowledge of this reform project. The various consultation papers and the Final Report of the Department for Business Enterprise and Regulatory Reform (BERR) Company Law Review Steering Group (CLRSG) are available at http://www.berr.gov.uk/bbf/co-act-2006/index.html The Final Report forms the basis of the Governments 2002 and 2005 White Papers. These are also available at the same web address. The proposals of the CLRSG and the Governments response, together with the relevant provisions of the Companies Act 2006, are discussed where they impact on each individual chapter, but we also expect students to go through these background documents themselves. A good working knowledge of these documents is, in our view, essential to your success on this Company law course. The Companies Act 2006 has been brought into force during the period 20072009.

BERR used to be the Department for Trade and Industry (DTI). In June 2009 BERR became the Department for Business, Innovation and Skills (BIS)

1.2 Approaching your study


This guide is designed to be your first reference point for each topic covered on the course. Read through each chapter carefully. The activities occur at points in each chapter where you need to pause and digest the information you have just covered. That means you should stop and think about what you have just learned. Feedback to many of the activities is provided at the end of the guide. However, try not to read the feedback immediately. Use the activity to aid your reflection. Read it and think generally about the issues it is trying to address. Do this throughout the chapter and when you have completed it move to the essential reading. After this give yourself some time to think about what you have learned or if things are unclear you may need to read over certain points again. Once you have read the chapter and the essential reading, attempt, in writing, the chapters activities. Use them as an opportunity to test your understanding of the area. At this point read the feedback provided to see if you are on the right track. Once you have completed this, move to the further reading. Again, after completing the further reading, give yourself time to think and re-read. Finally, you should attempt the sample examination question at the end of each chapter. Use the Reflect and review section at the end of each chapter to keep track of your progress.

Note that in this subject guide we ask you to do the essential reading after you have worked through the chapter.

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Go through the guide like this, covering each chapter in turn. Each chapter builds up your knowledge of the subject and so dipping into the guide as you feel like it will not work. Later chapters presume you have covered and understood the earlier ones. As we explain below, you will also have to monitor case developments, reform initiatives and seek out new company law writing to flesh out your understanding of the subject and develop your independence of thought.

1.2.1 Essential reading


Primary textbook

Dignam, A. and J. Lowry Company Law. (Oxford: Oxford University Press, 2008) fifth edition [ISBN 9780199232871].

This subject guide is centred on this textbook, which was written by the authors of this guide. References in the text to Dignam and Lowry are references to this textbook. It is your essential reading and so much of your study time should be taken up reading the textbook, though you will also have to study numerous case reports, complete the further reading and keep up to date with academic company law writing.

Other texts to consult

Davies, P. Gower and Davies Principles of Modern Company Law. (London: Sweet & Maxwell, 2008) eighth edition [ISBN 9780421949003].

Readings from Davies are specified in each chapter. Like Dignam and Lowry this book (Davies) is cited using just the authors name.

Pettet, B., J. Lowry and A. Reisberg Pettets Company Law: Company and Capital Markets Law. (Pearson, 2009) third edition [ISBN 9781405847308].

This text is particularly interesting as it fleshes out the interaction of company law with capital markets and securities regulation.

Sealy, L.S. and S. Worthington Cases and Materials in Company Law. (Oxford: Oxford University Press, 2008) eighth edition [ISBN 9780199298426]. Hicks, A. and S.H. Goo Cases and Materials in Company Law (Oxford: Oxford University Press, 2008) sixth edition [ISBN 9780199289851].

A statute book is a good addition to your personal company law library. These are generally updated every year and it is important that you use the most up to date version. The choice is between:

Core Statutes on Company Law. (Palgrave Macmillan) Blackstones Statutes on Company Law. (Oxford: Oxford University Press)

You are currently allowed to bring one of these into the examination. Check the Regulations for up to date details of what you are allowed to bring into the examination with you. Please note that you are allowed to underline or highlight text in these documents but you are not allowed to write notes or attach self-adhesive notelets, etc. on them. See the Regulations and the Learning skills for law study guide for further guidance on these matters.

Legal journals
A good Company law student is expected to be familiar and up to date with the latest articles and books on company law. Company law articles often appear in the main general UK legal academic journals:

Modern Law Review (MLR) Oxford Journal of Legal Studies (OJLS) Journal of Law and Society (JLS)

Company Law 1 Introduction


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Law Quarterly Review (LQR) Cambridge Law Journal (CLJ).

It is essential that you keep up to date with developments reported in these journals. Specific dedicated company or business law journals are also very useful for company law students. The Company Lawyer, Journal of Corporate Law Studies, European Business Organisation Law Review and Journal of Business Law are among the best, combining current academic analysis of issues with updates on case law and statute. Three significant books are also drawn to your attention. We dont suggest you buy these texts but rather that you use them in a library (if you can get access to one).

Parkinson, J.E. Corporate Power and Responsibility: issues in the theory of company law. (Oxford: Clarendon Press, 1993) [ISBN 0198252889]. Cheffins, B.R. Company Law: theory and structure. (Oxford: Oxford University Press, 1997) [ISBN 0198259735]. Dignam, A. and Galanis, M. The Globalization of Corporate Governance. (Ashgate, 2009) [ISBN 9780754646259].

Parkinson (1993) examines the corporate law issues surrounding the stakeholder debate in the UK (there is more on this in Chapter 16 on corporate governance, but for now it refers to a debate about whether stakeholders, such as employees and consumers, and issues raised by environmentalists and public interest bodies should be the focus of the exercise of corporate power). John Parkinson also chaired the corporate governance group as part of the Department of Trade and Industrys (now called Department for Business, Innovation and Skills (BIS)) CLRSG Review of UK company law. His views are therefore important in understanding the CLRSG findings and the corporate governance provisions in the Companies Act 2006. The second book we would draw your attention to here is Cheffins (1997). The company law and economics school is a growing and influential one in UK company law. Knowledge of it is essential to an understanding of many of the current debates in company law. The third book, Dignam and Galanis (2009), provides a perspective on the corporate governance material used in this study guide, based around the globalisation of product and securities markets.

Other sources
Your understanding of many of the issues we will study will be aided immeasurably if you understand the context within which company law issues affect businesses. All major national newspapers cover these issues in their business sections. In an ideal world you would read these sections each day, either by buying a newspaper, reading it online or going to the library to go through them. However, we do not live in an ideal world, so a good compromise is to buy or read in a library the Saturday version of the Financial Times or view it online. It contains an update on all the weeks business and general news developments. If you can manage to do this over the academic year, it will help to put your learning into context and aid your comprehension of the course. While company law cases appear in the main law reports there are two dedicated company law reports, British Company Law Cases (BCC) (published yearly by Cronor CCH) and Butterworths Company Law Cases (BCLC) edited by D.D. Prentice, which are very useful. Online sources such as Westlaw and Lexis, which you can access through the Online Library, also carry these reports as well as unreported cases. You might also find it useful sometimes to dip into texts such as Palmers Company Law Manual (Sweet and Maxwell) or Gore-Browne on Companies (Jordans publishers) in a good law library (if you can access one). These are practitioner texts which are regularly updated and contain a wealth of up to date information.

The essential reading for most chapters will include a list of important cases that you should read and make notes on. Where additional cases are listed, you should read them if you have time to do so.

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University of London External System

1.3 The examination


Important: the information and advice given in the following section is based on the examination structure used at the time this guide was written. However, the University can alter the format, style or requirements of an examination paper without notice. Because of this, we strongly advise you to check the instructions on the paper you actually sit. Although there are many ways to achieve examination success the following is our advice on how to deal with Company law examinations.

1.3.1 Preparation
No amount of last-minute study will solve the problem of a lack of preparation. You must begin your examination preparation from the first day the course begins. Using this guide as a starting point, take careful condensed notes in a loose-leaf file of everything you read. When you have finished a section, identify and write down a list of the key points that will act as a memory trigger for you when you return to that section again. While the sample examination questions in this guide are a good way to practise, you should go beyond this and practise answering previous LLB examination questions, which are available on the External System website. Be disciplined about this exercise by pretending you are doing it under examination conditions. Give yourself only 45 minutes to answer each question, including reading and planning time. You should plan out each week of study in advance using a diary, allowing at least two hours of study for company law each week. You should also allow time for a review of the weeks work and at the end of each month allow some time for a wider review of what you have achieved that month. Remember that examinations are not intended to be an accurate assessment of your knowledge of company law. They are a test of your ability to answer certain questions on company law on one particular day in one particular year. As such you need to learn and revise constantly over that year to give yourself the best chance of performing on the day. You also need to be physically and mentally well so make sure you do not overwork; eat well and include social and physical activities in your weekly schedule. Three months before the examination you should draw up an examination revision schedule. At this point you should have been working consistently over the previous months and have a good set of notes to revise from. You will now need to decide what subjects you will revise for the examinations. This needs careful thought. Many students only revise the bare minimum number of subject areas (four the number of questions candidates must answer in the examination). However, this leaves them vulnerable to one or more of these areas not being on the paper or one or more of the areas being combined in one question. It also means the student has little choice even if all four areas they have revised come up. One or all of the questions might be very difficult while the other questions on the paper are easier. For these reasons, if you are well-prepared at this point, you should plan to revise a minimum of six areas. If you wish to be more cautious (there are still no guarantees), revise at least eight areas for the examination after carefully going over the previous examination questions. Again, include time in your examination revision schedule for practising old examination questions under examination conditions.

Company Law 1 Introduction

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1.3.2 On the day of the examination


If you can, take the night before the examination off and do something relaxing. If you have to revise the night before, make sure you finish at a reasonable time and get a good nights sleep. On the morning of the examination go over your revision notes briefly then put them away and go to the examination without them. You dont need them now if you have done the work, so just try to relax. Give yourself plenty of time to travel to the examination as you dont need any extra stress on the day. When the examination starts you will usually have to answer four questions from eight. Read the whole paper question by question very carefully and then decide which questions to attempt. Do not just pick your favourite topic: try to evaluate whether another question is easier to answer, even if it is not your favourite topic. Remember, you are trying to maximise your marks. When you have decided which questions to do, draw up a brief plan of how you will answer each question. Once you have done this you should begin answering the first question. Timing is very important: divide up the total allowable examination time (three hours) into time for reading and planning (five minutes each question) and time to write the answer (usually 40 minutes). Remember to stick rigidly to this that means you stop writing immediately the 40 minutes writing time you have allotted is up. If you do not, you are throwing marks away. Few students understand this but it is much harder to squeeze marks out of a question you have been answering for 40 minutes than from a new question. By the time 40 minutes is up you will have probably got all the easy marks and all that is left are the difficult marks. It is much better to stop and start on a new question where there are still lots of easy marks to pick up.

1.3.3 Answering the question


You will by now be sick of being told that your number one aim in the examination is to answer the question. You are told this constantly both because it is true and because failing to follow this simple rule is the number one cause of failure in examinations. So take this advice seriously at every point in the examination you must ask yourself whether you are answering the question asked. Remember you are almost never asked in an examination to provide a general description of an area of law or provide an overview of the various arguments for or against a particular point of view. Lawyers argue and thats what it is all about not unsubstantiated opinion but reasoned argument recognising weakness and strength in your own and opposing arguments, but nevertheless arguing consistently for a particular point. The examination format seems to make students forget this. In general you will encounter two distinct types of question, problem and essay. Problem questions are relatively straightforward you simply apply the law to the facts of the question. To do this you look to see what you are being asked in the question this will help you decide what facts are relevant. For example if you are asked to advise Fred then only information which impacts on Fred will be relevant. You then go through each line of the question drawing out the relevant facts, applying the law to it and answering the question. Essay questions cause more difficulty as they provide more scope for a general discussion which fails to answer the question. Never, ever, read an examination question, identify it as a particular area (for example Salomon or veil lifting) and then simply write an essay covering all you know about Salomon or veil lifting. You will fail. Read the question, identify the area and analyse the question. Break it down into its constituent parts and really think what am I being asked here? and how can I best answer?. When you decide this try using the words of the question in your first sentence as a discipline to focus yourself on answering the question. For example, in Chapter 3 you will find the following sample examination question. The Salomon decision was a scandalous one which unleashed a tidal wave of irresponsibility into the business community. Discuss.

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You should note that it is not actually a question, rather it is a provocative statement followed by an invitation to discuss it. This type of question is often interpreted by students as an invitation to generally discuss the Salomon principle it is not. You are being asked to argue for or against this statement. It does not matter whether you argue for or against it as long as you substantiate your argument with cases, statutes and academic commentary and are consistent. So in answering this question you should start your essay using the words of the question to indicate what you are going to argue. For example:
This answer will show that the principle expounded by the House of Lords in Salomon v Salomon was not a scandalous one and in no way did it unleash a tidal wave of irresponsibility into the business community.

It is not enough to just do this and then provide a general description of the area. You must follow the argument through to the end, identifying weaknesses and strengths but holding firm to your argument. If things are uncertain, as the law often is, then identify the uncertainty and give your substantiated opinion as to which course the law should take. All the time asking yourself: Am I answering the question? Remember as well that an essay question has a beginning (where you introduce your argument), a middle (where you set out the detail of your argument) and an end (where you conclude by repeating briefly your argument). Always follow this format, as it will help you focus on your argument.

Reminder of learning outcomes


By this stage you should be able to:
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approach the study of Company law in a systematic way understand what the various elements of the subject guide are designed to do begin your study of Company law with confidence.

Good luck! Alan Dignam and John Lowry, Summer 2009

2 Forms of business organisation

Contents
2.1 2.2 2.3 2.4 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10 The sole trader . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11 The partnership . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11 The company . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12 Some general problems with the corporate form . . . . . . . . . . . . . 15 Reflect and review . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20

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Introduction
Companies are the dominant form of business association in the UK. They are not, however, the only form of business association. Sole traders and partnerships also exist as specific legal forms of business. In this chapter we explore the place of the company within the various legal forms of business organisation available in the UK in order to provide some insight as to how the company has come to be the dominant form. In doing so we will consider the various forms of business organisation from the point of view of their ability to raise capital (money), their ability to minimise risk and their ability to provide some sort of clear organisational structure. We will also explore some of the general problems that the corporate form poses for businesses. In general this subject is not a course in the detailed procedural aspects of company law. Having said that, in the course of this chapter, more than any other in the guide, we will touch upon procedural matters as they arise. This is because key aspects of the procedural nature of setting up a company are very useful for understanding later chapters such as Chapter 5: Company formation, promoters and pre-incorporation contracts and Chapter 9: Dealing with insiders. Some of you may find this procedural detail off-putting, but bear with it and complete the activities. It will pay dividends in the later chapters.

Learning outcomes
By the end of this chapter and the relevant readings you should be able to:
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illustrate the differences between the major forms of business organisation in the UK describe the advantages and disadvantages of each form of business organisation explain the different categories of company demonstrate the difficulties small businesses have with the company as a form of business organisation.

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Essential reading

Dignam and Lowry, Chapter 1: Introduction to company law. Davies, Chapter 1: Types and functions of companies and Chapter 2: Advantages and disadvantages of incorporation.

Company Law 2 Forms of business organisation

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2.1 The sole trader


A sole trader is a very simple legal form of business. As such there is very little for us to discuss here beyond its advantages and disadvantages. It is, as the name suggests, a one-person business.

Advantages
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No legal filing requirements or fees and no professional advice is needed to set it up. You just literally go into business on your own and the law will recognise it as having legal form. Simplicity one person does not need a complex organisational structure.

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Disadvantages
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It is not a particularly useful business form for raising capital (money). For most sole traders the capital will be provided by personal savings or a bank loan. Unlimited liability the most important point to note in terms of comparing this form to the company is that there is no difference between the sole trading business and the sole trader himself. The profits of the business belong to the sole trader but so do the losses. As a result he has personal liability for all the debts of the business. If the business collapses owing money (an insolvent liquidation see Chapter 16) then those owed money by the company (its creditors) can go after the personal assets of the sole trader (e.g. his car or house) in order to get their money back.

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Activity 2.1
From the point of view of raising capital, minimising risk and providing an organisational structure, assess the merits of a sole trading concern. No feedback provided.

2.2 The partnership


The partnership is the next step in terms of facilitating the growth of a business. Partnerships are very flexible legal business forms. While we are more familiar with complex partnerships such as law firms or accountancy firms, partnerships can also be very simple affairs. Section 1 of the Partnership Act 1890 defines a partnership as the relationship which subsists between persons carrying on a business in common with a view of profit. This is a very broad category and sometimes causes problems (see disadvantages below).

Advantages
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No formal legal filing requirement involved in becoming a partnership beyond the minimum requirement that there be two members of the partnership. Once there are two people who form the business it will be deemed a legal partnership. It facilitates investment as it allows two or more people to pool their resources. The maximum number of partners allowable is, since 2002, unlimited. Prior to that it was 20 unless you were a professional firm solicitors, accountants etc. If you are aware of the problems the Partnership Act can cause (see disadvantages below) then you can draft a partnership agreement to vary these terms of the Act and provide an accurate reflection of your intentions when entering the partnership. The partnership agreement can therefore be used to provide a very flexible organisational structure although this usually involves having to pay for legal advice.

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The Partnership Act 1890 can be a danger to the unwary. The broad definition of a partnership is a particular problem. For example three people going into business together without forming a company will be partners whether they know it or not. This can cause problems, as the Partnership Act 1890 imposes certain conditions for the continued existence of the partnership. If one of our three unknowing partners dies the Partnership Act will deem the partnership (even though the participants did not know they were partners) to have ended. This is the case even where a successful business is being operated through the partnership. As a result of these types of problems those who choose to be partners will usually draft a more formal arrangement called a partnership agreement specifying the terms and conditions of the partnership. The Act also entitles each partner: to participate in management to an equal share of profit to an indemnity in respect of liabilities assumed in the course of the partnership business not to be expelled by the other partners. A partnership will end on the death of a partner. If you are unaware of this when the partnership is formed, the rigidity of the Act may not reflect the intention of the partners. The partners are jointly and severally liable for the debts of the partnership. This means that each partner can be sued for the total debts of the partnership. In essence, partnerships are founded on relationships of trust. If that trust is breached then the remaining partner or partners can pay a heavy price as they must pay all the debts owed. However, if that relationship of trust is maintained then the partnership effectively reduces the risk of doing business compared to that taken by a sole trader because partners share the risk.

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Activity 2.2
From the point of view of raising capital, minimising risk and providing an organisational structure, assess the merits of a partnership. No feedback provided.

2.3 The company


A company is formed by applying to the registrar of companies, providing a constitution (essentially a set of rules for the company similar to a public law conception of a constitution, see below), the names of the first directors and members plus a small fee. This formation process is called incorporation. The registered company has become the dominant legal business form in the UK. The reasons for this are not as obvious as one might assume, as we will explore in this section.

2.3.1 Categories of company


Company law is mainly concerned with the company limited by shares (that is a company where the liability of the shareholders for the debts of the company is limited to the amount unpaid on their shares). There are also companies limited by guarantee. These companies were designed for charitable or public interest ventures where no profit is envisaged. As a result the people behind the venture guarantee to pay a certain amount towards the debts of the company should it fail. Companies limited by shares are also subdivided into public and private companies limited by shares.

Company Law 2 Forms of business organisation Differences between public and private companies limited by shares
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Before 1992 you needed two shareholders to form a private company limited by shares. The Twelfth EC Company Law Directive (89/667) changed this requirement and the Companies Act 2006 now provides for single person private companies. Public companies still need two shareholders. In private companies investment comes either from the founding members in the form of personal savings or from a bank loan. As such, private companies are prohibited from raising capital from the general public. Public companies, on the other hand, are formed specifically to raise large amounts of money from the general public. Private companies can restrict their membership to those the directors approve of or insist that those who wish to leave the company first offer their shares to the other members. Public companies could also do this but, as their aim is to raise money from the general public, a restriction on the sale of shares would not encourage the general public to invest. Public companies have a minimum capital requirement of 50,000 (s.763 CA 2006). That capital requirement does not have to be fully paid it just needs one quarter of the 50,000 to be paid and an ability to call on the members for the remaining amount. Private companies have no real minimum capital requirements. For example a private company can have an authorised share capital of 1 subdivided into shares of 1p each. Because public companies raise capital from the general public there is a raft of extra regulations that affects their activities. This is discussed extensively in Chapter 6 on raising equity. Private companies can also adopt a more streamlined procedure for meetings by introducing written agreements instead of formal meetings. Part 13 CA 2006 is designed to recognise that often in private companies the directors and the members of the company are one and the same and so requirements for meetings, timing of meetings and laying of accounts can be suspended to streamline the operation of the private company.

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Limited liability
One of the most obvious differences between the company and other forms of business organisation is that the members of both private and public companies have limited liability. This means that the members of the company are only liable for the amount unpaid on their shares and not for the debts of the company. We will explore how this operates in some detail in the next chapter. In order to warn those who might deal with a company that the members have limited liability the word limited or Ltd must appear after a private companys name or plc after a public company (ss.58 and 59 CA 2006).

2.3.2 The constitution of the company


As part of the registration procedure both public and private companies must provide a constitution which sets out the powers of the company and allocates them to the companys organs, usually the general meeting and the board of directors. This constitution historically consisted of two documents: the memorandum of association and the articles of association. The Companies Act 2006 requires just a single document that replaces the current constitution (see s.18 CA 2006). The memorandum still exists as a separate document as part of the registration requirements under the 2006 Act (see Chapters 9 and 14).

page 14 The memorandum


The memorandum is addressed to the general public and contains:
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the company name the companys share capital the address of the companys registered office the objects of the company (stating what the company is empowered by the state to do) a statement that the liability of its members is limited.

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The objects of the company was once a very complex area of study for company lawyers because of the tendency of companies to change the nature of their business without changing or because they were unable to change their objects clause. Thankfully for us all it has been the subject of a largely successful and ongoing reform programme. The Companies Act 2006 provides that companies will automatically have unlimited capacity. Companies can choose to have a restrictive objects clause if they wish but in general the objects clause issue should recede further. However, it still forms an important part of company law currently because, while under the 2006 Act regime the object clause is optional, companies formed under the 1985 Act will still have an objects clause in their memorandum for some time to come. One person in the case of a private company, or two in a public company, must subscribe to the memorandum. In essence, they agree to take some shares or share in the company and become its first shareholders. Share capital in public and private companies The share capital in the memorandum is known as the nominal or authorised share capital. It represents the amount of share capital that could be issued to investors. Once an amount has been issued to investors, that amount is called the issued share capital. The memorandum will also state the amounts that the authorised share capital is subdivided into. So, for example, 100 might be subdivided into shares of 1 each. The value given to each share is known as its par or nominal value. For new companies formed under the 2006 Act a statement of capital is needed but the need to set out the authorised share capital in the memorandum is no longer necessary (s.10 CA 2006). However, it continues to act as a restriction in the articles. Shares can be fully paid, partly paid or even unpaid. With partly and unpaid shares, the shareholder can be called upon to pay for them at a later date. Shares may be also be paid for in goods and services and not necessarily in cash. We will discuss share capital extensively in Chapter 8.

The articles of association


The articles of association are a set of rules for running the company. They set out the heart of any companys organisational structure by allocating power between the board of directors (the main management organ) and the general meeting (the main shareholder organ). Those forming a company can provide their own articles but if they do not a model set of articles (historically called Table A) is provided by the CA 2006 and will apply. Table A is generally adopted with some slight amendments. The articles can be altered if three-quarters of the members (by a special resolution) vote to do so (s.21 CA 2006). Additionally s.168 CA 2006 gives members the right to remove a director for any reason whatsoever by simple majority. Therefore, while the board is the primary management organ, under the constitution it is subject to the continuing approval of the shareholders in general meeting. Public and private companies now have separate sets of articles of association under the 2006 Act.

A simple majority vote is where more than 50 per cent of those who vote at the general meeting agree with the resolution. In this case where more than 50 per cent vote to remove a director.

Company Law 2 Forms of business organisation Advantages


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Companies are designed as investment vehicles. Companies have the ability to subdivide their capital into small amounts, allowing them to draw in huge numbers of investors who also benefit from the sub-division by being able to sell on small parts of their investment. Limited liability also minimises the risk for investors and is said to encourage investment. It is also said to allow managers to take greater risk in the knowledge that the shareholders will not lose everything. The constitution of the company provides a clear organisational structure which is essential in a business venture where you have large numbers of participants.

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Disadvantages
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Forming a company and complying with company law is expensive and time-consuming. It also appears to be an inappropriately complex organisational form for small businesses, where the board of directors and the shareholders are often the same people (we discuss this further below).

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Activity 2.3
a. What are the advantages and disadvantages of each form of business organisation? b. With a view to recommending a particular form of business organisation to a client wishing to set up a cyber-caf, compare and contrast each of the types discussed above. c. Explain the difference between a private and a public company. No feedback provided.

2.4 Some general problems with the corporate form


The dominance of the corporation as the preferred mechanism for organising a business in the UK has thrown up some important problems for company law. The problems stem from the one size fits all nature of the corporate form. While there is a distinction between public and private registered companies, that distinction masks the fact that the basic legal model provided for public and private companies is very similar. As a result the statutory framework has historically applied to one-person private companies and large public companies as if they were similar in nature. The problem is that they are not. The key difficulty arises because the statutory model assumes a separation of ownership from control. That is, it assumes that the investors are residual controllers exercising control once a year at the annual general meeting (AGM) and that the day-to-day management of the business is carried out by professional managers (directors). For large companies this is the case but for the vast majority of companies in the UK this separation of ownership from control does not exist (see Chapter 14). To illustrate this we need to examine how, for both a large and a small company, company law presumes the ownership and control system within the statutory model operates.

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2.4.1 A large company


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The general meeting meets once a year (this is the annual general meeting or AGM) primarily to elect the directors to the board. The directors will be a mix of professional managers (executive directors) and independent outsiders (non-executive directors); see Chapter 14. The executive directors will normally have a small shareholding but not usually a significant one. The shareholders are also provided with an annual report from the directors outlining the performance of the company over the past year and the prospects for the future (like a sort of report card on their performance). At the heart of the report are the accounts certified by the auditor (an independent accountant who checks over the accounts prepared by the directors). In between AGMs the directors run the company without any involvement by the shareholders. In a large company the board of directors will be more like a policy body which sets the direction the company goes in, but the actual implementation of that direction will be carried out by the companys employees. The directors in carrying out their function stand in a fiduciary relationship with the company. They therefore owe a duty to act bona fides (in good faith) in the interests of the company (this generally means the shareholders interests) and not for any other purpose (such as self-enrichment see Chapter 14). The employees who are authorised to carry out the companys business are the companys agents and therefore the company will be bound by their actions (see Chapter 13).

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A fiduciary is a person who is bound to act in the interests and for the benefit of another; trustees also have fiduciary duties.

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2.4.2 A small company


The same company law model applies to a small company but with significant differences in effect.
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The shareholders and directors will often be the same people. The same people will also be the only employees of the company. There is no separation of ownership from control, the shareholders are the managers and therefore most of the statutory assumptions about the companys organisational structure will not hold.

These differences (in effect the requirements for meetings and accounts), which are based on a presumption of the managers being different people from the shareholders, became a burden for small companies. As a result they have been significantly altered by the CA 2006 (see below).

2.4.3 The Freedman study


In an extremely interesting study, Freedman (1994) found that 90 per cent of all companies in the UK were small private concerns. She also surveyed small businesses as to the advantages and disadvantages of forming and running a company.

Advantages
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Prestige. The small businesses surveyed considered that one of the major advantages (in fact possibly the only advantage) of forming a company was that it conferred prestige, legitimacy and credibility on the venture. Limited liability. The ability of those who are behind the company to walk away from the companys debts. However for small businesses this was potentially negated by the practice of banks requiring the shareholders to provide guarantees

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Company Law 2 Forms of business organisation


for bank loans (a common source of finance among small businesses). Thus any debts owed to the banks could be reclaimed from the personal assets of the shareholders if the company was in insolvent liquidation.

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Disadvantages
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Burdensome regulatory requirements (meetings, accounts, etc.). Expensive as they had to pay for professional advice to deal with the regulatory requirements.

Solutions
Historically company law has not ignored this problem and some concessions have been made. In particular, a private company could, under the old 1985 Act, adopt the simplified elective regime in s.379A CA 1985 which allowed the suspension of:
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meetings timing of meetings laying of accounts.

A small private company could also adopt a written regime under the old Table A articles of association. Article 53, for example, which allowed a more informal written decisionmaking process. However, these concessions were largely seen as inadequate. The CLRSGs Final Report (Modern Company Law for a Competitive Economy: Final Report (2001), Chapters 2 and 4) recommended that the following statutory requirements be simplified for small businesses.
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Decision-making. Accounts. Audit. Constitutional structure. Dispute resolution.

As we will discuss later, the need to focus company law on the small business was a major theme (if not the major theme of the CLRSGs Final Report). As a result, the CLRSG recommended that legislation on private companies should be made easier to understand. In particular, there should be a clear statement of the duties of directors. The 2002 White Paper Modernising Company Law: The Governments Policy that followed the CLRSG Final Report, the March 2005 White Paper, the Company Law Reform Bill 2005 and the Companies Act 2006 have all carried through this focus on the quasi-partnership company with its think small first emphasis.

Minority issues
The fact that there are so few participants in a small business presents another problem for company law. That is, sometimes they disagree and if this continues, a minority shareholder can easily be excluded from the running of the company while remaining trapped within it. This occurs because company law presumes that the company operates through its constitutional organs. In order for the company to operate either the board of directors makes a decision or, if it cannot, then the general meeting can do so. It can, however, happen that a majority of shareholders holding 51 per cent (simple majority voting power) of the shares in the company could act to the detriment of the other 49 per cent. A 51 per cent majority would allow those members to elect only those who support their policies to the board. Thus the 49 per cent shareholder would be unrepresented on the board and powerless in the general meeting.

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These situations are worse in private companies where the minority shareholder often needs board approval for the sale of shares to an outsider or must offer the shares to the other members first. If the other members are obstructive then this pre-emption process can leave the minority shareholders trapped. Of course the fact that the majority holder is behaving badly will make it difficult to find a buyer willing to put themselves into a similarly weak position. Although the courts quickly came up with a limited exception to enforcing the constitutional structure (see Chapters 11 and 12) there has been a continuing tension between enforcing the constitutional structure (allowing directors to run the company unimpaired by factions among the shareholders) and protecting minority shareholders against genuinely fraudulent transactions (see Chapter 10). Eventually, a statutory remedy was introduced in s.459 CA 1985 and is now contained in s.994 CA 2006 to make it easier for shareholders to bring an action.

Activity 2.4
From the point of view of raising capital, minimising risk and providing an organisational structure, assess the merits of a registered company. No feedback provided.

Activity 2.5
Is the corporate form suitable for small companies?

Summary
The importance of this chapter is that it forms a context within which we can place the company and its success as a business form. The sole trader may be a suitable approach for informal one-person ventures, where the capital is mostly provided by the sole traders savings or a bank loan. It is unsuitable for larger organisational or investment purposes. The partnership is a very good business form which has many advantages over a company, particularly for small- and medium-sized businesses. Unfortunately it has fallen out of use as a significant business form. The increase in the number of partners allowed may go some way to increase its popularity. The company in turn has come to dominate. However the company as a form of business organisation is not without its problems. The company is designed as an investment vehicle, with limited liability for its shareholders and a clear organisational structure. It is designed for ventures where there is an effective separation of ownership from control and is therefore largely unsuitable for the majority of its users, who are small businesses. In many ways a partnership would be more suitable for an entrepreneur and less onerous for small businesses generally, especially given that limited liability is rarely a reality for these types of businesses. However, the continued use of the corporate form by small companies seems secure given the prestige attached to the tag Ltd. The Companies Act 2006 has gone some way towards meeting the needs of small businesses.

Useful further reading

Freedman, J. Small businesses and the corporate form: burden or privilege?, [1994] 57 MLR July, pp.55584. Freedman, J. and M. Godwin Incorporating the micro business: perceptions and misperceptions in Hughes, A. and D.J. Storey, (eds) Finance and the Small Firm. (London: Routledge, 1994) [ISBN 0415100364].

Sample examination question


In what way does company law facilitate the small business and is it adequate?

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Advice on answering the question


The key points to cover in your answer are the following.
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The distinction company law makes between public and private companies. The historical concessions in the elective regime in the s.379A CA 1985 and Table A, art.53. Minority protection concessions for small businesses and the fact that the CLRSG and the 2006 Act increase protection for minorities. A discussion of the CLRSGs think small first approach and its effect in the Companies Act 2006.

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Reflect and review


Look through the points listed below. Are you ready to move on to the next chapter? Ready to move on = I am satisfied that I have sufficient understanding of the principles outlined in this chapter to enable me to go on to the next chapter. Need to revise first = There are one or two areas I am unsure about and need to revise before I go on to the next chapter. Need to study again = I found many or all of the principles outlined in this chapter very difficult and need to go over them again before I move on.
Ready to move on I can illustrate the differences between the major forms of business organisation in the UK. I can describe the advantages and disadvantages of each form of business organisation. I can explain the different categories of company. I can demonstrate the difficulties small businesses have with the company as a form of business organisation. Need to revise first Need to study again

If you ticked need to revise first, which sections of the chapter are you going to revise?
Must revise 2.1 2.2 2.3 2.4 The sole trader The partnership The company Some general problems with the corporate form Revision done

3 The nature of legal personality

Contents
3.1 3.2 3.3 3.4 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22 Corporate personality . . . . . . . . . . . . . . . . . . . . . . . . . . 23 Salomon v Salomon & Co . . . . . . . . . . . . . . . . . . . . . . . . . . 23 Other cases illustrating the Salomon principle . . . . . . . . . . . . . . 24 Limited liability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25 Reflect and review . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27

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Introduction
In this chapter we explore the related concepts of corporate legal personality and limited liability. These concepts are central to developing understanding of company law and it is essential that you take time here to absorb these fundamental principles.

Learning outcomes
By the end of this chapter and the relevant readings, you should be able to:
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explain what is meant by corporate legal personality illustrate the key effects of corporate legal personality in relation to liability.

Essential reading

Dignam and Lowry, Chapter 2: Corporate personality and limited liability. Davies, Chapter 2: Advantages and disadvantages of incorporation and Chapter 8: Limited liability and lifting the veil at common law.

Cases

Salomon v Salomon & Co [1897] AC 22 Macaura v Northern Assurance Co [1925] AC 619 Lee v Lees Air Farming [1961] AC 12 Barings plc (In Liquidation) v Coopers & Lybrand (No 4) [2002] 2 BCLC 364 Giles v Rhind [2003] 2 WLR 237 Shaker v Al-Bedrawi [2003] 2 WLR 922.

Company Law 3 The nature of legal personality

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3.1 Corporate personality


Corporate personality refers to the fact that, as far as the law is concerned, a company really exists. This means that a company can sue and be sued in its own name, hold its own property and crucially be liable for its own debts. It is this concept that allows limited liability for shareholders as the debts belong to the legal entity of the company and not to the shareholders in that company.

The history of corporate personality


Corporate legal personality arose from the activities of organisations, such as religious orders and local authorities, which were granted rights by the government to hold property, sue and be sued in their own right and not to have to rely on the rights of the members behind the organisation. Over time the concept began to be applied to commercial ventures with a public interest element, such as rail building ventures and colonial trading businesses. However, modern company law only began in the mid-nineteenth century when a series of Companies Acts were passed which allowed ordinary individuals to form registered companies with limited liability. The way in which corporate personality and limited liability link together is best expressed by examining the key cases.

3.2 Salomon v Salomon & Co


It was fairly clear that the mid-nineteenth century Companies Acts intended the virtues of corporate personality and limited liability to be conferred on medium to large commercial ventures. To ensure this was the case there was a requirement that there be at least seven members of the company. This was thought to exclude sole traders and small partnerships from utilising corporate personality. However, as we will see below in the case of Salomon v Salomon & Co [1897] AC 22, this assumption proved to be mistaken. Mr Salomon carried on a business as a leather merchant. In 1892 he formed the company Salomon & Co Ltd. Mr Salomon, his wife and five of his children held one share each in the company. The members of the family held the shares for Mr Salomon because the Companies Acts required at that time that there be seven shareholders. Mr Salomon was also the managing director of the company. The newly incorporated company purchased the sole trading leather business. The leather business was valued by Mr Salomon at 39,000. This was not an attempt at a fair valuation; rather it represented Mr Salomons confidence in the continued success of the business. The price was paid in 10,000 worth of debentures (a debenture is a written acknowledgement of debt like a mortgage see Chapter 7) giving a charge over all the companys assets (this means the debt is secured over the companys assets and Mr Salomon could, if he is not repaid his debt, take the companys assets and sell them to get his money back), plus 20,000 in 1 shares and 9,000 cash. Mr Salomon also at this point paid off all the sole trading business creditors in full. Mr Salomon thus held 20,001 shares in the company, with his family holding the six remaining shares. He was also, because of the debenture, a secured creditor. However, things did not go well for the leather business and within a year Mr Salomon had to sell his debenture to save the business. This did not have the desired effect and the company was placed in insolvent liquidation (i.e. it had too little money to pay its debts) and a liquidator was appointed (a court-appointed official who sells off the remaining assets and distributes the proceeds to those who are owed money by the company see Chapter 16). The liquidator alleged that the company was but a sham and a mere alias or agent for Mr Salomon and that Mr Salomon was therefore personally liable for the debts of the company. The Court of Appeal agreed, finding that the shareholders had to be a bona fide association who intended to go into business and not just hold shares to comply with the Companies Acts.

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The House of Lords disagreed and found that:
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the fact that some of the shareholders were only holding shares as a technicality was irrelevant; the registration procedure could be used by an individual to carry on what was in effect a one-man business a company formed in compliance with the regulations of the Companies Acts is a separate person and not the agent or trustee of its controller. As a result, the debts of the company were its own and not those of the members. The members liability was limited to the amount prescribed in the Companies Act (i.e. the amount they invested).

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The decision also confirmed that the use of debentures instead of shares can further protect investors.

Activity 3.1
Read Salomon v Salomon & Co (1897) AC 22. a. Describe the key effects of the change in status from a sole trader to a limited company for Mr Salomon. b. What are the key principles that we can draw from the case? c. Should Mr Salomon have been liable for the debts of the company?

3.3 Other cases illustrating the Salomon principle


3.3.1 Macaura
The principle in Salomon is best illustrated by examining some of the key cases that followed after. In Macaura v Northern Assurance Co [1925] AC 619 Mr Macaura owned an estate and some timber. He agreed to sell all the timber on the estate in return for the entire issued share capital of Irish Canadian Saw Mills Ltd. The timber, which amounted to almost the entire assets of the company, was then stored on the estate. On 6 February 1922 Mr Macaura insured the timber in his own name. Two weeks later a fire destroyed all the timber on the estate. Mr Macaura tried to claim under the insurance policy. The insurance company refused to pay out arguing that he had no insurable interest in the timber as the timber belonged to the company. Allegations of fraud were also made against Mr Macaura but never proven. Eventually in 1925 the issue arrived before the House of Lords who found that:
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the timber belonged to the company and not Mr Macaura Mr Macaura, even though he owned all the shares in the company, had no insurable interest in the property of the company just as corporate personality facilitates limited liability by having the debts belong to the corporation and not the members, it also means that the companys assets belong to it and not to the shareholders.

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More modern examples of the Salomon principle and the Macaura problem can be seen in cases such as Barings plc (In Liquidation) v Coopers & Lybrand (No 4) [2002] 2 BCLC 364. In that case a loss suffered by a parent company as a result of a loss at its subsidiary (a company in which it held all the shares) was not actionable by the parent the subsidiary was the proper plaintiff. In essence you cant have it both ways limited liability has huge advantages for shareholders but it also means that the company is a separate legal entity with its own property, rights and obligations (see also Giles v Rhind [2003] 2 WLR 237 and Shaker v Al-Bedrawi [2003] 2 WLR 922).

Company Law 3 The nature of legal personality

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3.3.2 Lee
Another good illustration is Lee v Lees Air Farming [1961] AC 12. Mr Lee incorporated a company, Lees Air Farming Ltd, in August 1954 in which he owned all the shares. Mr Lee was also the sole Governing Director for life. Thus, as with Mr Salomon, he was in essence a sole trader who now operated through a corporation. Mr Lee was also employed as chief pilot of the company. In March, 1956, while Mr Lee was working, the company plane he was flying stalled and crashed. Mr Lee was killed in the crash leaving a widow and four infant children. The company, as part of its statutory obligations, had been paying an insurance policy to cover claims brought under the Workers Compensation Act. The widow claimed she was entitled to compensation under the Act as the widow of a worker. The issue went first to the New Zealand Court of Appeal who found that he was not a worker within the meaning of the Act and so no compensation was payable. The case was appealed to the Privy Council in London. They found that:
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the company and Mr Lee were distinct legal entities and therefore capable of entering into legal relations with one another as such they had entered into a contractual relationship for him to be employed as the chief pilot of the company he could in his role of Governing Director give himself orders as chief pilot. It was therefore a master and servant relationship and as such he fitted the definition of worker under the Act. The widow was therefore entitled to compensation.

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Activity 3.2
Read Macaura v Northern Assurance Co [1925] AC 619 and Lee v Lees Air Farming [1961] AC 12 carefully and then write a brief 300-word summary of each case. Re-read Dignam and Lowry, Chapter 2, paras 2.22.12 and paras 2.322.44.

3.4 Limited liability


As we showed above, separate legal personality and limited liability are not the same thing. Limited liability is the logical consequence of the existence of a separate personality. The legal existence of a company (corporation) means it can be responsible for its own debts. The shareholders will lose their initial investment in the company but they will not be responsible for the debts of the company. Just as humans can have restrictions imposed on their legal personality (as with children, for example), a company can have legal personality without limited liability if that is how it is conferred by the statute. A company may still be formed today without limited liability as a registered unlimited company (s.3(4) CA 2006).

Summary
There are some key points to take from this chapter. First, it is important at this stage that you grasp the concept of corporate personality. If at this stage you do not, then take some time to think about it and when you are ready come back and re-read Dignam and Lowry, Chapter 2, paras 2.22.12. Second, having grasped the concept of corporate personality you also need to understand its consequences (i.e. the fact that the company can hold its own property and be responsible for its own debts).

Useful further reading

Ireland, P. et al. The conceptual foundations of modern company law, [1987] JLS 14, pp.149165. Pettit, B. Limited liability a principle for the 21st century, [1995] CLP 124. Grantham, R.B. and E.F. Rickett The bootmakers legacy to company law doctrine in Grantham, R.B. and E.F. Rickett (eds) Corporate personality in the 20th Century. (Oxford: Hart Publishing, 1998) [ISBN 1901362833].

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Sample examination question


The Salomon decision was a scandalous one which unleashed a tidal wave of irresponsibility into the business community. Discuss.

Advice on answering this question


Start by setting out your position on this provocative statement. Do you agree with it or not? Either way you must take a position and argue it consistently. There are two parts to the statement (1) is it scandalous? and (2) did it unleash a tidal wave of irresponsibility? Make sure you address the points separately and tie them together in your conclusion. Go through the facts of Salomon with particular emphasis on the aspects of the case that might be scandalous (i.e. Mr Salomons evasion of personal liability for the debts of his one man company and his over-valuation of the business). Discuss whether a tidal wave of irresponsibility was unleashed into the business community. Points to make here are that creditors may lose out but investment and management risk-taking is facilitated.

Company Law 3 The nature of legal personality

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Reflect and review


Look through the points listed below. Are you ready to move on to the next chapter? Ready to move on = I am satisfied that I have sufficient understanding of the principles outlined in this chapter to enable me to go on to the next chapter. Need to revise first = There are one or two areas I am unsure about and need to revise before I go on to the next chapter. Need to study again = I found many or all of the principles outlined in this chapter very difficult and need to go over them again before I move on.
Ready to move on I can explain what is meant by corporate legal personality. I can illustrate the key effects of corporate legal personality in relation to liability. Need to revise first Need to study again

If you ticked need to revise first, which sections of the chapter are you going to revise?
Must revise 3.1 3.2 3.3 3.4 Corporate personality Salomon v Salomon & Co Other cases illustrating the Salomon principle Limited liability Revision done

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Notes

4 Lifting the veil of incorporation

Contents
4.1 4.2 4.3 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30 Legislative intervention . . . . . . . . . . . . . . . . . . . . . . . . . . 31 Judicial veil lifting . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32 Veil lifting and tort . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34 Reflect and review . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37

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Introduction
As we observed in Chapter 3 the application of the Salomon principle has mostly (remember Mr Macaura) beneficial effects for shareholders. The price of this benefit is often paid by the companys creditors. In most situations this is as is intended by the Companies Acts. Sometimes, however, the legislature and the courts have intervened where the Salomon principle had the potential to be abused or has unjust consequences. This is known as lifting the veil of incorporation. That is, the courts or the legislature have decided that in certain circumstances the company will not be treated as a separate legal entity. In this chapter we examine the situations where the legislature and the courts lift the veil.

Learning outcomes
By the end of this chapter and the relevant readings, you should be able to:
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describe the situations where legislation will allow the veil of incorporation to be lifted explain the main categories of veil lifting applied by the courts.

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Essential reading

Dignam and Lowry, Chapter 3: Lifting the veil. Davies, Chapter 8: Limited liability and lifting the veil at common law and Chapter 9: Statutory exceptions to limited liability.

Cases

Gilford Motor Company Ltd v Horne [1933] Ch 935 Jones v Lipman [1962] 1 WLR 832 D.H.N. Ltd v Tower Hamlets [1976] 1 WLR 852 Woolfson v Strathclyde RC [1978] SLT 159 Re a Company [1985] 1 BCC 99421 National Dock Labour Board v Pinn & Wheeler Ltd [1989] BCLC 647 Adams v Cape Industries plc [1990] 2 WLR 657 Creasey v Breachwood Motors Ltd [1992] BCC 638 Ord v Belhaven Pubs Ltd [1998] 2 BCLC 447 Williams v Natural Life Health Foods Ltd [1998] 2 All ER 577 Lubbe and Others v Cape Industries plc [2000] 1 WLR 1545.

Additional cases

Re Todd Ltd [1990] BCLC 454 Re Patrick & Lyon Ltd [1933] Ch 786 Re Produce Marketing Consortium Ltd (No 2) [1989] 5 BCC 569 Trustor AB v Smallbone [2002] BCC 795 Noel v Poland [2002] Lloyds Rep IR 30 Daido Asia Japan Co Ltd v Rothen [2002] BCC 589 Standard Chartered Bank v Pakistan National Shipping Corp (No 2) [2003] 1 AC 959 R v K [2005] The Times, 15 March 2005 MCA Records Inc v Charly Records Ltd (No 5) [2003] 1 BCLC 93 Koninklijke Philips Electronics NV v Princo Digital Disc GmbH [2004] 2 BCLC 50.

Family Law 4 Lifting the veil of incorporation

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4.1 Legislative intervention


As corporate affairs became more complex and group structures emerged (that is, where a parent company organises its business through a number of subsidiary companies in which it is usually the sole shareholder) the Companies Acts began to recognise that treating each company in a group as separate was misleading. Over time a number of provisions were introduced to recognise this fact. For example:
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s.399 CA 2006 provides that parent companies have a duty to produce group accounts s.409 CA 2006 also requires the parent to provide details of the shares it holds in the subsidiaries and the subsidiaries names and country of activity.

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However, it was the possibility of using the corporate form to commit fraud that prompted the introduction of a number of civil and criminal provisions. These provisions operate to negate the effect of corporate personality and limited liability in:
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s.993 CA 2006 which provides a not much used criminal offence of fraudulent trading ss.213215 Insolvency Act 1986 which contain the most important statutory veil lifting provisions.

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4.1.1 Insolvency Act, s.213


Section 213 of the Insolvency Act 1986 was designed to deal with situations where the corporate form was used as a vehicle for fraud. It is known as the fraudulent trading provision. If, in the course of the winding up of a company, it appears to the court that any business of the company has been carried on with intent to defraud creditors of the company or creditors of any other person, or for any fraudulent purpose, anyone involved in the carrying out of the business can be called upon to contribute to the debts of the company. This is most likely to be shareholders or directors but can also be employees and creditors. In Re Todd Ltd [1990] BCLC 454, for example, a director was found liable to contribute over 70,000 to the debts of the company because of his activities. There is also the possibility that criminal liability could follow, with a term of imprisonment as the ultimate penalty (s.993 CA 2006). While the criminal penalty was intended to act as a strong deterrent to fraudulent behaviour, it proved to have the unfortunate effect of neutralising the effectiveness of s.213 as the courts set a very high standard of proof for intent to defraud because of the possibility of a criminal charge also arising. In Re Patrick & Lyon Ltd [1933] Ch 786, this involved proving actual dishonesty, involving, according to current notions of fair trading among commercial men, real moral blame. This standard proved very difficult to obtain in practice and a new provision was introduced in s.214 of the Insolvency Act 1986 which covered the lesser offence of wrongful trading.

4.1.2 Insolvency Act, s.214


Wrongful trading does not require proving an intent to defraud. Rather it simply requires that a director, at some time before the commencement of the winding up of the company, knew or ought to have concluded that there was no reasonable prospect that the company would avoid going into insolvent liquidation, but continued to trade. The section operates on the basis that at some time before the company entered insolvent liquidation there will have been a point where the directors knew it was hopeless and the company could not trade out of the situation. The reasonable director would not at this point continue to trade. If he does continue to trade he risks having to contribute to the debts of the company under s.214. In Re Produce Marketing Consortium Ltd (No 2) (1989) 5 BCC 569 over a period of seven years the company slowly drifted into insolvency. The two directors involved did nothing wrong except that they did not put the company into liquidation after the point of no return became apparent. They were therefore liable under s.214 to contribute 75,000 to the debts of the company.

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Sections 213 and 214 differ in the way they affect the Salomon principle. Section 213 applies to anyone involved in the carrying on of the business and therefore directly qualifies the limitation of liability of members. Section 214 does not directly affect the liability of members as it is aimed specifically at directors. In small companies, directors are usually also the members of the company and so their limitation of liability is indirectly affected. Parent companies may also have their limited liability affected if they have acted as a shadow director. (A shadow director being anyone other than a professional advisor from whom the directors of the company are accustomed to take instructions or directions see Chapter 14.)

Activity 4.1
a. Explain the difference between ss.213 and 214 of the Insolvency Act 1986. b. Why was s.213 relatively unsuccessful? c. What is s.214 designed to achieve? No feedback provided.

Summary
The legislature has always been concerned to minimise the extent to which the Salomon principle could be used as an instrument of fraud. As a result it introduced the offence of fraudulent trading now contained in s.213 of the Insolvency Act 1986. The requirement to prove intent to defraud became too difficult in practice because of the possibility of a criminal offence arising and so the lesser offence of wrongful trading was introduced in order to provide a remedy where directors had behaved negligently rather than fraudulently. Thus if a director continued to trade in circumstances where a reasonable director would have stopped, the director concerned will be liable to contribute to the companys debts under s.214.

4.2 Judicial veil lifting


Veil lifting situations often present the judiciary with difficult choices as to where the loss should lie. As we observed with the Salomon, Lee and Macaura cases, the consequences of treating the company as a separate legal entity or not can be extreme. Over time the judiciary have swung from strictly applying the Salomon principle in these difficult situations to taking a more interventionist approach to try to achieve justice in a particular situation. The following cases should give some flavour of the types of situations that have arisen and the approach taken by the judiciary at the time. In Gilford Motor Company Ltd v Horne [1933] Ch 935 a former employee who was bound by a covenant not to solicit customers from his former employers set up a company to do so. He argued that while he was bound by the covenant the company was not. The court found that the company was merely a front for Mr Horne and issued an injunction against him. In Jones v Lipman [1962] 1 WLR 832 Mr Lipman had entered into a contract with Mr Jones for the sale of land. Mr Lipman then changed his mind and did not want to complete the sale. He formed a company in order to avoid the transaction and conveyed the land to it instead. He then claimed he no longer owned the land and could not comply with the contract. The judge found the company was but a faade or front for Mr Lipman and granted an order for specific performance. By the 1960s the increasingly sophisticated use of group structures was beginning to cause the courts some difficulty with the strict application of the Salomon principle. Take, for example, a situation where Z Ltd (the parent or holding company) owns all the issued share capital in three other companies A Ltd, B Ltd and C Ltd. These companies are known as wholly owned subsidiaries (s.1159(2) CA 2006). Z Ltd controls all three subsidiaries. In economic reality there is just one business but it is organised

Family Law 4 Lifting the veil of incorporation


through four separate legal personalities. In effect this structure allows the advantages of limited liability to be availed of by the legal personality of the parent company. As a result the parent could choose to conduct its more risky or liability-prone activities through A Ltd. The strict application of the Salomon principle would mean that if things go wrong the assets of Z Ltd, as a shareholder of A Ltd with limited liability, in theory cannot be touched. In DHN Ltd v Tower Hamlets [1976] 1 WLR 852 Lord Denning argued that a group of companies was in reality a single economic entity and should be treated as one. Two years later the House of Lords in Woolfson v Strathclyde RC [1978] SLT 159 specifically disapproved of Dennings views on group structures in finding that the veil of incorporation would be upheld unless it was a faade. The case of Adams v Cape Industries plc [1990] 2 WLR 657 represents a significant move by the senior judiciary towards introducing more certainty into the interpretation of Salomon issues.

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4.2.1 Adams v Cape Industries plc (1990)


Adams is a complex case but, broadly, the following occurred. Until 1979, Cape, an English company, mined and marketed asbestos. Its worldwide marketing subsidiary was another English company, named Capasco. Cape also had a US marketing subsidiary incorporated in Illinois, named NAAC. In 1974 in Texas, some 462 people sued Cape, Capasco, NAAC and others for personal injuries arising from the installation of asbestos in a factory. Cape protested at the time that the Texas court had no jurisdiction over it but in the end it settled the action. In 1978, NAAC was closed down by Cape and other subsidiaries were formed with the express purpose of reorganising the business in the US to minimise Capes presence there, in respect of taxation and other liabilities. Between 1978 and 1979, a further 206 similar actions were commenced and default judgments were entered against Cape and Capasco (who again denied they were subject to the jurisdiction of the court but this time did not settle). In 1979 Cape sold its asbestos mining and marketing business and therefore had no assets in the US. Adams sought the enforcement of the US default judgment in England. The key issue was whether Cape was present within the US jurisdiction through its subsidiaries or had somehow submitted to the US jurisdiction. According to the Court of Appeal that could only be the case if it lifted the veil of incorporation, either treating the Cape group as one single entity, or finding the subsidiaries were a mere faade or were agents for Cape. The court found that in cases where the courts had in the past treated a group as a single economic unit, thus disregarding the legal separateness of each company in the group, the court was involved in interpreting a statute or document (see below). This exception to maintaining corporate personality is qualified by the fact that there has to first be some lack of clarity about a statute or document which would allow the court to treat a group as a single entity. The court concluded that:
save in cases which turn on the wording of particular statutes or contracts, the court is not free to disregard the principle of Salomon v Salomon & Co Ltd [1897] AC 22 merely because it considers that justice so requires. Our law, for better or worse, recognises the creation of subsidiary companies, which though in one sense the creatures of their parent companies, will nevertheless under the general law fall to be treated as separate legal entities with all the rights and liabilities which would normally attach to separate legal entities.

The Court of Appeal recognised the mere faade concealing the true facts as being a well-established exception to the Salomon principle. The case of Jones v Lipman (1962) above is the classic example. There Mr Lipmans sole motive in creating the company was to avoid the transaction. In determining whether the company is a mere faade the motives of those behind the alleged faade may be relevant. The Court of Appeal looked at the motives of Cape in structuring its US business through its various subsidiaries. It found that although Capes motive was to try to minimise its presence in the US for tax and other liabilities (and that that might make the company morally culpable) there was nothing legally wrong with this.

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The court then finally considered the agency argument. This was a straightforward application of agency principle. If the subsidiary was Capes agent and acting within its actual or apparent authority, then the actions of the subsidiary would bind the parent. The court found that the subsidiaries were independent businesses free from the dayto-day control of Cape and with no general power to bind the parent. Therefore Cape could not be present in the US through its subsidiary agent. Adams therefore narrows the situations where the veil of incorporation is in effect lifted to three situations.
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Where the court is interpreting a statute or document (thus once fairness is rejected as the basis of intervention only a lack of clarity in the statute or document will allow intervention). Where the company is a mere faade. Where the subsidiary is an agent of the company.

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While there have been some notable departures from the Court of Appeals view in Adams (see Creasey v Breachwood Motors Ltd [1992] BCC 638, overruled by Ord v Belhaven Pubs Ltd [1998] 2 BCLC 447), the Court of Appeals interpretation in Adams of when veil lifting can occur has dominated judicial thinking up until very recently. There are now signs the courts seem to be relaxing the strict approach taken in Adams (see Ratiu v Conway (2006) 1 All ER 571 and Samengo-Turner v J&H Marsh & McLennan (Services) Ltd (2007) 2 All ER (Comm) 813).

Activity 4.2
Read Dignam and Lowry, 3.103.32 then write a short answer considering the following statement. The Court of Appeals decision in Adams takes an overly cautious approach to veil lifting which does little to serve the interests of justice.

4.3 Veil lifting and tort


A finding of tortious liability against a shareholder (usually also a director) for activities carried out through the medium of a company has the possibility of negating the Salomon principle. The courts have increasingly been faced with this possibility. The leading case on the issue is Williams v Natural Life Health Foods Ltd [1998] 2 All ER 577. There the House of Lords emphasised the Salomon principle in the context of a negligent misstatement claim. The managing director of Natural Life Health Foods Ltd (NLHF) was also its majority shareholder. The companys business was selling franchises to run retail health food shops. One such franchise had been sold to the claimant on the basis of a brochure which included detailed financial projections. The managing director had provided much of the information for the brochure. The claimant had not dealt with the managing director but only with an employee of NLHF. The claimant entered into a franchise agreement with NLHF but the franchised shop ceased trading after losing a substantial amount of money. He subsequently brought an action against NLHF for losses suffered as a result of negligent information contained in the brochure. NLHF subsequently ceased to trade and was dissolved. The claimant then continued the action against the managing director and majority shareholder alone, alleging he had assumed a personal responsibility towards the claimant. The House of Lords seemed particularly aware that the effect of this claim was to try to nullify the protection offered by limited liability. In its judgment the House of Lords considered that a director or employee of a company could only be personally liable for negligent misstatement if there was reasonable reliance by the claimant on an assumption of personal responsibility by the director so as to create a special relationship between them. There was no evidence in the present case that there had been any personal dealings which could have conveyed to the claimant that the managing director was prepared to assume personal liability for the franchise agreement (see also Noel v Poland [2002] Lloyds Rep. IR 30).

Family Law 4 Lifting the veil of incorporation


Other recent cases suggest that if the tort is deceit rather than negligence the courts will more readily allow personal liability to flow to a director or employee. (See Daido Asia Japan Co Ltd v Rothen [2002] BCC 589 and Standard Chartered Bank v Pakistan National Shipping Corp (No.2) [2003] 1 AC 959.) However, directors liability in tort has proved to be less than settled. In MCA Records Inc v Charly Records Ltd (No 5) [2003] 1 BCLC 93 a director had authorised a number of infringing acts under the Copyright Designs and Patent Act 1988. The Court of Appeal in a very detailed consideration of the issue of directors liability in tort, including the Williams case, took a more relaxed approach to the possibility of liability. The court concluded:
there is no reason why a person who happens to be a director or controlling shareholder of a company should not be liable with the company as a joint tortfeasor if he is not exercising control through the constitutional organs of the company and the circumstances are such that he would be so liable if he were not a director or controlling shareholder.

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The court then went on to find the director liable as a joint tortfeasor. (See also Koninklijke Philips Electronics NV v Princo Digital Disc GmbH [2004] 2 BCLC 50, where a company director was also held personally liable.)

Activity 4.3
Read Dignam and Lowry, 3.333.51 and consider whether involuntary creditors are adequately protected by the Adams decision.

Summary
It is important that you get a solid understanding of the issues facing the judiciary in this area. In essence the judiciary are being asked to decide who loses out when a business ends. In normal commercial situations this will be as the Companies Act intends therefore the burden falls on the creditors. However if there is a suggestion that the company has been used for fraud or fraud-like behaviour (e.g. Jones v Lipman) the courts may lift the veil. At various times, however, the Salomon principle was only a starting point and the courts would lift the veil in a number of situations if the interests of justice required them to do so. This led to great uncertainty which has been redressed by the restrictive case of Adams.

Useful further reading

Ottolenghi, S. From peeping behind the corporate veil to ignoring it completely, [1990] MLR 338. Gallagher, L. and P. Zeigler Lifting the corporate veil in the pursuit of justice, [1990] JBL 292. Lowry, J.P. Lifting the corporate veil, [1993] JBL 41, January, pp.4142. Rixon, F.G. Lifting the veil between holding and subsidiary companies, [1986] 102 LQR 415. Muchlinski, P.T. Holding multinationals to account: recent developments in English litigation and the Company Law Review, [2002] Co Law, p.168. Lowry, J.P. and Edmunds Holding the tension between Salomon and the personal liability of directors, [1998] Can Bar Rev 467.

Sample examination questions


Question 1 John and Amanda are brother and sister and have been running the family business Rix Ltd for 10 years. They both sit on the board of directors of Rix Ltd and each holds 30 per cent of the shares in the company. The remaining shares are held equally by their father, Jim, and uncle, Tom. Jim and Tom used to run the company but have retired now. They still have seats on the board of directors. For the first five years after the retirement of Jim and Tom the company made an annual

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profit of approximately 100,000. After that the profits declined for three years and in the last two years the company has made losses of 50,000 and 100,000. John and Amanda have grave concerns about the future of the business but, at a board meeting to discuss ceasing trading, Jim and Tom insist that things will get better. The board resolves to continue trading. Consider the implications for the board members of this decision. Question 2 Dick and his wife Bunny are owed 25,000 by Bio Ltd. Bio Ltd has refused to pay the money owed and Dick and Bunny have initiated a court action to recover the moneys owed to them. Bounce Ltd is the parent company of Bio Ltd and has recently been advised by its accountant that it could reduce its tax liability for the year 2008-2009 by removing all the assets from Bio Ltd and closing it down. Bounce Ltd has decided to follow that advice. Discuss the implications of this decision for Dick and Bunny.

Advice on answering these questions


Question 1 It appears that there is no suggestion of fraud here; rather it fits more with the case law on the application of s.214 IA 1986. Apply s.214 to the facts of this question. Does the board meeting represent the necessary point of no return? Consider the possible voting at the meeting. If it was unanimous, there is no problem and the wrongful trading provisions apply to them all. However, boards vote by simple majority and so the possibility remains that one of the directors could have dissented. What would be that directors position under s.214 if he or she wished to cease trading but the rest of the board voted to continue? If that director continues to carry out their role after the vote is he or she equally liable under s.214? Question 2 This is a relatively straightforward question similar on its facts to the Ord and Creasey cases. Ord follows Adams strictly and finds that a group reorganisation to minimise financial liability is allowable and will not engage a veil lifting exercise. Creasey is a rogue case but it is worth applying here as an alternative, in which case Dick and Bunny might be able to recover from the parent company. However, you should note the more recent case law such as Ratiu v Conway (2006) 1 All ER 571 which seems to be moving away from the narrow approach in Adams.

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Reflect and review


Look through the points listed below. Are you ready to move on to the next chapter? Ready to move on = I am satisfied that I have sufficient understanding of the principles outlined in this chapter to enable me to go on to the next chapter. Need to revise first = There are one or two areas I am unsure about and need to revise before I go on to the next chapter. Need to study again = I found many or all of the principles outlined in this chapter very difficult and need to go over them again before I move on.

Ready to move on I can describe the situations where legislation will allow the veil of incorporation to be lifted. I can explain the main categories of veil lifting applied by the courts.

Need to revise first

Need to study again

If you ticked need to revise first, which sections of the chapter are you going to revise?
Must revise 4.1 4.2 4.3 Legislative intervention Judicial veil lifting Veil lifting and tort Revision done

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Notes

5 Company formation, promoters and pre-incorporation contracts

Contents
5.1 5.2 5.3 5.4 5.5 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40 Determining who is a promoter . . . . . . . . . . . . . . . . . . . . . 41 The fiduciary position of promoters . . . . . . . . . . . . . . . . . . . 41 Duties and liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . 42 Pre-incorporation contracts . . . . . . . . . . . . . . . . . . . . . . . 43 Freedom of establishment . . . . . . . . . . . . . . . . . . . . . . . . 44 Reflect and review . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47

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Introduction
In this chapter we consider the issues that arise when people (called promoters) go though the process of incorporating a company and launching its business operations. We examine their duties and the legal consequences that arise from contracts entered into by promoters on behalf of the putative company prior to its registration (termed pre-incorporation contracts).

Learning outcomes
By the end of this chapter and the relevant readings, you should be able to:
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explain when a person will be treated as a promoter describe the duties and liabilities of promoters describe the issues arising from pre-incorporation contracts assess the impact of s.51 CA 2006 on pre-incorporation contracts and the liability of promoters.

Essential reading

Dignam and Lowry, Chapter 4: Promoters and pre-incorporation contracts. Davies, Chapter 5: Promoters.

Cases

Erlanger v New Sombrero Phosphate Co (1878) 3 App Cas 1218 Gluckstein v Barnes [1900] AC 240 Kelner v Baxter (186667) LR 2 CP 174 Phonogram Ltd v Lane [1982] QB 938 Braymist Ltd v Wise Finance Co Ltd [2002] 1 BCLC 415 berseering BV v Nordic Construction Co Baumanagement GmbH (Case 208/00) [2002] ECR I9919, ECJ Kamer van Koophandel en Fabrieken voor Amsterdam v Inspire Art Ltd (Case C-167/01) [2003] ECR I10155, ECJ.

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5.1 Determining who is a promoter


A person who takes the necessary steps to form a company is called a promoter. In Whaley Bridge Calico Printing Co v Green (1879) 5 QBD 109, Bowen J explained that: the term promoter is a term not of law, but of business, usefully summing up in a single word a number of business operations familiar to the commercial world by which a company is generally brought into existence. The promotion process generally involves the following activities.
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Registering the company with Companies House. Entering into pre-incorporation contracts. In the case of public companies, issuing a prospectus. Appointing directors and finding shareholders wishing to invest in the new company.

The CA 2006 does not define the term promoter. However, the judges have, on occasions, framed tests for determining whether a persons activities relate to the promotion of a company. The classic statement in this regard was made by Cockburn CJ in Twycross v Grant (187677) LR 2 CPD 469, who said that a promoter is:
one who undertakes to form a company with reference to a given project, and to set it going, and who takes the necessary steps to accomplish that purpose and so long as the work of formation continues, those who carry on that work must, I think, retain the character of promoters. Of course, if a governing body, in the shape of directors, has once been formed, and they take, as I need not say they may, what remains to be done in the way of forming the company, into their own hands, the functions of the promoters are at an end.

The definition is necessarily broad so as to prevent persons taking steps to avoid falling within a more tightly framed proposition in order to avoid the duties borne by promoters. The breadth of the definition is a legacy of a number of nineteenth-century cases involving fraudulent schemes being perpetrated against investors. The judges responded by holding that promoters were fiduciaries by analogy with trustees (see below) and thus subject to a range of duties aimed at ensuring high standards of behaviour.

5.2 The fiduciary position of promoters


It has long been settled that promoters are fiduciaries.
They stand, in my opinion, undoubtedly in a fiduciary position. They have in their hands the creation and moulding of the company; they have the power of defining how, and when, and in what shape, and under what supervision, it shall start into existence and begin to act as a trading corporation. (Erlanger v New Sombrero Phosphate Co (1878) 3 App Cas 1218, per Lord Cairns LC.)

The term fiduciary is best explained by reference to the particular obligations a fiduciary owes to his or her principal. As we will see in Chapter 15, Directors duties, fiduciary obligations are obligations owed to a principal to act with loyalty and good faith in dealings which affect that person (Penner, 2008). This duty entails more than just acting honestly and fairly. Fiduciaries must act solely in the interests of the principal and must not allow their own self-interests to dictate their behaviour in any way that might conflict with the principals best interests.

For more on the fiduciary relationship, see the LLB subject guide Law of trusts, Chapter 4, The trust relationship.

Activity 5.1
Read Erlanger v New Sombrero Phosphate Co (1878) 3 App Cas 1218. Describe how the House of Lords reached the conclusion that the syndicate, as promoters of the new company, stood in a fiduciary position to it and outline the content of the core fiduciary duty owed by promoters.

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5.3 Duties and liabilities


As indicated in the preceding section, the core duty of a promoter is that of loyalty and good faith. Given the activities of promoters in bringing a company into existence, a process which often involves acquiring property for the yet unformed corporation, the core duty is translated into a prohibition against making secret profits from such transactions. The anxiety of the law in this regard is directed towards addressing the problem of promoters selling property to the company in which they have a personal interest and from which they make a profit. Promoters are therefore required to make full disclosure of any such profit to an independent board of directors once the company comes into existence. Failure to make such disclosure enables the company to bring an action for rescission. In Erlanger v New Sombrero Phosphate Co, a syndicate purchased a mine for 55,000. The syndicate then formed a company and through a nominee sold the mine to it for 100,000 without disclosing their interest in the contract. The mining operations were fruitless and the shareholders removed the original directors and the new board successfully brought an action to have the sale rescinded. In Salomon v Salomon & Co Ltd [1897] AC 22 (see Chapter 3), the House of Lords took the view that if the board was not independent, disclosure of all material facts should be made to the original shareholders. But note that in Gluckstein v Barnes [1900] AC 240 the House of Lords refined the duty further by holding that disclosure to the original shareholders will not be sufficient if they are not truly independent and the scheme as a whole is designed to defraud the investing public. As we saw above (Erlanger v New Sombrero Phosphate Co), where full disclosure is not made by the promoters the contract is voidable at the companys option. However, the right to rescind will be lost where:
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the company affirms the contract (Re Cape Breton Co (1885) 29 Ch D 795) the company delays in exercising its right to rescind the contract.

For rescission to be available it must be possible to restore, at least substantially, the parties to their original position unless, due to the fault of the promoter, this possibility has been lost (Lagunas Nitrate Co v Lagunas Syndicate [1899] 2 Ch 392). Finally, it should be noted that where the contract has been affirmed, the company can nevertheless sue the promoter to account for the secret profit.

Activity 5.2
Read Gluckstein v Barnes [1900] AC 240. What are the consequences of a promoter making a secret profit from a transaction with the company?

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5.4 Pre-incorporation contracts


Obviously a company does not come into existence until the promoters have completed the registration requirements and the Registrar of Companies issues a certificate of incorporation. Prior to this time a company cannot be bound by contracts entered into in its name or on its behalf. In practice, however, promoters will need to contract with third parties for such things as a lease of premises, business equipment and connection to utilities so that once the certificate of incorporation is issued the company can begin trading. The problem that arises in relation to pre-incorporation contracts is whether promoters can avoid being personally liable on such contracts notwithstanding that the company did not exist at the time such contracts were concluded on its behalf. Quite clearly, an agent (the promoter) cannot bind a non-existent principal (the company) to contracts. The common law addressed the problem by applying settled principles of contract and agency, but partial reform was implemented by s.9(2) of the European Communities Act 1972, now found in s.51 CA 2006.

5.4.1 The common law position


It is a fundamental principle of the law of contract that a party must be in existence in order for an agreement (offer and acceptance) to crystallise into a binding contract. Given that at the time of a pre-incorporation contract the company does not exist, it becomes a stranger to the contract once it comes into existence: the privity doctrine operates to prevent rights and liabilities being conferred or imposed on the company (Kelner v Baxter (186667) LR 2 CP 174, see below). The Contracts (Rights of Third Parties) Act 1999, which allows enforcement of contracts by third parties if the contract expressly so provides or a term of the contract confers a benefit on the third party, does not apply to pre-incorporation contracts. As indicated above, the law of agency takes the view that a person cannot be an agent of a non-existent principal and so a company cannot acquire rights or obligations under a pre-incorporation contract. The common law position is illustrated by the decision in Kelner v Baxter. The promoters of a hotel company entered into a contract on its behalf for the purchase of wine. When the company formally came into existence it ratified the contract. The wine was consumed but before payment was made the company went into liquidation. The promoters, as agents, were sued on the contract. They argued that liability under the contract had passed, by ratification, to the company. It was held, however, that as the company did not exist at the time of the agreement it would be wholly inoperative unless it was binding on the promoters personally and a stranger cannot by subsequent ratification relieve them from that responsibility. On the other hand, a promoter can avoid personal liability if the company, after incorporation, and the third party substitute the original pre-incorporation contract with a new contract on similar terms. Novation, as this is called, may also be inferred by the conduct of the parties such as where the terms of the original agreement are changed (Re Patent Ivory Manufacturing Co, Howard v Patent Ivory Manufacturing Co (1888) 38 Ch D 156). However, novation is ineffective if the company adopts the contract due to the mistaken belief that it is bound by it (Re Northumberland Avenue Hotel Co Ltd (1886) 33 Ch D 16). A promoter can also avoid personal liability on a contract where he signs the agreement merely to confirm the signature of the company because in so doing he has not held himself out as either agent or principal. The signature and the contractual document will be a complete nullity because the company was not in existence (Newborne v Sensolid (Great Britain) Ltd [1954] 1 QB 45). As noted above, the common law position has now been modified, as a result of the UKs implementation of the First European Community Directive on Company Law, by s.51 CA 2006 (replacing s.36C CA 1985). The provision seeks to protect the third party by making promoters personally liable when the company, after incorporation, fails to enter into a new contract on similar terms.

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5.4.2 Companies Act 2006, s.51


Section 51(1) provides that:
a contract which purports to be made by or on behalf of a company at a time when the company has not been formed has effect, subject to any agreement to the contrary, as one made with the person purporting to act for the company or as agent for it, and he is personally liable on the contract accordingly.

The meaning of s.51 was considered by the Court of Appeal in Phonogram Ltd v Lane [1982] QB 938. Lord Denning MR took the phrase subject to any agreement to the contrary to mean that for a promoter to avoid personal liability the contract must expressly provide for his exclusion. The Court also held that it is not necessary for the putative company to be in the process of creation at the time the contract was entered into. In Braymist Ltd v Wise Finance Co Ltd [2002] 1 BCLC 415, an issue before the Court of Appeal was whether a person acting as agent of an unformed company could enforce a pre-incorporation contract under s.51. It was held that although the terms of the first Directive referred only to liability and not to enforcement, it did not follow that s.51 was similarly limited in scope so as to prevent enforcement of contracts made by persons on behalf of unformed companies. The words in the section and he is personally liable on the contract accordingly did not operate to negate this view. Rather the phrase merely serves to emphasise the abolition of the common law distinction between agents who incurred personal liability on pre-incorporation contracts and those who did not. The section is thus double-edged so that a party who is personally liable for the contract is also able to enforce it.

5.5 Freedom of establishment


Companies are no longer static entities whose operations are confined to the jurisdiction in which they were incorporated. In furtherance of the internal market goal, the EC Treaty creates a common market with free movement of goods, persons, services and capital. Articles 2, 43 and 48 of the EC Treaty seek to confer a right of establishment on natural persons and companies alike to carry on business in any Member State. The fundamental requirement is that companies must have been formed according to the law of a Member State and that they have their registered office, or centre of administration or principal place of business within the European Community (article 48 EC Treaty). A Member State which seeks to impede the right of a company registered in another Member State from carrying on business in its jurisdiction will be held to be acting in breach of its EC Treaty obligations. For example, in Centros Ltd v Erhversus-og Selkabssyrelsen (Case C-2212/97) [2002] 2 WLR 1048, the ECJ held that Denmark was in breach of EU law in refusing to allow Centros Ltd, a private company registered in England, to establish a branch in Denmark, even though Denmark was in fact its primary operational establishment. The Court rejected the argument of the Danish authorities that the Danish owners of Centros Ltd had chosen the UK as the state of incorporation of its undercapitalised company in order to avoid the minimum capital requirements required under Danish law. The motives of the owners could not be regarded as abusive but were a consequence of their freedom to incorporate a company in one Member State and set up a secondary establishment in another. See berseering BV v Nordic Construction Co Baumanagement GmbH (Case 208/00) [2002] ECR I9919, ECJ and Kamer van Koophandel en Fabrieken voor Amsterdam v Inspire Art Ltd (Case C-167/01) [2003] ECR I10155, ECJ. See further, Lowry (2004). The pan-European business entity, the European Company (SE), which became available in October 2004, will address the concerns of those Member States wishing to regulate under-capitalised companies operating within their jurisdictions. Further, the draft 14th EC Company Law Harmonisation Directive aims to facilitate corporate migration. A company will be able to move its registered office between Member States without having to disrupt its operations by reincorporating in the host jurisdiction.

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Activity 5.3
Read Phonogram Ltd v Lane [1982] QB 938 and Braymist Ltd v Wise Finance Co Ltd [2002] I BCLC 415. Re-read Dignam and Lowry, 4.134.20. What is the policy underlying s.51 CA 2006?

Summary
The key point to understand is that promoters are fiduciaries. Where promoters fail to disclose a profit to an independent board of directors the company can require them to account for it (i.e. to disgorge the profit). Section 51 of the CA 2006 is designed to protect third parties contracting with promoters by making the promoters personally liable on pre-incorporation contracts.

Useful further reading

Dyrberg, P. Full free movement of companies in the European Community at last, [2003] ELR 528. Green, N. Security of transaction after Phonogram, [1984] MLR 671. Griffiths, A. Agents without principals: pre-incorporation contracts and section 36C of the Companies Act 1985, [1993] LS 241. Gross, N. Pre-incorporation contracts, [1971] LQR 367. Lowry, J. Eliminating obstacles to freedom of establishment: the competitive edge of UK company law, [2004] CLJ 331. Penner, J. The Law of Trusts. (Oxford: Oxford University Press, 2008) sixth edition [ISBN 9780199540921] para 2.10. Sealy, L.S. and S. Worthington Cases and materials in company law. (Oxford: Oxford University Press, 2008) eighth edition [ISBN 9780199298426]. pp.8095. Twigg-Flesner, C. Full circle: purported agents right of enforcement under section 36C of the Companies Act 1985, [2001] Co Law 274.

Sample examination question


Gerald, Jill and Harry form a syndicate. They pool their savings and buy catering equipment. They run a business from an old school kitchen which Jill bought for 5,000. They supply pies and sandwiches to local hotels. The business is successful and they decide to form a company. Jill sells the kitchen to the company for 10,000. Gerald buys three vans for 5,000 each and resells them to the company for 6,000 each. Harry instructs British Telecom to install a telephone. He tells them that the company, when formed, will take over the liabilities in respect of telephone bills. Harry pays 100 deposit for the installation of the telephone. The company is incorporated and Harry, Jill and Gerald are named as sole directors. Harry telephones British Telecom and instructs them to bill the company in future. They do so but 500 worth of bills remain unpaid. The company has now failed and a liquidator has been appointed. Advise all parties as to their rights and liabilities.

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Advice on answering this question


This question is wide ranging and requires you to define promoters, explain their fiduciary duties with particular reference to the duty of disclosure to an independent board and to discuss the liability of promoters for secret profits. You need to discuss what promoters are: see Twycross v Grant. The liquidator will be concerned with:
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Jills sale of the kitchen to the company Geralds sale of the vans to the company Harrys transaction with British Telecom.

Both Jill and Gerald are promoters and owe fiduciary duties to the company. They are therefore precluded from making secret profits unless full disclosure of the transaction is made to an independent board which consents to the profits (Erlanger v New Sombrero Phosphate Co). However, the question states that Jill, Harry and Gerald are the sole directors. As such, are they independent? If you conclude they are not, you should discuss Salomon v Salomon. If they are also its sole members then, according to Gluckstein v Barnes, disclosure to them will not suffice either because they are not truly independent. In this situation you should argue whether Gluckstein should be distinguished if the company is private so that the scheme is not designed to defraud the investing public the court may distinguish Gluckstein on its facts. You will need to consider the companys remedies of rescission and accounting of profits (Lagunas Nitrate Co v Lagunas Syndicate). Note the circumstances in which rescission may be lost (Re Cape Breton Co) and that for rescission to be available it must be possible to restore the parties to their original position unless, due to the fault of the promoter, this possibility has been lost: Lagunas Nitrate Co v Lagunas Syndicate. Even if the respective contracts with Jill and Gerald have been affirmed, the company can nevertheless sue them to account for their secret profits. Harry has entered into a pre-incorporation contract. Because the company did not exist at the time of this contract can it be bound by it? You need to discuss Kelner v Baxter. Further, you will need to consider s.51 CA 2006, which makes a promoter personally liable unless there is an agreement with the third party, British Telecom, to the contrary (see Phonogram Ltd v Lane). For Harry to avoid liability the company must enter into a new contract with British Telecom on the same terms as that made by him (novation).

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Reflect and review


Look through the points listed below. Are you ready to move on to the next chapter? Ready to move on = I am satisfied that I have sufficient understanding of the principles outlined in this chapter to enable me to go on to the next chapter. Need to revise first = There are one or two areas I am unsure about and need to revise before I go on to the next chapter. Need to study again = I found many or all of the principles outlined in this chapter very difficult and need to go over them again before I move on.
Ready to move on I can explain when a person will be treated as a promoter. I can describe the duties and liabilities of promoters. I can describe the issues arising from preincorporation contracts. I can assess the impact of s.51 CA 2006 on preincorporation contracts and the liability of promoters. Need to revise first Need to study again

If you ticked need to revise first, which sections of the chapter are you going to revise?
Must revise 5.1 5.2 5.3 5.4 5.5 Determining who is a promoter The fiduciary position of promoters Duties and liabilities Pre-incorporation contracts Freedom of establishment Revision done

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Notes

6 Raising capital: equity

Contents
6.1 6.2 6.3 6.4 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50 Private and public companies . . . . . . . . . . . . . . . . . . . . . . 51 Raising money from the public . . . . . . . . . . . . . . . . . . . . . . 52 Insider dealing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54 Regulating takeovers . . . . . . . . . . . . . . . . . . . . . . . . . . . 56 Reflect and review . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59

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Introduction
Companies can raise money in a number of ways. For small companies the owners savings or bank loans usually provide the necessary finance. However as companies grow they may also wish to raise capital in the form of equity (shares) from the general public. In this chapter we will examine the legal issues surrounding raising equity from the general public.

Learning outcomes
By the end of this chapter and the relevant readings, you should be able to:
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distinguish between raising capital for public and private companies outline the relevant methods of selling shares to the general public describe how the listing regime protects investors explain the sanctions available where insider dealing has occurred.

Essential reading

Dignam and Lowry, Chapter 5: Raising capital: equity and its consequences. Davies, Chapter 25: Public offers of shares and Chapter 30: Insider dealing and manipulation.

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6.1 Private and public companies


6.1.1 Restriction on private companies
As we discussed in Chapter 2, companies can be either private or public. A key distinction between the two types of registered company is that in terms of equity or capital raising the law presumes that in private companies the investment is largely provided by the founding members, either through their personal savings or from bank loans, and that in public companies the intention is to raise large amounts of money from the general public. Private companies usually also restrict the ability of their shareholders to transfer their shares (see Dignam and Lowry, 1.15). Crucially, private companies are prohibited from raising capital from the general public (s.755 CA 2006). Public companies have no such prohibition and may freely raise capital from the general public. Sometimes where extremely large amounts of capital are needed, a public company will choose to raise capital through listing on the stock exchange. The Listing Rules of the London Stock Exchange (LSE) (the most sophisticated market for raising public funds) require that a company be a public company. Public companies are designed to secure investment from the general public. As such they can advertise the fact that they are offering shares to the public. In doing so the company must issue a prospectus giving a detailed and accurate description of the companys plans (see below). Because the general public are involved and need to be protected, the initial capital requirements for a public company are more onerous than for a private one. As we noted in Chapter 2, there is a minimum capital requirement of 50,000 (s.763 CA 2006). However, the capital requirement may be partly paid so the company does not actually have to have 50,000; it just needs one-quarter of that to be paid up, plus the ability to call on the members for the remaining amount (s.586 CA 2006). While there is no formal limitation on public companies preventing them from transferring shares as private companies do, it would be highly unusual, given that the aim is to raise money from the general public, who would be discouraged by such a restriction. In any case, if the public company is listed on the LSE such restrictions on transfer will be prohibited. Public companies also attract a higher level of regulation.

6.1.2 Public companies and the public interest


Public companies have a much greater potential to affect the general public than private companies because of their capital-raising activities. As a result the state has taken a greater interest in investor protection where public companies are concerned. For example, the CLRSG in its consultation document Completing The Structure (para 2.73) identified tighter accounting rules, a more onerous capital maintenance regime and stricter rules for the board of directors as three distinct areas where public companies were subject to enhanced regulation. Public companies are not necessarily listed on the stock exchange, but as we noted above, some public companies may decide to raise capital on the LSE. This involves applying to the LSE and fulfilling a very strict set of criteria to ensure the business is a sound one. A listing on the stock exchange is essentially a private contractual arrangement between a public company and the LSE (itself a listed public company) to gain access to a very sophisticated market for its shares. The public company, once it gains access to the stock market, is then generally known as a listed company and its shares as listed shares or securities. The LSE offers the facility of a secondary market, that is, a place where shares can be traded after they have been issued to shareholders. It also functions as a capital market for companies to sell new shares to the general public who can then trade them on the stock exchange. A listing also has the advantage that investors will have greater confidence in the business if it is within the regulatory ambit of the LSE and investors will be able to sell their shares easily through the LSE. The shareholders of listed companies tend to be what are called institutional investors. These institutional investors are made up of pension funds, insurance companies, and professional management funds who are investing funds on behalf of individuals.

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Activity 6.1
Explain the differences between a private and a public company for capital raising purposes. No feedback provided.

Summary
There are several distinctions between public and private companies. Perhaps the key distinction is that private companies cannot raise funds from the general public. As a result public companies are the major vehicles for capital (equity) raising in the UK. If a public company wishes to raise large amounts of equity then it might consider applying to be listed on the LSE.

6.2 Raising money from the public


While a public company seeking a listing on the LSE must comply with the regulations of the LSE the company must also choose a way to sell its shares to the general public. This can be done a number of ways and the following are the most relevant here.
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The company could offer its shares for subscription itself. This is done by issuing a prospectus and advertising in the trade or general press. An offer for sale. This is where the company has an agreement with an issuing house (a merchant bank) whereby it will allot its entire issue of shares to the issuing house. The issuing house will then try to sell the shares to its clients and the general public. The advantage of this type of sale is that the issuing house takes the risk that the shares will not sell. A placing. Here the shares may not be offered to the general public at all, but are placed with the clients of a merchant bank or group of merchant banks. The company could raise money through a rights issue. This is where new shares are offered to the existing shareholders in proportion to their existing shareholding. These pre-emption rights are conferred on shareholders by s.561 CA 2006. Once a company is listed, further capital raising is more straightforward without the complication of the initial listing process.

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6.2.1 The FSA and the LSE


The Financial Services Authority (FSA) is the main UK financial services regulator and therefore the listed market comes within its ambit. Until May 2000 the LSE was also the UKs competent authority for listing with responsibility for admitting securities (shares and debentures) to listing, making the Listing Rules and policing compliance with them. Following enactment of the Financial Services and Markets Act 2000 (FSMA), which replaced the Financial Services Act 1986, this function is carried out by the FSA, which is now the UK Listing Authority. The LSE is the principal Recognised Investment Exchange (RIE) for trading securities of UK and foreign companies, government stocks and options to trade company securities in the UK. Some 1,800 companies registered in the UK have listed securities. Once a company has obtained a listing by complying with the listing rules it can only maintain listed status if it complies with the continuing obligations specified in the listing rules. The LSEs statutory obligation to operate an orderly market also obliges it to monitor listed companies on an ongoing basis. As such the LSE and the FSA have an important co-operative role.

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Activity 6.2
a. What is a listed company? b. Why are private companies prohibited from becoming listed companies? c. What are the major forms of selling shares to the general public? d. Who has responsibility for regulating the UKs public markets? No feedback provided.

6.2.2 Obligations when listing


While the compliance regulations for companies seeking a listing are complex and voluminous they broadly cover the availability of past accounts, compliance with a minimum market capitalisation and a minimum proportion of the shares in public hands requirement. The Listing Rules focus specifically on the information that must be made available to the public by a company when its shares are being listed. These disclosure requirements operate on the principle that all documents issued must:
contain all such information as investors and their professional advisers would reasonably require, and reasonably expect to find there, for the purpose of making an informed assessment of: (a) the assets and liabilities, financial position, profits and losses, and prospects of the issuer of the securities; and (b) the rights attaching to those securities. s.80(1) FSMA 2000.

Thus the requirements aim to provide potential investors with such core information about the companys activities as will allow them to make an informed investment decision. If shares by listed companies are offered to the public a prospectus (the document issued to the public inviting them to invest in the shares) submitted to, and approved by, the FSA is required. Since 2005 and the implementation of the Prospectus Directive (Directive 2003/71/EC) in the Prospectus Regulations 2005, a single regime is now in place in Part VI of the FSMA regulating the prospectus requirements of listed and non-listed offerings.

6.2.3 Continuing obligations


Once a company has achieved a listing it continues to be subject to a number of obligations to disclose information necessary to maintain an orderly market and to protect investors. The continuing obligations require listed companies to publish half-yearly reports on their activities, together with profits and losses made during the first six months of each financial year. Further, by way of an additional requirement to the duty to issue full annual accounts and reports, a listed company must also publish a preliminary statement of the annual results. Directors of listed companies must also produce a fair business review covering the development and performance of the business which identifies the principal risks and uncertainties ahead (see Chapter 16 on the corporate governance implications of the new operating and financial review). The continuing obligations also operate as a means of preventing insider dealing (see below) as the Listing Rules require a listed company to publish price-sensitive information (information that may result in substantial movement in the price of its securities) as quickly as possible. Failure to comply with the listing regime carries the possibility that the FSA will sanction the company or individuals responsible for the failure. This could lead to a wide range of criminal and civil sanctions. On 20 January 2007 a version of the Transparency Directive (2004/109/EC) was implemented for UK listed companies. Part 43 of the CA 2006 amends Part VI of the FSMA in a number of ways to implement the requirements of the Directive. It requires companies to produce periodic financial reports and specifies the minimum content of those reports. It requires major shareholders to disclose their holdings at certain thresholds. On the implementation of the Directive, responsibility for the shareholding disclosures was moved from the DTI (now Department for Business Information and Skills (BIS)) to the FSA. The Directive also requires that companies disclose information

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to investors on a fast, non-discriminatory and pan-European basis. Additionally the Transparency regime provides for criminal and civil penalties for non-compliance.

6.2.4 Reforming the regulatory structure


The CLRSG considered the current regulatory arrangement for public companies in Regulatory and Institutional Framework for Company Law (Chapter 12 of Completing the Structure). It concluded after much discussion that it did not see any need for any more extensive redrawing of the regulatory map (paras 12.112113). The Companies Act 2006 did not, as a result, affect the regulatory structure within which listed companies operate. However, since the advent of the credit crisis in Autumn 2008, reform of the regulatory structure is a near certainty.

Activity 6.3
What is the listing regime trying to achieve by emphasising disclosure before and after listing?

Summary
When listing, a company has a number of possible methods of selling its shares: offering its shares itself for subscription, an offer for sale, a placing or a rights issue if already listed. The FSA is the UKs main financial regulator and is the listing authority in the UK. By necessity it works closely with the LSE to ensure that the listing regime, with its emphasis on disclosure, operates effectively.

6.3 Insider dealing


Having a companys shares listed on a stock exchange while advantageous for raising capital also carries with it the risk that insiders may wish to take advantage of their access to privileged confidential information by buying and selling shares on the basis of that information. Every country in the world with a major stock exchange has made this practice illegal because of its potential to destroy public confidence in the stock exchange. As we discussed above with regard to the continuing obligations of listed companies, the FSA and the LSE also attempt to ensure that opportunities to insider deal are minimised by requiring that companies disclose any significant information that might affect share prices as quickly as possible.

6.3.1 Criminal sanctions for insider dealing


Section 397 of the FSMA (formerly s.47 of the Financial Services Act 1986) contains a general catch-all criminal provision on false and misleading information which would cover insider dealing. However, Part V of the Criminal Justice Act 1993 contains the main criminal provisions specifically on insider dealing. Section 52(1) states:
[a]n individual who has information as an insider is guilty of insider dealing if, in the circumstances mentioned in subsection (3) (that is, it is a regulated market and the insider deals himself as a professional or through a professional intermediary), he deals in securities that are price-affected securities in relation to the information.

The insider will also be guilty of an offence if they induce others to deal in pricesensitive securities on a regulated market, whether or not the insider knows the information to be price sensitive (i.e. the information would make the share price go up or down) (s.52(2)(a)). It is also an offence just to disclose price sensitive information to another person in an irregular manner (s.52(2)(a)). If found guilty a fine or imprisonment for up to seven years is possible. However the criminal standard of proof proved very difficult to achieve because of the complexity of many insider dealing situations. As a result a civil offence was introduced.

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6.3.2 The civil sanction regime


The civil offence of market abuse is contained in s.118 of the FSMA. Market abuse.
(1) For the purposes of this Act, market abuse is behaviour (whether by one person alone or by two or more persons jointly or in concert) which (a) occurs in relation to- (i) qualifying investments admitted to trading on a prescribed market,

(ii) qualifying investments in respect of which a request for admission to trading on such a market has been made, or (iii) in the case of subsection (2) or (3) behaviour, investments which are related investments in relation to such qualifying investments, and (b) falls within any one or more of the types of behaviour set out in subsections (2) to (8).

(2) The first type of behaviour is where an insider deals, or attempts to deal, in a qualifying investment or related investment on the basis of inside information relating to the investment in question. (3) The second is where an insider discloses inside information to another person otherwise than in the proper course of the exercise of his employment, profession or duties. (4) The third is where the behaviour (not falling within subsection (2) or (3))- (a) is based on information which is not generally available to those using the market but which, if available to a regular user of the market, would be, or would be likely to be, regarded by him as relevant when deciding the terms on which transactions in qualifying investments should be effected, and (b) is likely to be regarded by a regular user of the market as a failure on the part of the person concerned to observe the standard of behaviour reasonably expected of a person in his position in relation to the market. (5) The fourth is where the behaviour consists of effecting transactions or orders to trade (otherwise than for legitimate reasons and in conformity with accepted market practices on the relevant market) which- (a) give, or are likely to give, a false or misleading impression as to the supply of, or demand for, or as to the price of, one or more qualifying investments, or (b) secure the price of one or more such investments at an abnormal or artificial level.

(6) The fifth is where the behaviour consists of effecting transactions or orders to trade which employ fictitious devices or any other form of deception or contrivance. (7) The sixth is where the behaviour consists of the dissemination of information by any means which gives, or is likely to give, a false or misleading impression as to a qualifying investment by a person who knew or could reasonably be expected to have known that the information was false or misleading. (8) The seventh is where the behaviour (not falling within subsection (5), (6) or (7))- (a) is likely to give a regular user of the market a false or misleading impression as to the supply of, demand for or price or value of, qualifying investments, or (b) would be, or would be likely to be, regarded by a regular user of the market as behaviour that would distort, or would be likely to distort, the market in such an investment, and the behaviour is likely to be regarded by a regular user of the market as a failure on the part of the person concerned to observe the standard of behaviour reasonably expected of a person in his position in relation to the market.

In order to investigate a suspected market abuse the FSA has sweeping investigative powers under the FSMA. It also has a number of possible sanctions such as public censure, fines, injunctions, restitution orders and powers to vary or cancel an investment authorisation.

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Activity 6.4
Why is insider dealing illegal?

Summary
Insider dealing is where insiders in a company seek to benefit from their access to privileged confidential information by buying and selling shares which would be affected by the privileged information. As a result criminal provisions were introduced in order to deal with this problem. These provisions proved unsuccessful as the standard of proof was too difficult to achieve. Civil sanctions were introduced in the FSMA to provide a lesser offence of market abuse.

6.4 Regulating takeovers


One of the consequences of listing on the LSE is that the shares of the company can be easily bought and sold. This also means that the entire listed shareholding can be bought in the listed marketplace, thus effecting a takeover of the company. Strangely, given the importance of this area, the Companies Act contains relatively few provisions on the regulation of takeovers.
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Section 219 CA 2006 contains disclosure requirements for directors salaries. The Transparency Directive requires anyone acquiring a 3 per cent holding in a company to disclose their interest to the company and again every time their interest increases or decreases by 1 per cent. Section 979 CA 2006 governs post-takeover compulsory purchase of a dissenting minority.

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Additionally, ss.895901 CA 2006 and s.110 Insolvency Act 1986 allow effective takeovers of companies in crisis and liquidation. The conduct of the takeover itself, which is of greatest concern to shareholders and companies, is left to the selfregulatory system to govern. Since 1968 the conduct of takeovers has been governed by the Panel on Takeovers and Mergers (the Panel). The Panel administers the rules on takeovers called the City Code on Takeovers and Mergers (the Code). The Panel and the Code aim to achieve equality of treatment and opportunity for all shareholders in a takeover bid. The Code, while flexible, emphasises a number of general principles. These are:
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equality of treatment and opportunity for all shareholders in takeover bids adequate information and advice to enable shareholders to assess the merits of the offer no action which might frustrate an offer is taken by a target company during the offer period without shareholders being allowed to vote on it the maintenance of fair and orderly markets in the shares of the companies concerned throughout the period of the offer.

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Until the CA 2006 the Panel was a non-statutory body but its decisions were subject to judicial review because of the public nature of its regulatory role (see R v Panel on Takeovers and Mergers ex p Datafin (1987) QB 815). However, the courts would only hear the review after the takeover was complete, thus eliminating the use of the courts in a tatical sense during the progress of a takeover bid. Prior to 2006 the Panel had no formal power to sanction but was held in great respect by the financial services sector. As a result the Panel had a number of actions it could take. First, the Panel could issue critical statements about the conduct of a bid which would alert shareholders to irregularities. Second, the Panels role was recognised by the FSA, the various selfregulatory bodies licensed by the FSA and the professional bodies. This means that the Panel could pass the matter to these bodies requesting a sanction. For example, a listed company that did not follow the Code could have the LSE remove or suspend its

Company Law 6 Raising capital: equity


listing and the companys professional advisers could have disciplinary proceedings brought against them by their professional body. The FSA might also have withdrawn its investment authorisation (see below) from any person who is the subject of an adverse ruling of the Panel.

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6.4.1 The reform of takeovers


The reform of takeovers in the EU has been a subject of much discussion since 1989 when the European Commission put forward a draft directive on European takeovers. Unfortunately there are very different views on takeovers within the EU member states and for more than a decade no progress was made. Eventually in 2001 political agreement was reached on a text of the Draft Directive by the Council of Ministers but it was rejected by the European Parliament. In April 2004 a much compromised Directive was eventually agreed (Directive 2004/25/EC of the European Parliament and of the Council of 21 April 2004 on Takeover Bids). The Directive requires the establishment of a statutory body which would oversee statutory takeover provisions. The CA 2006 Part 28, as a result, converted the selfregulating Panel (s 942 CA 2006) into just such a statutory body to oversee takeovers in the United Kingdom on 6 April 2007. Under the Takeover Directive reforms, the Panel now has its own range of sanctions contained in ss.952-956 CA 2006. Thus the Panel now has formal powers to issue statements of censure, issue directions, refer conduct to other regulatory bodies, order compensation to be paid for breach of the code and refer a matter for enforcement by the court. This means that the Panel can take action itself or pass the matter to other regulators requesting a sanction. For example, a listed company that does not follow the Code could face:
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the LSE removing or suspending its listing disciplinary proceedings being brought against the companys professional advisers by their professional body.

The FSA might also withdraw its investment authorisation from any person who is the subject of an adverse ruling of the panel.

This is necessary for all those who deal in the securities market.

Useful further reading

Marsh, J. Disciplinary proceedings against authorised firms and approved persons under The Financial Services and Markets Act 2000 in de Lacy, J. (ed.) The Reform of United Kingdom Company Law. (London: Cavendish, 2002) [ISBN 9781859476938]. Bagge, J., C. Evans, G. Wade and M. Lewis Market abuse: proposals for the new regime, [2000] X1(9) PLC 35. McVea, H. Whats wrong with insider dealing?, [1995] Legal Studies 390. Campbell, D. Note: what is wrong with insider dealing, [1996] Legal Studies 185. Morse, G.K. The City Code on Takeovers and Mergers self regulation or self protection?, [1991] JBL 509.

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Sample examination question


George is the managing director of Flub plc, a UK listed company which manufactures a range of medical products. On the morning of 4 July 2002 George received news that the companys new wonder drug had failed a crucial test and would not be going into production for years, if ever. The news is to be released the next day at mid-day. George went to a party that evening where he met his friend Martha who commented that George seemed a bit down. George replied that things had not been going well with some of the companys new products. Martha had shares in Flub plc and phoned her broker the next morning to discuss selling her shares. In the course of this conversation she mentions Georges comment the night before. The broker advises her to sell fast. Martha sells her shares before mid-day and avoids a huge loss when the bad news about Flubs wonder drug is announced. Discuss the insider dealing implications of the above.

The areas covered in Sections 6.1 and 6.2 above have historically provided the context for your general understanding of company law rather than being an examinable area in itself. As such the essential reading and the activities above should provide that context. Section 6.3 and 6.4 are examinable and so you should attempt the following sample question.

Advice on answering the question


Apply the criminal sanction first (s.52 Criminal Justice Act 1993). Go through the facts carefully and decide who might have dealt as an insider here George? Martha? The broker? Follow the price sensitive information and what each character does with it. Remember the insider will also be guilty of an offence if he induces others to deal (whether they know the information is price sensitive or not) in price sensitive securities on a regulated market (s.52(2)(a)). It is also an offence just to disclose price sensitive information to another person in an irregular manner (s.52(2)(a)). Will the standard of proof be a problem here? Go through the civil market abuse offence. This is more straightforward but again apply it to all the characters in the question.

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Reflect and review


Look through the points listed below. Are you ready to move on to the next chapter? Ready to move on = I am satisfied that I have sufficient understanding of the principles outlined in this chapter to enable me to go on to the next chapter. Need to revise first = There are one or two areas I am unsure about and need to revise before I go on to the next chapter. Need to study again = I found many or all of the principles outlined in this chapter very difficult and need to go over them again before I move on.
Ready to move on I can distinguish between raising capital for public and private companies. I can outline the relevant methods of selling shares to the general public. I can describe how the listing regime protects investors. I can explain the sanctions available where insider dealing has occurred. Need to revise first Need to study again

If you ticked need to revise first, which sections of the chapter are you going to revise?
Must revise 6.1 6.2 6.3 6.4 Private and public companies Raising money from the public Insider dealing Regulating takeovers Revision done

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Notes

7 Raising capital: debentures

Contents
7.1 7.2 7.3 7.4 7.5 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62 Debentures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63 Company charges . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63 Priority . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 67 Avoidance of floating charges . . . . . . . . . . . . . . . . . . . . . . 68 Reform . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69 Reflect and review . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73

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Introduction
We saw in Chapter 6 that a company raises capital by issuing shares. Another way for companies to raise money is by borrowing. In fact the majority of companies in the UK are private, with an issued share capital of 100 or less. For such companies loan capital is therefore a crucial means of financing their business activities and typically they approach high street banks for loans. Since banks are generally risk-averse, particularly since the onset of the global credit crisis, they will require security for their loans. In this chapter we therefore consider corporate borrowing by way of debentures or debenture stock and the types of charge that companies can issue to lenders as security.

Learning outcomes
By the end of this chapter and the relevant readings, you should be able to:
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explain what is meant by the term debenture describe the nature of fixed and floating charges and the distinction between them explain what is meant by book debts and outline the debate surrounding the issue of granting a fixed charge over them outline the priority of charges and the statutory registration scheme describe and assess the proposals for reform.

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Essential reading

Dignam and Lowry, Chapter 6: Raising capital: debentures. Davies, Chapter 31: Debentures; and Chapter 32: Company charges.

Cases

Re Yorkshire Woolcombers Association [1903] 2 Ch 284 Siebe Gorman & Co Ltd v Barclays Bank Ltd [1979] 2 Lloyds Rep 142 Chalk v Kahn [2000] 2 BCLC 361 Re New Bullas Trading Ltd [1994] 1 BCLC 485 Ashborder BV v Green Gas Power Ltd [2005] BCC 634 Queens Moat Houses plc v Capita IRG Trustees Ltd [2004] EWHC 868 Agnew v Commissioner of Inland Revenue [2001] 2 AC 710, PC National Westminster Bank plc v Spectrum Plus Ltd [2005] UKHL 41.

Additional cases

Arthur D Little Ltd v Ableco Finance LLC [2002] 2 BCLC 799 Smith v Bridgend County Borough Council [2002] 1 BCLC 77.

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7.1 Debentures
Put simply, a debenture is the document that evidences, or acknowledges, the companys debt (Levy v Abercorris Slate and Slab Co (1887) 36 Ch D 215, per Chitty J; see also Knightsbridge Estates Trust v Byrne [1940] AC 613). The definition provided by s.738 CA 2006 is far from helpful: debenture includes debenture stock, bonds and any other securities of a company, whether constituting a charge on the assets of the company or not. Thus a mortgage of freehold property by a company falls within the statutory definition as it is a security and a charge on its assets. A charge or security interest is a right in rem created by a grant or declaration of trust which, if fixed, implies a restriction on the debtors dominion over the asset(s) in question (Goode (2003)). Debenture stock is money borrowed from a number of different lenders on the same terms. Such lenders form a class who usually have their rights set out in a trust deed. The trustee, often a bank, represents their interests as a whole. The trust deed will generally set out the following terms.
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in rem (Latin) meaning the thing as opposed to the person (in personam)

The obligation to pay the principal sum with interest. The security, if any, that is given for the loan. The events that will trigger the enforcing of the security.

7.2 Company charges


Creditors will often require security from a borrower before lending money, so that in the event of a default on repayment the creditor can enforce the security interest. By requiring security from a debtor-company the creditor seeks to ensure priority over the general body of creditors should the company be wound up. The granting of security by a company does not mean that the title to the secured asset passes to the creditor. Instead it creates an encumbrance on the property. The creditor gets a right to have the security made available by an order of the court (National Provincial Bank v Charnley [1924] 1 KB 431, Atkin LJ). For companies, the most common species of charges given as security interests are fixed and floating charges.

7.2.1 Fixed and floating charges


Fixed charges
A company may grant a fixed charge to a creditor over certain property such as a warehouse. Such a charge is similar to a mortgage in that the rights of the creditor (the chargee) attach immediately to the property and the companys (the chargors) power to deal with the asset is restricted. In Agnew v Commissioner of Inland Revenue [2001] 2 AC 710 Lord Millett stated that:
A fixed charge gives the holder of the charge an immediate proprietary interest in the assets subject to the charge which binds all those into whose hands the assets may come with notice of the charge.

Floating charges
As its name suggests, a floating charge floats over the whole or a part (class) of the chargors assets, which may fluctuate as a result of acquisitions and disposals. Corporate property that can be made subject to a floating charge includes stock in trade, plant (ie machinery), and book debts (receivables). The distinguishing feature of a floating charge is that the company can continue to deal with the assets in the ordinary course of business without having to obtain the chargees permission. In Ashborder BV v Green Gas Power Ltd [2005] BCC 634, Etherton J reviewed the characteristics of the floating charge and examined the notion of the chargor being allowed to deal with the charged assets in the ordinary course of business. The judge noted that whether a transaction was within the ordinary course of business is a mixed

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question of fact and law and the viewpoint of the objective observer on the facts is a useful aid. A floating charge converts to a fixed charge over the assets within its scope upon the occurrence of a crystallising event such as a default on repayment or the winding up of the company.

The impact of liquidation


The distinction between a fixed and floating charge assumes critical importance if the company goes into liquidation (see Chapter 16) because of the ranking of chargees against the general body of creditors. In Re Yorkshire Woolcombers Association [1903] 2 Ch 284, Romer LJ listed the following distinguishing features of a floating charge.
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It is a charge on a class of assets of a company present and future. That class is one which, in the ordinary course of the business of the company, would be changing from time to time. By the charge it is contemplated that, until some future step is taken by or on behalf of those interested in the charge, the company may carry on its business in the ordinary way as far as concerns the particular class [charged].

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In determining whether a charge is fixed or floating the courts will look to the substance of the matter irrespective of what description the parties use to categorise it. In this regard Lord Millett explained, in Agnew v Commissioner of Inland Revenue, that:
In deciding whether a charge is a fixed or a floating charge, the Court is engaged in a two-stage process. At the first stage it must construe the instrument of charge and seek to gather the intentions of the parties from the language they have used. But the object at this stage of the process is not to discover whether the parties intended to create a fixed or a floating charge. It is to ascertain the nature of the rights and obligations which the parties intended to grant each other in respect of the charged assets. Once these have been ascertained, the Court can then embark on the second stage of the process, which is one of categorisation. This is a matter of law. It does not depend on the intention of the parties. If their intention, properly gathered from the language of the instrument, is to grant the company rights in respect of the charged assets which are inconsistent with the nature of a fixed charge, then the charge cannot be a fixed charge however they may have chosen to describe it.

Lord Millett noted that Romer LJs third distinguishing feature (see above) is the classic hallmark of a floating charge. More recently, in National Westminster Bank plc v Spectrum Plus Ltd [2005] UKHL 41, Lord Phillips MR explained that:
Initially it was not difficult to distinguish between a fixed and a floating charge. A fixed charge arose where the chargor agreed that he would no longer have the right of free disposal of the assets charged, but that they should stand as security for the discharge of obligations owed to the chargee. A floating charge was normally granted by a company which wished to be free to acquire and dispose of assets in the normal course of its business, but nonetheless to make its assets available as security to the chargee in priority to other creditors should it cease to trade. The hallmark of the floating charge was the agreement that the chargor should be free to dispose of his assets in the normal course of business unless and until the chargee intervened. Up to that moment the charge floated.

In Arthur D Little Ltd v Ableco Finance LLC [2002] 2 BCLC 799 the chargor, Arthur D Little Ltd, guaranteed the liabilities of its two parent companies to Ableco by creating a charge, described as a first fixed charge, over its shareholding in a subsidiary company, CCL. The chargor company retained both its voting and dividend rights with respect to the shares until default. The companys administrator argued that it was a floating charge. It was held, applying Lord Milletts reasoning in Agnew, that whether or not the charge was fixed or floating is a question of law and the particular charge in issue was fixed. It did not float over a body of fluctuating assets and, notwithstanding the companys voting and dividend rights, it could not deal with the asset in the ordinary course of business: the company could not dispose of, or otherwise deal with, the shares. The asset was therefore under the control of the chargee.

Company Law 7 Raising capital: debentures


In Queens Moat Houses plc v Capita IRG Trustees Ltd [2004] EWHC 868, it was held that the existence of a right unilaterally to require a chargee to release property from a charge did not render what is otherwise a fixed charge a floating charge.

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Activity 7.1
What are the principal characteristics of a floating charge and how does it differ from a fixed charge?

Summary
Whereas a fixed charge over an asset attaches immediately, a company has the freedom to continue to deal in the ordinary course of business with assets which are subject to a floating charge.

7.2.2 Book debts


Book debts are debts arising in a business in which it is the proper and usual course to keep books, and which ought to be entered in such books (Official Receiver v Tailby (1886) 17 QBD 88). It is common for a company to have debts continuously owed to it by customers for goods and services that the company has rendered. Rather than wait for payment a company can borrow money from creditors against the debts which remain unpaid. A question that has frequently come before the courts is whether a fixed charge can be created over book debts. Although the issue has now been settled by the Privy Council in Agnew v Commissioner of Inland Revenue [2001] 2 AC 710, PC and, more significantly, by the House of Lords in National Westminster Bank plc v Spectrum Plus Ltd (discussed below), it is worthwhile considering the cases that gave rise to the problem in order to understand the reasoning of the House of Lords in Spectrum. In Siebe Gorman & Co Ltd v Barclays Bank Ltd [1979] 2 Lloyds Rep 142, the company granted a debenture in favour of Barclays Bank. The security was expressed to be a first fixed charge over all of its present and future book debts. The debenture required the company to pay the proceeds of all book debts into its Barclays account and it prohibited the company from charging or assigning its book debts without first obtaining the banks consent. It was held that the companys charge over its receivables was fixed. The judge reasoned that taking the restrictions placed on the companys power to deal with the proceeds of the debts, together with the banks right to prevent the company making withdrawals from the account even when it was in credit, gave the bank a degree of control that was inconsistent with a floating charge. On the other hand, in Chalk v Kahn [2000] 2 BCLC 361 under the terms of the charge, described as a fixed charge, the chargor was required to pay the proceeds into a specified account not held with the chargee bank but with another bank. Since the chargee had no control over the account it was held that the charge was a floating charge. A particularly contentious decision is that reached by the Court of Appeal in Re New Bullas Trading Ltd [1994] 1 BCLC 485, in which it was held that it was possible to create a combined fixed and floating charge over book debts. Here a fixed charge was created over uncollected book debts but as soon as the proceeds of the debts were credited to a specified bank account a floating charge took effect over them. The decision in Re New Bullas attracted much criticism and in Agnew, Lord Millett declared New Bullas to be fundamentally mistaken. In Agnew the debenture was so drafted as to mirror that in New Bullas but the Privy Council held that where the chargor company is free to deal with the charged asset(s) in the ordinary course of business it must be construed as a floating charge. However, where the chargee retains control over the debts and their proceeds so as to severely restrict the companys freedom to deal with them, as in Siebe Gorman, it will be a fixed charge. The notion of a combined charge was rejected by the Privy Council. In National Westminster Bank plc v Spectrum Plus Ltd [2005] UKHL 41, the chargor, Spectrum, granted a fixed (specific) charge to the bank over its book debts to secure an overdraft of 250,000. The debenture stated that the security was a specific charge over all present and future book debts and other debts. It also prohibited Spectrum

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from charging or assigning debts and the company was required to pay the proceeds of collection into an account held with the bank. The debenture did not specify any restrictions on the companys operation of the account. Spectrums account was always overdrawn and the proceeds from its book debts were paid into the account which Spectrum drew on as and when necessary. When Spectrum went into liquidation the bank sought a declaration that the debenture created a fixed charge over the companys book debts and their proceeds. The Crown, however, argued that the debenture merely created a floating charge so that its claims in respect of tax owed by the company took priority over the bank. The trial judge, applying Brumark and declining to follow Bullas, held that, given the charge permitted Spectrum to use the proceeds of the debts in the normal course of business, it must be construed as a floating charge. In so holding the Vice-Chancellor also declined to follow Siebe Gorman. The bank successfully appealed to the Court of Appeal. Lord Phillips MR, delivering the leading judgment (Jonathan Parker and Jacob LJJ concurring), took the view that where a chargor is prohibited from disposing of its receivables before they are collected and is required to pay the proceeds into an account with the chargee bank, the charge is to be construed as fixed. He explained that it was not, as a matter of precedent, open to the Court of Appeal to hold that Bullas was wrongly decided even though the Privy Council had, in Brumark, expressed the view that the decision was mistaken. Further, Siebe Gorman was correctly decided given that the debenture in that case clearly restricted the companys ability to draw on the bank account into which the proceeds of its book debts were paid. The Court of Appeal noted that the form of debenture used in Siebe Gorman had been followed for some 25 years and thus it was inclined to hold that it had, by customary usage, acquired meaning. Lord Phillips observed that in Siebe Gorman:
Slade J could properly have held the charge on book debts created by the debenture to be a fixed charge simply because of the requirements (i) that the book debts should not be disposed of prior to collection and (ii) that, on collection, the proceeds should be paid to the Bank itself. It follows that he was certainly entitled to hold that the debenture, imposing as he found restrictions on the use of the proceeds of book debts, created a fixed charge over book debts.

A seven-member House of Lords, as expected, overturned the decision of the Court of Appeal and overruled Siebe Gorman and Bullas. Following the line of reasoning adopted by the Privy Council in Brumark, it held that although it is possible to create a fixed charge over book debts and their proceeds (Tailby v Official Receiver (1888)), the charge in the present case was a floating charge. Lord Scott delivered the leading judgment. He stressed that the ability of the chargor to continue to deal with the charged assets characterised it as floating. For a fixed charge to be created over book debts, the proceeds must, therefore, be paid into a blocked account (see Re Keenan [1986] BCLC 242). Lord Scott reasoned that:
The banks debenture placed no restrictions on the use that Spectrum could make of the balance on the account available to be drawn by Spectrum. Slade J in [Siebe Gorman] thought that it might make a difference whether the account were in credit or in debit. I must respectfully disagree. The critical question, in my opinion, is whether the charger can draw on the account. If the chargors bank account were in debit and the charger had no right to draw on it, the account would have become, and would remain until the drawing rights were restored, a blocked account. The situation would be as it was in Re Keeton Bros Ltd [above]. But so long as the charger can draw on the account, and whether the account is in credit or debit, the money paid in is not being appropriated to the repayment of the debt owing to the debenture holder but is being made available for drawings on the account by the charger.

Although the House of Lords has jurisdiction in an exceptional case to hold that its decision should not operate retrospectively or should otherwise be limited, it nevertheless held that in this case there was no good reason for postponing the effect of overruling Siebe Gorman.

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Activity 7.2
Read the Privy Councils opinion delivered in Agnew v Commissioner of Inland Revenue [2001] 2 AC 710. What does Agnew tell us about the classification of securities?

7.3 Priority
The general rule is that security interests are prioritised according to the order of their creation. However, as we saw above, a feature of the floating charge is that the company can continue to deal with the charged assets in the ordinary course of business. Therefore a fixed charge can be created which will take priority over an earlier floating charge. In order to protect their priority, floating chargees can insert a so-called negative pledge clause in the charge that prohibits the chargor from creating a charge that ranks equally with (pari passu) or in priority to the earlier floating charge. Such a restriction is not inconsistent with the nature of a floating charge (Re Brightlife Ltd [1987] Ch 200). However it should be noted that the subsequent chargee will not lose priority unless he has actual notice of the negative pledge clause. Mere notice of the earlier floating charge is not sufficient (Wilson v Kelland [1910] 2 Ch 306). Where there are competing floating charges the governing principle is that the earliest created takes priority. However, the parties may agree that the company may create a subsequent floating charge which will take priority or rank pari passu with the earlier floating charge (Re Benjamin Cope & Sons Ltd [1914] 1 Ch 800).

7.3.1 Registration
Understandably, a creditor who is considering lending money to a company may wish to find out the extent of its indebtedness. Companies are therefore required to register certain details of any charges on their assets. Section 860 of the CA 2006 specifies the categories of charge that must be registered. These include, among others:
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a charge for the purpose of securing any issue of debentures a charge on, or on any interest in, land (but not including a charge for any rent or other periodical sum issuing out of the land) a charge on book debts of the company a floating charge on the companys undertaking or property.

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The 21-day registration requirement


Part 25 of the CA 2006 lays down the registration requirements. The principal obligations are contained in ss.860 and 870 which provide that prescribed particulars of certain categories of charges created by a company, together with the instrument creating it, must be delivered to, or received by, the Companies Registrar within 21 days of the creation of the charge. Failure to deliver the particulars to the Registrar within the 21-day period renders the charge void against (see s.874):
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a liquidator any creditor of the company (see Smith v Bridgend County Borough Council [2002] 1 BCLC 77).

Note that the loan is not void for want of registration of the charge, but rather the failure to register results in the lender ranking as an unsecured creditor. If a charge has not been registered, the company and every defaulting officer is liable to a fine (s.860(4)). Once registered, the charge is valid from the date of its creation. This results in what has been termed the 21-day invisibility problem (see the CLRSGs consultation

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document Registration of Company Charges (October 2000), para 3.79). This is because whenever a person checks the register it cannot be assumed that it is comprehensive because there may be a charge for which the 21-day period is still running. Section 876 also requires companies to maintain at its registered office a register containing certain prescribed particulars of all fixed and floating charges. The failure to keep such a register does not affect the validity of the charge. However, an officer of the company who knowingly authorises or permits the omission of a required entry is liable to a fine. When a charge is registered the Registrar must issue a certificate stating the amount secured by the charge. The certificate is conclusive evidence that the statutory registration requirements have been complied with. The charge cannot then be set aside if the particulars are incorrect. See, for example:
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Re Eric Holmes (Property) Ltd [1965] Ch 1052 Re CL Nye Ltd [1971] Ch 442.

Registration is a perfection requirement. It does not determine priority which, as we saw above, depends upon the date the charge was created. Creditors who ought reasonably to have searched the register will be deemed to have constructive notice of the charge (Siebe Gorman, above). Rectification of the register may be possible where the court is satisfied that the failure to register within the required period or that an omission or misstatement of any particular was accidental or inadvertent, or is not of a nature to prejudice creditors or shareholders of the company, or that on other grounds it is just and equitable to grant relief (s.873). Generally, leave to register out of time is granted by the courts subject to the rights of intervening secured creditors and provided the company is solvent (see, for example, Re IC Johnson & Co Ltd [1902] 2 Ch 101).

7.4 Avoidance of floating charges


Section 245 of the Insolvency Act 1986 invalidates a floating charge created within 12 months (termed the relevant time) prior to the onset of insolvency unless it was created in consideration for money paid, or goods or services supplied, at the same time as or subsequent to the creation of the charge. The relevant time is extended to two years where the charge is created in favour of a connected person. However, s.245(4) provides that a floating charge created in favour of a non-connected person within the relevant time (i.e. 12 months) will not be invalidated if the company was able to pay its debts at the time the charge was created and did not become unable to do so as a result of creating the charge. It should be noted that this provision does not extend to charges created in favour of connected persons. The term connected person is defined by s.249 as a director or shadow director of the company; an associate of a director or shadow director of the company; and an associate of the company. The object of s.245 is to prevent an unsecured creditor obtaining a floating charge to secure his or her existing loan at the expense of other unsecured creditors.

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7.5 Reform
7.5.1 The registration process
The CLRSG concluded that registration would no longer be a mere perfection requirement but would become a priority point. Under this proposal, which is based upon Article 9 of the United States Uniform Commercial Code, all that is filed is a notice (financing statement) giving particulars of the property over which the filer has taken, or intends to take, security and certain other details, including the name and address of the creditor from whom a person searching the register can obtain further information (the October 2000 Consultation Document, para 2.6). The 21-day registration rule would be abandoned, as would the requirement that the charge instrument be presented with the application for registration. Detailed rules are set out which would form the basis for a system under which the priority of registered charges would be determined by their dates of registration at Companies House. The period between creation and registration would therefore cease to be relevant as there would be no period of invisibility; and so registration ceases to be a perfection requirement but becomes a priority point (see the Consultation Document, para 2.8, Rule 2). The CLRSG also returned to the issue of the conclusive certificate. The Consultation Document questions whether the Registrar should be placed in the position of verifying the content of information registered. An earlier study of security interests had commented that the burden of compliance with the registration requirements should fall upon the presenters of the documentation because they were better placed to determine whether what they deliver satisfies the legislative requirements and any liability for inaccuracy in the record should lie with them (A Review of Security Interests in Property (HMSO, 1989), the Diamond Report). Accordingly, the Registrars certificate should be conclusive only as far as it is practicable for it to be so. To achieve this objective several options are explored, the most radical of which is to dispense with the requirement that the document creating the charge should be delivered to the Registrar. In its place, the requirement could be that the company only submits particulars of the charge which would include the date of its creation. Companies House would simply verify that the required particulars had been filed on time. The presenters would be fully responsible for the information appearing on the public record.

7.5.2 The scope of registration


Finally, other significant proposals include those for widening the range of the categories of charges to be registered. It is argued that the concept of book debts could be broadened by dropping the reference to book and retaining the concept of debt thereby encompassing a wider category of money obligation. All charges on insurance policies would be made registrable irrespective of whether or not other contingent debts should be registrable. Further, in order to enhance the value of floating charges it is proposed that the parties should be permitted to register negative pledge clauses if they so wish. This would provide for constructive notice of the pledge either from the date the charge was created or from the date of its registration. The consultation period for the Steering Groups proposals closed on 5 January 2001. However, in its Final Report the Steering Group stated that insufficient time had been given to consult on its proposals and it therefore invited the DTI (now BIS) to consult with the Lord Chancellors Department with the object of referring the matter to the Law Commission.

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On 2 July 2002 the Law Commission published a consultation paper, Registration of Security Interests: Company Charges and Property other than Land (No 164) (LCCP). The LCCP states that a registration scheme should perform two functions, namely to:
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provide information to persons who are contemplating extending secured lending, credit rating agencies and potential investors about the extent to which assets that may appear to be owned by the company are in fact subject to security interests in favour of other parties; and determine the priority of securities (para 12 LCCP).

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The LCCP, endorsing the views of the CLRSG, therefore provisionally proposes the introduction of an electronic notice-filing system based on the US model (see above) to replace the current registration scheme for company charges. Further, the new scheme would extend to a seller who takes purchase-money security over the particular asset purchased with the finance provided. Such a seller would have priority over all other creditors. Failing to register a financing statement will result in loss of priority over a charge that is subsequently registered. It is also proposed that a security that has not been registered will be invalid against a liquidator and an administrator. It is recommended that notice filing should be extended to cover certain quasi-security interests (i.e. transactions that secure payment or performance of an obligation). Hirepurchase agreements, conditional sales and retention of title clauses would thereby become registrable (LCCP paras 12.8012.81). In August 2004 the Law Commission followed up its earlier work with the publication of a consultative report (CR), Company Security Interests. The Commission continue to recommend notice filing on the basis that its proposals provide significant improvements and cost-savings in secured finance for companies. The use of technology can make the registration of company charges much easier, cheaper and quicker (Law Commission, Press Release, 16 August 2004). To replace the paper-based registration scheme which has been in existence for over 100 years, it is stressed that notice filing could be carried out by a secured party online. The CR sets out a range of advantages that notice filing has. These include its speed and efficiency, the fact that advance filing is permissible so that a lenders priority could be protected while negotiations continue (the proposed system is based on the principle that the first to file has priority), and that the floating charge would, in practice, disappear and be superseded by a single type of security interest having all of the advantages of a floating charge but fewer disadvantages to the lender. Notice filing has not, however, escaped criticism. It has been pointed out that the proposed scheme could lead to misleading information being on file. For example, a lender searching the register has no way of determining whether a particular registration relates to an actual transaction or to a proposed transaction that may have been aborted because negotiations broke down. Further, fewer details are available than is the case under transaction filing (Calnan, 2004). The Law Commission counters this argument with the observation that the current system requires only two additional items; the amount secured by the charge and the date it was created... (para 2.47 CR). It says that the statement of the amount secured is of little use since, unless the charge is for a fixed amount, it is most unlikely to be accurate by the time anyone searches the register. With respect to the date of creation, the CR notes that providing such a date is not possible in a system that has the advantage of allowing filing before the charge has been agreed or has attached (para 2.47). In August 2005 the Law Commission published its final report, Company Security Interests. Its principal proposals include the following.
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A new system of electronic notice filing for registering charges. Removal of the 21-day time limit thus removing the invisibility period (see clearer priority rules below). Extending the list of registrable charges so that all charges are registrable unless specifically exempted. The principal exemptions will be for some charges over registered land and over financial collateral.

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Clearer priority rules. Priority between competing charges will be by date of filing unless otherwise agreed between the parties involved (this will also remove the current 21-day period of invisibility). The distinction between fixed and floating charges will be preserved. For floating charges it will no longer be necessary to rely on a negative pledge clause to prevent subsequent charges gaining priority. It will also be unnecessary to rely on automatic crystallisation clauses. If a charge over registered land is registered in the Land Registry, it will not need to be registered in the Company Security Register. Instead, the Land Registry will automatically forward to Companies House its information about companies charges. Sales of receivables will be brought within the scheme (e.g. factoring and discounting agreements, currently a factor, will only obtain priority if it gives notice to each account debtor). The rules on charges over investment securities and other forms of financial collateral are to be clarified. The report also contains draft Company Security Regulations 2006 prepared by the Law Commission for adoption by the DTI (now BIS) under powers contained in the Companies Act 2006.

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Activity 7.3
Explain the so-called 21-day invisibility problem. What proposals for reform have been put forward to address the problem?

Useful further reading

Beale, H. Reform of the law of security interests over personal property in Lowry, J. and L. Mistelis (eds) Commercial law: perspectives and practice. (London: LexisNexis Butterworths, 2006) [ISBN 1405710071]. Ferran, E. Principles of Corporate Finance Law (Oxford: Oxford University Press, 2008) [ISBN 9780199230518]. Capper, D. Fixed charges over book debts back to basics but how far back?, [2002] LMCLQ 246. Ferran, E. Floating charges the nature of the security, [1988] CLJ 213. Goode, R.M. Charges over book debts: a missed opportunity, [1994] LQR 592. Goode R.M. Legal problems of credit and security. (London: Sweet and Maxwell, 2003) [ISBN 0421471506]. Chapter 1. Berg, A. Brumark Investments Ltd and the innominate charge,[2001] JBL 532. de Lacy, J. Reflections on the ambit and reform of Part 12 of the Companies Act 1985 and the Doctrine of Constructive Notice in de Lacy, J. (ed.) The Reform of UK Company Law. (London: Cavendish, 2002) [ISBN 1859416934]. Gregory and Walton Book debt charges the saga goes on, [1999] LQR 14. McCormack, G. Extension of time for registration of company charges, [1986] JBL 282. Sealy, L.S. and S. Worthington Cases and materials in company law. (Oxford: Oxford University Press, 2008) eighth edition [ISBN 9780199298426]. Chapter 8. Worthington, S. Fixed charges over book debts and other receivables, [1997] LQR 562. Worthington, S. Floating charges an alternative theory, [1994] CLJ 81. Worthington, S. An unsatisfactory area of the law fixed and floating charges yet again, [2004] International Corporate Rescue 175.

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Sample examination question


Bill and Bob are the directors of Bank Finances plc (the company) which is a longestablished merchant bank that trades globally. In order to finance margin calls required by their Singapore office they agreed on 1 January 2003 to create a floating charge over the companys entire undertaking (in England) in favour of Ratfink Bank Ltd in return for a loan of 1,000,000,000 (1 billion). The floating charge contained a clause providing that it would crystallise in the event of any default or enforcement proceedings being taken against the company. This charge was registered on 21 January 2003. On 14 January 2003 the company refurbished its head office in London. In order to finance the interior design project Bill and Bob withheld money due to the Government in the form of VAT and PAYE and also obtained a loan from Beckleys Bank for 1,000,000. This loan was secured over the book debts of the company. The charge was registered on 17 January 2003. On 15 February, John demanded payment for the office furniture that his firm had supplied to the company. Following advice from the companys finance director the board secured the amount outstanding to John by a fixed charge over the companys factory. The finance director also advised the board that the company is in a position whereby it is unlikely to pay all its creditors and this financial situation is unlikely to be resolved. The company continued to trade until November 2003 when it went into liquidation. Advise the liquidator.

Advice on answering this question


You will need to begin by describing the features of fixed and floating charges. The question also requires you to explain: i. the rules governing priority between such charges ii. the position of such charges as against preferential and unsecured creditors iii. automatic crystallisation of floating charges iv. avoidance of floating charges under the 1986 Insolvency Act, s.245. Ratfink charge: expressed as a fixed charge but is this conclusive of the issue? See Re Yorkshire Woolcombers Association and Agnew v Commission of Inland Revenue. Is the charge properly registered? Beckleys charge: it is secured on book debts but what type of charge is it? See Siebe Gorman & Co Ltd v Barclays Bank Ltd and Agnew v Inland Revenue Commissioners. You should also consider the priority issue between Ratfink and Beckley. John: is it a fixed charge? You will need to discuss the priority issues between fixed and floating charges. Section 245 of the Insolvency Act 1986 should be considered can the liquidator avoid the floating charges? Finally, mention should be made of preferential creditors and the effect of the Insolvency Act 2006.

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Reflect and review


Look through the points listed below. Are you ready to move on to the next chapter? Ready to move on = I am satisfied that I have sufficient understanding of the principles outlined in this chapter to enable me to go on to the next chapter. Need to revise first = There are one or two areas I am unsure about and need to revise before I go on to the next chapter. Need to study again = I found many or all of the principles outlined in this chapter very difficult and need to go over them again before I move on.
Ready to move on I can explain what is meant by the term debenture. I can describe the nature of fixed and floating charges and the distinction between them. I can explain what is meant by book debts and outline the debate surrounding the issue of granting a fixed charge over them. I can outline the priority of charges and the statutory registration scheme. I can describe and assess the proposals for reform. Need to revise first Need to study again

If you ticked need to revise first, which sections of the chapter are you going to revise?
Must revise 7.1 7.2 7.3 7.4 7.5 Debentures Company charges Priority Avoidance of floating charges Reform Revision done

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Notes

8 Capital

Contents
8.1 8.2 8.3 8.4 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 76 Overview the maintenance of capital doctrine . . . . . . . . . . . . . 77 Raising capital: shares may not be issued at a discount . . . . . . . . . . 77 Returning funds to shareholders . . . . . . . . . . . . . . . . . . . . . 78 Prohibition on public companies assisting in the acquisition of their own shares . . . . . . . . . . . . . . . . . . . . . . . . . . . . 83 Reflect and review . . . . . . . . . . . . . . . . . . . . . . . . . . . . 87

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Introduction
In this chapter we consider a range of broadly related issues concerning the capital of a company. The underlying theme is the doctrine of maintenance of capital. This is directed towards ensuring that shareholders pay the price for their shares in money or moneys worth and that the companys capital is not illegally returned to them.

Learning outcomes
By the end of this chapter and the relevant readings, you should be able to:
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explain the objectives of the doctrine of maintenance of capital state the rule proscribing shares being issued at a discount describe the rules relating to dividend payments describe the procedure for reducing capital explain the regime governing financial assistance for the purchase of shares.

Essential reading

Dignam and Lowry, Chapter 7: Share capital. Davies, Chapter 11: Legal Capital and Minimum Capital; Chapter 12: Dividends and Distributions and Chapter 13: Capital Maintenance.

Cases

Bairstow v Queens Moat Houses plc [2001] 2 BCLC 531 Re Exchange Banking Co, Flitcrofts Case (1882) 21 ChD 519 Re Halt Garage (1964) Ltd [1982] 3 All ER 1016 Aveling Barford Ltd v Perion Ltd [1989] BCLC 626 Re Chatterley-Whitfield Collieries Ltd [1948] 2 All ER 593 Brady v Brady [1989] AC 755 Chaston v SWP Group plc [2003] 1 BCLC 675 Parlett v Guppys (Bridport) Ltd [1996] 2 BCLC 34 MT Realisations Ltd v Digital Equipment Co Ltd [2003] EWCA Civ 494 Dyment v Boyden [2005] 1 WLR 792; Carney v Herbert [1985] AC 301.

Additional cases

Guinness v Land Corporation of Ireland (1883) 22 ChD 349 Precision Dippings Ltd v Precision Dippings Marketing Ltd [1986] Ch 447.

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8.1 Overview the maintenance of capital doctrine


The legal rules governing maintenance of share capital are a mixture of legal and accounting principles that are aimed at ensuring that the companys capital is not dissipated on activities beyond its objects (Guinness v Land Corporation of Ireland (1883) 22 ChD 349). While a companys capital may be spent in carrying out its legitimate business activities no part of it can be returned to a member so as to subtract from the fund from which creditors are to be paid. Shareholders also benefit from the doctrine because the objective of the capital maintenance regime is to ensure that their investment is used only for the objects stated in the companys constitution (assuming the constitution restricts its objects; see Chapter 13, below). It should be noted that a companys share capital is not kept in a ring-fenced bank account to be drawn upon only in the event of winding up, in order to meet the claims of creditors. Rather, it is a book-keeping entry which serves as the basis for measures of profitability such as return on capital employed (ROCE). Before any returns (e.g. dividends) are paid to shareholders the accounts must show that the value of the companys assets exceeds the value of its share capital. As indicated above, the law is directed towards preventing illegal returns of capital to shareholders and there are numerous ways in which shareholders may receive legitimate returns on their investment: for example, by way of a dividend payment (see below). We now turn to consider the maintenance regime. It should be noted that the law distinguishes between private and public companies. It should also be borne in mind that, when reading the case law decided under the CA 1985 and its predecessors, the law was notoriously complex. In this respect, it should be noted that in accordance with the policy objectives of the company law review, the 2006 reforms are directed towards removing requirements that are unnecessary and burdensome for private companies.

8.2 Raising capital: shares may not be issued at a discount


The rule in Ooregum Gold Mining Company v Roper [1892] AC 125, which is now codified in s.552 of the CA 2006, is that shares may not be issued at a discount to their nominal value. Accordingly, a shareholder must pay the full nominal value of the shares he or she holds. But the rule does not require that the share is paid for in full when it is issued because payment may be deferred. Thus, there can be paid-up and unpaid-up capital where the shareholder remains liable to contribute the balance outstanding (i.e. the difference between the amount actually paid and the nominal value). From the outsiders perspective, the consequence of the rule is that he or she can be sure that the company has received (or has enforceable claims for) at least the sum total of its issued share capital. The consideration paid for a share does not have to be in money and so goods or services may be the price paid. In Re Wragg Ltd [1897] 1 Ch 796 the court held that the judgment of the directors which was made in good faith that the benefit received in return for the shares was equal in value to their nominal value was not open to challenge. Because of the scope this gives for abuse, public companies must satisfy strict statutory requirements where the consideration for shares is other than money (the decision in Re Wragg only applies to private companies). For example, for public companies s.593 CA 2006 requires an independent valuation of any non-cash consideration. Failure to comply with this provision renders the allottee/holder and any subsequent holder liable to pay again in cash together with interest (see ss.588 and 593(3) CA 2006). Thus, the allottee/holder could end up paying twice for the shares. The policy here is directed towards preventing public companies from issuing shares at a discount. The 2005 consultative document states that the requirement of authorised share capital is to be removed on the basis that it is invariably set at a level higher than the company will need and so it serves no useful practice. This is achieved by Part 17 of the CA 2006 which abolishes the concept of authorised share capital but retains the concept of nominal value. Thus, s.542(1) requires companies to issue shares with a

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fixed nominal value. The requirement for public companies to have a minimum share capital (50,000 or euro equivalent, currently fixed at 65,000) is retained by the 2006 Act (see ss.761 and 763).

Activity 8.1
Read Re Wragg Ltd [1897] 1 Ch 796. What approach did the Court of Appeal take towards the price a company may pay for property?

8.3 Returning funds to shareholders


8.3.1 Dividends
Part 23 of the CA 2006 codifies the common law by requiring that dividends may only be paid out of distributable profits (see, in particular, s.830). Thus, dividends may only be paid out of accumulated profits and not if the effect would be to reduce the companys net assets below the value of its share capital. A dividend paid in breach of this rule is unlawful and ultra vires. A director who knew (or ought to have known) that the payment amounted to a breach is liable to repay the dividends (see Bairstow v Queens Moat Houses plc [2001] 2 BCLC 531; and Re Exchange Banking Co, Flitcrofts Case (1882) 21 ChD 519). In Bairstow v Queens Moat Houses plc, the directors, who acted on the companys 1991 accounts that incorrectly showed inflated profits, paid dividends that exceeded the available distributable reserves. The Court of Appeal held that their liability was not limited to the difference between the unlawful dividends and the dividends that could have been lawfully paid. Directors owe fiduciary duties to the company and therefore have trustee-like responsibilities arising out of their duty to manage the company in the interests of all its members. They were therefore ordered to pay the company over 78 million. A shareholder who, with knowledge of the facts, receives an improper dividend payment will be held liable to repay it as a constructive trustee (Precision Dippings Ltd v Precision Dippings Marketing Ltd [1986] Ch 447; see also, IRC v Richmond [2003] EWHC 999). In Its a Wrap (UK) Ltd v Gula [2005] EWHC 2015, the liquidator sought repayment of dividends paid to the defendants who were the sole shareholders and directors of the company. During a two-year period in which there were no profits available for distribution, the companys accounts showed that dividends had nevertheless been paid to the defendants. When the company went into insolvent liquidation, the liquidator claimed that the dividends had been paid in contravention of s.263(1) CA 1985 (now s.830(1) CA 2006) and were therefore recoverable under s.277 CA 1985 (now s.847 CA 2006). The defendants argued that the sums in question were paid to them as remuneration and only appeared in the accounts as dividends because they had been advised that this was tax efficient. The court dismissed the liquidators claim. On the evidence it was clear that the defendants had sought to gain a proper tax advantage and had not deliberately set out to contravene the Act. The words is so made contained in s.277(1) (now s.847(2)) required that the defendants knew or had reasonable grounds to believe not just the facts giving rise to the contravention but also the legal result of the contravention. Not surprisingly, the Court of Appeal reversed the judges decision and held that the defendants ignorance of the law was no defence. Arden LJ stated that s.277 (now s.847) had to be interpreted in a manner consistent with Art. 16 of the Second Company Law Harmonisation Directive which it is designed to implement. On this particular issue she concluded that:
Section 277 [now s.847] must be intrepreted as meaning that the shareholder cannot claim that he is not liable to return a distribution because he did not know of the restrictions in the Act on the making of distributions. He will be liable if he knew or ought reasonably to have known of the facts which mean that the distribution contravened the requirements of the Act.

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8.3.2 Other examples of illegal returns of capital


Disguised gifts out of capital
In Re Halt Garage (1964) Ltd [1982] 3 All ER 1016, the court held that where the directors of a company are also shareholders their remuneration might be viewed as a disguised gift out of capital. In this case the director who had received remuneration (the wife of the majority shareholder) had not actually provided any services for several years due to ill health and the company had gone into insolvent liquidation. Oliver J held that only 10 out of the 30 per week that had been paid to her while she was ill was genuine remuneration. She was therefore liable to repay the balance. In Aveling Barford Ltd v Perion Ltd [1989] BCLC 626, Aveling Barford Ltd (AB Ltd) and Perion Ltd (P Ltd) were owned and controlled by Mr Lee. Aveling Barford Ltd, while not technically insolvent, did not have any distributable reserves. It did, however, own a sports ground for which planning permission for residential redevelopment had been granted. In October 1986 its directors decided to sell the sports ground, valued at 650,000, to Perion Ltd for 350,000. The sale was completed in February 1987. In August 1987 Perion Ltd resold it for 1.52 million. When Aveling Barford Ltd went into liquidation, the liquidator successfully sued to have Perion Ltd declared a constructive trustee of the proceeds of sale on the ground that the transaction was an unauthorised return of capital by Aveling Barford Ltd to Lee, its sole shareholder, via Perion Ltd. The decision in Aveling Barford has proved controversial because of its impact on companies in a group who want to transfer assets to each other. In Completing The Structure (November 2000) the CLRSG concluded that Part VIII of the Companies Act 1985 should be changed to enable intra-group transfer of assets to proceed in a more straightforward way. This has been implemented by ss.845-846 CA 2006.

8.3.3 Reduction of share capital


The CA 2006 contains a range of deregulatory measures that target the requirements contained in the CA 1985 that were considered unnecessary and burdensome for private companies. However, with respect to public companies, the provisions generally restate the pre-existing regime (see ss.642644 CA 2006). Under CA 2006 companies no longer need authority in the articles of association which permit a reduction of capital, although they are able to restrict or prohibit the power if they wish (s.641(6)). Section 641(1) states the general rule that a private limited company may reduce its capital by special resolution supported by a solvency statement; but that any limited company may reduce its capital by special resolution if confirmed by the court. In other words, a private company is not compelled to follow the new simplified procedure but can opt instead to go through the rather convoluted and expensive step of obtaining the courts confirmation, as was required under the 1985 Act and which is preserved for public companies.

Private companies: reduction of capital supported by a solvency statement


The simplified procedure for private companies to reduce their capital is detailed in ss.642644 CA 2006. The solvency statement, as required for private companies under s.641, must be made by all of the directors not more than 15 days before the date on which the special resolution is passed (s.642(1)). If one or more of the directors is not able or is not willing to make the statement, the company will not be able to use the solvency statement procedure to effect a reduction of capital unless the dissenting director or directors resign (in which case the solvency statement must be made by all of the remaining directors). Where the special resolution is passed as a written resolution, a copy of the directors solvency statement must be sent or submitted to every eligible member at or before the time at which the proposed resolution is sent or submitted to them (s.642(2)). If the resolution is passed at a general meeting, a copy of the solvency statement must be made available for inspection by members throughout the meeting (s.642(3)). However, the validity of the resolution is not affected by a failure to comply with these requirements (s.642(4)).

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Section 643 provides that the solvency statement must state that each of the directors has formed the opinion, taking into account all of the companys liabilities (including any contingent or prospective liabilities), that: a. as regards the companys situation at the date of the statement, there is no ground on which the company could then be found to be unable to pay its debts; and b. if it intended to commence the winding up of the company within 12 months of that date, the company will be able to pay its debts in full within 12 months of the winding up or, in any other case, the company will be able to pay its debts as they fall due during the year immediately following that date. Section 644 lays down the filing requirements in respect of a reduction of capital. Within 15 days after the special resolution is passed, the company must file with the Registrar a copy of the solvency statement together with a statement of capital and a statement of compliance. The special resolution itself must also be filed in accordance with s.30 CA 2006. The resolution does not take effect until these documents are registered (s.644(4)). If the directors make a solvency statement without having reasonable grounds for the opinions expressed in it, and that statement is subsequently delivered to the Registrar, every director who is in default commits an offence (see s.643(4); the penalties, which may include imprisonment, are set out in s.643(5)).

Public companies: reduction of capital confirmed by the court


As we have seen, public companies are required to have the special resolution for the reduction of capital confirmed by the court. The policy here is that the interests of creditors are safeguarded. Sections 645 and 646 CA 2006 (which restate s.136 of the 1985 Act) specify the procedure for making such an application for an order confirming the reduction, including the creditors right to object. The court will settle a list of creditors with a view to ensuring that each one of them has consented to the reduction. If a creditor does not consent the court may, in its discretion, dispense with that creditors consent where the company secures the debt or claim (s.646(4)). If, on such an application, an officer of the company intentionally or recklessly conceals a creditor or misrepresents the nature or amount of a debt owed by the company, or is knowingly concerned in any such concealment or misrepresentation, he or she commits an offence (s.647). The court may make an order confirming the reduction of capital on such terms and conditions as it thinks fit (s.648(1)). However, it will not confirm the reduction unless it is satisfied, with respect to every creditor of the company entitled to object, that either his consent to the reduction has been obtained, or his debt or claim has been discharged or secured (s.648(2)). The reduction will take effect on registration of the court order confirming the reduction (and statement of capital) by the Registrar (s.649(5)). Where there is a reduction of capital, certain shares will be cancelled or reduced in nominal value. Here the main issue the court has to consider, when deciding whether or not to exercise its discretion to approve the reduction, is whether the proposal strikes a fair balance between the interests of the different classes of shareholders. It has long been established that the rule most likely to achieve fairness is that money should be repaid in the order in which the classes of shares would rank, as regards repayment of capital, on a winding up. However if the proposed reduction varies or abrogates class rights it may be possible to disapply this prima facie approach. In Re Chatterley-Whitfield Collieries Ltd [1948] 2 All ER 593 the companys coal-mining business had been nationalised and it proposed to carry on operations on a reduced scale for which it would need less capital. It therefore decided to reduce its capital by paying off preference capital but keeping its ordinary shareholders. The court confirmed the reduction as fair because it was carried out in accordance with the rights of the two classes of shareholders in a winding up (see also Re Saltdean Estate Co Ltd [1968] 1 WLR 1844). If the reduction of a public companys capital has the effect of bringing the nominal value of its allotted share capital below the authorised minimum, the Registrar must not register the court order confirming the reduction unless either the court so

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directs, or the company is first re-registered as a private company (s.650). Section 651 provides for an expedited procedure for re-registration as a private company.

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8.3.4 Redemption or purchase by a company of its shares


Court approval for a reduction of capital can be avoided where the reduction is achieved through a redemption or purchase by a company of its own shares. The common law prohibited a company acquiring its own shares because of the risk to creditors (Trevor v Whitworth (1887) 12 App Case 409). This is given statutory effect by s.658(1) CA 2006. However, s.684 expressly allows a limited company to issue shares that are to be redeemed at the option of the company or the shareholder. A public company, however, must be authorised by its articles to issue redeemable shares (s.684(3)). For private companies no such authorisation is required, although their articles may exclude or restrict the issuing of redeemable shares (s.684(2)). Section 690(1) confers on limited companies the power to purchase their own shares, although this is subject to any restriction or prohibition in the articles of association. The difference between a redemption and a purchase of shares in this context is that for a redemption, the shares will have been issued on the basis that they are redeemable and so the holders will have been aware of the terms of the redemption from the outset. For a purchase of shares, the parties will need to agree the terms of the repurchase at the time the company seeks to exercise the power. The scope of the general prohibition contained in s.658(1) was considered in Acatos and Hutcheson plc v Watson [1994] BCC 446. It was held that it was not unlawful for a company to purchase another company whose only asset was a significant shareholding (nearly 30 per cent) in the purchasing company. This was so even though it would have been unlawful for the purchasing company to buy its own shares directly. Lightman J observed that to hold otherwise would permit target companies to protect themselves against a takeover bid by the simple device of buying shares in the purchasing company. He described this result as being absurd. As a result of the need for companies, particularly private companies, to have greater flexibility over their capital structure, the rule in Trevor v Whitworth has, as mentioned above, been relaxed.

Effecting a redemption of shares


For both public and private companies, the directors may determine the terms, conditions and manner of the redemption if so authorised by the articles of association or by a resolution of the company (s.685(1)). An ordinary resolution is required even though its effect is to amend the articles (s.685(2)). Shares may not be redeemed unless they are fully paid and the terms of the redemption may provide that the amount payable on redemption may, by agreement between the company and the shareholder concerned, be paid on a date later than the redemption date (s.686(1) and (2)). Where the directors are authorised to determine the terms, conditions and manner of redemption, they must do so before the shares are allotted and such details must be specified in any statement of capital which the company is required to file (s.685(3)). When a company redeems any redeemable shares it must give notice to the Registrar within one month, specifying the shares redeemed together with a statement of capital which details the companys shares immediately following the redemption (s.689). If default is made in complying with the notice requirements, an offence is committed by the company and every officer of the company who is in default (s.689(4)).

Effecting a purchase by a company of its own shares


As noted above, s.690(1) authorises a limited company to purchase its own shares, including any redeemable shares, subject to any restriction or prohibition in the

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companys articles. Further, a company may not purchase its own shares if as a result there would no longer be any issued shares other than redeemable shares (s.690(2)). Only fully paid shares can be purchased and they must be paid for on purchase ((s.691); payment by instalments is not, therefore, permissible (see Pena v Dale [2004] EWHC 1065 (Ch)). A company cannot subscribe for its own shares but is restricted to purchasing them from existing members (see Re VGM Holdings Ltd [1942] Ch 235). With respect to financing the purchase, a public company must use distributable profits or the proceeds of a fresh share issue made for the purpose of financing the purchase (s.692(2)). However, a private company may, as under the CA 1985, purchase its own shares out of capital (s.692(1) and s.709). As mentioned above, the main difference introduced by the 2006 Act for a private company is that the power to purchase its own shares need no longer be contained in the articles. The articles may, however, restrict or prohibit the exercise of this statutory power. Where a private company purchases its own shares out of capital, the directors are required to make a statement specifying the amount of the permissible capital payment for the shares in question. Section 714 provides that this statement must also confirm that the directors have made a full enquiry into the affairs and prospects of the company and that they have formed the opinion: a. as regards the companys situation immediately after the date on which the payment out of capital is made, there will be no grounds on which the company could then be found unable to pay its debts; and b. as regards the companys prospects for the year immediately following that date, the company will be able to continue to carry on business as a going concern and be able to pay its debts as they fall due in the year immediately following the date on which the payment out of capital is made. In forming their opinion on the companys solvency and prospects, the directors must take into account all of the companys liabilities (including contingent and prospective liabilities). Directors who make this statement without reasonable grounds for their opinion commit an offence (s.715). As an additional safeguard, s.714(6) provides that the directors statement must have annexed to it a report by the companys auditor confirming its accuracy. Further, the payment out of capital must be approved by a special resolution of the company which must be passed on the date of the directors statement or within the week immediately following (s.716). The holders of the shares in question are barred from voting on the resolution (s.717). Within the week immediately following the date of the s.716 resolution, the company must give public notice in the London Gazette (the official newspaper of record for the UK) and in an appropriate national newspaper of the proposed payment. This must also state that any creditor may apply to court under s.721 within five weeks of the resolution for an order preventing the payment (s.719). Following the purchase, the company must give notice to the Registrar. Such notice must include a statement of capital (s.708). In certain circumstances a company which purchases its own shares need not cancel them but can, instead, hold them in treasury from where they can be either sold or transferred, for example to an employee share scheme. This relaxation, which took effect on 1 December 2003, was introduced by the Companies (Acquisition of Own Shares) (Treasury Shares) Regulations 2003 (SI 2003/1116). The regulations inserted ss.162A 162G into the 1985 Act which are re-enacted in ss.724-732 CA 2006. For qualifying shares, as defined in s.724(2), to become treasury shares they must be purchased by the company out of distributable profits. There are a number of restrictions on the rights attaching to treasury shares. For example, s.726(2) states that the company may not exercise any right in respect of treasury shares. Any purported exercise of such a right is void. Further, no dividend or other distribution may be paid to the company (s.726(3)).

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8.4 Prohibition on public companies assisting in the acquisition of their own shares
8.4.1 Financial assistance
A company might wish to provide financial assistance for the purchase of its own shares by, for example, giving a gift to a third party on the understanding that the money would be used to buy the donor companys shares or, for instance, through guaranteeing a potential purchasers borrowing. This is prohibited by the Companies Act 2006. The policy underlying the prohibition is explained by Arden LJ in Chaston v SWP Group plc [2003] 1 BCLC 675:
[It] is derived from section 45 of the Companies Act 1929 which was enacted as a result of the previously common practice of purchasing the shares of a company having a substantial cash balance or easily realisable assets and so arranging matters that the purchase money was lent by the company to the purchaser The general mischief remains the same, namely that the resources of the target company and its subsidiaries should not be used directly or indirectly to assist the purchaser financially to make the acquisition. This may prejudice the interests of the creditors of the target or its group, and the interests of any shareholders who do not accept the offer to acquire their shares or to whom the offer is not made.

A loan does not deplete a companys net assets because, although funds leave the company, their loss is matched in the companys accounts by the debt to the company that is thereby created. Thus, the prohibition on financial assistance in the Act is wider than that which would be required if the only policy in operation was to maintain the companys share capital. As stressed by Arden LJ (above), it recognises the need to protect shareholders and outsiders from the company misusing its assets to finance the purchase of its own shares, even if the capital maintenance doctrine is not thereby infringed (see also the comments of Peter Smith J in Anglo Petroleum Ltd v TFB (Mortgages) Ltd [2006] EWHC 258 (Ch)).

8.4.2 The statutory provisions prohibiting financial assistance


The prohibition against public companies providing financial assistance is laid down by s.678(1) of the 2006 Act which provides:
Where a person is acquiring or proposing to acquire shares in a public company, it is not lawful for that company, or a company that is a subsidiary of that company, to give financial assistance directly or indirectly for the purpose of the acquisition before or at the same time as the acquisition takes place [emphasis supplied].

(Prior to the CA 2006 the prohibition also extended to private companies: see s.151 CA 1985.) It is noteworthy that s.678(1) makes no reference to proof of improper intention. Breach is therefore determined objectively from the surrounding circumstances. Section 678(3) broadens the prohibition so as to cover situations where assistance is provided by a private company in order to discharge a liability incurred by a purchaser for the purpose of acquiring shares, but which, at the time the post-acquisition assistance is given, has re-registered as a public company. Section 678(1) is supplemented by s.679(1), which extends the prohibition to cover financial assistance (directly or indirectly) provided by a public company which is a subsidiary of a private company for the purpose of acquiring shares in that private company before or at the same time as the acquisition takes place. Section 679(3) extends the prohibition to cover after the event financial assistance given by a public company to its private holding company. Section 677 (together with s.683(1) and (2)) seeks to limit the scope of the meaning of financial assistance by listing certain forms or ways in which it can arise. Examples include:

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the giving of a guarantee, security or indemnity, other than an indemnity in respect of the indemnifiers own neglect or default, or by way of release or waiver, or by way of loan.

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The giving of a security is illustrated by Heald v OConnor [1971] 1 WLR 497. Mr and Mrs Heald sold all of the shares in D.E. Heald (Stoke on Trent) Ltd to OConnor. The price was 35,000 but they lent him 25,000 in order to enable him to complete the purchase. The company thereby granted the vendors a floating charge over all of its assets by way of security for the loan. Thus, if OConnor defaulted, the security would be enforceable against the company. This was held to be illegal. A residual category falls within s.677(1)(d) which proscribes any other financial assistance given by a company where the net assets of the company are reduced to a material extent by the giving of the assistance, or the company has no net assets. Therefore, even if a public company were in a position to return funds to shareholders because it had distributable profits, it would not be able to provide any sort of financial assistance for the acquisition of its own shares which materially depleted its net assets. In this regard, s.677(2) and (3) state that in determining the companys net assets it is the actual value of the assets and liabilities, as opposed to their book value, that is to be applied (see Parlett v Guppys (Bridport) Ltd (1996); Grant v Lapid Developments Ltd [1996] 2 BCLC 24).

The exceptions
Section 681 contains a wide list of unconditional exceptions. Those in s.681(2) are unexceptional. They mainly relate to procedures which are specifically authorised elsewhere in the Act: for example, to effect a redemption of shares or a reduction of capital. So-called conditional exceptions are listed in s.682. They therefore only apply if the company has net assets and either: a. those assets are not reduced by the giving of the financial assistance, or b. to the extent that those assets are so reduced, the assistance is provided out of distributable profits. An example of a conditional exception is where the provision of financial assistance by the company is for the purposes of an employee share scheme, provided it is made in good faith in the interests of the company or its holding company (s.682(2)(b)), or which assists in the promotion of a policy objective such as facilitating the acquisition of the shares by an employees share scheme or by spouses or civil partners, widows, widowers or surviving civil partners or children of employees (see s 682(2)(c)). Section 678(2) and (3), however, also contain the principal purpose and incidental part of a larger purpose defences which are carried over from the 1985 Act. In essence, financial assistance is not prohibited:
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if the principal purpose of the assistance is not to give it for the purpose of an acquisition of shares, or where this assistance is incidental to some other larger purpose of the company and, in either case, where the financial assistance is given in good faith in the interests of the company.

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The exceptions are designed to ensure that the prohibition in s.678(1) does not also catch genuine commercial transactions which are in the interests of the company. However, attempting to assess a persons purpose is necessarily difficult (for instance, the need to distinguish purpose from effect) because the court will need to determine whether the giving of assistance for the purpose of an acquisition of shares is an incidental part of some larger purpose. Something is a purpose of a transaction between A and B if it is understood by both of them that it will enable B to bring about the desired result. The difficulties of assessing purpose came to the fore in Brady v Brady [1989] AC 755.

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In Brady v Brady [1989] AC 755 the scheme involved a companys business being divided between two brothers, Jack and Bob Brady, who were the controlling shareholders. They were not on speaking terms and the deadlock between them threatened the survival of the company and its subsidiaries. It was decided that Jack should take the haulage business and Bob the soft drinks business. However, the haulage business was worth more than the soft drinks business and so to make the division fair and equal, extra assets had to be transferred from the haulage business to the drinks business. This involved the principal company, Brady, transferring assets to a new company controlled by Bob. It was conceded that s.151 (now s.678) had been breached because the transfer involved Brady providing financial assistance towards discharging the liability of its holding company, M, for the price of shares which M had purchased in Brady. When Jack sought specific performance of the agreement, Bob, who by now had decided against the arrangement, contended that it was an illegal transaction. Jack argued, however, that the financial assistance was an incidental part of a larger purpose of the company (i.e. the removal of deadlock between the two brothers which had threatened to result in the liquidation of the business). The House of Lords held that the purpose of the transaction was to assist in financing the acquisition of the shares: the essence of the reorganisation was for Jack to acquire Brady Ltds shares and therefore the acquisition of those shares was not incidental to the reorganisation. Lord Oliver concluded that the acquisition was not a mere incident of the scheme devised to break the deadlock. It was the essence of the scheme itself and the object which the scheme set out to achieve. This approach means that in looking for some larger overall corporate purpose, it is necessary to distinguish purpose from the reason why a purpose is formed. The commercial advantages flowing from providing the financial assistance for the acquisition of the shares may be the reason for providing it but the commercial advantages are a by-product of providing the assistance they are not an independent purpose to which the financial assistance can be considered incidental. The approach of the House of Lords in Brady towards the interpretation of the purpose exceptions has been criticised on the basis that it unduly restricts the width of the defences (see s.678, above), and, indeed, it makes it very hard to ascertain exactly what sort of situations would fall within these exceptions. Ascertaining whether or not the prohibition has been breached is a fact-intensive exercise and the case law provides little guidance in predicting an outcome. In MT Realisations Ltd v Digital Equipment Co Ltd [2003] EWCA Civ 494, Mummery LJ stressed that:
each case is a matter of applying the commercial concepts expressed in non-technical language to the particular facts. The authorities provide useful illustrations of the variety of fact situations in which the issue can arise; but it is rare to find an authority which requires a particular result to be reached on different facts.

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The facts of Dyment v Boyden [2005] 1 WLR 792 (CA) provide an interesting illustration of how an allegation of financial assistance can arise. The Court of Appeal had to consider whether rent which was significantly greater than the market value of the premises in question constituted a breach of s.678 (s.151 of the 1985 Act). Because of local authority rules the transfer of shares had to be undertaken in order that the respondents no longer retained an interest in the company. The Court of Appeal held that the trial judge was right in finding that the companys entry into the lease was in connection with the acquisition by the appellant of the shares but was not for the purpose of that acquisition. His finding that the entry into the lease was for the purpose of acquiring the premises rather than the shares was a finding of fact with which the Court of Appeal should not interfere.

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Section 680 CA 2006 makes breach of the prohibition a criminal offence with the company being liable to a fine and every officer of it who is in default liable to imprisonment or a fine or both. The effect of this is to make the transaction unlawful which can affect the enforceability of the underlying agreement. In Carney v Herbert [1985] AC 301, the Privy Council had to decide if the vendors of shares in A Ltd could sue the purchaser (or the guarantor thereof) for the purchase price when a subsidiary of A Ltd had provided illegal financial assistance in relation to the purchasers acquisition (by charging land owned by it as security for the purchasers promise to pay for the shares). If the agreement could not have been severed, the purchaser would have been able to keep the shares without any payment being made for them. Lord Brightman, delivering the decision of the Privy Council, stated:
as a general rule, where parties enter into a lawful contract of, for example, sale and purchase, and there is an ancillary provision which is illegal but exists for the exclusive benefit of the plaintiff, the court may and probably will, if the justice of the case so requires, and there is no public policy objection, permit the plaintiff, if he so wishes, to enforce the contract without the illegal provision.

The Privy Council therefore severed the illegal charges and allowed the vendors to sue for the purchase price.

Activity 8.2
Read Brady v Brady [1989] AC 755, [1988] 2 All ER 617. Write a short essay of not more than 300 words explaining how Lord Oliver defined the concept of larger purpose.

Summary
For financial assistance to be unlawful under s.678 CA 2006 the companys net assets must be reduced to a material extent (Parlett v Guppys (Bridport) Ltd [1996] 2 BCLC 34).

Sample examination question


To what extent, if at all, is the law on financial assistance destructive of genuine transactions? Is there any rational policy running through the legislation or case law? How could the law in this area be improved?

Advice on answering this question


This is a wide-ranging question and your answer will require careful planning if you are to cover its scope in the time allowed. The principal points you should address are the following.
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An examination of the policy concerns underlying the capital maintenance doctrine. The prohibition in s.678 CA 2006 against providing financial assistance for the acquisition of shares. You should describe what amounts to financial assistance. Note pre and post acquisition assistance. The policy underlying s.678 (see Chaston v SWP Group plc). The principal purpose exception. Analyse Brady v Brady with particular reference to Lord Olivers speech.

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Reflect and review


Look through the points listed below. Are you ready to move on to the next chapter? Ready to move on = I am satisfied that I have sufficient understanding of the principles outlined in this chapter to enable me to go on to the next chapter. Need to revise first = There are one or two areas I am unsure about and need to revise before I go on to the next chapter. Need to study again = I found many or all of the principles outlined in this chapter very difficult and need to go over them again before I move on.
Ready to move on I can explain the objectives of the doctrine of maintenance of capital. I can state the rule proscribing shares being issued at a discount. I can describe the rules relating to dividend payments. I can describe the procedure for reducing capital. I can explain the regime governing financial assistance for the purchase of shares. Need to revise first Need to study again

If you ticked need to revise first, which sections of the chapter are you going to revise?
Must revise 8.1 8.2 8.3 8.4 Overview the maintenance of capital doctrine Raising capital: shares may not be issued at a discount Returning funds to shareholders Prohibition on public companies assisting in the acquisition of their own shares Revision done

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Notes

9 Dealing with insiders: the articles of association and shareholders agreements

Contents
9.1 9.2 9.3 9.4 9.5 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90 The operation of the articles of association . . . . . . . . . . . . . . . . 91 The articles of association . . . . . . . . . . . . . . . . . . . . . . . . 91 The contract of membership . . . . . . . . . . . . . . . . . . . . . . . 93 Shareholders agreements . . . . . . . . . . . . . . . . . . . . . . . . 96 Altering the articles . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96 Reflect and review . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99

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Introduction
In Chapter 2 we briefly touched upon the constitution of the company. In this chapter we continue our examination of the companys constitutional structure with a particular focus on how corporate power is allocated internally between the general meeting and the board of directors (these bodies are often called the organs of the company).

Learning outcomes
By the end of this chapter and the relevant readings, you should be able to:
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explain the function of the articles of association describe the problems that arise with enforcing the contract of membership explain why shareholder agreements have become increasingly common describe the mechanisms for altering the articles and any restrictions on alteration.

Essential reading

Dignam and Lowry, Chapter 8: The constitution of the company: dealing with insiders. Davies, Chapter 3: Sources of company law and the companys constitution.

Cases

Salmon v Quin & Axtens Ltd [1909] 1 Ch 311 Rayfield v Hands [1960] Ch 1 Foss v Harbottle [1843] 2 Hare 461 Eley v Positive Government Security Life Assurance Co [1876] 1 Ex D 20 Punt v Symons & Co Ltd [1903] 2 Ch 506 Russell v Northern Bank Development Corporation [1992] BCLC 431 Re Duomatic [1969] 2 Ch 365 Allen v Gold Reefs Co Of West Africa [1900] 1 Ch 656 Clements v Clements Bros Ltd [1976] 2 All ER 268.

Additional cases

MacDougall v Gardiner [1875] 1 Ch D 13 Pender v Lushington [1877] 6 Ch D 70 Hickman v Kent or Romney Marsh Sheep-Breeders Association [1915] 1 Ch 881 Puddephatt v Leith [1916] 1 Ch 200 Menier v Hoopers Telegraph Works [1874] LR 9 Ch D 350 Greenhalgh v Arderne Cinemas Ltd [1951] Ch 286 Brown v British Abrasive Wheel Co Ltd [1919] 1 Ch 290 Dafen Tinplate Co. Ltd v Llannelly Steel [1920] 2 Ch 124 Globalink Telecommunications Ltd v Wilmbury Ltd [2003] 1 BCLC 145.

Company Law 9 Dealing with insiders: the articles of association and shareholders agreements

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9.1 The operation of the articles of association


The articles of association are the internal rules of the company. They contain the central governance arrangements for the interaction of the:
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shareholders company board.

On incorporation the founders of a company can provide their own set of articles. If they do not, a set of model articles (historically called Table A) is provided by the Companies (Model Articles) Regulations 2008. The model articles, with some amendments, are usually adopted. Because of this, the model articles effectively provide the key legislative model for the running of the company. While companies often have very complex organisational structures, the allocation of power in the model articles between the general meeting and the board of directors is at the core of every corporate structure. It is this allocation of power that is the central function of the articles of association. As a result, even though the model articles are only a default set of rules, their almost universal adoption has meant that they form the core organisational structure of the UK registered company:
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the board of directors (the management organ) the general meeting (the members organ).

The model articles also allocate the powers of each organ. The following are the most important provisions in the articles.

9.2 The articles of association


9.2.1 The model articles
While previous Companies Acts have provided a single set of articles for private and public companies, under the CA 2006, as a response to criticism of this one size fits all approach, public and private companies now have separate articles of association. For example, with regard to the general meeting, the model articles provided by the CA 2006 regulates the organisation of meetings (article 3842 private, article 28-33 public) and voting at the meeting (article 43-48 private, article 34-40 public). Similarly the model articles provide, with regard to the board of directors, for the allocation of management power to the board (article 3-6 private and public), directors appointment (article 17-20 private, article 20- 24 public) and decision making by directors (article 7-16 private, article 7-19 public). It is important to note here that the articles do not provide for the general removal of directors except in the case of incapacity or resignation (articles 18 private and 22 public). Direct removal is covered by s.168 CA 2006, which gives members the right by simple majority (a vote for the resolution of more than 50 per cent of those who vote) to remove a director for any reason whatsoever.

Key management powers


Historically the most important allocation of power in the articles was contained in Article 70 of the old table A. Article 70 provided that:
[s]ubject to the provisions of the [CA 1985], the memorandum and the articles and to any directions given by special resolution, the business of the company shall be managed by the directors who may exercise all the powers of the company.

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This is now contained in articles 3 and 4 of the model articles (public and private) and states:
Directors general authority 3. Subject to the articles, the directors are responsible for the management of the companys business, for which purpose they may exercise all the powers of the company.

Shareholders reserve power 4. (1) The shareholders may, by special resolution, direct the directors to take, or refrain from taking, specified action. (2) No such special resolution invalidates anything which the directors have done before the passing of the resolution.

As a result, the board is empowered to run the company, subject to:


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certain qualifications (i.e. the memorandum) and specifically the objects of the company and any other articles restricting directors powers special resolutions, directions from the shareholders and the Companies Act.

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Although the power to run the company is subject to qualifications, it is important to note that the board is the primary power-wielding organ of the company. In Howard Smith Ltd v Ampol Petroleum Ltd (1974) Lord Wilberforce summed up the position:
[t]he constitution of a limited company normally provides for directors, with powers of management, and shareholders, with defined voting powers having power to appoint the directors, and to take, in general meeting, by majority vote, decisions on matters not reserved for management... it is established that directors, within their management powers, may take decisions against the wishes of the majority of shareholders, and indeed that the majority of shareholders cannot control them in the exercise of these powers while they remain in office.

It is common, for example, to restrict the boards ability to borrow up to a certain amount without shareholder approval

The power delegated to the board derives from the total power the company actually has, thus the power they wield is always limited by the objects clause. It is also worth noting that the discretion is, of course, tempered by the very practical fact that s.168 CA 2006 allows the majority of the members to remove the board. Thus the board cannot stray too far from the shareholders wishes if they are to keep their jobs. The board is also given, by virtue of articles 30 (private) and 70 (public), the power to decide whether to distribute any surplus profits to the shareholders in the form of dividends. Although technically the general meeting declares the dividend it cannot do so unless the board recommends a dividend. This may not seem like a significant power but it is a very important independent management power exercised by the board. The shareholders cannot therefore get any income from their shareholding unless the directors allow it.

Key shareholder powers


While s.336 CA 2006 does mean that private companies are no longer required to hold an annual general meeting, it is important to note that the meeting is, in theory, designed to fulfill an important supervisory function for public companies. The general meeting is in effect the residual power organ which meets once a year (s.336 CA 2006) to exercise its continued supervision over the board (article 3). Significantly, the general meeting has certain other powers. For example its most important power is the power to elect and remove directors (article 20 (public) gives both the shareholders and the board the power to elect directors but the CA 2006, s 168 provides that only shareholders may remove directors). It may also issue shares (article 43 (public), although this is commonly altered to give the board that power). Section 437 CA 2006 requires that the annual accounts and reports be put before the annual general meeting of a public company (there is however no requirement for a vote on these reports but it is common practice for larger companies to require a vote). The Directors Remuneration Report Regulations 2002 (SI 2002/1986 and

Company Law 9 Dealing with insiders: the articles of association and shareholders agreements
s.420 CA 2006) also require that each directors pay package be put to the general meeting for a vote. The general meeting is also empowered by s.21 CA 2006 to alter the articles if three-quarters of the members (by a special resolution,) vote in favour of the resolution. Thus in effect the members can alter the internal rules by which the companys power is allocated.

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9.2.2 General reform


The CLRSG addressed two key issues with regard to the operation of the articles of association. First they found that the general meeting was a burden on small companies and recommended doing away with the need for a general meeting for private companies unless the company wished to have one (Final Report, July 2001, Chapter 2). The CLRSG also recommended that public companies could dispense with annual general meetings if all the shareholders agree (Final Report, para 7.6). This has been implemented for private companies but public companies, as we noted above, are still required to hold an annual general meeting (s.336 CA 2006.). For most public companies the general meeting, in theory, fulfils an important accountability function. In reality, however, large shareholders dont tend to vote, leading to accountability problems. The CLRSG recommended that institutional investors who hold the vast majority of shares (insurance companies, pension funds and investment trusts) should disclose their voting record at general meetings to increase accountability and transparency (Final Report, Chapter 6 paras 6.226.40). The White Paper (2002, Vol I, paras 2.62.48) adopted all the procedural recommendations of the CLRSG regarding the general meeting except the recommendation to force institutional investors to disclose their votes (para 2.47) and the CA 2006 does not contain a provision requiring compulsory disclosure.

Activity 9.1
a. What is the function of the articles of association? (No feedback provided.) b. Get a copy of the model articles and read through it. Try to identify what it is that each article is trying to achieve.

Summary
The articles of association form a core part of company law as they allocate corporate power between the management and the shareholder organs. It is an area where the reform driver of think small first has been particularly successful.

9.3 The contract of membership


The shareholders and the company are said to have a contract with each other. This consists of the constitution of the company (the memorandum and articles). At the heart of this contract is s.33(1) CA 2006, which states:
The provisions of a companys constitution bind the company and its members to the same extent as if there were covenants on the part of the company and of each member to observe those provisions.

This rather odd statutory contract was introduced in the nineteenth century to automatically bind the shareholders and the company together to observe the constitution of the company (see Hickman v Kent or Romney Marsh Sheep-Breeders Association (1915) 1 Ch 881). It is an odd contract, as it can be varied without the consent of all the parties to it by special resolution. It also binds future members. It does, however, have a key advantage far beyond just the observation of the constitution. When new members join the company by buying shares, the constitution will automatically bind them to observe the pre-existing constitution.

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As such, it removes the possibility of re-negotiating the rules every time a new shareholder arrives. This facilitates the development of the share market as the shares are more transferable where they come with a fixed set of rights. However, as we will discover below, unlike a normal contract the operation of the s.33 contract is surrounded by a great deal of uncertainty.

9.3.1 A contract inter se?


One of the first questions the courts were asked to deal with was whether the s.33 contract and its predecessors bound the shareholders to each other (inter se). If so, a shareholder could enforce the contract directly against another shareholder. This would mean that enforcing articles was more straightforward. If not, only the company can do so and that would be a more complex matter, involving approval from the board or general meeting for such an action. This is an important issue for minority shareholders as the majority shareholders might not wish to enforce the articles. Unfortunately the answer to this question is unclear as there is conflicting case law on the point. For example, in Salmon v Quin & Axtens Ltd [1909] 1 Ch 311, Farwell LJ found that the contract was unenforceable between members. On the other hand, in Rayfield v Hands [1960] Ch 1, Vaisey J considered that there was a contract inter se which was directly enforceable by one member against another. The CLRSG in their Final Report (para 2.26) recommend clarifying the issue by allowing all rights in the constitution to be enforced against the company and the other members unless the constitution provided otherwise. However this has not been followed through in the Companies Act 2006 (see 9.3.4 below).

9.3.2 Who can sue?


Continuing the complexity of the issue of enforcement of the s.33 contract is the question of who can sue to enforce the contract. Can a member of the company enforce the contract against the company? The answer to the question seems to depend on whether the breach complained of is a wrong to the company or a wrong to the individual. As we will see in Chapter 11 this concerns a central aspect of company law majority rule. As a general rule individual shareholders are not empowered to initiate proceedings for a wrong to the company. This is known as the rule in Foss v Harbottle (1843) 2 Hare 461. Only the company through its organs the board or the general meeting can sue on such a wrong (see Chapter 11 for a detailed analysis of majority rule). So if the article that has been breached is classified as a corporate right then only the company can enforce it. However, a shareholder may be able to enforce the contract against the company directly if the article in question constitutes a personal right. Lord Wedderburn (1957) suggests that the following have been considered personal rights in the past.
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Voting rights. Share transfer rights. A right to protect class rights. Pre-emption rights. The right to be registered as a shareholder. The right to obtain a share certificate. The right to enforce a dividend that has been declared. The right to enforce the procedure for declaring the dividend. The right to have directors appointed in accordance with the articles. Other procedural rights such as notices of meetings.

Company Law 9 Dealing with insiders: the articles of association and shareholders agreements
While this offers a good overview of the characteristics of personal rights in the articles the case law on the matter is still somewhat confused (see the contrasting views in MacDougall v Gardiner (1875) 1 Ch D 13 and Pender v Lushington (1877) 6 Ch D 70).

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9.3.3 Outsider rights


To add to the confusion surrounding the enforcement of the s.33 contract is the question of whether everything contained in the articles falls within the s.33 contract. Companies have sometimes added what are called outsider rights to the articles. These are rights that have nothing to do with the membership of the company but may cover a wide range of other issues. For example, in Eley v Positive Government Security Life Assurance Co (1876) 1 Ex D 20 the articles contained a clause which ensured that a particular member of the company was appointed as the companys solicitor. The member was not appointed as the companys solicitor and sued for breach of contract. The court found that he could not rely on breach of that clause in the articles as the cause of his action as there was no contractual relationship between the member as solicitor and the company. However, again here the courts have been somewhat contradictory. In Salmon v Quin & Axtens Ltd [1909] 1 Ch 311 the articles of association provided that the consent of both managing directors was needed for certain decisions. Mr Salmon was a managing director and member of the company and he dissented from a decision to buy and let some property. The general meeting then passed a resolution authorising the purchase and letting of the property. Mr Salmon sued as a member to enforce the article requiring his consent as managing director to the transactions. In coming to their decision the House of Lords accepted a general personal right of members to sue to enforce the articles by allowing a member to obtain an injunction to stop the completion of the transactions entered into in breach of the articles. Here the matter was viewed by the judges in terms of enforcing a member right which tangentially affected his right as a director, rather than a director right which has a tangential effect on the membership. (For a more recent example see Globalink Telecommunications Ltd v Wilmbury Ltd [2003] 1 BCLC 145).

9.3.4 Reform
The CLRSGs Final Report (July 2001 paras 7.347.40) recommended clarifying the s.14 issues by allowing all the articles to be enforceable by the members against the company and each other unless the contrary was provided. The courts would also be able to strike out trivial actions. These same recommendations are present in the Governments Consultative Document March 2005 (para 5.1). However, strangely, the CA 2006 simply reworded the old problematic s.14 of the CA 1985. Thus after nearly a decade of examining the failings in the area the Government seems content to ignore the CLRSG and its own White Papers to leave the issues in this area unresolved.

Activity 9.2
Why is the enforcement of the s.33 contract so complex?

Summary
The s.33 contract fulfils a useful function. It ensures that all the members (even future ones) and the company are bound to observe the constitution. It is an unusual contract in that:
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it binds future parties who cannot renegotiate it it can be continually altered by special resolution.

As a result, not all the parties to the contract have to agree to the alteration yet will be bound by the new terms. However it is the enforcement of the statutory contract that has exercised much judicial and academic thought. Can it be enforced by a member against another member? Can a member enforce it against the company? Are all the articles, even outsider articles, enforceable? Unfortunately the Companies Act 2006 leaves these questions unresolved.

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9.4 Shareholders agreements


Given the confusion surrounding the enforcement of the s.33 contract it is unsurprising that shareholders began to take things into their own hands by forming shareholders agreements. Shareholders agreements are agreements between shareholders themselves (that is all the shareholders or just between some of them) or between the company and the shareholders (all of them or just some of them). The agreement usually concerns the exercise of the shareholders rights in certain given situations. For example, to only allow an increase in the authorised share capital of the company if all the parties to the shareholders agreement agree, or to exercise votes at the general meeting in a particular way. The key advantage of a shareholders agreement is that it is easily enforceable against another party to the agreement (see Puddephatt v Leith [1916] 1 Ch 200). In small- to medium-sized companies it is also common to add the company to the agreement for security. Companies may, however, be limited in what they can agree to do. For example in Punt v Symons & Co Ltd [1903] 2 Ch 506 the court held that a company could not contract out of the right to alter its articles. This means in effect that a provision of a shareholders agreement which binds the company not to alter its articles will not be enforceable. However here we find somewhat contradictory case law once again. In Russell v Northern Bank Development Corporation [1992] BCLC 431 the House of Lords considered a shareholders agreement where the company agreed not to increase the share capital of the company without the agreement of all the parties to the shareholders agreement. The company did attempt to increase the share capital of the company and one of the shareholders who was a party to the shareholders agreement objected and attempted to enforce the agreement. The statutory conflict here was between the agreement and s.121 CA 1985, which allowed companies to increase their share capital if their articles contain an authority (note s.617 CA 2006 has amended this provision so authority is now unnecessary). The article of the company did provide such an authorisation. The House of Lords found that the companys agreement not to increase its share capital was contrary to s.121 and, therefore, unenforceable. However, the court did not declare the whole shareholders agreement invalid just the companys agreement not to increase the share capital. This meant that the shareholder who objected could not enforce it against the company but could enforce it against the other members. As all the members of the company were party to the shareholders agreement this has the same effect as if the company was bound. The shareholders could not vote to increase the share capital.

9.5 Altering the articles


One of the odd features of statutory contract in s.33 is that the contract can be varied by the members by special resolution (s.21 CA 2006). Sometimes the courts have allowed more informal methods of change to occur. In Re Duomatic [1969] 2 Ch 365 the court allowed a decision not made at the general meeting, but which clearly had the backing of all the shareholders, to stand. However, there are restrictions on the shareholders ability to alter the articles. As we have observed above, the alterations to the articles must not conflict with any statutory provisions. Further, the members must exercise their power to alter the articles in good faith. This power to alter the articles has been famously expressed by Lindley MR in Allen v Gold Reefs Co of West Africa [1900] 1 Ch 656 as being:
exercised subject to those general principles of law and equity which are applicable to all powers conferred on majorities enabling them to bind minorities. It must be exercised, not only in the manner required by law, but also bona fide for the benefit of the company as a whole, and it must not be exceeded. These conditions are always implied, and are seldom, if ever, expressed.

Company Law 9 Dealing with insiders: the articles of association and shareholders agreements
The exercise of a members votes generally may also be subject to a bona fides qualification. In Clements v Clements Bros Ltd [1976] 2 All ER 268 Foster J declined to recognise the ability of a majority shareholder to authorise an allotment of shares, the motive behind the share allotment being to dilute the voting power of the minority shareholder plaintiff. Foster J considered that the majority shareholder was not entitled to exercise her vote in any way she pleases. He based his decision on what he termed equitable considerations and thus the mala fides (bad faith) element of the allotment precluded it from ratification (see also Menier v Hoopers Telegraph Works (1874) LR 9 Ch D 350 and Greenhalgh v Arderne Cinemas Ltd [1951] Ch 286). However, in general the courts are extremely reluctant to overturn a decision of the general meeting on the grounds of a lack of bona fides, doing so in only a small number of cases (see Brown v British Abrasive Wheel Co Ltd [1919] 1 Ch 290 and Dafen Tinplate Co Ltd v Llannelli Steel [1920] 2 Ch 124).

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Activity 9.3
a. What are the main advantages and disadvantages of a shareholders agreement? b. Are there any restrictions on a shareholders ability to exercise his votes as he wishes?

Summary
As a result of the uncertainty surrounding the s.33 contract, shareholders have formed contractually binding agreements which the courts have been willing to enforce. The only real complication with these agreements is where the company is a party to the agreement and some or all of the agreement is contrary to a statutory provision. In such a case the company cannot contract out of its statutory obligation. Alteration of the companys constitution normally occurs by special resolution. However, sometimes the courts have allowed more informal processes to stand. There may also be restrictions on the ability of shareholders to vote if a statutory obligation is affected or a minority shareholder is disadvantaged.

Useful further reading

Wedderburn, K.W. Shareholders rights and the rule in Foss v Harbottle, [1957] CLJ 194. Ferran, E. The decision of the House of Lords in Russell v Northern Bank Development Corporation Limited, [1994] CLJ 343. Prentice, G.N. The enforcement of outsider rights, [1980] 1 Co Law 179. Gregory, R. The section 20 contract, [1981] 44 MLR 526. Drury, R.R. The relative nature of a shareholders right to enforce the company contract, [1986] CLJ 219. Goldberg, G.D. The enforcement of outsider rights under section 20 (1) of the Companies Act 1948, [1972] MLR 362. Goldberg, G.D. The controversy on the section 20 contract revisited, [1985] MLR 158.

Sample examination question


Roy, John and Sarah are the directors of Abbot Ltd, a company that manufactures horseshoes. They also each hold one-third of the shares in the company. The articles of association are the model articles for private companies amended by the following clause: All decisions of the board are by majority vote except for votes on transactions with a value greater than 50,000. In such a case a decision is only valid if all the directors consent to the transaction.

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Roy, John, Sarah and the company are also the only parties to a shareholders agreement in which all the parties agree not to increase the share capital of the company without the agreement of all the parties to the shareholders agreement. Roy has recently returned from holiday and found that during his absence there had been a board meeting which approved the purchase of a large tract of land for development purposes worth 100,000. The board also proposes funding the purchase by increasing the share capital of the company. Roy is very unhappy about these developments and wishes to stop them. Advise him about his options.

Advice on answering this question


Discuss the enforcement of the articles first, comparing our facts with Salmon v Quin & Axtens Ltd [1909] 1 Ch 311 and the other contradictory case law. There are lots of commentaries on this issue in your further reading so its a good idea to include some of these views. On the shareholder agreement issue again here discuss the facts in the question in comparison with Russell v Northern Bank Development Corporation [1992] BCLC 431 and the other contradictory case law.

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Reflect and review


Look through the points listed below. Are you ready to move on to the next chapter? Ready to move on = I am satisfied that I have sufficient understanding of the principles outlined in this chapter to enable me to go on to the next chapter. Need to revise first = There are one or two areas I am unsure about and need to revise before I go on to the next chapter. Need to study again = I found many or all of the principles outlined in this chapter very difficult and need to go over them again before I move on.
Ready to move on I can explain the function of the articles of association. I can describe the problems that arise with enforcing the contract of membership. I can explain why shareholder agreements have become increasingly common. I can describe the mechanisms for altering the articles and any restrictions on alteration.. Need to revise first Need to study again

If you ticked need to revise first, which sections of the chapter are you going to revise?
Must revise 9.1 9.2 9.3 9.4 9.5 The memorandum The articles of association The contract of membership Shareholders agreements Altering the articles Revision done

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Notes

10 Class rights

Contents
10.1 10.2 10.3 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Shares and class rights . . . . . . . . . . . . . . . . . . . . . . . . . 102 103

Classes of shares . . . . . . . . . . . . . . . . . . . . . . . . . . . . 104 Variation of class rights . . . . . . . . . . . . . . . . . . . . . . . . . 105 Reflect and review . . . . . . . . . . . . . . . . . . . . . . . . . . . 108

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Introduction
In this chapter we consider the nature of a share and the interest that a shareholder has in the company. We go on to examine how the capital of a company may be divided into various classes carrying with them different rights for their holders. Finally, we consider how the company may vary the rights attaching to a class of shares.

Learning outcomes
By the end of this chapter and the relevant readings, you should be able to:
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explain the legal nature of a share describe the various classes of shares describe how class rights attaching to shares are determined outline the procedure for varying class rights.

Essential reading

Dignam and Lowry, Chapter 9: Classes of shares and variation of class rights. Davies, Chapter 19: Controlling members voting, pp.663-674 and Chapter 23, The nature and classification of shares.

Cases

Borlands Trustee v Steel Bros & Co Ltd [1901] 1 Ch 279 Scottish Insurance Corp Ltd v Wilson and Clyde Coal Co Ltd [1949] 1 All ER 1068 Cumbrian Newspapers Group Ltd v Cumberland and Westmoreland Herald Newspapers and Printing Co Ltd [1987] Ch 1 White v Bristol Aeroplane Co Ltd [1953] Ch 65 Greenhalgh v Arderne Cinemas Ltd [1946] 1 All ER 512.

Additional cases

Re National Telephone Co [1914] 1 Ch 755 Macaura v Northern Assurance Co Ltd [1925] AC 619.

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10.1 Shares and class rights


In small quasi-partnership type private companies (see Chapter 12) a small number of shares may be issued to the partners/directors in order to give them complete control over the enterprise. Such companies usually look to the banks to finance the business operations of the company by means of loan capital (see Chapter 7). In large companies, however, shares are generally issued as a major source of capital. It is because shareholders bear the ultimate risk should the economic fortunes of the company fail that residual control over management is vested in them (see Chapter 14). It was recognised in Andrews v Gas Meter Co [1897] 1 Ch 361 that a company may issue shares with different rights attaching to them. Such class rights (for example, the preferential dividend rights attaching to preference shares) are largely a matter of contract between the member and the company and, as we will see below, a company seeking to vary such rights must go through a statutory procedure.

10.1.2 The nature of a share


A share is both a contract between the shareholder and the company (see Chapter 9) and a right of property, somewhat unhelpfully termed a chose in action, which can be bought, sold and charged. The classic definition of a share was delivered by Farwell J in Borlands Trustee v Steel Bros & Co Ltd [1901] 1 Ch 279:
A share is the interest of a shareholder in the company measured by a sum of money, for the purpose of liability in the first place, and of interest in the second, but also consisting of a series of mutual covenants entered into by all the shareholders inter se in accordance with [section 14 CA 1984, now s.33 CA 2006]. The contract contained in the articles of association is one of the original incidents of the share. A share is not a sum of money but an interest measured by a sum of money and made up of various rights contained in the contract, including the right to a sum of money of a more or less amount.

We saw in Chapter 3 that shareholders do not have an interest in the property belonging to the company (see Macaura v Northern Assurance Co Ltd [1925] AC 619); rather their relationship is with the company as a separate and distinct entity in its own right. A shareholder thus has rights in the company not against it as in the case of debenture holders (see Chapter 7). In Short v Treasury Commissioners [1948] 1 KB 116 (affirmed by the House of Lords [1948] AC 534) the legal nature of a share was subjected to considerable examination by the court in relation to its valuation. The Government purchased all of the shares in the company, valuing them on the basis of the quoted share price. The shareholders argued that because the whole of the issued shares were being acquired then the entire undertaking should be valued and the price apportioned between them. It was held, however, that where a purchaser is buying control but none of the sellers holds a controlling interest, the higher price that control demands can be ignored. The Treasury was therefore able to purchase the company for a price considerably less than its asset value.

See further, Sealy, L.S. and Worthington, S., Cases and Materials in Company Law. (Oxford: Oxford University Press, 2008) 8th edition [ISBN 9780199298426] pp.42648).

Activity 10.1
Explain the nature of a share.

Summary
An important feature of a share is that it represents the yardstick for measuring the members interest in the company. For example, it determines the voting rights of the holder at general meetings and the right to participate in surplus capital in the event of the company being wound up. Finally, a share is a species of property (a chose in action) that can be purchased, sold, bequeathed and mortgaged.

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10.2 Classes of shares


As seen above, broadly speaking it can be said that a shareholder has rights and liabilities that arise from the general nature of a share. There is a presumption of equality between shareholders so that they are deemed to enjoy equal voting and dividend rights, when the company is a going concern, and equal rights to participate in any surplus assets should the company be wound up. This presumption of equality will be rebutted where a company issues shares that carry different class rights. For example, the holders of preference shares generally enjoy preferential dividend rights and priority in the return of capital in a winding up. Generally, the articles of association give the company the power to issue shares with such rights or restrictions as the company may by ordinary resolution determine. The different classes of shares commonly issued are ordinary, preference, redeemable and employees shares.

10.2.1 Ordinary shares


The basic class will be ordinary shares (often termed equities), which is the default category. Ordinary shareholders participate in any dividends after payment has been made to preference shareholders. Ordinary shareholders also participate in any surplus should the company be wound up, after preference shareholders have had their capital returned. The holders of ordinary shares control the general meeting on the basis of one vote per share.

10.2.2 Preference shares


Holders of preference shares have certain preferential rights attached to their shares. A fixed preferential cumulative dividend will be paid to them in any year in which the company has distributable profits. The cumulative element means that arrears become payable in respect of those years in which a dividend was not declared. It is presumed that preference shares are cumulative (Webb v Earle (1875) LR 20 Eq 556). Where preference shares are participating as to dividend, they have the right to a further dividend payment after the ordinary shareholders have received a distribution equivalent to their initial fixed rate. Preference shareholders are also generally entitled to a return of capital on a winding up in priority to the ordinary shareholders, but unless they have an express right of participation, they do not have a claim to any surplus assets (Scottish Insurance Corpn Ltd v Wilson and Clyde Coal Co Ltd [1949] 1 All ER 1068). Preference shares generally have restricted voting rights so that their owners cannot vote in general meetings unless, for example, their dividends are in arrears.

10.2.3 Redeemable shares


Section 684 of the Companies Act 2006 provides that a company having a share capital may issue shares which are to be redeemed or are liable to be redeemed at the option of the company or the shareholder. Such shares may not be redeemed unless they are fully paid and the terms of redemption must provide for payment on redemption (s.689(1)). Private companies may redeem shares out of capital (s.687(1)) but public companies may only redeem redeemable shares out of distributable profits or from the proceeds of a new issue of shares that is made for the purpose of redemption (s.687(2)).

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10.2.4 Employees shares


To give employees a stake in the business, companies may issue shares to them. Such shares enjoy certain tax advantages. Employee shares are generally issued through an employee share scheme which is defined as being a scheme for facilitating the holding of shares or debentures in a company by or for the benefit of: a bona fide employees or former employees of the company, including its subsidiary or holding company, or b their spouses, civil partners, surviving spouses, surviving civil partners or minor children or step-children under the age of 18 (s.1166). Such shares are normally issued as ordinary shares or preference shares and are typically subject to restrictions relating to their disposal.

10.3 Variation of class rights


Section 630 of the CA 2006 lays down the procedure for effecting a variation of class rights. The objective of the statutory requirements is to protect the class rights of shareholders so that they cannot be varied or abrogated by the simple expedient of altering the memorandum, the articles or the shareholders resolution in which they are contained. Before turning to the procedure it is useful to consider two questions. 1. What are class rights? 2. What course of conduct will amount to a variation or abrogation of class rights?

10.3.1 What are class rights?


In Cumbrian Newspapers Group Ltd v Cumberland and Westmoreland Herald Newspapers and Printing Co Ltd [1987] Ch 1, Scott J stated that rights or benefits conferred by a companys articles of association can be classified into three distinct categories:
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Rights or benefits which are annexed to particular shares, such as dividend rights, and rights to participate in surplus assets on a winding up. Where the articles provide that particular shares carry particular rights, these are class rights for the purposes of s.125 CA 1985 (see now s.630 CA 2006). Rights or benefits that, although contained in the articles, are conferred on individuals who are not qua members or shareholders but, for ulterior reasons, are connected with the administration of the companys affairs (see Chapter 9). Rights or benefits that, although not attached to any particular shares, are conferred on the beneficiary in his or her capacity as member or shareholder in the company.

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qua members in the

capacity of members.

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On the facts of the case it was held that provisions in the articles which gave the claimant a pre-emptive right over the transfer of shares in the defendant company, together with the right to nominate a director to its board so long as it held 10 per cent of the ordinary shares, were class rights. Scott J said:
A company which, by its articles, confers special rights on one or more of its members in the capacity of member or shareholder thereby constitutes the shares for the time being held by that member or members a class of shares for the purposes of section 125. The rights are class rights.

In determining the scope of class rights the courts have developed certain rules of construction. For example it is presumed that any rights attaching to a share are exhaustive (i.e. comprehensive) (see Re National Telephone Co [1914] 1 Ch 755). However, preference shares are presumed to be entitled to a cumulative dividend even if the terms of issue are silent on the matter (Webb v Earle (1875) LR 20 Eq 556).

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10.3.2 What amounts to a variation or abrogation of class rights?


While s.630 stipulates the procedure to be followed in order to effect a variation of class rights, the CA 2006 offers little insight into the meaning of variation or abrogation. Guidance must therefore be drawn from the case law. The courts have adopted a restrictive approach and have drawn a distinction between conduct which impacts upon the substance of a shareholders class right (which would amount to a variation) and conduct which merely affects its exercise or enjoyment. In White v Bristol Aeroplane Co Ltd [1953] Ch 65, article 68 of the companys articles of association provided that the rights attached to any class of shares may be affected, modified, varied, dealt with, or abrogated in any manner with the approval of an extraordinary resolution passed at a separate meeting of the members of that class. The preference shareholders argued that an issue of additional shares, both preference and ordinary, affected their voting rights and therefore fell within article 68. However, the company contended that the proposal did not amount to a variation of class rights but rather it was the effectiveness of the exercise of those rights that had been affected and therefore a separate meeting of the preference shareholders was not required. The Court of Appeal rejected the preference shareholders contention. Romer LJ explained that the proposal would not affect the rights of the shareholders: the only result would be that the class of persons entitled to exercise those rights would be enlarged (see also Greenhalgh v Arderne Cinemas Ltd [1946] 1 All ER 512). A successful claim was brought in Re Old Silkstone Collieries Ltd [1954] Ch 169. The companys colliery was nationalised by the government of the day. While waiting for the final settlement of compensation, the company had twice reduced its capital by returning part of the preference shareholders capital investment. On both occasions the company had promised the shareholders that they would not be bought out entirely but that they would retain their membership so that they could participate in the compensation scheme to be introduced under the nationalisation legislation. Subsequently, it was proposed to reduce the companys capital for a third time by returning all outstanding capital to the preference shareholders. The effect of this would be to cancel the class completely and they would no longer qualify for compensation. The Court of Appeal refused to sanction the reduction, holding that the proposal amounted to an unfair variation of class rights in so far as the preference shareholders had been promised that they would participate in the compensation scheme. But note that a cancellation of a class of shares on a reduction of capital will not generally be held to constitute a variation of class rights. Such a course of action is viewed as consistent with the terms of issue of the particular shares in question (see House of Fraser plc v ACGE Investments Ltd [1987] BCLC 293; Re Saltdean Estate Co Ltd [1968] 3 All ER 829).

Activity 10.2
Explain what is meant by class rights.

10.3.3 The statutory procedure for effecting a variation of class rights


As commented above, the procedure for varying class rights is set out in s.630 CA 2006. The provision is far more straightforward than its predecessor (see s.125 CA 1985). Section 630 provides that class rights may only be varied:
(a) (b) in accordance with the relevant provisions in the companys articles; or if no such provision is made in the articles, if the holders of three-quarters in value of the shares of that class consent either in writing or by special resolution (passed at a separate meeting of the holders of such shares.

The company must then notify the registrar of any variation of class rights within one month from the date on which the variation is made (ss.637 and 640). Although the CLRSG had recommended that the consent of 75 per cent of the holders of the class affected should be a statutory minimum, notwithstanding any less onerous procedure contained in the companys articles, this was removed from the Companies

Company Law 10 Class rights


Bill at a fairly late stage. As a consequence, the companys articles may specify either less or more demanding requirements for variation of class rights than the default provisions laid down in the Act (see s.630(3)). This has two important effects.
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First, if, and to the extent that, the company has adopted a more onerous regime in its articles for the variation of class rights, for example requiring a higher percentage than the statutory minimum, the company must comply with the more onerous regime. Second, if and to the extent that the company has protected class rights by making provision for the entrenchment of those rights in its articles (see s.22 CA 2006), that protection cannot be circumvented by changing the class rights under s.630.

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It should be noted that the statutory procedure is supplemented by the common law requirement that the shareholders voting at a class meeting must have regard to the interests of the class as a whole (British America Nickel Corpn v MJ OBrien Ltd [1927] AC 369, Viscount Haldane; and Re Holders Investment Trust [1971] 2 All ER 289, Megarry J).

10.3.4 The right of a minority to object to a variation


Section 633 of the CA 2006 provides that, whether a variation has been effected through the statutory procedure or under a provision contained in the companys constitution, the holders of not less than 15 per cent of the issued shares of the class affected may, if they did not consent to or vote in favour of the variation, apply to the court within 21 days of the resolution to have it cancelled. The effect of such an application is to suspend the variation until it is confirmed by the court. If, on hearing the application and having regard to all the circumstances of the case, the court is satisfied that the variation would unfairly prejudice members of the class of shareholders represented by the applicant, it shall disallow the variation (s.633(5)). If it is not so satisfied, the court must confirm it.

Activity 10.3
Why is it important to identify a class right?

Useful further reading

Grantham, R.B. The doctrinal basis of the rights of company shareholders, [1998] CLJ 554. Ireland, P. Company law and the myth of shareholder ownership, [1999] MLR 32. MacNeil, I. Shareholders pre-emptive rights, [2002] JBL 78. Polack, K. Company law class rights, [1986] CLJ 399. Rixon, F. Competing interests and conflicting principles: an examination of the power of alteration of articles of association, [1986] MLR 446. Sealy, L.S. and S. Worthington, Cases and Materials in Company Law. (Oxford: Oxford University Press, 2008) Chapter 9. Worthington, S. Shares and shareholders: property, power and entitlement (Part I), [2001] Co Law 258.

Sample examination question


Explain what is meant by a class right, and what restrictions govern the alteration of class rights?

Advice on answering this question


You should begin by defining what is meant by class rights attaching to a share. Discuss Scott Js formulation in Cumbrian Newspapers Group Ltd v Cumberland and Westmoreland Herald Newspapers and Printing Co Ltd. Explain what amounts to a variation or abrogation of class rights. Discuss the statutory procedure which the company must follow in order to vary class rights.

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Reflect and review


Look through the points listed below. Are you ready to move on to the next chapter? Ready to move on = I am satisfied that I have sufficient understanding of the principles outlined in this chapter to enable me to go on to the next chapter. Need to revise first = There are one or two areas I am unsure about and need to revise before I go on to the next chapter. Need to study again = I found many or all of the principles outlined in this chapter very difficult and need to go over them again before I move on.
Ready to move on I can explain the legal nature of a share. I can describe the various classes of shares. I can describe how class rights attaching to shares are determined. I can outline the procedure for varying class rights. Need to revise first Need to study again

If you ticked need to revise first, which sections of the chapter are you going to revise?
Must revise 10.1 10.2 10.3 Shares and class rights Classes of shares Variation of class rights Revision done

11 Majority rule

Contents
11.1 11.2 11.3 11.4 11.5. Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 110

The rule in Foss v Harbottle the proper claimant rule . . . . . . . . . . 111 Forms of action . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 112 Derivative claims . . . . . . . . . . . . . . . . . . . . . . . . . . . . 114 The statutory procedure: Part 11 of the CA 2006 . . . . . . . . . . . . . 116 The proceedings, costs and remedies . . . . . . . . . . . . . . . . . . 118 Reflect and review . . . . . . . . . . . . . . . . . . . . . . . . . . . 120

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Introduction
As we saw in Chapter 3, a consequence of the Salomon doctrine is that a company can sue in its own right to vindicate a wrong done to it. Thus, whenever a wrong has been committed against the company, the proper claimant is the company itself. However, a company is a metaphysical person and as such it must act through its organ of management (the directors) and the decision to bring legal proceedings is generally vested in the board (see the model articles of association for private and public companies, article 3 (directors general authority) respectively, at http://www.berr.gov.uk/files/file45533.doc). But what if the wrongdoers are the directors themselves who, controlling the company, prevent it from seeking legal redress against them? In this chapter we consider how the law seeks to solve this problem by permitting minority shareholders, in certain exceptional circumstances, to bring a derivative action on the companys behalf. It is worth bearing in mind here when examining this issue that there is a tension between the theory of corporate personality and majority rule. As a result this is a conceptually difficult and technical topic that requires concentrated study. Given its complexity, you will need to read and reflect on these conceptual tensions. Dont be put off if you do not understand the topic immediately take a break and then re-read the material. You will find that patiently working through the chapter perhaps several times will pay dividends.

Learning outcomes
By the end of this chapter and the relevant readings, you should be able to:
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describe the rule in Foss v Harbottle (the proper claimant rule) and the policies that underlie it describe and critically assess the exceptions to the rule in Foss v Harbottle describe the various types of shareholder actions outline the difficulties which confront a shareholder who seeks to initiate litigation when a wrong has been done to the company by those in control assess the statutory procedure for bringing a derivative claim.

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Essential reading

Dignam and Lowry, Chapter 10: The principle of majority rule. Davies, Chapter 17: The Derivative claim and personal actions against directors.

Cases

Foss v Harbottle (1843) 2 Hare 461 Edwards v Halliwell [1950] 2 All ER 1064 MacDougall v Gardiner (1875) 1 ChD 13 Estmanco (Kilner House) Ltd v GLC [1982] 1 WLR 2 Wallersteiner v Moir (No 2) [1975] 2 QB 273 Prudential Assurance Co Ltd v Newman Industries Co Ltd (No 2) [1980] 2 All ER 841; [1982] Ch 204 CA Smith v Croft (No 2) [1988] Ch 114 Johnson v Gore Wood & Co [2001] 1 All ER 481 Ellis v Property Leeds (UK) Ltd [2002] 2 BCLC 175 Giles v Rhind [2001] 2 BCLC 582.

Additional cases

Mumbray v Lapper [2005] EWHC 1152 (Ch) Re Downs Wine Bar [1990] BCLC 839 Day v Cook [2002] 1 BCLC 1 Walker v Stones [2001] 2 WLR 623 CA Shaker v Al-Bedrawi [2002] EWCA Civ 1452.

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11.1 The rule in Foss v Harbottle the proper claimant rule


The rule in Foss v Harbottle (1843) 2 Hare 461 is that when a wrong has been committed against the company, the proper claimant in respect of that wrong is the company itself. The rationale for the rule is twofold:
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it prevents a multiplicity of legal proceedings being brought in respect of the same issue if minority shareholders were permitted to initiate such proceedings there could be hundreds of actions it upholds the principle of majority rule: if the majority of shareholders do not wish to pursue an action then the minority is bound by that decision. (For a particularly clear explanation of the tension between the rule in Foss v Harbottle and corporate personality, see Sealy, L.S. and S. Worthington Cases and Materials in Company Law. (2008) pp.50002).

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It should be noted that the model articles of association for private and public companies (see article 3) place the management of companies into the hands of their directors and the decision whether to sue a third party who has committed a wrong against the company or, on the other hand, to defend an action brought against the company falls within the remit of the board. Consequently, even where the directors do not hold a majority of shares (as is common in large private companies and public companies) the shareholders cannot generally direct them to sue or defend an action (Breckland Group Holdings Ltd v London and Suffolk Ltd (1988) 4 BCC 542). In essence, the rule in Foss v Harbottle is a procedural device. As explained by Jenkins LJ in Edwards v Halliwell [1950] 2 All ER 1064, it has two limbs.
i. The proper plaintiff in an action in respect of a wrong done to a company is prima facie the company itself. ii. Where the alleged wrong is a transaction which might be made binding on the company and all its members by a simple majority of the members, no individual member of the company is allowed to maintain an action in respect of that matter for the simple reason that, if a mere majority of the members of the company is in favour of what has been done, then cadit quaestio (in other words, the majority rule).

In Foss v Harbottle (1843) 2 Hare 461 the claimants were two shareholders in the Victoria Park Company. They brought an action against the companys five directors and promoters, alleging that the defendants had misappropriated assets belonging to the company and had improperly mortgaged its property. The claimants sought an order to compel the defendants to make good the losses suffered by the company. They also applied for the appointment of a receiver. It was held that the action must fail. The harm in question was suffered by the whole company, not just by the two shareholders. It was open to the majority in general meeting to approve the defendants conduct. To allow the minority to bring an action in these circumstances would risk frustrating the wishes of the majority. A clear application of the rule that illustrates how it fits with the principle of majority rule is MacDougall v Gardiner (1875) 1 ChD 13. The chairman of the Emma Silver Mining Co had adjourned a general meeting of the company without allowing a vote to be taken on the issue of adjournment as requested by a shareholder, MacDougall. He therefore brought an action claiming first, a declaration that the chairman had acted improperly and second, an injunction to restrain the directors from taking any further action. The Court of Appeal held that the basis of the complaint was something that in substance the majority of the shareholders were entitled to do and there was no point in suing where ultimately a meeting has to be called at which the majority will, in any case, get its way. Against this background Lord Davey in Burland v Earle [1902] AC 83 formulated what has become a classic statement of the rule.

Cadit quaestio (Latin) The matter (literally question) falls.

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It is an elementary principle of the law relating to joint stock companies that the Court will not interfere with the internal management of companies acting within their powers, and in fact has no jurisdiction to do so. Again, it is clear law that, in order to redress a wrong done to the company or to recover money or damages alleged to be due to the company, the action should prima facie be brought by the company itself.

(See also Mozley v Alston (1847) 1 Ph 790; Gray v Lewis (1873) 8 Ch App 1035; Re Downs Wine Bar [1990] BCLC 839.)

Activity 11.1
Consider the key differences between private companies and public companies. Do you think the relationship between the board of directors and the shareholders may depend upon the size of the company? No feedback provided.

Activity 11.2
Read MacDougall v Gardiner (1875) 1 Ch D 13. Upon what basis did Mellish LJ reach the conclusion that the Rule in Foss v Harbottle operated to defeat the claim? When, in his view, may a minority sue?

11.2 Forms of action


Having considered the issue of standing to sue, we now turn to examine the types of action available to the minority.

The representative action


A representative action is brought by a shareholder on behalf of himself and all other members who have an interest in the litigation (r.19.6 Civil Procedure Rules). For example, where a class of shareholders allege that a class right has been infringed (see Chapter 10, above). The action avoids the costs of multiple suits. The courts judgment will be binding on those represented (see, for example, Quin & Axtens Ltd v Salmon [1909] 1 Ch 311). Thus, a representative action is brought where a wrong has been committed by the company to a class of shareholders (see Pender v Lushington, below).

Personal actions
Mellish LJ explained in MacDougall v Gardiner, (above) that where the right of a shareholder has been infringed by the majority, he can sue. Here, the injury or wrong in question is not suffered by the company as such, but by the shareholder personally. Therefore, the anxiety underlying Foss v Harbottle does not arise. A shareholders rights can arise by virtue of a contract, for example, under the companys constitution or a shareholders agreement. Thus, where a dividend is declared but not paid, a shareholder can sue for payment by way of a legal debt. See, for example, Wood v Odessa Waterworks Co (1889) 43 Ch D 636 (Ch D)).

Personal actions for reflective loss


Where a wrong results in a loss to the company which leads to a diminution in the value of a members shareholding so that the only loss suffered by the shareholder is reflected in the loss sustained by the company, the shareholder cannot sue (Prudential Assurance Co Ltd v Newman Industries Ltd (No 2) [1982] 1 All ER 354). The shareholders loss in this situation has been termed reflective loss by Lord Bingham and Lord Millett in Johnson v Gore Wood & Co [2001] 1 All ER 481. Quite simply, the rule in Foss v Harbottle means that the company is the proper claimant and the shareholders reflective loss will be remedied if the company sues the wrongdoer. However, if the shareholder can establish that the defendants conduct constituted a breach of some legal duty owed to them personally (for example, under the law of contract, torts or trusts), and the court is satisfied that

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such breach of duty caused the member personal loss which is separate and distinct from that sustained by the company, the member will be able to sue (Johnson v Gore Wood & Co). The authorities were summarised by Lord Bingham in the Johnson decision as supporting three propositions.
i. Where a company suffers loss caused by a breach of duty owed to it, only the company may sue in respect of that loss. No action lies at the suit of a shareholder suing in that capacity and no other (i.e. a shareholder is not entitled to sue merely as a shareholder) to make good a diminution in the value of the shareholders shareholding where that merely reflects the loss suffered by the company. A claim will not lie by a shareholder to make good a loss which would be made good if the companys assets were replenished through action against the party responsible for the loss, even if the company, acting through its constitutional organs, has declined or failed to make good that loss ii. Where a company suffers loss but has no cause of action to sue to recover that loss, the shareholder in the company may sue in respect of it (if the shareholder has a cause of action to do so), even though the loss is a diminution in the value of the shareholding iii. Where a company suffers loss caused by a breach of duty to it, and a shareholder suffers a loss separate and distinct from that suffered by the company caused by breach of a duty independently owed to the shareholder, each may sue to recover the loss caused to it by breach of the duty owed to it but neither may recover loss caused to the other by breach of the duty owed to that other.

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Recently the no reflective loss principle has been subjected to considerable judicial scrutiny. For example, in Ellis v Property Leeds (UK) Ltd [2002] 2 BCLC 175, the Court of Appeal held that the bar on such claims applies equally where the claimant is suing qua director as to when he sues qua shareholder. It will also trigger to prevent a claim brought qua creditor or employee and the fact that a company is in administrative receivership does not prevent it from pursuing any claim for wrongdoing (see Gardner v Parker [2004] EWCA Civ 781, in which the Court of Appeal also stressed that the bar is an obvious consequence of the rule against double recovery). However, the prohibition can be circumvented where the shareholder is able to bring a claim qua beneficiary of a trust of shares of which the wrongdoer is trustee (see Walker v Stones [2001] 2 WLR 623, CA; Shaker v Al-Bedrawi [2002] EWCA Civ 1452). A further example of a successful claim for reflective loss is afforded by Giles v Rhind [2001] 2 BCLC 582. The company was insolvent due to a former directors breach of certain duties (not to compete or misuse confidential information). Both duties were also express terms in a shareholders agreement to which the defendant and claimant were parties. Although the company had initiated an action against its former director, the administrative receivers discontinued it when the defendant director applied for a security of costs order. In effect, the defendant had, by his breach of duty, rendered the company incapable of seeking legal redress against him. The claimant sought to recover losses to the value of his shareholding, loss of remuneration and loss of the value of loan stock. The Court of Appeal, in placing considerable emphasis on the fact that the defendants own wrongdoing had, in effect, disabled the company from suing him for damages, found that this situation had not confronted the House of Lords in Johnson v Gore Wood & Co (above). Given that the duties in question were expressly provided for in the shareholders agreement it was held that the claimant could pursue his claim for breach of the agreement, including his losses in respect of the value of his shareholding. The claims for loss of remuneration and losses of capital and interest in respect of loans made by him to the company did not, in any case, fall within reflective losses. Thus, in Giles v Rhind (No 2) [2003] Ch 118, the court awarded a substantial sum by way of damages.

Activity 11.3
Try to summarise Lord Binghams three propositions in Johnson in simple language. No feedback provided.

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Summary
In Johnson v Gore Wood & Co the House of Lords explained that the reason for disallowing the shareholders claim for reflective loss is that if a member could sue there would be a risk of double recovery. As pointed out by Arden LJ in Day v Cook [2002] 1 BCLC 1, the members claim is trumped by the companys. Thus, for a shareholder to bring a personal claim for a loss it must be shown that there was breach of a duty owed personally to him or her and that a personal loss was suffered which is separate from any loss suffered by the company.

Activity 11.4
Read Giles v Rhind [2003] 1 BCLC 1. What was the issue that came before the Court of Appeal in this case which had not been addressed by the House of Lords in Johnson v Gore Wood & Co?

11.3 Derivative claims


Derivative claims are defined by s.260(1) CA 2006 as proceedings brought by a member of a company in respect of a cause of action vested in the company and seeking relief on behalf of the company. The statutory provisions (see below) setting out the procedural requirements do not replace the rule in Foss v Harbottle with a substantive rule but rather seek to implement the recommendations of the Law Commission (see the LCCP No 142 (1996) and the ensuing Report, No 246 (Cm 3769, 1997)) that there should be a new derivative procedure with more modern, flexible and accessible criteria. The Law Commissions Report endorsed the proper claimant principle as sound, but criticised the rule in Foss v Harbottle as complicated and unwieldy. The company is joined as a defendant because, in order to be a claimant, it has to come to court voluntarily which it is plainly prevented from doing. By being joined as a party to the action the company will be bound by the judgment and can enforce any remedy awarded. The wrongdoers will also be joined as defendants. Because of amendments introduced at a fairly late stage as the Companies Bill was proceeding through Parliament, the common law exceptions to the rule in Foss v Harbottle are, perhaps unfortunately, still material because the conditions laid down for obtaining the courts permission to continue the claim are rooted in the common law requirements. Consequently, we cannot jettison the old case law entirely and so before embarking on a consideration of the statutory procedure, we must first examine the relevant common law principles given that they may well serve to inform the judges on how they exercise their discretion under ss.261264 of the CA 2006 (discussed below).

11.3.1 Exceptions to the proper claimant rule


The rule in Foss v Harbottle does not operate as an absolute bar to minority suits. Otherwise the company would never be able to seek legal redress where the directors, holding or controlling the majority of shareholder votes, committed a wrongful act against it (for example, by selling to themselves company property at undervalue), since they would be able to use their voting power to block any resolution of the minority to sue for breach of fiduciary duty. To counter such abuse there are, therefore, certain exceptions to the rule whereby a shareholder is permitted to sue on behalf of the company. In Edwards v Halliwell [1950] 2 All ER 1064, Jenkins LJ sought to codify the exceptions as follows.
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Where the act complained of is illegal or is wholly ultra vires the company. This has now been put on a statutory footing by s.40 CA 2006. However, note that this right is lost once the contract is concluded (see s.40(4); see further, Chapter 13, below). Where the matter in issue requires the sanction of a special majority, or there has been non-compliance with a special procedure.

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Where a members personal rights have been infringed. Where a fraud has been perpetrated on the minority and the wrongdoers are in control.

Attempts to add a fifth exception where it would be in the interests of justice to relax the rule were roundly rejected by the Court of Appeal in Prudential Assurance v Newman (No 2) [1980] 2 All ER 841. Wedderburn in his frequently cited article, Shareholders rights and the rule in Foss v Harbottle [1957] CLJ 194 and [1958] CLJ 93, has argued that in reality there is only one true exception, namely the fourth exception in Jenkins LJs list. He reasons that the first two are not exceptions because the rule is directed towards preventing a minority from challenging acts that can be legitimised by a simple majority and conduct falling within these first two grounds cannot be sanctioned by an ordinary majority. The third so-called exception covers a wrong by the company and not a wrong to the company. We now turn to the true exception to the rule.

11.3.2 Fraud on the minority


The meaning of fraud
A shareholder will be permitted to sue on behalf of the company where a fraud has been perpetrated against the company by those who hold and control the majority of votes and can therefore block any resolution to bring proceedings in the companys name. The judges have left the definition of fraud in this context open, although various guidelines have been laid down. In Burland v Earle (above), fraud was defined as: when the majority are endeavouring directly or indirectly to appropriate to themselves money, property or advantages which belong to the company or in which the other shareholders are entitled to participate. Not all breaches of duty by directors amount to a fraud on the minority, only breaches which cannot be ratified by the majority (see Cook v Deeks, in Chapter 15). Megarry V-C in Estmanco (Kilner House) Ltd v GLC [1982] 1 WLR 2 explained that:
Fraud in the phrase fraud on a minority seems to be being used as comprising not only fraud at common law but also fraud in the wider equitable sense of that term

In Daniels v Daniels [1978] Ch 406, Templeman J expressed the view that the term fraud should extend to cases of self-serving negligence. He said that the fraud on the minority principle would be satisfied: where directors use their powers intentionally or unintentionally, fraudulently or negligently in a manner which benefited themselves at the expense of the company. But note that negligence per se is not sufficient. In Pavlides v Jensen [1956] Ch 565 Danckwerts J accepted that the forbearance of shareholders extends to directors who are an amiable set of lunatics. In this case, although the directors were negligent, they did not derive any personal benefit. Contrast the common law position with the reforms introduced by the CA 2006, Part 11 (below).

The meaning of control


In order for a minority shareholder to bring a derivative action on behalf of the company it must also be established that the wrongdoers (for example, the directors) held or controlled sufficient votes to prevent legal proceedings being brought against them in the name of the company. There has been judicial debate over whether actual (de jure) control is required, for example whether the wrongdoers control 51 per cent or more of the votes, or whether de facto control is sufficient. In Prudential Assurance Co Ltd v Newman Industries Co Ltd (No 2) (above), the Court of Appeal adopted a restrictive approach to the issue and this lead was followed by Knox J in Smith v Croft (No 2) [1988] Ch 114, who stated that if the majority of the shareholders who were independent of the wrongdoers did not wish the action to proceed for disinterested reasons, as occurred on the facts of the case, the single member who sought to initiate the proceedings would be denied standing to sue (locus standi). The judge went on to observe that in determining the independence of the shareholders who did not support an action being brought against the wrongdoers:

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[their] votes should be disregarded if, but only if, the court is satisfied either that the vote or its equivalent is actually cast with a view to supporting the defendants rather than securing benefit to the company.

Summary
To fall within the exception to the rule in Foss v Harbottle the minority shareholder must establish fraud on the part of the wrongdoers (a non-ratifiable breach) and wrongdoer control. If a majority of the independent minority shareholders decide not to support the action, the individual shareholder will not be able to initiate proceedings. Davies concludes that this development, together with the antipathy shown towards individual shareholders who initiate actions (see, for example, the Court of Appeals refusal to endorse the public spirit of the plaintiffs in bringing the action in Prudential Assurance v Newman (above)), would seem to suggest that the derivative action is now seen as a weapon of last resort (see Davies, Chapter 17: The enforcement of directors duties, p.463).

11.4 The statutory procedure: Part 11 of the CA 2006


As we noted above, s.260(1) CA 2006 defines derivative claims as proceedings brought by a member of a company in respect of a cause of action vested in the company and seeking relief on behalf of the company. The grounds for bringing a derivative claim are laid down by s.260(3) which provides that such a claim may be brought only in respect of a cause of action arising from an actual or proposed act or omission involving negligence, default, breach of duty or breach of trust by a director of the company. It is clear that claims against directors for breach of their duties owed to the company fall within its scope. In this respect s.260(3) is wider than the common law action it replaces, in so far as it permits a derivative claim in cases involving breach of the duty to exercise reasonable care, skill and diligence (see s.174 CA 2006). Significantly, under the statutory procedure there is no need to demonstrate fraud on the minority and wrongdoer control, so that even where the defendant director has acted in good faith and has not gained personally, a claim can nevertheless be brought (see Pavlides v Jensen). Section 260(3) also makes it clear that a derivative claim may be brought, for example, against a third party who dishonestly assists a directors breach of fiduciary duty or one who knowingly receives property in breach of a fiduciary duty. Further, it is immaterial whether the cause of action arose before or after the person seeking to bring or continue the derivative claim became a member of the company (s.260(4)).

The application for permission to continue a derivative claim


Section 261 states that once a derivative claim has been brought, the member must apply to the court for permission to continue it. This is the first step in a two stage process. A paper hearing will take place where the court considers the members evidence. The onus is on the member to establish that they have a prima facie case for permission to continue the derivative claim. If this is not demonstrated the court will dismiss the application. If the application is dismissed at this stage, the applicant may request the court to reconsider its decision at an oral hearing, although no new evidence will be permitted at this hearing from either the member or the company. The Practice Direction 19C, Derivative Claims, which amends Part 19 of the Civil Procedure Rules (CPR), provides that this stage of the application will normally be decided without submissions from the company. If the court does not dismiss the application at this stage, the application will then proceed to the full permission hearing and the court may order the company to provide evidence at this stage.

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Section 263(2) sets out the criteria which the court must take into account when determining whether to grant permission to a member to continue a derivative claim. It directs that permission must be refused if the court is satisfied that:
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a person acting in accordance with s.172 (duty to promote the success of the company) would not seek to continue the claim; or where the claim arises from an act or omission that is yet to occur, that the act or omission has been authorised by the company; or where the complaint arises from an act or omission that has already occurred, that act or omission was authorised before it occurred, or has been ratified since it occurred.

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These factors represent a total bar to a derivative claim proceeding. The requirement that the court should take into account the importance that a director, acting in accordance with the duty to promote the success of the company, would attach to the claim appears to dispense with the old common law prerequisite of wrongdoer control. The list of factors to be taken into account for determining the refusal of permission is supplemented by s.263(3). This sets out the factors which the court must, in particular, take into account when exercising its discretion to grant permission to continue a derivative claim. These factors are: a. whether the member is acting in good faith b. the importance that a person acting in accordance with s.172 (duty to promote the success of the company) would attach to pursuing the action c. whether prior authorisation or subsequent ratification of the act or omission would be likely to occur d. whether the company has decided not to pursue the claim e. whether the shareholder could pursue the action in his own right. Section 263(4) goes on to add the requirement, as laid down in Smith v Croft (No 2) (above), that the court shall have particular regard to any evidence before it as to the views of members who have no personal interest in the derivative claim. There will need to be a factual enquiry into whether or not the breach is likely to be ratified. In practice the courts will probably adjourn the permission hearing in order for the question of ratification to be put to the company. Provision is also made for a member of the company to apply to the court to continue a derivative claim originally brought by another member but which is being poorly conducted by him or her. Section 264 provides that the court may grant permission to continue the claim where the manner in which the proceedings have been commenced or continued by the original claimant amounts to an abuse of the process of the court, the claimant has failed to prosecute the claim diligently and it is appropriate for the applicant to continue the claim as a derivative claim. Similarly, by virtue of s.262, where a company has initiated proceedings and the cause of action could be pursued as a derivative claim, a member may apply to the court to continue the action as a derivative claim on the same grounds listed in s.264. This addresses the situation where directors, fearing a derivative claim by a member, seek to block it by causing the company to sue but with no genuine intention of pursuing the action diligently. In assessing the statutory reforms it is noteworthy that there is little or no change of emphasis in terms of formulation. The focus of the rule laid down in Foss v Harbottle and its jurisprudence was on prohibiting claims unless one of the exceptions to the rule was satisfied. The statutory language similarly proceeds from the rather negative standpoint that the court must dismiss the application or claim in the circumstances specified in ss.261(2), 262(3), 263(2)(3) and 264(3). The modern case law, though decided prior to the 2006 Act, suggests that the mandatory requirement for permission cannot be dismissed as a mere technicality. It reflects the real and important principles that the Court of Appeal reaffirmed in Barrett v Duckett and underlines the need for the court to retain control over all the stages of a derivative

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action (see Portfolios of Distinction Ltd v Laird). Against the background of the statutory criteria for granting permission to continue the claim, the decision in Jafari-Fini v Skillglass [2005] EWCA 356, is of interest. The Court of Appeal upheld the judges refusal to allow the derivative claim to continue. Chadwick LJ explained that the company itself would not benefit from the action and the claimant shareholder had alternative avenues open to him, specifically a personal claim. A major deterrent against speculative claims is, of course, costs. Although CPR, r.19.9E enables the court to order the company to indemnify the member, in practice such an order will rarely be granted where permission is denied. Finally, it is also noteworthy that the law on ratification has been tightened and the votes of the wrongdoers will no longer be counted on such ordinary resolutions (although such members may be counted towards the quorum and may participate in the proceedings; see further, ss.175 and 239 CA 2006).

11.5. The proceedings, costs and remedies


If permission is granted to continue the claim the member will bring the action on the companys behalf. The Civil Procedure (Amendment) Rules 2007 (SI 2007/2204), r.7 and Schedule 1 substitute CPR 19.9 and inserts new CPR rr.19.9A 19.9F. As noted above, the company for whose benefit a remedy is sought must be made a defendant in the proceedings in order formally to be a party to the action and be bound by any judgment. If permission is granted to continue the claim the member will bring the action on the companys behalf. Unless otherwise permitted or required by r.19.9A or r.19.9C, the claimant may take no further action in the proceedings without the permission of the court. A practical hurdle which confronts a shareholder litigant is the cost of a proposed action. This is covered by r.19.9E. The court may order the company to indemnify the claimant against any liability in respect of costs incurred in the claim or in the permission application, or both. An application for costs made at the time of applying for permission to continue the claim is commonly called a pre-emptive costs order. It derives from the decision Wallersteiner v Moir (No 2) [1975] 2 QB 273, where Buckley LJ observed that the shareholder who initiates the derivative claim may be entitled to be indemnified by the company at the end of the trial for his costs provided he acted reasonably in bringing the action. The position in the event of the action failing was also considered by the court. Lord Denning MR said:
But what if the action fails? Assuming that the minority shareholder had reasonable grounds for bringing the action that it was a reasonable and prudent course to take in the interests of the company he should not himself be liable to pay the costs of the other side, but the company itself should be liable, because he was acting for it and not for himself. In addition, he should himself be indemnified by the company in respect of his own costs even if the action fails. It is a well-known maxim of the law that he who would take the benefit of a venture if it succeeds ought also to bear the burden if it fails In order to be entitled to this indemnity, the minority shareholder soon after issuing his writ should apply for the sanction of the court in somewhat the same way as a trustee does.

In Smith v Croft (No 2) (above), decided under the old RSC (Rules of the Supreme Court), Walton J held that the shareholders personal means to finance the action was a relevant factor to be taken into account by the court in determining the need for an indemnity. The judge also added that even where the shareholder is impecunious, he should still be required to meet a share of the costs as an incentive to proceed with the action with due diligence.

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Summary
If you have understood the rationale underlying the Rule in Foss v Harbottle, together with the fundamental principles of company law that underpin it, you clearly understand the proper claimant rule. If at this stage you still have difficulties understanding this area dont worry it is a notoriously difficult topic. If you are still having difficulties, re-read Dignam and Lowry, Chapter 10 before going on to read the other sources listed in Useful further reading below. Also, as you reflect on the rule, bear in mind that the judges do not see themselves serving as appeal tribunals for the benefit of dissenting minority shareholders (Carlen v Drury (1812) 1 Ves & B 154; see Dignam and Lowry, para 10.3). The statutory procedure at least sets out the steps to be followed in an accessible way. We await the case law it will generate with interest, particularly with respect to how the judges will exercise their discretion in granting (or refusing) permission to continue the claim.

Useful further reading

Lord Wedderburn Shareholders rights and the rule in Foss v Harbottle, [1957] CLJ 194 and [1958] CLJ 93. Boyle, A.J. The new derivative action, [1997] 18 Co Law 256. Ferran, E. Litigation by shareholders and reflective loss, [2001] CLJ 245. Law Commission Consultation Paper No 142. Law Commission Report No 246. Drury, R.R. The relative nature of a shareholders right to enforce the company contract, [1986] CLJ 219. Prentice, D.D. Shareholder actions: the rule in Foss v Harbottle, [1988] LQR 341. Sealy, L.S. Problems of standing, pleading and proof in corporate litigation in Pettet, B.G. (ed.) Company law in change. (London: Stevens & Sons, 1987) [ISBN 0420477500]. Sullivan, G.R. Restating the scope of the derivative action, CLJ [1985] 236. CLSRG Developing the Framework, para 4.127; Completing the Structure, paras 5.865.87; Final Report, para 7.46.

Sample examination question


The view has been expressed that Part 11 of the Companies Act 2006 (Derivative Claims And Proceedings By Members) will lead to a spate of speculative or vexatious litigation. Discuss.

Advice on answering this question


This is a wide-ranging question and you will need to organise your answer carefully. It requires detailed consideration of the statutory procedure for bringing a derivative claim and the old case law surrounding the rule in Foss v Harbottle. Your answer should:
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outline the new statutory procedure discuss what the rule in Foss v Harbottle is and identify its purpose (Edwards v Halliwell and MacDougall v Gardiner) assess the case law surrounding the exceptions to the rule and consider, against this background, whether the judges, in exercising their discretion under Part 11 CA 2006, are likely to open the floodgates of litigation or whether they are likely to adopt a strict approach towards granting permission to continue the claim.

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You should conclude by considering the vexed question of costs. What incentive is there for bringing an action on behalf of the company?

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Reflect and review


Look through the points listed below. Are you ready to move on to the next chapter? Ready to move on = I am satisfied that I have sufficient understanding of the principles outlined in this chapter to enable me to go on to the next chapter. Need to revise first = There are one or two areas I am unsure about and need to revise before I go on to the next chapter. Need to study again = I found many or all of the principles outlined in this chapter very difficult and need to go over them again before I move on.
Ready to move on I can describe the rule in Foss v Harbottle (the proper claimant rule) and the policies that underlie it. I can describe and critically assess the exceptions to the rule in Foss v Harbottle. I can describe the various types of shareholder actions. I can outline the difficulties which confront a shareholder who seeks to initiate litigation when a wrong has been done to the company by those in control. I can assess the statutory procedure for bringing a derivative claim. Need to revise first Need to study again

If you ticked need to revise first, which sections of the chapter are you going to revise?
Must revise 11.1 11.2 11.3 11.4 The rule in Foss v Harbottle the proper claimant rule Forms of action Exceptions to the proper claimant rule The statutory procedure: Part 11 of the CA 2006 Revision done

12 Statutory minority protection

Contents
12.1 12.2 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 122

Winding up on the just and equitable ground . . . . . . . . . . . . . 123 Unfair prejudice s.994 CA 2006 . . . . . . . . . . . . . . . . . . . . Reflect and review . . . . . . . . . . . . . . . . . . . . . . . . . . . 125 132

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Introduction
In this chapter we examine the statutory rights of minority shareholders. What rights do they have? How can they enforce them and against whom? What remedies are appropriate and available? You should bear in mind that minority shareholders in an owner-managed private company often depend upon the way the company is run for their living; such shareholders frequently work for the company and participate in its management. As a result the stakes can be extremely high when a minority dispute occurs in such a company.

Learning outcomes
By the end of this chapter and the relevant readings, you should be able to:
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describe the range of statutory remedies available to minority shareholders explain the just and equitable winding up remedy state the main grounds for a just and equitable winding up describe the scope of the unfair prejudice remedy describe the remedies available under the unfair prejudice provision.

Essential reading

Dignam and Lowry, Chapter 11: Statutory shareholder remedies. Davies, Chapter 20: Unfair prejudice.

Cases

Ebrahimi v Westbourne Galleries Ltd [1973] AC 360 Virdi v Abbey Leisure Ltd [1990] BCC 60 Nicholas v Soundcraft Electronics Ltd [1993] BCLC 360 Re City Branch Group Ltd [2004] EWCA Civ 815 Re Ghyll Beck Driving Range Ltd [1993] BCLC 1126 Re Elgindata Ltd [1991] BCLC 959 Phoenix Office Supplies Ltd v Larvin [2002] EWCA Civ 1740 Re Macro (Ipswich) Ltd [1994] 2 BCLC 354 Re London School of Electronics Ltd [1986] Ch 211 Re Saul D Harrison & Sons plc [1995] 1 BCLC 14 CA ONeill v Phillips [1999] 1 WLR 1092 Re Sam Weller & Sons Ltd [1989] 5 BCC 810 Anderson v Hogg [2002] BCC 923 Grace v Biagioli [2006] 2 BCLC 70 Richardson v Blackmore [2006] BCC 276 Re OC (Transport) Services Ltd [1984] BCLC 251 Irvine & Ors v Irvine [2006] EWHC 1875 (Ch) Re Bird Precision Bellows Ltd [1984] Ch 419.

Additional cases

Re Yenidje Tobacco Co Ltd [1916] 2 Ch 426 Re a Company (No 00477 of 1986) [1986] BCLC 376 Re Blue Arrow plc [1987] BCLC 585.

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12.1 Winding up on the just and equitable ground


12.1.1 Defining just and equitable grounds
Section 122(1)(g) of the Insolvency Act 1986 (IA 1986) provides that a company may be wound up by the court if the court is of the opinion that it is just and equitable that the company should be wound up. The provision derives from partnership law where the court had equitable jurisdiction to dissolve a partnership where relations had broken down between the partners and the only alternative was to dissolve the business. For companies the remedy has come to the fore in relation to small private companies termed quasi-partnerships. Such companies are akin to partnerships because the personal relationships between the directors (who generally have a number of roles, for example as both shareholders and employees) are so crucial to the effective operation of the companys business that if confidence breaks down between them the company is effectively disabled. It should be noted, however, that given the range of remedies available under the unfair prejudice provision (see 12.2 below) that provision has now become the dominant means available to minority shareholders seeking redress. However, it does not provide for winding up and so s.122(1)(g) IA 1986 is still of relevance. Winding up on the just and equitable ground was subjected to extensive analysis by the House of Lords in Ebrahimi v Westbourne Galleries Ltd [1973] AC 360. The company was incorporated to take over the Oriental rug business which N and the petitioner, E, had been running as a partnership for some 10 years. Initially N and E were equal shareholders and the only directors. When Ns son joined the company as director and shareholder, E became a minority both within the board and at the general meeting, where he could be outvoted by the combined shareholding of N and his son. Relations between E on the one hand, and N and his son on the other, broke down and E was voted off the board using the power conferred by s.303 CA 1985 (now s.168 CA 2006). It was held that even though E had been removed from the board in accordance with the Companies Act and the articles of association, the just and equitable ground conferred on the court the jurisdiction to subject the exercise of legal rights to equitable considerations. Since E had agreed to the formation of the company on the basis that the essence of their business relationship would remain the same as with their prior partnership, his exclusion from the companys management was clearly in breach of that understanding. It was therefore just and equitable to wind up the company. Lord Wilberforce listed the typical elements in petitions brought under the just and equitable ground.
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The basis of the business association was a personal relationship and mutual confidence (generally found where a pre-existing partnership has converted into a limited company). An understanding that all or certain shareholders (excluding sleeping partners) will participate in management. There was a restriction on the transfer of members interests preventing the petitioner leaving.

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Lord Wilberforce stressed that the court was entitled to superimpose equitable constraints upon the exercise of rights set out in the articles of association or the Companies Act. He went on to say that the words just and equitable are:
a recognition of the fact that a limited company is more than a mere legal entity, with a personality in law of its own: that there is room in company law for recognition of the fact that behind it, or amongst it, there are individuals, with rights, expectations and obligations inter se which are not necessarily submerged in the company structure

It should be noted that Lord Cross stressed that petitioners under s.122(1)(g) IA 1986 should come to court with clean hands. If a petitioners own misconduct led to the breakdown in relations relief will be denied.

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The following are illustrations of the grounds which will support a petition under s.122(1)(g). i. The companys substratum has failed The petitioner will need to establish that the commercial object for which the company was formed has failed or has been fulfilled (see Re German Date Coffee Co (1882) 20 Ch D 169; Virdi v Abbey Leisure Ltd [1990] BCLC 342; Re Perfectair Holdings Ltd [1990] BCLC 423). ii. Fraud The remedy will enable shareholders to recover their investment where the company was formed by its promoters in order to perpetrate a fraud against them (see Re Thomas Edward Brinsmead & Sons [1887] 1 Ch 45). iii. Deadlock If the relationship between the parties has broken down with no hope of reconciliation, the court may order a dissolution (see Re Yenidje Tobacco Co Ltd [1916] 2 Ch 426). iv. Justifiable loss of confidence in the companys management Winding up may be ordered where there is a lack of confidence in the competence or probity of its management, provided the company is, in essence, a quasi-partnership (see Loch v John Blackwood Ltd [1924] AC 783). v. Exclusion from participation in a small private company where there was a relationship based on mutual confidence A classic example is the case of Ebrahimi v Westbourne Galleries (above).

12.1.2 Relationship with other remedies


Winding up is a measure of last resort. Thus where the petitioner is acting unreasonably in seeking to have the company wound up instead of seeking an alternative remedy, the petition may be struck out (s.125(2) IA 1986).

Activity 12.1
Read Re a Company (No 004415 of 1996) [1997] 1 BCLC 479. Why did the court strike out the winding up petition?

Activity 12.2
Read Virdi v Abbey Leisure Ltd [1990] BCLC 342. Why was winding up under s.122(1)(g) IA 1986 considered to be an appropriate remedy?

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12.2 Unfair prejudice s.994 CA 2006


Section 994(1) CA 2006, replacing s.459 CA 1985, provides that:
A member of a company may apply to the court by petition for an order on the ground (a) (b) that the companys affairs are being or have been conducted in a manner which is unfairly prejudicial to the interests of its members generally or of some part of its members (including at least himself), or that any actual or proposed act or omission of the company (including an act or omission on its behalf) is or would be so prejudicial.

Although, as will be seen, s.996 provides for a range of remedies, petitioners generally seek an order requiring the respondents, who are usually the majority shareholders, to purchase their shares. The courts have adopted a flexible approach towards what constitutes the companys affairs. Thus, in Nicholas v Soundcraft Electronics Ltd [1993] BCLC 360, the Court of Appeal held that the failure of a parent company (Soundcraft Electronics) to pay debts due to its subsidiary (in which the petitioner was a minority shareholder) constituted acts done in the conduct of the affairs of the company. In Re City Branch Group Ltd [2004] EWCA Civ 815, the Court of Appeal held that an order under s.994 could be made against a holding company where the affairs of a wholly-owned subsidiary have been conducted in an unfairly prejudicial manner and the directors of the holding company are also the directors of the subsidiary. See also, Re Phoneer Ltd [2002] 2 BCLC 241; Gross v Rackind [2004] 4 All ER 735, CA; Re Legal Costs Negotiators Ltd [1999] 2 BCLC 171, CA.

12.2.1 The elements of the remedy


The petitioner must establish that his or her interests as a member have been unfairly prejudiced.

Interests
Although the petitioner must be a shareholder in order to bring the action, the conduct which forms the basis of his complaint need not affect him in his capacity as a member. For example, exclusion from the management of the company, which is conduct affecting the petitioner qua director, will suffice (ONeill v Phillips [1999] 1 WLR 1092). The use of the term interests is expansive in effect, thereby effectively avoiding the straitjacket which terminology based on the notion of rights would impose on the scope of the provision (Re Sam Weller & Sons Ltd [1989] 5 BCC 810; see also Re a Company (No 00477 of 1986) [1986] BCLC 376). In Ebrahimi v Westbourne Galleries, Lord Wilberforce recognised that in most companies, irrespective of size, a members rights under the articles of association and the Companies Act could be viewed as an exhaustive statement of his or her interests as a shareholder. However, as we saw above, he went on to list three situations in which equitable considerations could be superimposed. 1. Where there is a personal relationship between shareholders which involves mutual confidence. 2. Where there is an agreement that some or all should participate in the management. 3. Where there are restrictions on the transfer of shares which would prevent a member from realising his or her investment. This element of Lord Wilberforces speech received extensive consideration by the House of Lords in ONeil v Phillips [1999] 1 WLR 1092, in which it was concluded that for the purposes of s.994 the court can apply equitable restraints to contractual rights.

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Re Ghyll Beck Driving Range Ltd [1993] BCLC 1126 is an excellent example of a s.994 case. A father and son, along with two other people, incorporated a company to operate a golf range. They were each equal shareholders and directors. Within six months of the companys existence the relationship between the parties had become acrimonious due mainly to disagreements over business strategy which left the petitioner feeling isolated. Following a fight between the father and the petitioner the business was managed without consulting him. It was held that the petitioner had been unfairly excluded from the management of the company when from the start it had been anticipated that all four would participate in managing the business. The court therefore ordered the majority to purchase the petitioners shares on the basis that the affairs of the company had been conducted in a manner unfairly prejudicial to his interests. However, it should be noted that s.994 does not mean that the judges administer arbitrary justice without reference to the commercial relationship that exists between the parties. Indeed, Lord Wilberforce had recognised in Ebrahimi that the starting point for the court was always to look to the agreement between the parties, for example, as contained in the articles. In Re a Company (No 004377 of 1986) [1987] BCLC 94, the majority, including the petitioner, voted for a special resolution to amend the companys articles so as to provide that a member, on ceasing to be an employee or director of the company, would be required to transfer his or her shares to the company. To remedy a situation of management deadlock, the petitioner was dismissed as director and was offered 900 per share. When he declined this offer the companys auditors valued his shares in accordance with the pre-emption clauses. He petitioned the court under s.459 (now s.994) to restrain the compulsory acquisition of his shares, arguing that he had a legitimate expectation that he would continue to participate in the management of the company. Hoffmann J held that there could be no expectation on the part of the petitioner that should relations break down the article would not be followed. The judge stressed that s.994 could not be used by the petitioner to relieve him from the bargain he made. Further, in Re Saul D Harrison & Sons plc [1995] 1 BCLC 14, Hoffmann LJ laid down guidelines for determining unfairness. He stressed that fairness for the purposes of s.994 must be viewed in the context of a commercial relationship and that the articles of association are the contractual terms which govern the relationships of the shareholders with the company and each other. The first question to ask, therefore, is whether the conduct of which the shareholder complains was in accordance with the articles of association. See also Re Posgate & Denby (Agencies) Ltd [1987] BCLC 8; Re Blue Arrow plc [1987] BCLC 585; Strahan v Wilcock [2006] EWCA Civ 13.

Summary
The interests of members include rights derived from the companys constitution or statute or a shareholders agreement or some general equitable duty owed by the directors to the company. A member will also have an interest in maintaining the value of his or her shares, as was shown in Re Bovey Hotel Ventures Ltd July 31, 1981 (unreported) cited by Nourse J. in Re R.A. Noble & Sons (Clothing) Ltd [1983] BCLC 273. Further, as seen in Re Ghyll Beck Driving Range Ltd, a members interests may also encompass the expectation that they will continue to participate in management (see also Re a Company (No 003160 of 1986) [1986] BCLC 391; Re a Company (No 004475 of 1982) [1983] Ch 178).

Unfair prejudice
The petitioner must establish that the conduct in question is both prejudicial (in the sense of causing prejudice or harm) to the relevant interests and also unfairly so (Re a Company, ex p Schwarcz (No 2) [1989] BCLC 427, per Peter Gibson J). In Re Ringtower Holdings plc (1988) 5 BCC 82, Peter Gibson J stated that the test is unfair prejudice, not of unlawfulness, and conduct may be lawful but unfairly prejudicial The notion of unfairness was considered by the Jenkins Committee (Cmnd. 1749, 1962) to be a visible

Company Law 12 Statutory minority protection


departure from the standards of fair dealing and a violation of the conditions of fair play on which every shareholder who entrusts his money to a company is entitled to rely (para 204, adopting the view expressed by Lord Cooper in Elder v Elder & Watson Ltd [1952] SC 49). Although there is no requirement that the petitioner should come to court with clean hands, his or her conduct will be relevant in assessing whether the conduct of the company, though prejudicial, is unfair. In ONeil v Phillips [1999] WLR 1092 (the only House of Lords decision on the unfair prejudice remedy so far) Lord Hoffmann held that fairness was to be determined by reference to traditional or general equitable principles. He stressed that company law developed from the law of partnership which was treated by equity as a contract of good faith. The facts of ONeil v Phillips were that the company, Pectel Ltd, provided asbestos stripping services to the construction industry. In 1983 the issued share capital of the company, 100 1 shares, was owned entirely by Mr Philips (P). Mr ONeill (O) was employed by the company in 1983 as a manual worker. P was favourably impressed by O and he received rapid promotion. In early 1985 O received 25 per cent of the companys shares and he was made a director. In May 1985 O was informed by P that he, O, would eventually take over the running of the companys business and at that time would receive 50 per cent of the profits. In December 1985 P retired from the board and O became sole director and effectively the companys managing director. The business enjoyed good profitability for a while, but its fortunes declined during the economic recession of the late 1980s. In August 1991, disillusioned with Os management of the business, P used his majority voting rights to appoint himself managing director and took over the management of the company. O was informed that he would no longer receive 50 per cent of the profits but his entitlement would be limited to his salary and dividends on his 25 per cent shareholding. Early discussions about further share incentives when certain targets were met were aborted. O thereupon issued a petition alleging unfairly prejudicial conduct on the part of P. The House of Lords found that Ps conduct would have been unfair had he used his majority voting power to exclude O from the business. He had not done this, but had simply revised the terms of Os remuneration. Ps refusal to allot additional shares as part of the proposed incentive scheme was not unfair as the negotiations were not completed and no contractual undertaking had been entered into by the parties. Nor was Ps decision to revise Os profit-sharing arrangement considered to be unfair conduct. Os entitlement to 50 per cent of the companys profits was never formalised and it was, in any case, conditional upon O running the business. That condition was no longer fulfilled as P had to assume control over the running of the business. Although O argued that he had lost trust in P, that alone could not form the basis for a petition under the unfairly prejudicial conduct provision. To hold otherwise would be to confer on a minority shareholder a unilateral right to withdraw his capital. Os petition therefore failed. He did not prove that Ps conduct was both unfair and prejudicial. Thus, a petitioner will need to demonstrate either that they relied on some preassociation understanding, or a post-association agreement that was either legally binding or that they specifically relied on. (For recent examples, see the approach of Jonathan Parker J in Re Guidezone Ltd [2000] 2 BCLC 321 and the comments of Auld and Jonathan Parker LJJ in Phoenix Office Supplies Ltd v Larvin [2002] EWCA Civ 1740 to the effect that a petitioner cannot enlist s.994 to force a right of exit from the company that does not exist under the companys constitution.) On the other hand, the failure on the part of the majority shareholders to hold meetings and to otherwise conduct the affairs of the company as a going concern will be held to be unfairly prejudicial to the interests of the minority (Fisher v Cadman [2005] EWHC 377 (Ch)).

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Examples of unfair prejudice include the following.
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Exclusion from management, which is a typical s.994 complaint (see Re XYZ Ltd (No 004377 of 1986) [1987] 1 WLR 102; Re Ghyll Beck Driving Range Ltd (above); Brownlow v GH Marshall Ltd [2001] BCC 152; Phoenix Office Supplies Ltd v Larvin [2002] EWCA Civ 1740). Mismanagement (breach of the directors duties of care and skill) (see Re Elgindata Ltd [1991] BCLC 959; and Re Macro (Ipswich) Ltd [1994] 2 BCLC 354). Excessive remuneration taken by the directors and the failure to pay dividends (see Re Sam Weller & Sons Ltd [1990] Ch 682; Re a Company (No 004415 of 1996) [1997] 1 BCLC 479; Re Cumana Ltd [1986] BCLC 430; Anderson v Hogg [2002] BCC 923; Grace v Biagioli [2006] 2 BCLC 70). Breach of fiduciary duties the case law shows that s.994 may be used to obtain a personal remedy despite the rule in Foss v Harbottle (see Re London School of Electronics Ltd [1986] Ch 211; Re Little Olympian Each-Ways Ltd (No 3) [1995] 1 BCLC 636). See also, Re Baumler (UK) Ltd [2005] 1 BCLC 92; Re Cumana Ltd [1986] BCLC 430, CA. It should be noted that in Re Baumler (UK) Ltd, George Bompas QC (sitting as a Deputy Judge of the High Court) observed that in the case of a quasi-partnership company, a breach of duty by one participant may lead to such a loss of confidence on the part of the innocent participant and breakdown in relations that the innocent participant is entitled to relief under s.996 of the CA 2006 (see below). The judge noted that, in effect, the unfairness lies in compelling the innocent participant to remain a member of the company.

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Summary
In Re Saul D Harrison and ONeill v Phillips Lord Hoffmann took the opportunity to inject content into the concept of fairness. He reaffirmed the sanctity of the s.33 contract (see Chapter 9 of this guide). The House of Lords stressed that the remedy did not confer on the petitioner a unilateral right to withdraw his capital. In order to succeed under s.994 a petitioner will need to prove either a breach of contract (including the s.33 contract) or breach of a fundamental understanding which, although lacking contractual force, makes it inequitable for the majority to go back on the promise. See also, Re Guidezone Ltd and the comments of Auld and Jonathan Parker LJJ in Phoenix Office Supplies Ltd v Larvin.

Activity 12.3
Read Re Macro (Ipswich) Ltd [1994] 2 BCLC 354. a. What was the principal allegation of the petitioners? b. How did Arden J approach the issue of assessing whether the conduct was unfairly prejudicial? c. What remedy was sought?

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12.2.2 Remedies
Section 996(1) CA 2006 provides that the court:
may make such order as it thinks fit for giving relief in respect of the matters complained of.

Section 996(2) goes on to add that:


Without prejudice to the generality of subsection (1), the courts order may: (a) (b) (c) (d) (e) regulate the conduct of the companys affairs in the future; require the company (i) (ii) to refrain from doing or continuing an act complained of, or to do an act which the petitioner has complained it has omitted to do,

authorise civil proceedings to be brought in the name and on behalf of the company by such person or persons and on such terms as the court may direct; require the company not to make any, or specified, alterations in its articles without the leave of the court; provide for the purchase of the shares of any members of the company by other members or by the company itself and, in the case of a purchase by the company itself, the reduction of the companys capital accordingly.

Note the width of the courts powers under s.996(1) (compare the winding up remedy, above). In Re Phoneer Ltd, the petitioner sought a winding up order on the just and equitable ground and the respondent cross-petitioned for winding up under s.994. Roger Kaye QC, granting a winding up order since both parties obviously desired it, noted that section 996 enables, but does not compel, the court to make an order under that section. Although the respondent held 70 per cent of the shares, the judge felt that on the facts of the case justice is served by ordering the winding up of the company on the basis of a 50/50 split. The court can fashion a remedy to the wrong done: see Re A Company ex parte Estate Acquisition & Development Ltd [1991] BCLC 154. Section 996(2) specifies certain remedies available (see above). The most common remedy sought is that under s.996(2)(e) (purchase of shares). Indeed, in Grace v Biagioli [2005] EWCA Civ 1222 , the Court of Appeal affirmed the view that there is a presumption in favour of a buyout order for successful unfair prejudice petitions.

Valuation of shares
Valuing shares in quoted companies is a fairly straightforward exercise because reference can be made to their market price. For unquoted companies and the vast majority of s.994 petitions fall within this category the valuation exercise is a far more difficult undertaking. The court has a wide discretion to do what is fair and equitable in all the circumstances of the case and under the Civil Procedure Rules the court is expected to adopt a vigorous approach towards share valuation (North Holdings Ltd v Southern Tropics Ltd [1999] BCC 746). In Re Bird Precision Bellows Ltd [1984] Ch 419, affirmed by the Court of Appeal [1985] 3 All ER 523, the court reviewed the approach to be adopted towards valuing shares. It was stressed that the overriding objective was to achieve a fair price and that normally no discount would be applied given that the petitioner is an unwilling vendor of what is, in effect, a partnership share (i.e. the shares will be valued on a pro rata basis according to the value of all the issued share capital). If, however, the shareholding is acquired by way of an investment a discount may, in the circumstances, be fair so as to reflect the fact that the petitioner has little control over the companys management (see the speech of Lord Hoffmann in ONeill v Phillips; see also, Profinance Trust SA v Gladstone [2002] 1 BCLC 141, CA). In Irvine & Ors v Irvine [2006] EWHC 1875 (Ch), the High Court decided that, for the purposes of a buyout ordered following a successful petition under s.994 CA 2006, a shareholding of 49.96 per cent was to be valued as any other minority holding. It held

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that no premium should be attached to the shares simply because the buyer was the majority shareholder who would gain control of the whole of the issued share capital. The court also held that, where the parties had agreed a method for valuing the shares that made no distinction between the various assets of the company, the valuation of the cash surplus held by the company was also to be subject to the minority discount and was not to be treated as having been notionally distributed to the shareholders prior to the buyout order. See also Richardson v Blackmore [2006] BCC 276; Re OC (Transport) Services Ltd [1984] BCLC 251.

Useful further reading

Lowry, J. Mapping the boundaries of unfair prejudice in J. de Lacey (ed.) The Reform of UK Company Law. (London: Cavendish, 2002). Lowry, J. Reconstructing shareholder remedies: The Law Commissions Consultation Paper No. 142., [1987] Co Law 247. Lowry, J. Stretching the ambit of s.459 of the Companies Act 1985: the elasticity of unfair prejudice, [1995] LMCLQ 337. Prentice, D.D. The theory of the firm: minority shareholder oppression: sections 459461 of the Companies Act 1985, [1988] OJLS 55. Reisberg, A. Indemnity Costs Orders Under s.459 Petitions [2004] Comp Law 116. Reisberg, A. Shareholders Remedies: In Search of Consistency of Principle in English Law [2005] European Business Law Review 1063. Riley, C. Contracting out of company law: s.459 of the Companies Act 1985 and the role of the courts, [1992] MLR 782.

You should read this volume of the Company Lawyer because it is devoted to reviewing the Law Commissions reform proposals.

Sample examination question


Wheels Ltd was formed five years ago to provide lorry transport facilities to the computer industry. It has an issued share capital of 500 divided into 300 A shares of 1 each and 400 B shares of 50 pence each. Alf, Bob and Colin are the directors of the company. Alf and Bob each hold half the A shares and Colin holds all the B shares. The articles of association of the company provide that: a. the A shares carry two votes each and the B shares carry one vote each b. Colin is to be a director of the company at a salary of 20,000 per year. Until 2003 the three directors worked well together and the company prospered. However, at a board meeting in August of that year, Alf and Bob disagreed with Colin over a fundamental matter of business policy and the meeting ended abruptly when Colin hit Alf. Colin was later fined 50 for assault by local magistrates. Since then Alf and Bob have continued to run the company but the business policy pursued after the meeting in August 2003 has clearly proved unsuccessful and, although the company is still solvent, it has made no profits since then. Colin continued to receive his salary after the August meeting but has attended no board meetings since then, even though Alf and Bob have periodically invited him to do so. Three months ago Alf and Bob stopped payment of Colins salary. Colin is now saying that he will attend the next board meeting as he intends to make one last effort to lick the company into shape. Alf and Bob do not want him back and want to run the company without him. Advise Alf and Bob and Colin.

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Advice on answering this question


This question requires you to discuss the particular issues relating to unfairly prejudicial conduct that arise in relation to small quasi-partnership type of companies. Of particular significance here are:
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the exclusion from management the remedies available under s.996 CA 2006 the enforceability of rights provided by the articles of association.

You must examine the elements of the unfair prejudice remedy. In considering the approach of the court towards s.994 petitions you will need to discuss, in particular, Lord Wilberforces speech in Ebrahimi v Westbourne Galleries Ltd, Lord Hoffmanns speech in ONeil v Phillips and the decision in Re Saul D Harrison. More particularly the focus of the claim will centre on exclusion from management, which is a typical s.994 complaint (Re Ghyll Beck Driving Range Ltd), and mismanagement (breach of the directors duties of care and skill) (Re Elgindata Ltd and Re Macro (Ipswich) Ltd). Finally, your answer should address the range of remedies available under s.996 with emphasis given to buyout orders, together with how the court may value Colins shares (Re Bird Precision Bellows Ltd and ONeill v Phillips).

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Reflect and review


Look through the points listed below. Are you ready to move on to the next chapter? Ready to move on = I am satisfied that I have sufficient understanding of the principles outlined in this chapter to enable me to go on to the next chapter. Need to revise first = There are one or two areas I am unsure about and need to revise before I go on to the next chapter. Need to study again = I found many or all of the principles outlined in this chapter very difficult and need to go over them again before I move on.
Ready to move on I can describe the range of statutory remedies available to minority shareholders. I can explain the just and equitable winding up remedy. I can state the main grounds for a just and equitable winding up. I can describe the scope of the unfair prejudice remedy. I can describe the remedies available under the unfair prejudice provision. Need to revise first Need to study again

If you ticked need to revise first, which sections of the chapter are you going to revise?
Must revise 12.1 12.2 Winding up on the just and equitable ground Unfair prejudice ss.994 and 996 CA 2006 Revision done

13 Dealing with outsiders: ultra vires and other attribution issues

Contents
13.1 13.2 13.3 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 134

The objects clause problem . . . . . . . . . . . . . . . . . . . . . . . 135 Reforming ultra vires . . . . . . . . . . . . . . . . . . . . . . . . . . 136 Other attribution issues . . . . . . . . . . . . . . . . . . . . . . . . . 139 Reflect and review . . . . . . . . . . . . . . . . . . . . . . . . . . . 143

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Introduction
As we discussed briefly in Chapter 9, companies were at one time conferred with the power in their constitutional documents to carry out certain specific functions (the objects) by a specific statute or grant from the Crown. The objects clause was a necessary part of the constitutional documents of early charter and statute companies as they were formed to carry out certain functions by a specific charter or statute. However, as the registered company opened up corporate status to ordinary businesses, a particular problem arose. These registered companies were also required to have specific purposes (objects) in their memorandum but were much more likely to change the nature of their business over time. This was both a problem for companies who legitimately wished to change the nature of their business and for outsiders who were dealing with the company and were in danger of having unenforceable contracts because the company was acting outside its powers. Over time the courts became somewhat flexible about the issue but eventually statutory intervention was needed to solve the remaining problems. The chapter also considers how responsibility is attributed to the company for tortious and criminal actions.

Learning outcomes
By the end of this chapter and the relevant readings, you should be able to:
uu uu uu

explain why the objects clause issue has caused such difficulty describe the effect of the legislative reform process on the ultra vires issue discuss the recommendations of the CLRSG and the reforms in the Companies Act 2006 as they impact on ultra vires issues explain why attribution in other areas was and is similarly problematic.

uu

Essential reading

Dignam and Lowry, Chapter 12: The constitution of the company: dealing with outsiders. Davies, Chapter 7: Corporate actions.

Cases

Ashbury Carriage Company v Riche [1875] LR 7 HL 653 Re Jon Beauforte (London) Ltd [1953] Ch 131 Re Introductions Ltd v National Provincial Bank [1970] Ch 199 Royal British Bank v Turquand [1856] 6 E & B 327 Campbell v Paddington [1911] 1 KB 869 Lennards Carrying Co Ltd v Asiatic Petroleum Co Ltd [1915] AC 705 Tesco Supermarkets Ltd v Nattrass [1971] 2 All ER 127 Meridian Global Funds Management Asia Ltd v Securities Commission [1995] 2 AC 500.

Additional cases

Re German Date Coffee Co [1882] 20 Ch D 169 Freeman & Lockyer v Buckhurst Park Properties Ltd [1964] 2 QB 480 McNicholas Construction Co Ltd v Customs and Excise Commissioners (2000) STC 553 P & O European Ferries Ltd [1990] 93 CrApp R 72 (CA) MCI WorldCom International Inc v Primus Telecommunications Inc [2004] 1 BCLC 42 EIC Services Ltd v Phipps [2004] 2 BCLC 589 Morris v Bank of India [2005] 2 BCLC 328.

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13.1 The objects clause problem


Two key issues combined in this area to cause problems. First, in the nineteenth century it was impossible to change a companys objects clause. This was modified somewhat in the twentieth century, but until 1989 the objects clause could only be changed in very limited circumstances. Second, the doctrine of constructive notice could combine with the ultra vires rule to leave outsiders with unenforceable contracts. The doctrine of constructive notice applies to public documents. A companys memorandum and articles of association are public documents which are provided as part of the registration process and constructive notice deems anyone dealing with registered companies to have notice of the contents of its public documents. As a result an outsider dealing with a company is deemed to have knowledge of its objects clause and has therefore entered into the unenforceable contract with that knowledge. In the late nineteenth century the courts adopted a fairly strict interpretation of the ultra vires rule. In Ashbury Carriage Company v Riche (1875) LR 7 HL 653 the House of Lords considered that the ultra vires doctrine did apply to registered companies. If a company incorporated by, or under, statute acted beyond the scope of the objects stated in the statute or in its memorandum of association such acts were void as beyond the companys capacity even if ratified by all the members. Over the course of the twentieth century the courts retreated from this strict position, allowing companies to carry out transactions reasonably incidental to the objects of the company and eventually accepting very wide objects clauses as being valid either a list of all possible commercial activities or a statement that the company could carry out any commercial venture it wished. However, problems still remained.

Some examples
In Re Jon Beauforte (London) Ltd [1953] Ch 131 the companys objects stated that it was to carry on a business as gown makers but the business had evolved into making veneered panels. No change had been made to the objects clause to reflect this change. A coal merchant had supplied coal to the company which was ordered on company notepaper headed with a reference to the company being a veneered panel maker. The coal merchant was deemed because of constructive notice to know of the original objects clause and because of the headed notepaper to have actual notice of the change in the business. As a result the transaction was ultra vires and void. In Re Introductions Ltd v National Provincial Bank (1970) Ch 199 the case concerned a company incorporated in 1951, around the time of the Festival of Britain, with the specific object of providing foreign visitors with accommodation and entertainment. After the Festival was over the company diversified and eventually devoted itself solely to pig breeding, which the original framers of the objects had not considered (naturally enough). The company had granted National Provincial Bank a debenture (see Chapter 7) to secure a substantial overdraft which had accumulated prior to its eventual insolvent liquidation. The company was held to have acted ultra vires and therefore the transaction was void and the bank could not enforce the debenture or even claim as a normal creditor in the liquidation (see Chapter 17 on the statutory liquidation procedure). As a result of cases like this it was generally agreed that only legislative intervention could solve the problem in the long term.

Activity 13.1
a. Read Re German Date Coffee Co [1882] 20 Ch D 169. Do you consider this a harsh application of the ultra vires doctrine? b. Read Re Jon Beauforte (London) Ltd (1953) Ch 131 and Re Introductions Ltd v National Provincial Bank (1970) Ch 199. Write a 300 word summary of each.

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Summary
The issue of ultra vires stems primarily from a historical hangover from charter or statute companies. At first the courts applied the doctrine strictly to registered companies, despite the harshness of its effect. Over time, however, the courts began to loosen their interpretation of the objects clause where they could. They also began to accept very widely drafted objects clauses. However, as we have seen, problems occasionally still arose which had a drastic effect on the outsiders ability to enforce a contract. Statutory reform was needed.

13.2 Reforming ultra vires


13.2.1 Changes following EC membership
In 1972 the UK joined the European Community and as part of its obligations on entry it introduced legislation reforming ultra vires in s.9(1) of the European Communities Act 1972. This removed the doctrine of constructive notice where it concerned the memorandum and articles of association. It also contained a saving provision for ultra vires transactions where the transaction was dealt with by the directors and the third party was acting in good faith. While this reform narrowed the extent of the ultra vires rule it still left the potential for problems to arise. In 1989 further reforms were introduced which allowed the memorandum to be easily changed and for the company to have a general wide objects clause (ss.4 and 3A CA 1985). Three new sections (ss.35, 35A and 35B) were also introduced. Section 35 thus became the main saving provision for outsiders in classic ultra vires situations. It stated:
(1) The validity of an act done by a company shall not be called into question on the ground of lack of capacity by reason of anything in the companys memorandum.

Under the CA 1985 the memorandum formed part of the companys constitution. Now however, s.8 of the CA 2006 has reduced the memorandum of association to a more limited function. The memorandum is now a simple document providing certain basic information and key declarations to the public which state that subscribers wish to form the company and agree to become members taking at least one share each. The subscribers to the memorandum are those who agree to take some shares or share in the company, thus becoming its first members. If the application to the Registrar is successful the subscribers become the first members of the company and the proposed directors become its first directors. To eliminate any remaining problems with the objects clause the CLRSG, in the Final Report (July 2001 para 9.10) and the Consultative Document (March 2005, Chapter 5), proposed that companies be formed with unlimited capacity. The CA 2006 partly implements the recommended approach. Companies registered under the 2006 Act have unrestricted objects unless a company chooses to have an objects clause stating what it is empowered to do (s.31 CA 2006). If a company does chose to have an objects clause, and for companies formed under the previous Principal Acts in 1948 and 1985 with an objects clause (unless these companies now remove their objects clause (s.31(2) CA 2006)), the objects clause forms part of the articles of association (s.28 CA 2006). As most companies currently in existence were formed under principal Companies Acts that required an objects clause, this change will only really affect companies newly incorporated under the CA 2006. For companies already in existence with an objects clause, that clause still operates to restrict them and will now become part of their articles of association (s.28 CA 2006). In recognition of the fact a large number of companies will still have an objects clause, s.35 CA 1985 has been replaced by an almost exact replica in s.39 CA 2006 which states:
(1) The validity of an act done by a company shall not be called into question on the ground of lack of capacity by reason of anything in the companys constitution.

Company Law 13 Dealing with outsiders: ultra vires and other attribution issues
As a result of the reform process, what were traditional ultra vires actions became a question of whether the required internal authority to transact was given to those who transacted with the outsider.

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13.2.2 Internal authority


When examining issues of internal corporate authority, agency principles and specific statutory provisions will usually determine the outcome. Normal principles of agency provide that a principal will be bound by a contract entered into on his behalf by his agent if that agent acted within either the actual scope of the authority given by the principal before the contract or the apparent or ostensible scope of his authority. The principal may also ratify a contract entered into without authority. Companies, because of their complexity, pose certain problems for agency principles. While specific authority is conferred on the board to run the company, once the authority goes below board level actual authority in the context of a corporation or any other complex organisation can be difficult to locate conclusively. This is because authority to carry out some functions may not be specifically conferred but rather is implicit in the nature of the job. A stationery manager may not have any actual authority to purchase stationery, yet it is implicit in his appointment that he is empowered to do so. Further authorisation can be given through apparent or ostensible authority. This arises when no actual authority is conferred, yet the company allows someone to hold themselves out as having that authority for example, allowing someone to act as managing director even though they have never been appointed (see, for example, Freeman & Lockyer v Buckhurst Park Properties Ltd [1964] 2 QB 480; MCI WorldCom International Inc v Primus Telecommunications Inc [2004] 1 BCLC 42). Here again the companys constitution can cause problems for outsiders dealing with the company. Sometimes the constitution will specify a procedure that has to be carried out before authority is conferred. For example, it is common for directors to have to seek approval of the general meeting for large loans. Again the doctrine of constructive notice could potentially be problematic here. In Royal British Bank v Turquand (1856) 6 E & B 327 an action was brought for the return of money borrowed by the company. The company argued that it was not required to pay back the money because the manager who negotiated the loan should have been authorised by a resolution of the general meeting to borrow but he had no such authorisation. As a result of constructive notice the bank was deemed to know this. In attempting to mitigate this effect the court held that the public documents only revealed that a resolution was required, not whether the resolution had been passed. The bank had no knowledge that the resolution had not been passed and thus it did not appear on the face of the public documents that the borrowing was invalid. Outsiders are therefore entitled to assume that the internal procedures have been complied with. This is known as the indoor management rule. The Companies Act 1989 introduced ss.35A and 35B into the CA 1985. Both these sections concern the issue of internal authority. Section 35A states:
(1) (2) In favour of a person dealing with a company in good faith, the power of the board of directors to bind the company, or authorise others to do so, shall be deemed to be free of any limitation under the companys constitution. For this purpose a person deals with a company if he is a party to any transaction or other act to which the company is a party; a person shall not be regarded as acting in bad faith by reason only of his knowing that an act is beyond the powers of the directors under the companys constitution; and a person shall be presumed to have acted in good faith unless the contrary is proved.

(a) (b) (c)

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The section had the effect of protecting outsiders who deal either directly with the board or those authorised to bind the company. It is worth noting that the section set the standard of bad faith fairly high as sub-s.2(b) specifically allowed third parties to have knowledge that the transaction was irregular. As a result it implied that active dishonesty might be required in order to qualify as bad faith (see EIC Services Ltd v Phipps [2004] 2 BCLC 589). To further emphasise the lower good faith requirement subs.2(c) set a presumption of good faith. The section also contained a similar provision to s.35 allowing shareholders to prevent an imminent irregular transaction and protected insiders who deal with the company, which the indoor management rule did not. However, s.322A CA 1985 was also introduced as an amendment to the CA 1985 by the CA 1989 and s.35A was subject to it. That section provided that a transaction between the company and a director or a person connected to him (family etc.) which exceeded the powers of the board was voidable at the instance of the company. Section 35B CA 1985 also attempted to deal with the issue of constructive notice. It states:
[a] party to a transaction with the company is not bound to enquire as to whether it is permitted by the companys memorandum or as to any limitation on the powers of the board of directors to bind the company or authorise others to do so.

This was intended to act in tandem with s.711A CA 1985 to abolish the concept of constructive notice for corporations. However, s.711A has never been implemented and so only s.35B deals with constructive notice (s.40 CA 2006 (see below)).

13.2.3 Further internal authority reform in the CA 2006


With regard to internal authority the CA 2006 makes little change to previous law simply replicating the provisions of ss.35A and 35B CA 1985 in one new section (s.40 CA 2006).
40 Power of directors to bind the company (1) In favour of a person dealing with a company in good faith, the power of the directors to bind the company, or authorise others to do so, is deemed to be free of any limitation under the companys constitution. (2) For this purpose a person deals with a company if he is a party to any transaction or other act to which the company is a party,

(a)

(b) a person dealing with a company is not bound to enquire as to any limitation on the powers of the directors to bind the company or authorise others to do so, is presumed to have acted in good faith unless the contrary is proved, and is not to be regarded as acting in bad faith by reason only of his knowing that an act is beyond the powers of the directors under the companys constitution.

(i) (ii) (iii) (3)

The references above to limitations on the directors powers under the companys constitution include limitations deriving (a) from a resolution of the company or of any class of shareholders, or from any agreement between the members of the company or of any class of shareholders.

(b) (4)

This section does not affect any right of a member of the company to bring proceedings to restrain the doing of an action that is beyond the powers of the directors. But no such proceedings lie in respect of an act to be done in fulfilment of a legal obligation arising from a previous act of the company.

Company Law 13 Dealing with outsiders: ultra vires and other attribution issues
(5) (6) This section does not affect any liability incurred by the directors, or any other person, by reason of the directors exceeding their powers. This section has effect subject to section 41 (transactions with directors or their associates), and section 42 (companies that are charities).

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Additionally s.322A CA 1985 (connected persons) is also replicated in a new section (s.41 CA 2006).

Activity 13.2
Have the reforms described above solved the ultra vires problem for companies?

Activity 13.3
a. How did the 1989 reforms attempt to deal with the remaining ultra vires problems? b. Describe the different types of authority that can be conferred by a company. c. Explain how the indoor management rule works. d. Describe the latest reforms in this area. No feedback provided.

Summary
The issue of ultra vires in the context of companies, while once a significant danger, has largely been dealt with by statutory reform. Further reform as a result of the work of the CLRSG has followed in due course in the CA 2006. The area remains an important one in the context of company law as it offers a very good illustration of how authority is conferred on the company and legitimately exercised by its agents who deal with the outside world.

13.3 Other attribution issues


13.3.1 Vicarious liability in tort
Agency and statutory provisions, however, have not solved all the problems inherent in attributing responsibility to a company for its actions. Corporate liability for tort was one such problem that the courts originally had great difficulty with in the corporate context. At first the courts considered that a tort was an ultra vires act in that a company could never be authorised by its objects clause to commit a tort. However, in Campbell v Paddington [1911] 1 KB 869 it was accepted that companies could commit torts and the courts have subsequently applied the principle of vicarious liability to the company as employer. As a result a company can be vicariously liable in tort for the acts of its employees, even though they may not be specifically authorised to carry out the act that leads to the tort but are nevertheless acting within the scope of their employment. It is important to note here that attribution through vicarious liability in the context of a tort involves no fault on the part of the company: it is simply legally responsible for the acts of another. Where a fault qualification or intention is required by law, attribution of liability becomes more complex. As a result, vicarious liability will not attribute criminal liability for the act of an employee. Where fault or intention is needed the courts began to develop a complex attribution concept known as the alter ego or organic theory of the company.

Alter ego (Latin) another (alternative) self.

13.3.2 The organic theory


One of the first examples of this concept occurred in Lennards Carrying Co Ltd v Asiatic Petroleum Co Ltd [1915] AC 705. In that case the fault requirement arose in relation to a particular section of the Merchant Shipping Act 1894. Viscount Haldane LC set out an organic theory of the corporation in order to deal with the fault issue. He considered that:

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a corporation is an abstraction. It has no mind or will of its own any more than it has a body of its own; its active and directing will must consequently be sought in the person of somebody who for some purposes may be called an agent but who is really the directing mind and will of the corporation, the very ego and centre of the personality of the corporation somebody who is not merely an agent or servant for whom the company is liable upon the footing respondeat superior, but somebody for whom the company is liable because his action is the very action of the company itself.

As a result, if one individual can be identified who can be said to be essentially the companys alter ego and that individual has the required fault, then the fault of that individual will be attributed to the company. The attribution of responsibility here is very different than through vicarious liability in tort, where the company is responsible for the actions of another. The individuals fault here is attributed to the company because the law treats the individual and the company as the same person. There is, however, a central problem with the alter ego theory in that it required the identification of a single individual in what was often a complex corporate organisational structure. This was often not possible unless a very small company was at issue. The theory has been particularly problematic in attributing criminal responsibility to companies, especially when attempting to determine the companys mens rea or guilty mind. In Tesco Supermarkets Ltd v Nattrass [1971] 2 All ER 127 Tesco was charged with an offence under the Trade Descriptions Act 1968. They had advertised goods at a reduced price but sold them at a higher price. In order to avoid conviction Tesco had to show that they had put in place a proper control system. Tesco argued that they had and that the manager of the store had been at fault. The court considered whether the manager was acting as an organ of the company. Lord Reid found that:
[a] living person has a mind which can have knowledge or intention or be negligent and he has hands to carry out his intentions. A corporation has none of these; it must act through living persons, though not always one or the same person. Then the person who acts is not speaking or acting for the company. He is acting as the company and his mind which directs his acts is the mind of the company. There is no question of the company being vicariously liable. He is not acting as a servant, representative, agent or delegate. He is an embodiment of the company or, one could say, he hears and speaks through the persona of the company, within his appropriate sphere, and his mind is the mind of the company.

Respondeat superior (Latin) the superior is responsible. This is the doctrine that an employer is responsible for things done by his or her employees as part of their employment.

In this case the manager who was at fault was not the guiding mind and therefore Tesco could not be liable for his action. Subsequently the application of the organic theory has effectively acted as an immunity from criminal prosecution for large complex corporate organisations where it is impossible to identify a single individual responsible for the companys action.

13.3.3 The issue of control


Relatively recently the courts have moved away from viewing fault or intention attribution for companies in this narrow way. In the Privy Council decision in Meridian Global Funds Management Asia Ltd v Securities Commission [1995] 2 AC 500 Lord Hoffmann considered that the organic theory provided a misleading analysis. The real issue was: who were the controllers of the company for the purposes of attribution? This was compatible with the maintenance of the Salomon principle and had the advantage of being able to attribute liability to the company for the actions of individuals lower down the organisational structure. In the Meridian case the controllers were found to be two senior managers. Lord Hoffmanns approach has subsequently been applied with some success in McNicholas Construction Co Ltd v Customs and Excise Commissioners [2000] STC 553. There the knowledge of the companys site managers of a VAT fraud was enough to attribute liability to the company for the fraud. (See also Crown Dilmun v Sutton [2004] 1 BCLC 468, ChD and Morris v Bank of India [2005] 2 BCLC 328.)

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13.3.4 Corporate responsibility for injury and death


The application of the organic theory where crimes of violence are at issue still remains a particularly difficult problem. Such crimes happen mainly in the workplace but occasionally enter the public domain through major transport disasters like the Zeebrugge ferry tragedy (the sinking of the Herald of Free Enterprise). Larger more complex corporate organisations can never be attributed with the required mens rea as identification of an alter ego is impossible in such complex delegated structures (see P & O European Ferries Ltd (1990) 93 Cr App R 72 (CA)). In response to a number of high-profile disasters and the growing problem of workplace deaths, the Government proposed the creation of a specific offence of corporate manslaughter (Reforming the Law on Involuntary Manslaughter: The Governments Proposals (May 2000). The new offence of corporate manslaughter has been now introduced in the Corporate Manslaughter and Corporate Homicide Act 2007 which came into force on 6 April 2008. The offence of corporate manslaughter is based around management failure of the company or its parent, leading to the cause of death. Thus if the way the company is managed fails to protect the health and safety of those employed in or affected by the companys activities and the manner in which its management fails is far below the standards that would be reasonably expected of a company in such circumstances it will be guilty of the offence. The history of the Act can be found at http://www.corporateaccountability. org/manslaughter/reformprops/main.htm

Activity 13.4
Read Lord Hoffmanns judgment in Meridian Global Funds Management Asia Ltd v Securities Commission [1995] 2 AC 500 and prepare a 300-word summary on his view of the corporate attribution issue.

Summary
Attributing law designed to apply to humans to the corporate form has continued to be a difficult task. Vicarious liability in tort has proved an elegant solution, but where fault or intention is necessary the courts have yet to find a similarly elegant solution. The Meridian case has certainly moved things forward from the difficulties created by the alter ego or organic theory. However, the courts failure to find a way of attributing crimes of violence to the corporate form has instigated a statutory reform process which is still under way.

Useful further reading

Ferran, E. The reform of the law on corporate capacity and directors and officers authority, Parts 1 and 2, [1992] Co Law 124 and 177. Hannigan, B. Contracting with individual directors in Rider, B.A.K. (ed.) The Corporate Dimension. (Bristol: Jordan Publishing, 1998) [ISBN 0853084769]. Poole, J. Abolition of the ultra vires doctrine and agency problems, [1991] Co Law 43. Munoz Slaughter, C. Corporate social responsibility: a new perspective, [1977] Co Law 313. Sullivan, B. [2001] Corporate killing some government proposals, Crim L Rev 31.

Sample examination questions


Question 1 The objects clause of Robin Ltd states that the company is to carry on a business as a supplier of diving equipment. Additionally the companys borrowing is limited to a maximum of 100,000 by a clause in the memorandum. Ranjid has recently been appointed the managing director of Robin Ltd. His contract of employment states that the managing director of Robin Ltd is empowered to the full and usual extent of a managing director. Ranjid immediately plans to expand the business to include the provision of diving lessons. This involves the hiring of three diving instructors and the purchase of a premises worth 200,000, which will be funded through a bank loan. Ranjid also plans to donate 50,000 to the Save the Coral Reef Foundation, a registered charity.

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Sean is one of the major shareholders in Robin Ltd and although he approved the appointment of Ranjid he is very concerned by the plans of the new managing director. Sean comes to you for advice. Advise him concerning the issues raised in this question. Question 2 The objects clause of Ram Ltd provides that: a. The business of the company shall be the construction of churches and all other forms of religious accommodation. b. The company may make whatever borrowings and charge whatever of its assets as the directors may consider desirable. Although never formally appointed managing director, Brian, to the knowledge and with the full agreement of his co-directors, Bernice and Camilla, carries out the day-to-day management of Ram Ltd. Brian, acting on behalf of Ram Ltd, agreed that the company would manufacture and supply 5,000 deck chairs for the Brighton Local Authority beachfront. To finance this operation he borrowed 50,000 from Y Bank plc to enable Ram to purchase the machinery to carry out this agreement. The loan was evidenced by a debenture which was signed on Rams behalf by Brian and Bernice. Owing to serious mismanagement the company incurred considerable losses and with only 1,000 deck chairs completed was found to be hopelessly insolvent and put into compulsory liquidation. Advise the liquidator.

Advice on answering the questions


Question 1 Address the issue of whether the giving of diving lessons is ultra vires. If it is, would the statutory provisions save any transaction that was outside the objects? Does Ranjid have the authority to authorise the bank loan? If he does not but goes ahead anyway, will the company be bound? If he hires the instructors are their employment contracts enforceable? Is the donation to charity outside the companys powers or is it just a matter of whether Ranjid is authorised to do this? Are there any breach of duty issues? Question 2 Start with the objects issue is the borrowing ultra vires? Apply the facts to the statutory provisions is the transaction saved in the banks favour? Are Brian and the other directors in breach of duty by authorising an ultra vires act? Examine the internal authority issues Brians appointment. Apply Freeman & Lockyer v Buckhurst Park Properties Ltd [1964] 2 QB 480. Is the signing of the debenture by Brian and Bernice enough to comply with part (b) of the objects clause?

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Reflect and review


Look through the points listed below. Are you ready to move on to the next chapter? Ready to move on = I am satisfied that I have sufficient understanding of the principles outlined in this chapter to enable me to go on to the next chapter. Need to revise first = There are one or two areas I am unsure about and need to revise before I go on to the next chapter. Need to study again = I found many or all of the principles outlined in this chapter very difficult and need to go over them again before I move on.
Ready to move on I can explain why the objects clause issue has caused such difficulty. I can describe the effect of the legislative reform process on the ultra vires issue. I can discuss the recommendations of the CLRSG and the reforms in the Companies Act 2006 as they impact on ultra vires issues. I can explain why attribution in other areas was and is similarly problematic. Need to revise first Need to study again

If you ticked need to revise first, which sections of the chapter are you going to revise?
Must revise 13.1 13.2 13.3 The objects clause problem Reforming ultra vires Other attribution issues Revision done

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Notes

14 The management of the company

Contents
14.1 14.2 14.3 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 146

Directors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 147 Categories of director . . . . . . . . . . . . . . . . . . . . . . . . . . 150 Disqualification of directors . . . . . . . . . . . . . . . . . . . . . . . 151 Reflect and review . . . . . . . . . . . . . . . . . . . . . . . . . . . 157

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Introduction
The first part of this chapter considers the relationship between the board of directors and the general meeting. It then goes on to outline the various categories of director, their appointment and removal. It also discusses the Company Directors Disqualification Act 1986 (CDDA 1986) relating to the disqualification of unfit directors.

Learning outcomes
By the end of this chapter and the relevant readings, you should be able to:
uu uu

define the term director explain the role of the board of directors and its relationship with the general meeting describe the various categories of director explain the process for awarding remuneration describe how the general meeting can remove a director from the board explain how directors can be disqualified from holding office.

uu uu uu uu

Essential reading

Dignam and Lowry, Chapter 13: Corporate management. Davies, Chapter 10, Disqualification of directors; and Chapter 14: The board.

Cases

Automatic Self-Cleansing Filter Syndicate Co Ltd v Cunninghame [1906] 2 Ch 34 Secretary of State for Trade and Industry v Tjolle [1998] BCC 282 Secretary of State for Trade and Industry v Hollier [2006] EWHC 1804 (Ch) Re Kaytech International plc [1999] BCC 390 Yukong Line Ltd of Korea v Rendsburg Investments Corpn of Liberia (No 2) [1998] BCC 870 Re Hydrodam (Corby) Ltd [1994] BCC 161 Bushell v Faith [1970] AC 1099 Re Cannonquest, Official Receiver v Hannan [1997] BCC 644 Re Sevenoaks Stationers (Retail) Ltd [1991] Ch 164 Re Polly Peck International plc (No 2) [1994] 1 BCLC 574 Re Grayan Building Services Ltd [1995] Ch 241 Re Lo-Line Electric Motors Ltd [1988] Ch 4.

Additional cases

John Shaw & Sons (Salford) Ltd v Shaw [1935] 2 KB 113) Barron v Potter [1914] 1 Ch 895 Unisoft Group Ltd (No 2) [1993] BCLC 532.

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14.1 Directors
14.1.1 Defining the term director
As we saw in Chapter 3, companies are artificial legal entities and as such they must operate through their human organs. The management of the company is vested in the board of directors, who are expected to act on a collective basis, although the articles may and in large companies generally do provide for delegation of powers to smaller committees of the board or to individual directors. It should be borne in mind that in small private companies the same individuals may wear a number of hats: as directors, workers and shareholders. In large companies, however, there is generally a clear division between the board and the shareholders (although it should be borne in mind that even here directors will often receive shares as part of their remuneration package). The Companies Act 2006 does not define the term director beyond stating in s.250 that the term includes any person occupying the position of director, by whatever name called. Thus, whatever title the articles adopt to describe the members of the companys board (for example, governors), the law will nevertheless view them as directors. Section 154 lays down the minimum number of directors that companies must have: two for public companies and one for private companies.

14.1.2 The position of the board of directors


The CA 2006 does not attribute specific roles to company directors. The Act is also silent with respect to the structure and form of corporate management, leaving such matters to the companys constitution. Although it is now accepted that in the modern company the board enjoys a position of management autonomy this has not always been the case. Until the end of the nineteenth century the general meeting of the company had constitutional supremacy: the board of directors was viewed as its agent and had to act in accordance with decisions of the general meeting. However, by the early twentieth century, with shareholding becoming more dispersed and directors beginning to be appointed on the basis of professional merit rather than social standing, articles of association were drafted so as to give boardrooms greater independence. Consequently, the judicial response was that the board should no longer be viewed as the agent or servant of the general meeting. In Automatic Self-Cleansing Filter Syndicate Co Ltd v Cunninghame [1906] 2 Ch 34 the question for the Court of Appeal was whether the directors were bound to give effect to an ordinary resolution of the general meeting requiring them to sell the companys undertaking to a new company incorporated for the purpose. The companys articles of association, in terms similar to article 3 of the model articles of association for private and public companies (see below), provided that the management of the business and the control of the company was in the hands of its directors. Collins MR, having reviewed the relevant article, explained that:
it is not competent for the majority of the shareholders at an ordinary meeting to affect or alter the mandate originally given to the directors by the articles of association the mandate which must be obeyed is not that of the majority it is that of the whole entity made up of all the shareholders.

See also Gramophone and Typewriter Ltd v Stanley [1908] 2 KB 89; and John Shaw & Sons (Salford) Ltd v Shaw [1935] 2 KB 113. As indicated above, article 3 (directors general authority) of the model articles of association for private and public companies, (see http://www.berr.gov.uk/files/ file45533.doc; see also the 1985 Table A, article 70) confers on the board virtual managerial autonomy. Article 3 provides:
Directors general authority Subject to the articles, the directors are responsible for the management of the companys business, for which purpose they may exercise all the powers of the company.

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The power of the general meeting is limited to certain matters such as the right to alter the articles (s.21); share capital (ss.617 and 641); and to delegate authority to allot shares (ss.549 and 551). If shareholders disapprove of a director they can remove him from office by ordinary resolution (s.168 CA 2006, see 14.1.5below). However, executive power will revert to the general meeting where the board of directors is deadlocked so that it is incapable of managing the company (Barron v Potter [1914] 1 Ch 895).

Summary
Directors are not mere delegates or agents of the general meeting but are under a duty to act bona fide in the interests of the company as a whole (see Chapter 15). Article 3 confers extensive managerial powers on directors, who can thus pursue a course of action different from that prescribed by a bare majority of shareholders. However, the general meeting can remove a director by ordinary resolution (s.168 CA 2006).

Activity 14.1
Read Gramophone and Typewriter Ltd v Stanley [1908] 2 KB 89. To what extent can a controlling shareholder dictate how directors should act?

14.1.3 Appointment of directors


Subject to certain statutory provisions, the appointment of directors is left to the articles of association. Section 16(6) CA 2006 provides that the persons named in the statement of proposed officers are, on the companys incorporation, deemed to be its first directors and secretary. We have seen above that s.154 stipulates the minimum number of directors for companies. Section 160 goes on to provide that for public companies the appointment of directors shall be voted on individually. Section 157 lays down the minimum age of 16 for appointment as a director. Beyond these particular statutory provisions the Companies Act 2006 is silent on boardroom appointments, leaving the issue to the articles of association. Although first directors are appointed in accordance with s.12 CA 2006 their successors are elected by the shareholders in a general meeting. Article 20 of the model articles of association for public companies (the 1985 Table A, article 73) provides that at the first annual general meeting (AGM) all the directors shall retire from office and at every subsequent AGM any directors who have been appointed by the directors since the last AGM or who were not appointed at one of the preceding two AGMs, must retire from office. It should be noted that this requirement does not appear in the model articles for private companies.

Summary
Sections 154-167 CA 2006 govern the appointment and registration of directors. The principal requirements for appointment are:
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every private company is to have at least one director, and every public company to have at least two (s.154) 16 is set as the minimum age (as in Scotland) for a director to be appointed (s.157) the appointment of a director of a public company is to be voted on individually, unless there is unanimous consent to a block resolution (s.160) the acts of a person acting as a director are valid notwithstanding that it is afterwards discovered that there was a defect in his appointment, that he was disqualified from holding office, that he has ceased to hold office, or that he was not entitled to vote on the matter in question (s.161, replacing s.285 of the CA 1985). (See the construction given to the provision in Morris v Kanssen [1946] AC 459, Lord Simonds.)

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14.1.4 Directors remuneration


As with trustees, directors are not entitled as of right to be paid for their services unless the articles of association or a service contract between them and the company provide otherwise (Re George Newman & Co [1895] 1 Ch 674). Article 18 (model articles of association for private companies) and article 22 (model articles of association for public companies) provide that the directors shall be entitled to such remuneration as they determine. Given the power of directors to set their own remuneration, issues of transparency and accountability obviously arise. The temptation for directors to vote themselves fat cat awards has generated much debate over the past 20 years or so and this is considered in the corporate governance section of this chapter. For the present it should be noted that the BIS (formerly the DTI) published a number of proposals for reinforcing the accountability of directors to shareholders over boardroom pay awards (see the DTI consultative documents, Directors Remuneration (URN 99/923) (London, DTI, 1999) and (URN 01/1400) (London DTI, 2001)). A significant proposal was that there should be a mandatory requirement for the companys annual report to contain a statement of remuneration policy and details of the remuneration of each director. This was implemented for all quoted companies for financial years ending on or after 31 December 2002 by statutory instrument (the Directors Remuneration Report Regulations 2002 (SI 2002/1986)), which came into force on 1 August 2002; now incorporated into the ss.420-422 CA 2006. The remuneration report must be approved by the board of directors and signed on behalf of the board by a director or secretary of the company (s.422(1)). Where a directors remuneration report is approved but it does not comply with the statutory requirements, every director of the company who knew of its non-compliance, or was reckless as to whether it complied, and failed to take reasonable steps to secure compliance or to prevent the report from being approved, commits an offence punishable by fine (s.422). Section 439 goes on to provide that prior to the accounts meeting, a quoted company must give to those members entitled to receive it notice of its intention to move an ordinary resolution approving the directors remuneration report for the financial year. Failure to comply with this requirement is an offence punishable by fine (s.440). Section 412 of the CA 2006 requires disclosure in the annual accounts of directors emoluments, including present and past directors pensions and compensation for loss of office. Sections 228-330 provides that the terms of a directors service contract must be made available for inspection either at its registered office or the place where its register of members is kept if other than its registered office. Breach of this requirement may result in a fine on conviction.

Activity 14.2
Read Guinness plc v Saunders [1990] 2 AC 663. a. What were the material terms of the companys articles of association? b. Why did the House of Lords order Mr Ward to repay the company the 5.2m awarded him by way of remuneration?

14.1.5 Removal of directors


Section 168(1) of the CA 2006 provides that a company may by ordinary resolution remove a director before the expiration of his period of office, notwithstanding anything in the articles or in any agreement between him and the company. Special notice must be given of the resolution (i.e. at least 28 days notice must be given before the meeting at which the resolution is to be moved (ss.168(2) and 312)). The director concerned is entitled to address the meeting at which it is proposed to remove him (s.169(2)). He may also require the company to circulate to the shareholders his representations in writing providing they are of a reasonable length (s.169(4)).

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While the power contained in s.168 cannot be removed by the articles, it is possible for a director to entrench himself by including in the articles a clause entitling him to weighted voting in the event of a resolution to remove him. In Bushell v Faith [1970] AC 1099 the articles provided that on a resolution to remove a particular director, his shares would carry the right to three votes per share. This meant that he was able to outvote the other shareholders who held 200 votes between them. In other words, the ordinary resolution could be blocked by him. The House of Lords approved the clause. Lord Upjohn reasoned that: Parliament has never sought to fetter the right of the company to issue a share with such rights or restrictions as it may think fit. He went on to state that in framing s.168 (s.303 CA 1985) all that Parliament was seeking to do was to make an ordinary resolution sufficient to remove a director and concluded that: Had Parliament desired to go further and enact that every share entitled to vote should be deprived of its special rights under the articles it should have said so in plain terms by making the vote on a poll one vote one share. Nowadays, however, while weighted voting clauses are commonly encountered in private companies of a quasipartnership nature, they are expressly prohibited by the LSE Listing Rules.

14.2 Categories of director


14.2.1 Executive and non-executive directors
Executive directors are full-time officers who generally have a service contract with the company. The articles will normally provide for the appointment of a managing director, sometimes called a chief executive, who has overall responsibility for the running of the company. Non-executive directors are normally appointed to the boards of larger companies to act as monitors of the executive management. They are typically part-time appointments. For the role of non-executive directors see section 14.4 of this chapter.

14.2.2 De facto directors


A de facto director is one who has not been formally appointed but has nevertheless acted as a director (Re Kaytech International plc [1999] BCC 390, CA). The issue of whether or not an individual is a de facto director generally arises in relation to disqualification orders under the Company Directors Disqualification Act (CDDA) 1986 (see below). The courts have formulated guidelines for determining the issue. In Re Richborough Furniture Ltd [1996] BCC 155, Lloyd J stated that emphasis should be given to the functions performed by the individual concerned (see also Secretary for State for Trade and Industry v Jones [1999] BCC 336). In Secretary of State for Trade and Industry v Tjolle [1998] BCC 282 Jacob J stated that the essential test is whether the person in question was part of the corporate governing structure. This was approved by the Court of Appeal in Re Kaytech International plc. In Secretary of State for Trade and Industry v Hollier [2006] EWHC 1804 (Ch), Etherton J, having made the point that no one can simultaneously be a de facto and a shadow director, went on to state that although various tests have been laid down for determining who may be a de facto director there is no single touchstone. The key test is whether someone is part of the governing structure of a company in that he participates in, or is entitled to participate in, collective decisions on corporate policy and strategy and its implementation.

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14.2.3 Shadow directors


In order to evade the duties to which directors are subject a shareholder might avoid formal appointment as such yet nevertheless direct the boards decision making. In this case the shareholder may be classified as a shadow director and will be subject to the statutory and common law obligations of directors (see Yukong Line Ltd of Korea v Rendsburg Investments Corpn of Liberia (No 2) [1998] BCC 870). For example, the s.214 Insolvency Act 1986 provides that a shadow director may be liable to contribute to the companys assets if it goes into insolvent liquidation and it is proved that at some time before the liquidation he knew or ought to have known that there was no reasonable prospect of avoiding insolvent liquidation. Section 251(1) of the CA 2006 defines a shadow director as a person in accordance with whose directions or instructions the directors are accustomed to act (see also s.22(5) CDDA 1986). Those who provide professional advice are expressly excluded. But a professional person may be held to be a shadow director if his or her conduct amounts to effectively controlling the companys affairs (Re Tasbian Ltd (No 3) [1993] BCLC 297). In Re Hydrodam (Corby) Ltd [1994] BCC 161, Millett J, considering the definition contained in s.741(2) CA 1985, took the view that in determining whether or not an individual is a shadow director four factors are relevant, namely that:
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the de jure and de facto directors of the company must be identifiable the person in question directed those directors on how to act in relation to the companys affairs or that he was one of the persons who did the directors did act in accordance with his instructions they were accustomed so to act.

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Millet J explained that a pattern of behaviour must be shown in which the board did not exercise any discretion or judgment of its own but acted in accordance with the directions of others. However, merely controlling one director is not sufficient; the shadow director must exercise control over the whole board or at least a governing majority of it (Re Lo-line Electric Motors Ltd [1988] Ch 477; Unisoft Group Ltd (No 2) [1993] BCLC 532).

Activity 14.3
Read Secretary of State for Trade and Industry v Deverell [2001] Ch 340. What was the courts approach to the determination of whether or not the respondent was a shadow director?

14.3 Disqualification of directors


The CDDA 1986 seeks to protect the general public against abuses of the corporate form. The effect of a disqualification order is that a person shall not, without the leave of the court, be a director of a company, or a liquidator or administrator of a company, or be a receiver or manager of a companys property or, in any way, whether directly or indirectly, be concerned or take part in the promotion, formation or management of a company, for a specified period beginning with the date of the order (s.1(1)). A disqualified person cannot, therefore, act in any of the alternative capacities listed and so, for example, a disqualified director cannot participate in the promotion of a new company during the disqualification period (Re Cannonquest, Official Receiver v Hannan [1997] BCC 644). Nor can he or she be concerned or take part in the management of a company by virtue of acting in some other capacity, for example a management consultant (R v Campbell [1984] BCLC 83).

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14.3.1 Discretionary orders


Conviction of an offence
Section 2 CDDA 1986 provides that the court may, at its discretion, issue a disqualification order against a person convicted of an indictable offence (whether on indictment or summarily) in connection with the promotion, formation, management, liquidation or striking off of a company, or with the receivership or management of a companys property. The offence does not have to relate to the actual management of the company provided it was committed in connection with its management. The maximum period of disqualification is five years where the order is made by a court of summary jurisdiction, and 15 years in any other case (s.2(3)).

Persistent breaches of the companies legislation


The court may disqualify a director where it appears that he or she has been persistently in default in complying with statutory requirements relating to any return, account or other document to be filed with, delivered or sent, or notice of any matter to be given, to the Registrar (s.3(1)). Persistent default will be presumed by showing that in the five years ending with the date of the application the person in question has been convicted (whether or not on the same occasion) of three or more defaults (s.3(2)). Section 5 goes on to provide that a disqualification order for persistent default can be made by a magistrates court (in England and Wales) at the same time as a person is convicted of an offence relating to the filing of returns, etc.

Fraud
The court may make a disqualification order against a person if, in the course of the winding up of a company, it appears that he: a. has been guilty of an offence for which he is liable (whether he has been convicted or not) under s.993 CA 2006 (fraudulent trading), or b. has otherwise been guilty, while an officer or liquidator of the company or receiver or manager of its property, of any fraud in relation to the company or of any breach of his duty as such officer, liquidator, receiver or manager (s.4). The maximum period for disqualification is 15 years (s.4(3)). Where a person has been found liable under s.213 or s.214 of the Insolvency Act 1986 (respectively the fraudulent trading and wrongful trading provisions, see Chapter 16 of this guide), the CDDA 1986 gives the court a discretion to disqualify such person for a period of up to 10 years.

Disqualification after investigation of the company


Section 8 CDDA 1986 provides that if it appears to the Secretary of State from a report following a DTI investigation that it is expedient in the public interest that a disqualification order should be made against any person who is or has been a director or shadow director of any company, he may apply to the court for a disqualification order. The court can disqualify such a person for up to 15 years if it is satisfied that his conduct in relation to the company makes him unfit to be concerned in the management of a company. This power has been used where, following a DTI investigation, it was apparent that a director had abused his or her power to allot shares in order to retain control of the company (Re Looe Fish Ltd [1993] BCC 348).

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14.3.2 Mandatory disqualification orders for unfitness


Section 6(1) CDDA 1986 provides that the court shall make a disqualification order against a person in any case where it is satisfied: a. that he is or has been a director of a company which has at any time become insolvent (whether while he was a director or subsequently), and b. that his conduct as a director of that company (either taken alone or taken together with his conduct as a director of any other company or companies) makes him unfit to be concerned in the management of a company. The minimum period of disqualification is two years and the maximum period is 15 years (s.6(4)). In contrast with the other grounds for disqualification noted above, s.6 is restricted to directors or shadow directors, including de facto directors. The policy underlying s.6 was explained by Dillon LJ in Re Sevenoaks Stationers (Retail) Ltd [1991] Ch 164 as being to protect the public, and in particular potential creditors of companies, from losing money through companies becoming insolvent when the directors of those companies are people unfit to be concerned in the management of a company. An insolvent company is defined as including a company which goes into liquidation at a time when its assets are insufficient to meet the payment of its debts, liabilities and liquidation expenses (s.6(2)). An application under s.6 must be brought by the Secretary of State or, if the company is in compulsory liquidation, by the Official Receiver, if it appears to him that it is expedient in the public interest that a disqualification order should be made against any person (s.7(1)).

The meaning of unfitness


Section 6 CDDA 1986 provides that the court must be satisfied that the directors conduct makes him unfit to be concerned in the management of a company. This has been construed as meaning unfit to manage companies generally rather than unfit to manage a particular company or type of company (Re Polly Peck International plc (No 2) [1994] 1 BCLC 574; see also Re Grayan Building Services Ltd [1995] Ch 241). In determining whether a persons conduct renders him unfit to be a director, s.9 CDDA 1986 directs the court to take into account the matters listed in Schedule 1, although those matters are not exhaustive. The list is divided into those matters which are generally applicable and those that are applicable only where the company has become insolvent. The first category comprises:
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misfeasance or breach of any fiduciary or other duty by the director (para 1) the degree of the directors culpability in concluding a transaction which is liable to be set aside as a fraud on the creditors (paras 2 and 3) the extent of the directors responsibility for any failure by the company to comply with the numerous accounting and publicity requirements of the Companies Act 2006 (paras 4 and 5).

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Those matters to which regard is to be had when the company is insolvent are listed in Part II of Schedule 1 and include:
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the extent of the directors responsibility for the causes of the company becoming insolvent (para 6) the extent of the directors responsibility for any failure by the company to supply any goods or services which have been paid for, in whole or in part (para 7).

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In Re Lo-Line Electric Motors Ltd [1988] Ch 477 Sir Nicholas Browne-Wilkinson V-C said that while ordinary commercial misjudgment is not in itself sufficient to establish unfitness, conduct which displays a lack of commercial probity or conduct which is grossly negligent or displays total incompetence would be sufficient to justify disqualification (see also Re Dawson Print Group Ltd [1987] BCLC 601; Secretary of State for Trade and Industry v Ettinger, Re Swift 736 Ltd [1993] BCLC 896).

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In Secretary of State for Trade and Industry v Swan (No 2) [2005] EWHC 603, Etherton J subjected the responsibilities of a non-executive director, against whom an application for disqualification under s.6 had been brought, to detailed consideration. N, a senior non-executive director and deputy chairman of the board and chairman of the audit and remuneration committees of Finelist plc, together with S, the companys CEO, were disqualified for three and four years respectively. Ns reaction upon being informed by a whistle-blower of financial irregularities (cheque kiting) going on within the group was held to be entirely inappropriate. He failed to investigate the allegations properly. Nor did he bring them to the attention of his fellow non-executive directors or to the auditors. The judge held that Ns conduct fell below the level of competence to be expected of a director in his position and he was, therefore, unfit to be concerned in the management of a company.

Activity 14.4
Read Secretary of State for Trade and Industry v TC Stephenson [2000] 2 BCLC 614. What were the allegations made against the director by the Secretary of State? What was the decision of the court?

Summary
The courts will look for abuses of the privilege of limited liability as evidenced by capricious disregard of creditors interests or culpable commercial behaviour amounting to gross negligence. Non-executive directors who lack corporate financial experience may rely on the advice and assurances provided by the companys accountants although they should be vigilant and raise objections whenever they have concerns about the financial operation of the company.

14.3.3 Disqualification undertakings


The Insolvency Act 2000 amends the CDDA 1986 by introducing a procedure whereby in the circumstances specified in ss.7 and 8 of the 1986 Act, the Secretary of State may accept a disqualification undertaking by any person that, for a period specified in the undertaking, the person will not be a director of a company, or act as a receiver, or in any way, whether directly or indirectly, be concerned or take part in the promotion, formation or management of a company unless (in each case) he has the leave of the court (s.6(2) of the 2000 Act, inserting s.1A into the CDDA 1986). In determining whether to accept a disqualification undertaking by any person, the Secretary of State may take account of matters other than criminal convictions, notwithstanding that the person may be criminally liable in respect of those matters. It is further provided that if it appears to the Secretary of State that the conditions mentioned in s.6(1) are satisfied with respect to any person who has offered to give him a disqualification undertaking, he may accept the undertaking if it appears to him that it is expedient in the public interest that he should do so (instead of applying or proceeding with an application for a disqualification order) (s.6(3) of the 2000 Act, inserting s.7(2A) into the CDDA 1986). Section 8 of the CDDA 1986 is amended by IA 2000 so that where it appears to the Secretary of State from the report of a DTI investigation that, in the case of a person who has offered to give him a disqualification undertaking, (a) the conduct of the person in relation to a company of which the person is or has been a director or shadow director makes him unfit to be concerned in the management of a company, and (b) it is expedient in the public interest that he should accept the undertaking (instead of applying or proceeding with an application for a disqualification order), he may accept the undertaking (s.6(4) of the 2000 Act, inserting s.8(2A) into the CDDA 1986). Section 8A of the CDDA 1986 provides that, on the application of a person who is subject to a disqualification undertaking, the court may: a. reduce the period for which the undertaking is to be in force, or b. provide for it to cease to be in force (s.6(5) IA 2000).

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These reforms are designed to save court time so that in the specified circumstances, disqualification can be achieved administratively without the need to obtain a court order.

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Competition disqualification orders


Directors who have breached competition law may also be disqualified by virtue of s.204 of the Enterprise Act 2002 which inserts ss.9A9E into the CDDA 1986 with effect from June 2003. Section 9A places the court under a duty to make a disqualification order against a director of a company which commits a breach of competition law provided that the court considers that his conduct as a director makes him unfit to be concerned in the management of a company. The maximum period for disqualification is 15 years. Application for a disqualification order on this ground may be made by the Office of Fair Trading (OFT) and certain other specified regulators (including, among others, the Director General of Telecommunications, the Gas and Electricity Markets Authority, and the Rail Regulator). The 2002 Act also introduces a parallel scheme for competition disqualification undertakings under s.9B to the one for disqualification undertakings introduced by the Insolvency Act 2000. The OFT or a specified regulator may accept a disqualification undertaking for up to 15 years from a director instead of applying for a court order. Section 9C provides that if the OFT (or specified regulator) has reasonable grounds for suspecting that a breach of competition law has occurred, it may carry out an investigation for the purpose of deciding whether to make an application under s.9A for a disqualification order.

Useful further reading


Axworthy, C.S. Corporate Directors who needs them?, [1988] 51 MLR 273. Bradley, C. Enterprise and entrepreneurship: the impact of director disqualification, [2001] JCLS 53. Finch, V. Disqualification of directors: a plea for competence, [1990] MLR 385. Hicks, A. Disqualification of directors 40 years on, [1988] JBL 27. Lowry, J. The whistle-blower and the non-executive director [2006] Journal of Corporate Law Studies 249. Milman, D. Personal liability and disqualification of company directors: something old, something new, [1992] NILQ 1. Sullivan, G.R. The relationship between the board of directors and the general meeting in limited companies, [1977] 93 LQR 569.

Sample examination question


Freedom Publishers Ltd (the company) is a private limited company with articles in the form of Table A, with the addition of the following clause: In the event of there being a resolution before a general meeting to dismiss a director, that directors shares shall carry five times the normal number of votes. The company has issued 10,000 shares, which are held as to 2,000 each by the three directors, Karl, Fred and Rosa. The remaining 4,000 are distributed among 10 or so shareholders. Karl and Fred have become disturbed by the fact that recently Rosa has taken up with a new boyfriend who is a member of an extremist political party and they feel that Rosa might not be able to continue to support the progressive publishing policies of the company. They consult you to consider whether Rosa could be dismissed as a director, telling you that they are likely to be able to command the support of all the other shareholders (apart, obviously, from Rosa). Advise Karl and Fred as to what course or courses of action they should follow.

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Advice on answering the question


This is a wide-ranging question requiring you to address a number of issues. It is important to organise and structure your answer clearly. The following points should be looked at. Discuss s.168 CA 2006 and weighted voting. You will need to explain the House of Lords decision in Bushell v Faith. A means of defeating Rosas voting power on a resolution to remove her is for the company to alter its articles by special resolution under s.21 CA 2006 (see Chapter 10 of this guide). Alternatively, the company might choose to issue additional shares in order to defeat Rosas voting power (ss.549-551 CA 2006). However she may be able to challenge such an allotment on the basis that it is for an improper purpose (see Chapter 15 of this guide, particularly Howard Smith Ltd v Ampol Petroleum [1974] AC 821 and Hogg v Cramphorn [1967] Ch 254). In any case, if Rosa exercises pre-emption rights (see ss.561572 CA 2006) this will frustrate the scheme to defeat her weighted voting rights.

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Reflect and review


Look through the points listed below. Are you ready to move on to the next chapter? Ready to move on = I am satisfied that I have sufficient understanding of the principles outlined in this chapter to enable me to go on to the next chapter. Need to revise first = There are one or two areas I am unsure about and need to revise before I go on to the next chapter. Need to study again = I found many or all of the principles outlined in this chapter very difficult and need to go over them again before I move on.
Ready to move on I can define the term director. I can explain the role of the board of directors and its relationship with the general meeting. I can describe the various categories of director. I can explain the process for awarding remuneration. I can describe how the general meeting can remove a director from the board. I can explain how directors can be disqualified from holding office. Need to revise first Need to study again

If you ticked need to revise first, which sections of the chapter are you going to revise?
Must revise 14.1 14.2 14.3 Directors Categories of directors Disqualification of director Revision done

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Notes

15 Directors duties

Contents
15.1 15.2 15.3 15.4 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Directors duties . . . . . . . . . . . . . . . . . . . . . . . . . . . . 160 161

The restatement of directors duties: Part 10 of the CA 2006 . . . . . . . 163 Relief from liability . . . . . . . . . . . . . . . . . . . . . . . . . . . 178 Specific statutory duties . . . . . . . . . . . . . . . . . . . . . . . . Reflect and review . . . . . . . . . . . . . . . . . . . . . . . . . . . 178 183

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Introduction
In this chapter we consider the duties of directors and Part 10 of the CA 2006, which sets out the equitable and common law duties of directors by way of statutory restatement. In addition, we will consider certain other statutory duties of directors aimed at addressing specific types of abuses. We will also examine the scope of the courts discretion to relieve directors from liability for breaches of duty. In considering the fiduciary duties of directors you should bear in mind the work you did for the Law of trusts in Part I of the LLB (see in particular Chapter 17 of that subject guide, Breach of fiduciary duty).

Learning outcomes
By the end of this chapter and the relevant readings, you should be able to:
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discuss the fiduciary position of directors discuss the content and scope of the duties of directors restated in Part 10 of the CA 2006 explain the authorisation process describe the principal transactions with directors that require the approval of members explain the courts discretion to relieve directors from liability describe the specific statutory duties of directors.

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Essential reading

Dignam and Lowry, Chapter 14: Directors duties. Davies, Chapter 16: Directors duties and Chapter 17: The derivative claim and personal actions against directors.

Cases

Percival v Wright [1902] 2 Ch 421 Allen v Hyatt (1914) 30 TLR 444 Gething v Kilner [1972] 1 WLR 337 Peskin v Anderson [2001] BCLC 372 Multinational Gas and Petrochemical Co Ltd v Multinational Gas and Petrochemical Services Ltd [1983] Ch 258 Re Smith & Fawcett Ltd [1942] Ch 304 Fulham Football Club Ltd v Cabra Estates plc [1994] BCLC 363 Extrasure Travel Insurances Ltd v Scattergood [2002] All ER (D) 307 (Jul) (Ch D) Item Software (UK) Ltd v Fassihi [2004] EWCA Civ 1244 Howard Smith Ltd v Ampol Petroleum Ltd [1974] AC 821 Teck Corporation Ltd v Millar [1972] 33 DLR (3d) 288 Regal (Hastings) Ltd v Gulliver [1942] 1 All ER 378, [1967] 2 AC 134n Cook v Deeks [1916] 1 AC 554 Industrial Development Consultants Ltd v Cooley [1972] 1 WLR 443 Bhullar v Bhullar [2003] EWCA Civ 424 Foster Bryant Surveying Ltd v Bryant [2007] EWCA Civ 200 Guinness plc v Saunders [1990] 2 AC 663 Neptune (Vehicle Washing Equipment) Ltd v Fitzgerald (No 2) [1995] BCC 1000 Re DJan of London Ltd [1993] BCC 646

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Re Duckwari plc [1997] 2 BCLC 713 Re Duckwari plc (No 2) [1999] Ch 268 Re Duckwari plc (No 3) [1999] 1 BCLC 168.

Additional cases

Colin Gwyer and Associates Ltd v London Wharf (Limehouse) Ltd [2003] 2 BCLC 153, Ch D Thorby v Goldberg (1964) 112 CLR 597 Gwembe Valley Development Co Ltd v Koshy [2003] EWCA Civ 1478 Norman v Theodore Goddard [1991] BCLC 1028 Bairstow v Queens Moat Houses plc [2000] 1 BCLC 549 Tito v Waddell (No 2) [1977] Ch 106.

15.1 Directors duties


Directors, being the principal management organ of the company, must act for its benefit and they therefore occupy a fiduciary position. Their fiduciary status can be traced to the origins of the modern company when companies were established by a deed of settlement that generally declared the directors to be trustees of the funds and assets of the business venture. The courts thus had a ready-made template in the form of trustee liability that was harnessed in order to frame the fiduciary duties of directors. The common law also constructed the duties of care and skill of directors and the legislature has added to the obligations of directors, generally as reactive measures to specific abuses. We will consider the three sources of directors duties in turn: equity, common law and statute (and particularly, Part 10 of the CA 2006).

15.1.1 The origins of Part 10 CA 2006


In July 1999 the Law Commission and the Scottish Law Commission issued a joint report, Company Directors: Regulating Conflicts of Interests and Formulating a Statement of Duties (Nos 261 and 173, respectively). The Law Commissions examination of directors duties and Part X of the Companies Act 1985 was already underway at the time of the DTIs (now BIS) announcement in March 1998 of the company law review. As part of this wider project the Law Commissions undertook to place their final report before the CLRSG. The DTI had charged the Commissions with the objective of determining whether or not the relevant statutory provisions could be reformed, made more simple or dispensed with altogether (the Law Commissions Consultation Paper No 153 (LCCP), para 1.7). The aim was to examine the presentation of the law governing directors duties rather than its reform. The report was lodged with the CLRSG in July 1999. The Law Commissions recommendations, and the DTIs response (see below), are wide ranging. The Law Commissions examined the case for restating directors duties in statute. Arguments against this were founded on loss of flexibility, while those in favour saw advantages in terms of certainty and accessibility. The Commissions conclusion was that the case for legislative restatement was made out and that the issue of inflexibility could be addressed by:
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ensuring the restatement was at a high level of generality by way of a statement of principles; and by providing that it was not exhaustive: ie while it would be a comprehensive and binding statement of the law in the field covered, it would not prevent the courts inventing new general principles outside the field.

uu

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The hallmark of the Law Commissions approach was their regard for the wider economic context in which company law, particularly that regulating directors, operates. It is asserted that in regulating the enterprise, the law should operate efficiently, promoting prosperity (LCCP para 2.8). More particularly, it is recommended that the law should move towards a general principle of meaningful disclosure, and that approval rules should be seen as the exception (Law Com No 261 and 173, para 3.72). The CLRSG proposed that the duties of directors should be restated and to this end the general duties owed by a director of a company to the company are set out in Part 10 CA 2006. We will examine each restated duty in turn. The Final Report of the CLRSG accepted the case for codification for two principal reasons.
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First, directors should know what is expected of them and therefore such a statement will further the CLRs objectives of reforming the law so as to achieve clarity and accessibility. Second, the process of formulating such a statement would enable defects in the present law to be corrected in important areas where it no longer corresponds to accepted norms of modern business practice.

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The CLR thought that this was particularly so with respect to the duties of conflicted directors. Before we begin our examination of directors duties, we first consider the important question of to whom are the duties owed?

15.1.2 To whom are the duties owed?


The orthodox answer to this question is now contained in s.170 CA 2006. It states that directors duties are owed to the company and not to shareholders individually (although note the corporate governance debate considered in Chapter 16 of this guide). Consequently, a breach of duty is a wrong done to the company and the proper claimant in proceedings in respect of the breach is the company itself (see Chapter 11 of this guide). The classic case which is now given the force of statute by s.170 is Percival v Wright [1902] 2 Ch 421. The directors offered to buy the shares held by the companys members without disclosing that at the time of the purchase they were negotiating with an outsider for the sale of the company at a higher price. The shareholders claimed that the directors were in breach of their fiduciary duty to them and that the sale ought to be set aside for non-disclosure. The court rejected their claim. The duty was owed to the company and, in any case, there was no unfair dealing by the directors. The shareholders had initially approached the directors asking them to purchase their shares. The decision in Percival v Wright leaves the critical question unanswered; namely, what is the company? Some assistance in solving this issue can be gleaned from the Report of the Second Savoy Hotel Investigation (The Savoy Hotel Ltd, and the Berkeley Hotel Co Ltd, Report of an Investigation under s.165 (6) of the Companies Act 1948, (H M Stationery Office, 1954)). The Report concluded that it was not enough for directors to act in the short-term interests of the company alone (see Greenhalgh v Arderne Cinemas Ltd [1951] Ch 286, on the meaning of the company as a whole), but that regard must be taken of the long-term interests of the company. In other words, the duty is not confined to the existing body of shareholders, but extends to future shareholders. Some assistance in addressing this issue is also given in s.172 CA 2006 (see 15.2.2 below). It is noteworthy that subsections (3) and (4) of s.170, taken together, direct the courts to have regard to the pre-existing case law when interpreting the statutory statement. The relevance of the existing jurisprudence is, therefore, put beyond doubt.

Company Law 15 Directors duties


In this regard, it is noteworthy that the courts have been able to distinguish Percival v Wright on its facts and have held that fiduciary duties, carrying a duty of disclosure, can be owed to shareholders. For example, when recommending whether a takeover offer should be accepted it has been held that directors owe a duty to the shareholders which includes a duty to be honest and not to mislead (see Allen v Hyatt (1914) 30 TLR 444; Gething v Kilner [1972] 1 WLR 337; Heron International Ltd v Lord Grade [1983] BCLC 244; Coleman v Myers [1977] 2 NZLR 225; Multinational Gas and Petrochemical Co Ltd v Multinational Gas and Petrochemical Services Ltd [1983] Ch 258; Peskin v Anderson [2000] 2 BCLC 1, affirmed [2001] BCLC 372).

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Activity 15.1
Read Coleman v Myers [1977] 2 NZLR 225. What were the special circumstances that led the court to distinguish Percival v Wright and hold that the directors owed fiduciary obligations to the shareholders?

15.1.3 Other points to note about s.170


Section 170(2) CA 2006 codifies the common law position that resignation is no defence to an action for breach of the no-conflict rule (s.175, see 15.2.5 below) or to an action where a director has accepted a benefit from a third party (s.176, see 15.2.6 below). (See also: IDC v Cooley [1972] 1 WLR 443; Canadian Aero Service Ltd v OMalley (1973) 40 DLR (3d) 371; CMS Dolphin Ltd v Simonet [2001] 2 BCLC 704, discussed below.)

Summary
The general principle at common law, and now carried forward by s.170 CA 2006, is that directors owe their duties to the company and not to the shareholders.

15.2 The restatement of directors duties: Part 10 of the CA 2006


Part 10 of the 2006 Act restates seven duties for directors. These are:
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the duty to act within powers (s.171) the duty to promote the success of the company (s.172) the duty to exercise independent judgment (s.173) the duty to exercise reasonable care, skill and diligence (s.174) the duty to avoid conflicts of interest (s.175) the duty not to accept benefits from third parties (s.176) the duty to declare interest in proposed transaction or arrangement (s.177)

The duty to declare interest in an existing transaction or arrangement is laid down by s.182. You should read each of these sections of the Act in full.

15.2.1 Duty to act within powers, s.171


Section 171 provides that:
A director of a company must (a) (b) act in accordance with the companys constitution, and only exercise powers for the purposes for which they are conferred.

This section restates the duty requiring a director to exercise his powers in accordance with the terms upon which they were granted (ie to comply with the companys constitution), and do so for a proper purpose (ie a purpose for which power was conferred).

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For the purpose of paragraph (a), the companys constitution is defined in s.17 CA 2006 as including the companys articles of association, decisions taken in accordance with the articles and other decisions taken by the members, or a class of them, if they can be regarded as decisions of the company. The importance of directors appreciating the purposes of the company as detailed in the constitution is critical if they are to fulfil the duty laid down by s.172 to promote the success of the company (see 15.2.2 below). The articles of association may increase the burden of the duties by, for example, requiring directors to obtain shareholder authorisation for their remuneration packages. However, the articles may not dilute the duties except to the extent expressly provided for in the relevant provisions. In this regard, s.173 (duty to exercise independent judgment (see 15.2.3 below)) provides that a director will not be in breach if he has acted in accordance with the constitution. As we will see, s.175 (duty to avoid conflicts of interest (see 15.2.5 below)) provides that a director will not be in breach where, subject to the constitution, the matter has been authorised by independent directors. Paragraph (b) of s.171 codifies the proper purposes doctrine formulated by Lord Greene MR in Re Smith & Fawcett Ltd [1942] Ch 304, where he stated that directors must not exercise their powers for any collateral purpose. The facts of Extrasure Travel Insurances Ltd v Scattergood [2002] All ER (D) 307 (Jul) (ChD) afford a clear illustration of a power (the power to deal with corporate assets) being exercised for an improper purpose. More generally, however, the issue of whether directors have used a power for a proper purpose arises in relation to their authority to issue shares. If shares are allotted in exchange for cash where the company is in need of additional capital the duty will not be broken. But where directors issue shares in order to dilute the voting rights of an existing majority shareholder because he or she is blocking a resolution supporting, for example, a takeover bid, then the duty will be breached (see Hogg v Cramphorn [1967] Ch 254). In Piercy v S Mills & Co Ltd [1920] 1 Ch 77 the court set aside a share issue on the basis that this was done simply and solely for the purpose of retaining control in the hands of the existing directors. The Privy Council in Howard Smith Ltd v Ampol Petroleum Ltd [1974] AC 821 subjected the content of the duty to thorough scrutiny. The directors allotted shares to a company which had made a takeover bid. The effect of the share issue was to reduce the majority holding of two other shareholders, who had made a rival bid, from 55 to 36 per cent. The two shareholders sought a declaration that the share allotment was invalid as being an improper exercise of power. The directors argued, however, that the allotment was made primarily in order to obtain much needed capital for the company. It was held that the directors had improperly exercised their powers:
it must be unconstitutional for directors to use their fiduciary powers over the shares in the company purely for the purpose of destroying an existing majority, or creating a new majority which did not previously exist. To do so is to interfere with that element of the companys constitution which is separate from and set against their powers.

Lord Wilberforce stressed that the court must examine the substantial purpose for which a power is exercised and must reach a conclusion as to whether that purpose was proper or not (see also Extrasure Travel Insurances Ltd v Scattergood; Criterion Properties plc v Stratford UK Properties LLC [2003] BCC 50). The power to issue shares may be exercised for reasons other than the raising of capital provided those reasons relate to a purpose benefiting the company as a whole; as distinguished from a purpose, for example, of maintaining control of the company in the hands of the directors themselves or their friends (Harlowes Nominees Pty Ltd v Woodside (Lake Entrance) Oil Co (1968) CLR 483). Further, it has been held that it may be in the companys interest for directors to forestall a resolution accepting a takeover offer by issuing shares. In Teck Corporation Ltd v Millar [1972] 33 DLR (3d) 288 the British Columbia Supreme Court held that an allotment of shares designed to defeat a takeover was proper even though it was made against the wishes of the existing shareholder and deprived him of control. Berger J stressed that, provided the

Company Law 15 Directors duties


directors act in good faith, they are entitled to consider the reputation, experience and policies of anyone seeking to take over the company and to use their power to protect the company if they decide, on reasonable grounds, that a takeover will cause substantial damage to the company. See further, Criterion Properties plc v Stratford UK Properties LLC [2004] UKHL 28.

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Activity 15.2
Read Lord Wilberforces opinion delivered in Howard Smith Ltd v Ampol Petroleum Ltd [1974] AC 821. What steps should the court go through when determining whether or not an exercise of power by directors was for an improper purpose?

Summary
The proper purposes doctrine restated in s.171 is an incident of the central fiduciary duty of directors to promote the success of the company (s.172, see 15.2.2 below). The power of directors to issue shares (ss.549-551 CA 2006), may be exercised for reasons other than the raising of capital provided those reasons relate to a purpose benefiting the company as a whole.

15.2.2 Duty to promote the success of the company, s.172


Section 172 reasserts the notion of the primacy of shareholders while recognising that well-managed companies operate on the basis of enlightened shareholder value (see Developing the Framework (URN 00/656, Department of Trade and Industry (DTI), 2000), paras 2.192.22; and Completing the Structure (URN 00/1335, DTI, 2000), para 3.5). According to this approach, directors, while ultimately required to promote shareholder interests, must take account of the factors affecting the companys relationships and performance. This duty has two elements. First, a director must act in the way he or she considers, in good faith, would be most likely to promote the success of the company for the benefit of its members as a whole. Secondly, in doing so, the director should have regard (among other matters) to the factors listed in s.172(1). This list is not exhaustive, but highlights areas of particular importance which reflect wider expectations of responsible business behaviour. The question of what will promote the success of the company is one for the directors good faith judgment. This aligns the duty with the position long taken by the courts that, as a general rule, their role is not to interfere in the internal management of companies. The orthodoxy here is that the management of companies is best left to the judgment of their directors, subject to the good faith requirement. In discharging this duty and, more particularly, in taking account of the factors listed in subsection (1), directors are bound to exercise reasonable care, skill, and diligence (s.174, see 15.2.4 below). A director will, therefore, need to demonstrate that the stakeholder interests listed informed his or her deliberations. In this regard, it is noteworthy that the requirement for a business review introduced by s.417 CA 2006 (though not applying to small companies and is qualified with respect to medium-sized companies) specifies that its purpose is to inform members of the company and help them assess how the directors have performed their duty under section 172. Section 172(1) restates Lord Greene MRs formulation of the duty in Re Smith & Fawcett Ltd:
directors must exercise their discretion bona fide in what they consider not what a court may consider is in the interests of the company

This non-interventionist policy (the internal management rule) was explained by Lord Eldon LC in Carlen v Drury (1812) 1 Ves & B 154, who said: This Court is not required on every Occasion to take the Management of every Playhouse and Brewhouse in the Kingdom.

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In Item Software (UK) Ltd v Fassihi [2005] 2 BCLC 91, Arden LJ, having noted that the fundamental duty [of a director] is the duty to act in what he in good faith considers to be the best interests of his company, concluded that this duty of loyalty is the time-honoured rule (citing Goulding J in Mutual Life Insurance Co of New York v Rank Organisation Ltd [1985] BCLC 11). The determination of good faith is partly subjective in that the court will not substitute its own view about a directors conduct in place of the boards own judgment. In Regentcrest plc v Cohen [2001] 2 BCLC 80, Jonathan Parker J observed the question is whether the director honestly believed that his act or omission was in the interests of the company. The issue, therefore, relates to the directors state of mind (see also, Extrasure Travel Insurances Ltd v Scattergood (above)). However, in determining whether the duty has been discharged an objective assessment is also made. In Charterbridge Corporation Ltd v Lloyds Bank Ltd [1970] Ch 62, Pennycuick J stated that the test for determining whether this duty has been discharged must be whether an intelligent and honest man in the position of a director of the company concerned, could, in the whole of the existing circumstances, have reasonably believed that the transactions were for the benefit of the company. Thus, in Neptune (Vehicle Washing Equipment) Ltd v Fitzgerald (No 2) [1995] BCC 1000, the companys sole director resolved at a board meeting in which he and the company secretary were the only attendees, that his service contract should be terminated and that 100,892 be paid to him as compensation. It was held that he was not acting in what he honestly and genuinely considered to be in the best interests of the company but rather was acting exclusively to further his own personal interests. (See also Knight v Frost [1999] 1 BCLC 364; Ball v Eden Project Ltd [2002] 1 BCLC 313, Laddie J; Item Software (UK) Ltd v Fassihi [2004] EWCA Civ 1244.)

Section 172 and section 417 CA 2006: the business review


The business review, forming part of the directors annual report, is a narrative report of the companys business activities designed to flesh out the figures contained in the accounts. The intent behind the provision seems to be more of a declaration rather than an obligation on directors. It certainly explains how the requirements in s.417(5) and (6) are directed towards giving members an understanding of such trends and factors. These requirements refer, among other things, to certain matters being included in the review such as the main trends and factors likely to affect the future development, performance and position of the companys business (including information about environmental matters, the companys employees, social and community issues and the companys relationship with its suppliers). As has been noted, the statutory objective of the business review is laid down in s.417(2). It provides that:
The purpose of the business review is to inform members of the company and help them assess how the directors have performed their duty under section 172.

It is therefore made clear that the review is an integral part of the duty of loyalty. In informing the members about the directors performance of this duty, s.417(4) states that the review must give a balanced and comprehensive analysis. To achieve this, subsection (6) requires the use of key performance indicators (KPIs) relating to financial matters and to environmental and employee matters. Although the particular KPIs used are left to the discretion of the directors, they must be effective in measuring the development, performance or position of the business.

Insolvency and creditors section 172(3)


Note that s.172(3) states that the duty to promote the success of the company has effect subject to any rule of law requiring directors to act in the interests of creditors. In this respect English and Australian courts have reasoned that where a company is insolvent directors must have regard to the interests of the creditors. In West Mercia Safetywear Ltd v Dodd [1988] BCLC 250 the Court of Appeal, citing with approval the decision of the New South Wales Court of Appeal in Kinsela v Russell Kinsela Pty Ltd (1986)

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10 ACLR 395, held that shareholders cannot absolve directors from a breach of duty to creditors so as to bar the liquidators claim. In Dillon LJs view the following passage from Street CJs judgment in Kinsela was of particular note.
In a solvent company the proprietary interests of the shareholders entitle them as a general body to be regarded as the company when questions of the duty of directors arise... But where a company is insolvent the interests of the creditors intrude. They become prospectively entitled, through the mechanism of liquidation, to displace the power of the shareholders and directors to deal with the companys assets. It is in a practical sense their assets and not the shareholders assets that, through the medium of the company, are under the management of the directors pending either liquidation, return to solvency, or the imposition of some alternative administration...

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The recognition of the existence of directors duties to creditors has received the endorsement of the House of Lords. In Winkworth v Edward Baron Development Co Ltd [1986] 1 WLR 1512, Lord Templeman explained that directors owe a fiduciary duty to the company and its creditors, present and future, to ensure that its affairs are properly administered and to keep the companys property inviolate and available for the repayment of its debts (see also, Lonhro Ltd v Shell Petroleum Co Ltd [1980] 1 WLR 627 HL, at 634 per Lord Diplock).

Standing to sue
The question of standing to sue to enforce this duty (locus standi) arose in Yukong Line Ltd of Korea v Rendsburg Investment Corpn of Liberia (No 2) [1998] 2 BCLC 485 in which it was pointed out that creditors have no standing, individually or collectively, to bring an action in respect of any such duty. Toulson J held that a director of an insolvent company who, in breach of duty to the company, transferred assets beyond the reach of its creditors owed no corresponding fiduciary duty to an individual creditor of the company. The appropriate means of redress was for the liquidator to bring an action for misfeasance (s.212 Insolvency Act 1986). Notwithstanding the logistical issue of locus standi raised by Toulson J, the question of directors duties to creditors again emerged in two recent decisions of the Companies Court. In Re Pantone 485 Ltd [2002] 1 BCLC 266, Richard Reid QC, sitting as a deputy judge in the High Court, observed that:
In my view, where the company is insolvent, the human equivalent of the company for the purposes of the directors fiduciary duties is the companys creditors as a whole, i.e. its general creditors. It follows that if the directors act consistently with the interests of the general creditors but inconsistently with the interest of a creditor or section of creditors with special rights in a winding up, they do not act in breach of duty to the company.

Again, in Colin Gwyer and Associates Ltd v London Wharf (Limehouse) Ltd [2003] 2 BCLC 153, it was held that a resolution of the board of directors passed without proper consideration being given by certain directors to the interests of creditors would be open to challenge if the company had been insolvent at the date of the resolution. Leslie Kosmin QC, sitting as a deputy judge in the High Court, stated that in relation to an insolvent company, the directors, when considering the companys interests, must have regard to the interests of the creditors. The court was required to test the directors conduct by reference to the Charterbridge Corp Ltd v Lloyds Bank Ltd [1970] Ch 62 test (i.e. could an honest and intelligent man, in the position of the directors, in all the circumstances, reasonably have believed that the decision was for the benefit of the company). In the case of insolvent companies the test is to be applied with the benefit of the creditors substituted for the benefit of the company. Section 172(3) also makes express reference to any enactment. In this respect, it should be noted that section 214 of the Insolvency Act 1986 provides that a liquidator of a company in insolvent liquidation can apply to the court to have a person who is or has been a director of the company declared personally liable to make such contribution to the companys assets as the court thinks proper for the benefit of the unsecured creditors. The liquidator must prove that the director in question allowed

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the company to continue to trade, at some time before the commencement of its winding up, when he knew or ought to have concluded that there was no reasonable prospect that the company would avoid going into insolvent liquidation.

Activity 15.3
Read Extrasure Travel Insurances Ltd v Scattergood [2002] All ER (D) 307 (Jul), Ch D. Where a company is a member of a group, in whose interests should the directors act?

15.2.3 Duty to exercise independent judgment, s.173


Section 173 provides the following.
(1) (2) A director of a company must exercise independent judgment. This duty is not infringed by his acting in accordance with an agreement duly entered into by the company that restricts the future exercise of discretion by its directors, or in a way authorised by the companys constitution.

(a) (b)

This provision restates the principle developed in the case law that directors must exercise their powers independently and not subordinate their powers to the control of others by, for example, contracting with a third party as to how a particular discretion conferred by the articles will be exercised. This is a facet of the duty to promote the success of the company laid down in section 172. Directors are not permitted to delegate their powers unless the companys constitution provides otherwise. The duty operates so as to prohibit directors fettering their discretion by contracting with an outsider as to how a particular discretion conferred by the articles will be exercised except, possibly, where this is to the companys commercial benefit. In Fulham Football Club Ltd v Cabra Estates plc [1994] BCLC 363, four directors of Fulham football club agreed with Cabra, the clubs landlords, that they would support Cabras planning application for the future development of the clubs ground rather than the plan put forward by the local authority. In return for this undertaking, Cabra paid the football club a substantial fee. The directors subsequently decided to renege on this promise and wanted to give evidence to a planning enquiry opposing the development. They argued that their agreement with Cabra was an unlawful fetter on their powers to act in the best interests of the company. The Court of Appeal rejected this argument. It was held that:
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the agreement with the landlords was part of a contract that conferred significant benefits on the company the directors, in giving their undertaking to Cabra, had not improperly fettered the future exercise of their discretion.

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In fact, it was not a case of directors fettering their discretion because they had exercised it at the time they gave their undertaking. The Court drew a distinction between:
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directors fettering their discretion, which is a clear breach of duty directors exercising their discretion in a manner which restricts their future conduct; this is not a breach of duty.

Neil LJ endorsed the view of Kitto J in the Australian case Thornby v Goldberg (1964) 112 CLR 597 stating:
There are many kinds of transaction in which the proper time for the exercise of the directors discretion is the time of the negotiation of a contract and not the time at which the contract is to be performed... If at the former time they are bona fide of opinion that it is in the interests of the company that the transaction should be entered into and carried into effect I see no reason in law why they should not bind themselves.

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15.2.4 Duty to exercise reasonable care, skill and diligence, s.174


Section 174 gives statutory effect to the modern judicial stance taken towards the determination of the standard of care expected of directors. It provides the following.
(1) (2) A director of a company must exercise reasonable care, skill and diligence. This means the care, skill and diligence that would be exercised by a reasonably diligent person with the general knowledge, skill and experience that may reasonably be expected of a person carrying out the functions carried out by the director in relation to the company, and the general knowledge, skill and experience that the director has.

(a) (b)

In Re DJan of London Ltd [1993] BCC 646, Hoffmann LJ, applying s.214(4) of the Insolvency Act 1986, held the director negligent and prima facie liable to the company for losses caused as a result of its insurers repudiating a fire policy for non-disclosure. The director had signed the inaccurate proposal form without first reading it. The effect of s.174 is that a directors actions will be measured against the conduct expected of a reasonably diligent person. This is therefore an objective test. However, subjective considerations will also apply according to the level of any special skills the particular director may possess. The focus on objective assessment can also be seen in cases brought under the Company Directors Disqualification Act 1986 (see Chapter 14, above), particularly in relation to where directors delegate their powers. Inactivity on the part of directors is no longer acceptable. Therefore little weight is given to any contention to the effect that the director was unaware of a state of affairs because he had trusted others to manage the company (see Re Landhurst Leasing plc [1999] 1 BCLC 286). Thus, a director cannot take a passive role in the management of the company. This is also the case in small private owner-managed companies (termed quasi-partners) where a spouse or son assumes the role of director without ever expecting to play a pro-active part in the affairs of the company. In Re Brian D Pierson (Contractors) Ltd [2001] 1 BCLC 275 the court refused to countenance such symbolic roles:
The office of director has certain minimum responsibilities and functions, which are not simply discharged by leaving all management functions, and consideration of the companys affairs to another director without question, even in the case of a family company One cannot be a sleeping director; the function of directing on its own requires some consideration of the companys affairs to be exercised.

Further, in Re Westmid Packing Services Ltd, Secretary of State for Trade and Industry v Griffiths [1998] 2 BCLC 646, Lord Woolf stated that:
The collegiate or collective responsibility of the board of directors of a company is of fundamental importance to corporate governance under English company law. That collegiate or collective responsibility must however be based on individual responsibility. Each individual director owes duties to the company to inform himself about its affairs and to join with his co-directors in supervising or controlling them.

See also Dorchester Finance Co Ltd v Stebbing [1989] BCLC 498.

Activity 15.4
Read Foster Js judgment in Dorchester Finance v Stebbing [1989] BCLC 498. Were the non-executive directors (NEDs) held liable for signing blank cheques and leaving them with Stebbings, the executive director? Was a lower standard of care required of two of the defendants because they were NEDs? Was the fact that they were qualified accountants material?

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15.2.5 Duty to avoid conflicts of interest, s.175


Section 175 replaces the equitable obligation to avoid conflicts of interest whereby directors are liable to account for any profit made personally in circumstances where their interests may conflict with their duty owed to the company. The substance of this duty is strict. This is reflected in the language of s.175(1), in that it is framed in terms of the possibility of conflict rather than actual conflicts of interest.
A director of a company must avoid a situation in which he has or can have, a direct or indirect interest that conflicts, or possibly may conflict, with the interests of the company.

This encompasses the significant body of case law spanning over a century or so which the provision codifies. See Re Lands Allotment Co [1894] 1 Ch 616 and JJ Harrison (Properties) Ltd v Harrison [2002] 1 BCLC 162, confirming that a director holds the proceeds made from a breach of fiduciary duty as a constructive trustee. The fundamental objective of the duty to avoid conflicts of interest is aimed at curbing any temptation directors may succumb to when faced with the opportunity of preferring their own interests over and above those of the companys. As explained by Lord Herschell in Bray v Ford [1896] AC 44:
It is an inflexible rule of a court of equity that a person in a fiduciary position is not, unless otherwise expressly provided, allowed to put himself in a position where his interest and duty conflict. It does not appear to me that this rule is founded upon principles of morality. I regard it rather as based on the consideration that, human nature being what it is, there is a danger, in such circumstances, of the person holding a fiduciary position being swayed by interest rather than by duty, and thus prejudicing those whom he was bound to protect.

A modern formulation of this duty was delivered by Millett LJ in Bristol and West Building Society v Mothew [1998] Ch 1:
The distinguishing obligation of a fiduciary is the obligation of loyalty. The principal is entitled to the single-minded loyalty of his beneficiary. This core liability has several facets. A fiduciary must act in good faith; he must not make a profit out of his trust; he must not place himself in a position where his duty and his interest may conflict...

The classic decision on this aspect of the fiduciary obligation is Regal (Hastings) Ltd v Gulliver [1942] 1 All ER 378, [1967] 2 AC 134n. Regal owned a cinema and its directors wished to acquire two additional local cinemas and sell the whole undertaking as a going concern. They formed a subsidiary company in order to take a lease of the other two cinemas but the landlord was not prepared to grant the subsidiary a lease on these two cinemas unless the subsidiarys paid-up capital was 5,000. The company was unable to inject more than 2,000 in cash for 2,000 shares and so the original arrangement was changed. It was decided that Regal would subscribe for 2,000 shares and the outstanding 3,000 shares would be taken up by the directors and their associates. Later, the whole business was sold by way of takeover and the directors made a profit. The purchasers of Regal installed a new board of directors and the company successfully brought an action against its former directors claiming that they should account for the profit they had made on the sale of their shares in the subsidiary. Lord Russell of Killowen stated that the opportunity and special knowledge to obtain the shares had come to the directors qua fiduciaries and having obtained these shares by reason of the fact that they were directors of Regal, and in the course of the execution of that office, are accountable for the profits which they have made out of them. Lord Russell went on to add that:
the rule of equity which insists on those, who by use of a fiduciary position make a profit, being liable to account for that profit, in no way depends on fraud, or absence of bona fides; or upon such questions or considerations as whether profit would or should otherwise have gone to the plaintiff

The liability arises from the mere fact of a profit having, in the stated circumstances, been made.

Company Law 15 Directors duties Corporate opportunities


An incident of the duty to avoid a conflict of interests is the so-called corporate opportunity doctrine. This makes it a breach of fiduciary duty by a director to appropriate for his own benefit an economic opportunity which is considered to belong rightly to the company which he serves (Prentice, [1974] MLR 464). A corporate opportunity is viewed as an asset of the company which may not therefore be misappropriated by the directors. In Cook v Deeks [1916] 1 AC 554, three of the four directors diverted to their own personal benefit certain railway construction contracts which were offered to the company. Notwithstanding that their conduct was ratified by the company, the directors were held accountable. Lord Buckmaster said that the directors, while entrusted with the conduct of the affairs of the company [had] deliberately designed to exclude, and used their influence and position to exclude, the company whose interest it was their first duty to protect. The distinction between Regal (Hastings) where ratification was a possibility and Cook v Deeks in which the Privy Council ruled out the question of ratification as a means of avoiding liability is not easy to discern. The answer probably lies in the fact that in the decision for Cook v Deeks the directors were fraudulent. In Regal (Hastings) the House of Lords accepted that the directors acted in good faith. In Industrial Development Consultants Ltd v Cooley [1972] 1 WLR 443, the defendant, who was managing director of Industrial Development Consultants Ltd (IDC), a design and construction company, failed to obtain for the company a lucrative contract to undertake work for the Eastern Gas Board. The Gas Board subsequently approached Cooley indicating that they wished to deal with him personally and would not, in any case, contract with IDC. Cooley did not disclose the offer to the company. However, he promptly resigned his office so that he could take up the contract after deceiving the company into thinking he was suffering from ill health. Roskill J held that he was accountable to the company for all of the profits he received under the contract. Information which came to Cooley while he was managing director and which was of concern to the plaintiffs and relevant for the plaintiffs to know, was information which it was his duty to pass on to the plaintiffs. It was irrelevant to the issue of liability that Cooley had been approached in his personal capacity and that the Gas Board would not have contracted with IDC. Roskill J concluded that:
if the defendant is not required to account he will have made a large profit as a result of having deliberately put himself into a position in which his duty to the plaintiffs who were employing him and his personal interests conflicted.

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See also Bhullar v Bhullar, Re Bhullar Bros Ltd [2003] EWCA 424; Gwembe Valley Development Co Ltd v Koshy [2003] EWCA Civ 1478. On post-resignation breaches (s.175(4)) see Foster Bryant Surveying Ltd v Bryant [2007] EWCA Civ 200. In this regard in Peso Silver Mines v Cropper [1966] 58 DLR (2d) 1, the board of Peso was offered the opportunity to buy a number of mining claims. Some of these were located on land which adjoined the companys own mining territories. The board bona fide declined the offer because:
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of the then financial state of the company there was some doubt over the value of the claims.

Later, the companys geologist formed a syndicate with the defendant and two other Peso directors to purchase and work the claims. When the company was taken over, the new board (as in Regal (Hastings)) brought an action claiming that the defendant held his shares on constructive trust for the company. The claim was unsuccessful. It was held that the decision of the directors to reject the opportunity had been made in good faith and for sound commercial reasons in the interests of the company. See also, Laskin Js approach towards the issue of determining liability in Canadian Aero Service Ltd v OMalley [1973] 40 DLR (3d) 371.

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Recent decisions have made it clear that the general fiduciary obligations of a director do not prevent him from:
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making the decision, while still a director, to set up in a competing business after his directorship has ceased taking preliminary steps to investigate or forward that intention provided he did not engage in any actual competitive activity while his directorship continued.

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In this regard, see:


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Island Export Finance Ltd v Umunna [1986] BCLC 460. Balston Ltd v Headline Filters Ltd [1990] FSR 385. Framlington Group plc v Anderson [1995] 1 BCLC 475. Coleman Taymar Ltd v Oakes [2001] 2 BCLC 749.

A director may utilise confidential information or know-how acquired while working for the company after he departs but not trade secrets (see Dranez Anstalt v Hayek [2002] 1 BCLC 693; CMS Dolphin Ltd v Simonet [2001] 2 BCLC 704). It is worth noting that s.175(4)(a) recognises that unexpected situations can arise where a conflict exists, but that conflict alone does not necessarily constitute a breach by directors. As explained by Lord Goldsmith, (see Official Report, 6/2/2006; coll GC289):
Once you know that you are now in a situation of conflict, you will have to do something about it, but you are not in breach simply because it happened when, as is set out in subsection (4)(a), it could not, reasonably be regarded as likely to give rise to the conflict.

Competing directorships: conflicts of interest and duty and conflicts of duties


Section 175(7) states that any reference in this section to a conflict of interest includes a conflict of interest and duty and a conflict of duties. This at last injects a long awaited measure of cohesion in to the law and settles a long running dispute surrounding what was seen to be an anomalous decision of Chitty J in London and Mashonaland Co Ltd v New Mashonaland Exploration Co Ltd [1891] WN 165 in which it was held that no breach of duty arose where a director held office with two or more competing companies. The modern courts have adopted a stricter stance in viewing competing directors as giving rise to an irreconcilable conflict of interest and duty. See SCWS v Meyer [1959] AC 324, where Lord Denning said that such directors walk a very fine line, and Plus Group Ltd v Pyke [2002] EWCA Civ 370. See also Bell v Lever Bros Ltd [1932] AC 161, HL; Hivac Ltd v Park Royal Scientific Instruments Ltd [1946] Ch 169. Thus, s.175(7) brings competing directorships into the general prohibition of conflicts of duty.

Avoiding liability for conflicts of duty: authorisation by the directors s.175(5)


A major concern expressed by the Company Law Review was that the case law on conflicts of duty holds the potential to fetter entrepreneurial and business start-up activity by existing directors and that the statutory statement of duties should only prevent the exploitation of business opportunities where there is a clear case for doing so (Completing the Structure). The 2005 White Paper echoes this concern by stating that it is important that the duties do not impose impractical and onerous requirements which stifle entrepreneurial activity (at para 3.26). Section 175(5)(a) therefore implements the CLRSGs recommendation that conflicts may be authorised by independent directors unless, in the case of a private company, its constitution otherwise provides. For a public company the directors will only be able to authorise such conflicts if its constitution expressly permits (s.175(5)(b)). Further, s.175(6) provides that board authorisation is effective only if the conflicted directors have not participated in the taking of the decision or if the decision would have been valid

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even without the participation of the conflicted directors. The votes of the conflicted directors in favour of the decision will be ignored and the conflicted directors are not counted in the quorum.

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Self-dealing directors: ss.175(3) and 177 CA 2006


The underlying rationale of the self-dealing rule, which prohibits a director from being interested in a transaction to which the company was a party, was explained by the House of Lords in Aberdeen Rly Co v Blaikie Bros (1854) 1 Macq 461. The company had contracted with John Blaikie for the supply of iron chairs. At the time of the contract John Blaikie was both a director of Aberdeen Railway and a partner of Blaikie Bros. Lord Cranworth LC, having stated that no-one, having [fiduciary] duties to discharge, shall be allowed to enter into engagements in which he has, or can have, a personal interest conflicting, or which possibly may conflict, with the interests of those whom he is bound to protect, went on to stress that:
his duty to the company imposed on him the obligation of obtaining these iron chairs at the lowest possible price. His personal interest would lead him in an entirely opposite direction, would induce him to fix the price as high as possible. This is the very evil against which the rule in question is directed.

In a similar vein Megarry VC observed in Tito v Waddell (No 2) [1977] Ch 106:


The self-dealing rule is (to put it very shortly) that if a trustee sells the trust property to himself, the sale is voidable by any beneficiary ex debito justitiae, however fair the transaction.... [E]quity is astute to prevent a trustee from abusing his position or profiting from his trust: the shepherd must not become a wolf.

See also, the joint judgment of Rich, Dixon and Evatt JJ in Furs Ltd v Tomkies (1936) 54 CLR 583. It is noteworthy that the statutory statement of directors duties does not follow the common law position. Self-dealing is removed from the realms of directors fiduciary duties and replaced with a statutory obligation to disclose an interest. Section 175(3) makes it clear that the duty to avoid conflicts of interest contained in s.175(1) does not apply to a conflict of interest arising in relation to a transaction or arrangement with the company. Rather, self-dealing falls within s.177(1). This provides that: [i]f a director is in any way, directly or indirectly, interested in a proposed transaction or arrangement with the company, he must declare the nature and extent of that interest to the other directors. In similar terms s.182 applies to cases where a director has an interest in a transaction after it has been entered into by the company. The provisions do not apply to substantial property transactions, loans, quasi-loans and credit transactions which require the approval of the companys members (ss.190 203, see 15.3 below). Sections 177 and 182 reflect the common practice that companies articles of association generally permitted directors to have interests in conflict transactions provided they were declared to the board. The reason why the common law tolerated such relaxation of the rule was explained by Upjohn LJ in Boulting v Association of Cinematograph Television and Allied Technicians [1963] 2 QB 606:
It is frequently very much better in the interests of the company... that they should be advised by someone on some transaction, although he may be interested on the other side of the fence. Directors... may sometimes be placed in such a position that though their interest and duty conflict, they can properly and honestly give their services to both sides and serve two masters to the great advantage of both. If the person entitled to the benefit of the rule is content with that position and understands what are his rights in the matter, there is no reason why he should not relax the rule, and it may commercially be very much to his advantage to do so.

The principal distinction between the two statutory provisions is that, whereas breach of s.177 carries civil consequences (s.178), breach of s.182 results in criminal sanctions (s.183). More particularly, s.178 states that the consequences of breach (or threatened breach) of ss.171-177 are the same as would apply if the corresponding common law

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rule or equitable principle applied. This is subject to the proviso introduced by s.180(1) that, subject to any provision to the contrary in the companys constitution, if s.177 is complied with, the transaction is not liable to be set aside by virtue of any common law rule or equitable principle requiring the consent of members. The question has arisen as to whether disclosure has to be made at a formal meeting of the board. In Lee Panavision Ltd v Lee Lighting Ltd [1992] BCLC 22 and Runciman v Walter Runciman plc [1992] BCLC 1084 it was held that informal disclosure to all members of the board would suffice. In MacPherson v European Strategic Bureau Ltd [1999] 2 BCLC 203 each of the shareholders and the directors knew the precise nature of others interest so that there was, in effect, unanimous approval of the agreement. The court therefore held that:
[n]o amount of formal disclosure by each other to the other would have increased the others relevant knowledge.

However it should be noted that the board has to be given precise information about the transaction in question (Gwembe Valley Development Co Ltd v Koshy [2000] BCC 1127), affirmed by the Court of Appeal [2003] EWCA Civ 1478.

15.2.6 Duty not to accept benefits from third parties, s.176


Section 176(1) provides that a director must not accept a benefit from a third party conferred by reason of: a. his being a director, or b. his doing (or not doing) anything as director. This duty is an element of the wider no-conflict duty laid down in s.175 and it too will not be infringed if acceptance of the benefit cannot reasonably be regarded as likely to give rise to a conflict of interest. It should be noted that it applies only to benefits conferred because the director is a director of the company or because of something that the director does or does not do as director. The word benefit, for the purpose of this section, is not defined in the Act although during the Parliamentary debates on the Bill it was made clear that it includes benefits of any description, including non-financial benefits (Official Report, 9/2/2006; coll GC330 (Lord Goldsmith)). While s.175(5) provides for board authorisation in respect of conflicts of interest, this is not the case with this particular duty. However, the company may authorise the acceptance of benefits by virtue of s.180(4). Section 176(2) defines a third party as a person other than the company or its holding company or its subsidiaries and thus s.176(3) provides that benefits provided by the company fall outside the prohibition.

15.2.7 Remedies for breach of duties


Section 178 CA 2006 preserves the existing civil consequences of breach (or threatened breach) of any of the general duties. Although an attempt was made to codify the remedies available for breach of directors duties, this proved to be a very difficult exercise and eventually it became too difficult to pursue. It provides: 1. the consequences of breach (or threatened breach) of sections 171 to 174 are the same as would apply if the corresponding common law rule or equitable principle applied 2. the duties in those sections (with the exception of section 174 (duty to exercise reasonable care, skill and diligence)) are, accordingly, enforceable in the same way as any other fiduciary duty owed to a company by its directors. In the case of fiduciary duties the consequences of breach may include:
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damages or compensation where the company has suffered loss (see Re Lands Allotment Co [1894] 1 Ch 616, CA; Joint Stock Discount Co v Brown (1869) LR 8 Eq 381) restoration of the companys property (see Re Forest of Dean Coal Co (1879) 10 Ch D 450; JJ Harrison (Properties) Ltd v Harrison [2002] 1 BCLC 162, CA) an account of profits made by the director (see Regal(Hastings) Ltd v Gulliver)

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injunction or declaration (see Cranleigh Precision Engineering Ltd v Bryant [1965] 1 WLR 1293.) rescission of a contract where the director failed to disclose an interest (see Transvaal Lands Co v New Belgium (Transvaal) Land & Development Co [1914] 2 Ch 488, CA).

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Presumably the rules developed for establishing the liability of accessories (for example, in the case of receipt of property pursuant to a breach of fiduciary duty, or dishonest assistance of such a breach) will be applied notwithstanding that the breach may be of a duty which is now statutorily defined and imposed. The liability to account arises even where the director acted honestly and where the company could not otherwise have obtained the benefit (Regal (Hastings) Ltd v Gulliver; IDC v Cooley). In Murad v Al-Saraj [2005] EWCA Civ 959, Arden LJ explained the policy underlying such liability:
It may be asked why equity imposes stringent liability of this nature... equity imposes stringent liability on a fiduciary as a deterrent pour encourager les autres. Trust law recognises what in company law is now sometimes called the agency problem. There is a separation of beneficial ownership and control and the shareholders (who may be numerous and only have small numbers of shares) or beneficial owners cannot easily monitor the actions of those who manage their business or property on a day to day basis. Therefore, in the interests of efficiency and to provide an incentive to fiduciaries to resist the temptation to misconduct themselves, the law imposes exacting standards on fiduciaries and an extensive liability to account.

In Coleman Taymar Ltd v Oakes [2001] 2 BCLC 749, Robert Reid QC, sitting as a Deputy Judge of the High Court, stated that a company is entitled to elect whether to claim
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damages (equitable compensation) or an account of profits against a director who, in breach of duty, makes a secret profit.

However, even though the profit may arise out of the use of position as opposed to the use of trust property, the judges more typically resort to the language of the constructive trust as the means for fashioning a remedy (see Boardman v Phipps [1967] 2 AC 46, although, Lord Guest excepted, all of their Lordships spoke of the defendants liability to account). In A-G for Hong Kong v Reid [1994] 1 AC 324, Lord Templeman explained that Boardman demonstrates the strictness with which equity regards the conduct of a fiduciary and the extent to which equity is willing to impose a constructive trust on property obtained by a fiduciary by virtue of his office. In JJ Harrison (Properties) Ltd v Harrison [2002] 1 BCLC 162, CA, a director usurped a corporate opportunity by acquiring for his own benefit development land owned by the company. At the time of valuation he failed to disclose that planning permission was forthcoming which, once granted, would greatly inflate its value. The company, having unsuccessfully applied for planning permission a couple of years earlier, was unaware that local authority policy in this respect had changed. The director purchased the land from the company in 1985 for 8,400. Having obtained planning permission through, to add insult to injury, use of the companys resources, he then resold part of it for 110,300 in 1988 and the rest in 1992 for 122,500. The director resigned and the company sought to hold him liable as a constructive trustee. Chadwick LJ, citing Millett LJ in Paragon Finance plc v DB Thackerar & Co (1999), said:
It follows from the principle that directors who dispose of the companys property in breach of their fiduciary duties are treated as having committed a breach of trust that, a director who is, himself, the recipient of the property holds it upon a trust for the company. He, also, is described as a constructive trustee.

In the CMS Dolphin Ltd v Simonet, Lawrence Collins J subjected the issue of remedies for diverting a corporate opportunity to detailed analysis. He held that S was a constructive trustee of the profits referable to exploiting the corporate opportunity

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and, in general, it made no difference whether the opportunity is first taken up by the wrongdoer or by a corporate vehicle established by him for that purpose.
I do not consider that the liability of the directors in Cook v Deeks would have been in any way different if they had procured their new company to enter the contract directly, rather than (as they did) enter into it themselves and then transfer the benefit of the contract to a new company.

The basis of a directors liability in this situation is that, as seen in Cook v Deeks, the opportunity in question is treated as if it were an asset of the company in relation to which the director had fiduciary duties. He thus becomes a constructive trustee of the fruits of his abuse of the companys property (per Lawrence Collins J, above).

Activity 15.5
Read Regal (Hastings) Ltd v Gulliver [1942] 1 All ER 378, [1967] 2 AC 134n What is the basis of the liability of the directors in this case? Who brought the claim?

15.2.8 Consent, approval or authorisation by members


Certain transactions require the approval of the members of the company. These are contained in Part 10, Chapter 4 of the CA 2006 and include:
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long-term service contracts (s.188) substantial property transactions (s.190) loans, quasi-loans and credit transactions (ss.197214) payments for loss of office (ss.215 222).

The policy underlying the requirement of shareholder approval of these specified transactions was explained by Carnwath J in British Racing Drivers Club Ltd v Hextall Erskine & Co [1997] 1 BCLC 182. He stressed that the possibility of conflicts of interests in these circumstances is such that there is a danger that the judgment of directors may be distorted and so it ensures that the matter will be... widely ventilated, and a more objective decision reached. Section 180 thus sets out, in part, the relationship between the general duties of directors and these more specific provisions contained in Part 10, Chapter 4 of the Act. Section 180(1) provides that if the requirement of authorisation is complied with for the purposes of s.175 (see s.175(4) and (5), above), or if the director has declared to the other directors his interest in a proposed transaction with the company under s.177, these processes replace the equitable rule that required the members to authorise such breaches of duty. This is made subject to any enactment (for example, the above transactions contained in Chapter 4 of Part 10) or any provision in the companys articles which require the authorisation or approval of members. Thus, the companys constitution can reverse the statutory change and can insist on certain steps being taken requiring the consent of the members in certain circumstances. In that event, that provision would have to be given effect to. That is the consequence of the change of approach and therefore a change of approach to the appropriate consequence of there not being members approval in particular cases because it would no longer be required (see Official Report, 9/2/2006; coll GC337). Section 180(3) states that compliance with the general duties does not remove the need for the approval of members to the transactions falling within Chapter 4 CA 2006. Further, s.180(2) provides that the general duties apply even though the transaction falls within Chapter 4, except that there is no need to comply with ss.175 or 176 where the approval of members is obtained. Section 180(4) preserves the common law position on prior authorisation of conduct that would otherwise be a breach of the general duties. Thus, companies may, through their articles, go further than the statutory duties by placing more onerous requirements on their directors (e.g.

Company Law 15 Directors duties


by requiring shareholder authorisation of the remuneration of the directors). It also makes it clear that the companys articles may not dilute the general duties except to the extent that this is explicitly permitted. The effect of this provision seems to be that interested members can vote on a resolution to approve a prospective breach of the statutory duties, but cannot do so to ratify a breach after the event (s.239).

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15.2.9 Ratification by members of a directors breach of duty


Under the common law a director could avoid liability for breach of duty by disclosing the breach to, and obtaining the consent of, by ordinary resolution, the company in general meeting (see Regal Ltd v Gulliver [1967] 2 AC 134; and Gwembe Valley Development Co Ltd v Koshy [2004] 1 BCLC 131). The Companies Act 2006 maintains this rule, albeit subject to one major change. Section 239(1) states that the provision applies to the ratification by a company of conduct by a director amounting to negligence, default, breach of duty or breach of trust in relation to the company. It thus extends the ratification process to all breaches of the duties set out in the statutory restatement in Part 10 of the Act. The common law is modified by s.239(3) and (4) which provide that the ratification is effective only if the votes of the director in breach (and any member connected with him) are disregarded. The effect therefore is to disenfranchise the defaulting director. In North-West Transportation Co Ltd v Beatty (1887)) 12 App Cas 589 PC, it had been held that the director could vote, qua shareholder, in favour of the resolution ratifying his breach of duty. The reform follows the recommendation of the CLRSG which took the view that the question of the validity of a decision by the members of the company to ratify a wrong on the company by the directors (whether or not a fraud) should depend on whether the necessary majority had been reached without the need to rely upon the votes of the wrongdoers, or of those who were substantially under their influence, or who had a personal interest in the condoning of the wrong. See DTI Consultation Document (November 2000) Completing the Structure para 5.85. Section 239(6)(a) goes on to provide that nothing in the section affects the validity of a decision taken by the unanimous consent of the members of the company. This appears to mean that the restrictions on who may vote on a resolution, contained in s.239(3)(4), will not apply when every member, including the director qua shareholder, agrees to condone the breach of duty. This places on a statutory footing the common law principle that a breach of duty is ratifiable by obtaining the informal approval of every member who has a right to vote on such a resolution.

15.2.10 Cases within more than one of the general duties


The way in which the duties are framed results in an overlap between them. Section 179 serves to emphasise that the effect of the duties is cumulative:
Except as otherwise provided, more than one of the general duties may apply in any given case.

See Re Duomatic Ltd [1969] 2 Ch 365; Parker & Cooper Ltd v Reading [1926] Ch 975; EIC Services Ltd v Phipps [2003] 1 WLR 2360; Euro Brokers Holdings Ltd v Monecor (London) Ltd [2003] 1 BCLC 506, CA.

It is therefore necessary for directors to comply with every duty that may be triggered in any given situation. For example, the duty to promote the success of the company (s.172) will not authorise the director to breach his duty to act within his powers (s.171), even if he considers that it would be most likely to promote the success of the company.

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15.3 Relief from liability


Section 1157 CA 2006, replacing s.727 CA 1985, confers on the court the discretion to relieve, in whole or in part, an officer of the company from liability for:
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negligence default breach of duty breach of trust.

This can occur in cases where it appears to the court that:


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the officer has acted honestly and reasonably having regard to all the circumstances of the case, he ought fairly to be excused on such terms as the court thinks fit.

A classic illustration of the way the provision might be used is Re Welfab Engineers Ltd [1990] BCLC 833. The directors of a company which had been trading at a loss sold its main asset for the lower of two competing bids on the understanding that the company would continue to be run as a going concern. Shortly afterwards the company went into liquidation. The liquidator brought misfeasance proceedings against the directors. It was held that the directors had not acted in breach of duty in accepting the lower offer but, even if they had, it was a case in which relief would be granted under s.1157. Hoffmann J took the view that the directors were motivated by an honest and reasonable desire to save the business and the jobs of the companys employees. Another example is Re DJan of London Ltd. You will recall that the director in question incorrectly completed a proposal form for property insurance. The insurers subsequently repudiated liability on the policy when the company claimed for fire damage. The director had signed the proposal without reading it. Hoffmann LJ thought that it was the kind of mistake that could be made by any busy man. In granting the director partial relief from liability, the court noted that he held 99 of the companys shares (his wife held the other). Therefore the economic reality was that the interests the director had put at risk were those of himself and his wife. The judge observed that it may seem odd that a person found to have been guilty of negligence, which involves failing to take reasonable care, can ever satisfy the court that he acted reasonably. Nevertheless, the section clearly contemplates that he may do so. It follows that conduct may be reasonable for the purposes of s.1157, despite amounting to lack of reasonable care at common law. In Re Duckwari plc (No 2) (above), the point was made obiter that a director who intends to profit by way of a direct or indirect personal interest in a substantial property transaction could not be said to have acted reasonably and therefore would be denied relief under s.1157. See also: Re Brian D Pierson (Contractors) Ltd [1999] BCC 26; Re Simmon Box (Diamonds) Ltd [2000] BCC 275; Bairstow v Queens Moat Houses plc [2000] 1 BCLC 549.

15.4 Specific statutory duties


The CA 2006 carries over from the CA 1985 certain statutory duties originally designed to deal with an increasing number of cases involving fraudulent asset stripping by directors (HC Official Report, SC A, 2 July 1981, col 425).

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15.4.1 Substantial property transactions


Sections 190196, which replace ss.320322 CA 1985, require substantial property transactions involving the acquisition or disposal of substantial non-cash assets by directors or connected persons (including shadow directors (s.223(1)(b)) to be approved in advance by the companys members. A substantial property transaction is defined as arising where the market value of the asset exceeds the lower of 100,000 or 10 per cent of the companys net asset value, if more than 5,000 (s.191). The principal features of the regime are the following.
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It permits a company to enter into a contract which is conditional on member approval. This implements a recommendation of the Law Commissions (s.190). The company is not to be liable under the contract if member approval is not forthcoming (s.190(3)). It provides for the aggregation of non-cash assets forming part of an arrangement or series of arrangements for the purpose of determining whether the financial thresholds have been exceeded so that member approval is required (s.190(5)). It excludes payments under directors service contracts and payments for loss of office from the requirements of these clauses (s.190(6)). This implements a recommendation of the Law Commissions. It provides an exception for companies in administration or those being wound up (s.193).

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In Re Duckwari plc [1997] 2 BCLC 713, the company had acquired a non-cash asset from a person connected with one of its directors for 495,000. Four years later in 1993, following the collapse of the property market, the property was valued for the purpose of the proceedings at 90,000. It was no longer possible to avoid the transaction and so the company sought an indemnity for its losses. It was held that irrespective of whether the transaction is or can be avoided, the director or connected person and any other director who authorised the transaction will be liable to account to the company for any profit or loss sustained as a result of the breach of s.190 CA 2006 (see Re Duckwari plc (No 2) [1999] Ch 253 and Re Duckwari plc (No 3) [1999] 1 BCLC 168).

15.4.2 Loans and guarantees


The regulation of loans by companies to their directors dates back to the Companies Act 1948. It was severely tightened in the CA 1980 in order to address the growing problem identified in a series of DTI investigations of directors secretly directing money to themselves under the guise of loans from their companies on highly favourable terms (see the White Paper, The Conduct of Company Directors (Cmnd 7037, 1977)). In contrast to the CA 1985, ss.197214 CA 2006 do not impose an absolute prohibition on loans to directors (including shadow directors (s.223(1)(c)) and connected persons, but make such transactions subject to the approval of the companys members by resolution and, in certain circumstances, also subject to the approval by the members of its holding company. Further, there are no criminal sanctions for breach of the provisions but rather s.213 provides for civil consequences only and s.214 also provides for subsequent affirmation. The requirement for members approval of loans applies to all UK registered companies with the exception of wholly-owned subsidiaries (s.195(7)). The provisions relating to quasi-loans and credit transactions apply only to public companies and associated companies (ss.198-203). There are a number of exceptions to the requirement for members approval which have been consolidated (see ss.204 209). These cover: expenditure on company business (s.204); expenditure on defending proceedings etc (s.205); expenditure in connection with regulatory action or investigation (s.206); expenditure for minor and business transactions (s.207); expenditure for intra-group transactions (s.208); expenditure for money-lending companies (s.209).

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The effect of a breach of ss.197, 198, 200, 201 or 203 is that the transaction or arrangement is voidable at the instance of the company (s.213(2)). Further, regardless of whether the company has elected to avoid the transaction, an arrangement or transaction entered into in contravention of the provision renders the director (together with any connected person to whom voidable payments were made and any director who authorised the transaction or arrangement) liable to account to the company for any gain he made as well as being liable to indemnify the company for any loss or damage it sustains as a result of the transaction or arrangement (s.213(4)). A director who is liable as a result of the company entering into a transaction with a person connected with him has a defence if he can show that he took all reasonable steps to secure the companys compliance with ss.200, 201 or 203. The Act does not define loan, although s.199 does define the term quasi-loan and related expressions (see s.199).

Useful further reading


Conaglen, M. The content and function of fiduciary loyalty, [2005] LQR 452. Davies, P. and J. Rickford, An Introduction to the New UK Companies Act [2008] ECFR 49. Edmunds, R. and J. Lowry The continuing value of relief for directors breach of duty, [2003] MLR 195. Ferran, E. Company Law Reform in the UK [2001] Singapore Jrnl of International and Comparative Law 516 Finch, V. Creditor interests and directors obligations in Sheikh, S. and W. Rees Corporate Governance & Corporate Control. (London: Cavendish, 1995) [ISBN 1874241481]. Finch, V. Company directors: who cares about skill and care?, [1992] MLR 179. Grantham, R. The unanimous consent rule in company law, [1993] CLJ 245. Lowry, J. Regal (Hastings) fifty years on: breaking the bonds of the ancien rgime, [1994] NILQ 1. Lowry, J. and R. Edmunds The corporate opportunity doctrine: the shifting boundaries of the duty and its remedies, [1998] MLR 515. Lowry, J. Self-dealing directors constructing a regime of accountability, [1997] NILQ 211. Penner, J. The Law of Trusts. (Oxford: Oxford University Press, 2008) [ISBN 9780199540921].paras 2.1014. Prentice, D. The corporate opportunity doctrine, [1974] MLR 464. Sealy, L. S. The director as trustee, [1967] CLJ 83. Worthington, S. Corporate governance: remedying and ratifying directors breaches, [2000] LQR 638. Worthington, S. The duty to monitor: a modern view of the directors duty of care in Patfield, F. M. (ed.) Perspectives on Company Law: 2. (London: Kluwer Law International, 1997) [ISBN 9041106782]. Worthington, S. Reforming directors duties, [2001] MLR 439. Berg, A. The company law review: legislating directors duties, [2000] JBL 472. White Paper: Modern Company Law For a Competitive Economy: Developing the Framework, (2000) DTI, March. Developing Directors Duties [1999] CfiLR (special edition devoted to the Law Commissions report on directors duties (Nos 261 and 173) and the DTIs fundamental review of core company law).

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Keay, A. The duty of directors to take account of creditors interests: has it any role to play, [2002] JBL 379. Payne, J. A re-examination of ratification, [1999] CLJ 604. Sealy, L. S. Bona fides and proper purposes in corporate decisions, [1989] Monash Univ LR 265. Law Commission and the Scottish Law Commission, Company Directors: Regulating Conflicts of Interests And Formulating A Statement Of Duties (Nos 261 and 173, respectively).

Sample examination question


Arthur, Beatrice and Charles are the directors of Dynamic Development plc, a company whose main objects are to engage in the business of computer software development and any other business which, in the opinion of the directors is in the interests of the company. In November 2002 the company was approached by Fred, a computer games software designer, who wished to sell one-half of his interest in certain products which he has designed but not yet launched on the market. At a meeting attended by all three directors and Fred the possibility of such a joint venture was discussed but rejected by the company on the grounds that, given the volatile nature of consumer demand and the fast-changing nature of the computer games market, the venture was too risky. In January 2003 Fred approached Arthur, Beatrice and Charles with a view to obtaining their personal involvement in the venture. Arthur declined but Beatrice and Charles accepted Freds invitation. They incorporated a new company, Zenco Ltd, with Beatrice and Charles each holding one-half of the issued share capital in the company; they were also its two directors. This arrangement was not disclosed to Dynamic Development plc. In April 2003 Dynamic Development plc was taken over by Pro-Computers plc and Arthur, Beatrice and Charles were replaced by nominees of Pro-Computers. The new board has now learned of the Zenco Ltd project and that the initial investment made by Beatrice and Charles has tripled to 250,000. Advise Dynamic Development plc.

Advice on answering this question


You will need to begin with describing the restatement of the duties of directors in Part 10 CA 2006 with particular reference to s.175 (duty to avoid conflicts of interests), s.172 (duty to promote the success of the company), s.188 (remedies) and s.179 (cumulative effect of the restated duties). The objective of the no-conflict duty was explained by Lord Herschell in Bray v Ford and by Millett LJ in Bristol and West Building Society v Mothew. You should also state what the consequences are of a breach of duty (i.e. the directors liability to account for any profits obtained (see s.178)). As Millett LJ points out, the core liability has several facets: a director must not make a profit out of his trust and a director must not place himself in a position where his duty and his interest may conflict. The question requires a detailed analysis of s.175 and particularly Regal (Hastings) Ltd v Gulliver, IDC v Cooley and Bhullar v Bhullar. In particular you should refer to the reasoning of Lord Russell in Regal (Hastings) in which he reviews the basis of the directors liability to account. With respect to the January 2003 approach by Fred you should note that in Cooley the judge stressed that it was irrelevant to the issue of liability that the defendant director had been approached in his personal capacity. Reference will also, however, need to be made to Peso Silver Mines v Cropper where, on the particular facts of the case, liability was avoided because it was held that the company had bona fide declined the offer to buy the mining claims. You need to discuss whether the decision by Dynamic Development plc not to join with Fred was reached in accordance with s.172 (duty to promote the success of the company) or was it made in order to facilitate the defendant directors pursuing the opportunity themselves. Here you will discuss Cook v Deeks, and

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Bhullar v Bhullar. The fact that Arthur was a party to the boards decision to reject Freds offer, together with the fact that he declined Freds personal invitation might point to the boards decision being made in accordance with s.172. On the information you are given it is difficult to reach a firm conclusion in this regard, but it is an issue that must be addressed. You will also need to discuss s.175(5)(b) as the company is a plc. You must reach a conclusion on the issue of liability. This shows the Examiner that you have thought about the issues. One final point in this regard: you should mention that the claim is being brought by Dynamic Development plc because breach of fiduciary duty is a wrong against the company (see Chapter 11 of the subject guide) and the proper claimant rule therefore applies (see now Part 11 of the CA 2006). Finally, discuss s.1157 CA 2006. It is a belt and braces provision so that inevitably defendant directors will argue for relief from liability. Note that the court may relieve the defendants in whole or in part.

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Reflect and review


Look through the points listed below. Are you ready to move on to the next chapter? Ready to move on = I am satisfied that I have sufficient understanding of the principles outlined in this chapter to enable me to go on to the next chapter. Need to revise first = There are one or two areas I am unsure about and need to revise before I go on to the next chapter. Need to study again = I found many or all of the principles outlined in this chapter very difficult and need to go over them again before I move on.
Ready to move on I can discuss the fiduciary position of directors. I can discuss the content and scope of the duties of directors restated in Part 10 of the CA 2006. I can explain the authorisation process. I can describe the principal transactions with directors that require the approval of members. I can explain the courts discretion to relieve directors from liability. I can describe the specific statutory duties of directors. Need to revise first Need to study again

If you ticked need to revise first, which sections of the chapter are you going to revise?
Must revise 15.1 15.2 15.3 15.4 Directors duties Revision done

The restatement of directors duties: Part 10 of the CA 2006 Specific statutory duties Relief from liability

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Notes

16 Corporate governance

Contents
16.1 16.2 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 186

Introducing corporate governance . . . . . . . . . . . . . . . . . . . 187 The debate in the UK . . . . . . . . . . . . . . . . . . . . . . . . . . 189 Reflect and review . . . . . . . . . . . . . . . . . . . . . . . . . . . 194

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Introduction
This chapter examines the corporate governance debate in the UK. It is an extremely important area. Students are not only expected to be up to date with current corporate governance issues but are expected to have a detailed knowledge of the history and theory that informs the corporate governance debate. This chapter provides an overview but, as with other areas of this course, students need to engage with the further reading to build up a detailed knowledge of this area.

Learning outcomes
Having completed this chapter and the relevant reading you should be able to:
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describe the main historical periods in the development of the modern company explain the various corporate theories that influence the corporate governance debate illustrate the current trends in corporate governance writing form your own view of what the main purpose of a company should be.

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Essential reading

Dignam and Lowry, Chapter 15 Corporate governance I: corporate governance and corporate theory and Chapter 16 Corporate governance II: the UK corporate governance debate.

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16.1 Introducing corporate governance


Corporate governance is a somewhat flexible term. It covers a wide range of academic literature, from the debate as to who should own and control the corporation (shareholders or stakeholders such as employees, general public, environmental concerns etc.) to the more narrow issue of purely the relationship between shareholders and directors. However if we start with an overview of certain key developments in the history of corporate theory the general meaning of corporate governance should become clearer.

16.1.1 The concession or fiction theory


The original charter and statutory companies were in no sense ordinary businesses but rather they were special ventures which were granted the advantages of incorporation by state because of the public interest in the success of the business venture. Rail, telegraph and colonial trade companies are probably the highest profile example of these companies. For corporate theory purposes the importance of the state in granting corporate status is central. As a result legal theorists discussed these companies in terms of what is known as the concession or fiction theory (hereafter, concession or fiction). This theory describes incorporation as a concession granted or legal fiction created by the state because of the public good being carried out by the business. The state is central to the companys existence and it therefore only exists and is legitimised because it serves the public good. This theory makes it relatively easy to justify the imposition of corporate regulations aimed at promoting the public interest. This theorys dominance parallels the time when grants of chartered status were relatively unusual occurrences confined to the privileged few who had both a public interest venture and the influence to obtain a grant of chartered status.

16.1.2 Corporate realism


This changed, however, with the advent of the registered company in the middle of the nineteenth century. Anyone could register such a company for their own private purpose and the states role was correspondingly diminished in the incorporation process. A second theory, called the corporate realism theory (hereafter, corporate realism), was, at least partly, better suited to the registered company. It argued that the company was no fiction but had a real existence. It did not, therefore, depend on its members or the state for its existence. In essence the members have come together to form an association which, once formed, has an interest of its own, which is not related in any way to its individual members interests. The strength of corporate realism is that it can best explain the separate existence of the corporation and therefore justify departure from a shareholder-oriented focus for the corporation. Its high point followed the advent of large managerial companies with enormous dispersed shareholdings. In 1932 Berle and Means, an economist and a lawyer, made two key observations about the operation of American companies in the 1930s. First, that shareholders were so numerous (described as dispersed ownership and subsequently as the Berle and Means corporation) that no individual shareholder had an interest in attempting to exercise control over management. In their view 65 per cent of the largest two hundred US companies were controlled entirely by their managers. Second, they expressed concern that managers were not only unaccountable to shareholders but exercised enormous economic power which had the potential to harm society. At the same time Dodd (1932) sought to put flesh onto some of the key remaining questions posed by corporate realism. Crucially he sought to answer the question what are the interests of this real person if they are not equated with the shareholders? He argued that, just as other real persons have citizenship responsibilities that require personal self-sacrifice, a corporation has social responsibilities which may sometimes be contrary to its economic objectives. In turn, managers of this citizen corporation are expected to exercise their powers in a manner which recognises the companys social responsibility to employees, consumers and the general public.

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16.1.3 The aggregate theory


Berle (1932) responded to Dodds article with an opposing argument based on the aggregate theory (hereafter, aggregate). That theory describes the company as the central institution formed by the aggregation of private contracting individuals. That is the members come together to pool their investment on terms they all agree. The state therefore has little to do with the corporation as a nexus of private contracting individuals. As such Berle was opposed to Dodds solution. He believed that the Dodd answer was too vague. It would be practically unenforceable and lead to the furtherance of managerial dominance. Instead he sought to focus the companys accountability mechanism on just the shareholders. He argued that the managers are trustees for the shareholders, not the corporation. Thus, the managers are accountable to the shareholders and shareholder wealth maximisation is the sole corporate interest. Until the late 1960s the tangible success of managerial companies and the ability of these companies to behave as corporate citizens meant that corporate realism was the dominant theory. However, by the 1980s a change was occurring in the way shareholders were behaving. Reform in state pension and health care funding had pushed enormous amounts of money into the equity markets through institutional investors (pension finds, investment funds and insurance companies). At the same time barriers to capital inflows and outflows were removed in many countries which resulted in international investment funds operating in both the London and New York markets. In all, the institutional investor emerged as a dominant force in those markets, holding nearly 80 per cent of the shares in the UK market and 6070 per cent of the shares in the US market by the late 1980s. While institutional investors preferred to remain largely passive investors for the most part, they did favour market mechanisms in order to promote shareholder wealth maximisation. Thus share options grew as a percentage of managements total salary as this focused management on share price as a measure of performance and the non-executive director emerged as a monitoring mechanism on management.

16.1.4 Nexus of contracts theory


Along with this change came a challenge to corporate realism from the work of economists who provided evidence that managerial self-interest was a dominant feature of managerial corporations. Aggregate theory, which evolved into the nexus of contracts theory, with its emphasis on the shareholder as a monitoring mechanism, was revitalised by economic theory and remains the dominant theory today. While largely a reformulation of aggregate theory, this provided the additional tools based around economic efficiency to attack the managerial firm and the pluralism of corporate realists such as Dodd. In a nexus of contracts analysis the firm is reduced to contracts and markets and thus the firm is not in any sense a real person. Therefore, it has no interests of its own into which one can place corporate social responsibility. Additionally, the allocation of resources by management to social issues would be inefficient as the monitoring mechanism within the firm in a nexus of contracts analysis ensures efficiency through a presumption that shareholders maximise their own self-interest (see Jensen and Meckling (1976)). The emergence of the Berle and Means corporation has not been universal. Indeed it only emerged in the UK in the late 1960s. In most of the rest of the world a managerial class emerged but not accompanied by dispersed ownership. Rather founding families, other companies and banks held controlling stakes in these companies. Thus, outside the UK and the US the accountability issue has not formed such a large part of the corporate governance debate. The differences in the corporate governance systems around the world has also become a major area of study based around the preconditions necessary for the emergence of a US/UK corporate governance system (see Coffee (2001)).

Activity 16.1
Provide some examples from your study of company law that illustrate the key points of the various corporate theories.

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16.2 The debate in the UK


UK company law has traditionally given primacy to the interests of shareholders. However arguments supporting the status quo within the corporate governance debate in the UK have not, until recently, been influenced by economic theory (see Cheffins (1997)). Historically arguments against the primacy UK company law gives to shareholders have been based on three general points.
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First, corporations are very powerful and therefore have an enormous effect on society. Thus a narrow accountability to shareholders is insufficient to protect societys interests. Second, some, like Parkinson (1995), argue that the assumption that shareholders have a moral claim to primacy by virtue of their property rights is plainly incorrect. If shareholder primacy is to be justified it must be on other grounds. Third, the moral claims of others (stakeholders) either outweigh the shareholders claims or at are at least equal to them when it comes to allocating primacy.

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However, these moral claims seemed overwhelmed by the efficiency-based arguments of the government and the private sector in the 1980s. In response, by the early 1990s a two-fold approach was emerging in the corporate governance literature. First, it was still morally right to include stakeholders in the decision-making process and, second, it could be justified on competitive grounds. For example, contented employees are more productive, the business entity benefits through lower transaction costs because of higher levels of trust and a greater sense of community, and so ultimately the economy and society benefits.

16.2.1 The Cadbury committee


The first tangible effect of this corporate governance debate was the report of the Cadbury Committee (1992) on the Financial Aspects of Corporate Governance, established by the Financial Reporting Council, the London Stock Exchange and the combined accounting bodies. The report was an industry attempt to address some of the accountability concerns expressed about UK listed companies. While fairly narrowly focused the report succeeded in identifying the lack of managerial accountability at the heart of most UK listed companies. The key recommendation of the Cadbury Committee was to introduce non-executive directors to the main board, the idea being that these non-executive directors would bring some objectivity to board decisions. Cadbury also recommended that a committee structure should be put in place to improve the accountability of the appointment of directors, the pay (remuneration) of directors and the audit process. Therefore a listed company should have three sub-committees of the board to cover appointments, remuneration and audit. The accountability process would be ensured by having non-executives on each of the sub-committees. The remuneration committee in particular was to be made up wholly or mainly of non-executives and the audit committee should have at least three non-executives. The London Stock Exchange implemented the Cadbury recommendations on a comply or explain basis (i.e. if you dont comply you need to explain why) and subsequently the Cadbury model has been adopted by stock exchanges around the world. Accountability issues rumbled on after Cadbury, particularly regarding directors pay, and by 1995 the Greenbury Committee (Directors Remuneration, Report of the Study Group, 1995) was formed to report on directors pay. Greenbury identified that there is an inherent conflict of interest in directors deciding on their own pay and recommended an enhanced disclosure regime for directors pay and a nonexecutive only remuneration committee. Unfortunately the open disclosure regime recommended by the Greenbury committee only succeeded in providing a reference point for managers to negotiate higher salaries as they could point to higher salaries in other similar companies to justify higher pay claims.

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Pay has continued to be a corporate governance problem, as the central conflict of interest in a board deciding on its own pay has remained despite the creation of remuneration committees. As a result the government introduced a requirement in August 2002 (the Directors Remuneration Report Regulations 2002, (SI 2002/1986)) that all listed companies must present a remuneration report to their general meeting for consideration. The vote is advisory only and so does not affect the contractual validity of the directors contracts. It is, however, intended to give shareholders a direct voice as to levels of acceptable pay. The Work Foundation often produces figures on directors pay and its website is worth monitoring (www.theworkfoundation.com See, in particular, Life at the top: The labour market for FTSE-250 chief executive.) Additionally, since the advent of the credit crisis in Autumn 2008, a significant concern has arisen that the structure of pay within listed companies had a role in encouraging risk which in turn almost led to the collapse of the global financial system. As a result, in 2009 shareholders have been voting against the remuneration packages of a number of high profile companies. A third committee called the Hampel Committee reported in 1998 and, while offering nothing new to the accountability issues, provided an opportunity to combine the Cadbury and Greenbury recommendations into one single code called the Combined Code. The Hampel Committees importance lies in that fact that its failure to meaningfully engage in the corporate governance debate antagonised the government into putting corporate governance firmly on its reform agenda within the ambit of the CLRSG.

16.2.2 CLSRG intervention


The corporate governance focus of the CLRSG was on how to make companies more accountable to wider stakeholder interests. After a long exploratory process the CLRSG focused on including in a simplified reform of directors duty, obligations to stakeholder groups. The CLRSG recommended that directors duties should be expanded to include stakeholder constituencies and its recommendations were adopted by the Companies Act 2006 in s.172.
172 Duty to promote the success of the company (1) A director of a company must act in the way he considers, in good faith, would be most likely to promote the success of the company for the benefit of its members as a whole, and in doing so have regard (amongst other matters) to (a) (b) the likely consequences of any decision in the long term, the interests of the companys employees, the need to foster the companys business relationships with suppliers, customers and others, the impact of the companys operations on the community and the environment, the desirability of the company maintaining a reputation for high standards of business conduct, and the need to act fairly as between members of the company.

(c) (d) (e) (2) (3) (f)

Where or to the extent that the purposes of the company consist of or include purposes other than the benefit of its members, subsection (1) has effect as if the reference to promoting the success of the company for the benefit of its members were to achieving those purposes. The duty imposed by this section has effect subject to any enactment or rule of law requiring directors, in certain circumstances, to consider or act in the interests of creditors of the company

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The idea behind the strange formulation of the section is to encourage or legitimise enlightened directors considering the interests of stakeholders in their decisionmaking process. It retains the primacy of the shareholders while gently nudging directors to think about stakeholders. The change in the formulation of the directors core duty is accompanied by the introduction of a business review (s.417 CA 2006) which would provide a narrative statement on the companys activities as they affect stakeholder constituencies.

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16.2.3 The operating and financial review


The change in the formulation of the directors core duty was originally accompanied in the White Paper (http://www.berr.gov.uk/files/file25406.pdf at page 10) by the introduction of an Operating and Financial Review (OFR) which would provide a narrative statement on the companys activities as they affect stakeholder constituencies. The idea was that directors will have to give more credence to stakeholders if they have to write a report on the effect of the companys activities on those stakeholders. However the OFR soon became a matter of some controversy. In March 2005, the Companies Act 1985 (Operating and Financial Review and Directors Report etc.) Regulations 2005 were introduced requiring quoted companies to prepare an OFR. The report would have covered broadly:
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the businesss development and performance during the financial year the companys (or groups) position at the end of the year the main trends and factors underlying the development, performance and position of the company (or group) and which are likely to affect it in the future.

In doing this, the directors would have to consider if it is necessary to report on a range of factors that may be relevant to the understanding of the business, including, for example, environment, employee and social and community issues. (DTI Guidance on the OFR and changes to the directors report (January 2005).) The controversy surrounding the OFR focused on the potential increase in personal liability that directors may have for forward-looking financial information. In response, somewhat remarkably, the then Chancellor, Gordon Brown, announced on 28 November 2005 that the OFR would be repealed from 12 January 2006. (See the Companies Act 1985 (Operating and Financial Review) (Repeal) Regulations 2005, SI 2005/3442.) This ill-thought out repeal was complicated further by the fact that the European Accounts Modernisation Directive (Directive 2003/51/EC) requires a fair business review (FBR) to take place. As a result the BIS guidance now runs as follows.
The Business review requires a balanced and comprehensive analysis of the development and performance of the company during the financial year and the position of the company at the end of the year; a description of the principal risks and uncertainties facing the company; and analysis using appropriate financial and non-financial key performance indicators (including those specifically relating to environmental and employee issues). Companies producing a business review must disclose information that is material to understanding the development, performance and position of the company, and the principal risks and uncertainties facing it. This will include information on environmental matters and employees, on the companys policies in these areas and the implementation of those policies. Moreover, key performance indicators must be used where appropriate (including those specifically relating to environmental and employee issues). Similarly, companies producing a business review will need to consider disclosing information on trends and factors affecting the development, performance and position of the business, where this is necessary for a balanced and comprehensive analysis of the development, performance and position of the business to describe the principal risks and uncertainties facing it, or to provide an indication of likely future developments in the business of the company.

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In essence, having repealed the OFR, the DTI then stated that while an Operating and Financial Review is no longer required there is still a requirement to produce a fair business review which is very similar to the OFR. The requirement for the business review based on the guidance above is now contained in s.417 CA 2006. See the guidance at: http://www.berr.gov.uk/whatwedo/businesslaw/corp-govresearch/page21369.html The collapse of the US company Enron in 2002 (you can find out more about this on the website: http://specials.ft.com/enron/FT3GIIYBNXC.html) spurred the government into announcing a review of the role of non-executive directors in UK companies. The review was carried out by Derek Higgs, who consulted widely and produced a final report in January 2003. Its key recommendation was to provide a good definition of independence for non-executives, which was adopted by the LSE. A non-executive director will now only be considered independent when the board determines that the director is independent in character and judgment and there are no relationships or circumstances which could affect, or appear to affect, the directors judgment. Such relationships and circumstances arise where the director:
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is or has been an employee of the company has or had a business relationship with the company is being paid by the company other than a directors fee and certain other payments has family ties to the company or its employees holds cross-directorships or has significant links with other directors through involvement in other companies or bodies represents a significant shareholder has served on the board for 10 years.

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The Higgs independence criteria have subsequently been adopted by the London Stock Exchange. (http://www.berr.gov.uk/whatwedo/businesslaw/corp-governance/ higgs-tyson/page23342.html).

Activity 16.2
Read Chapters 15 and 16 of Dignam and Lowry and then consider the following. The committees on corporate governance have been an amazing success. We know this not only because of the domestic improvements in corporate governance they have brought about but because similar systems have been adopted by international agencies and other jurisdictions around the world. Do you agree with the above statement? Explain your views.

Useful further reading

Berle, A. and G. Means, The modern corporation and private property. (New York: Harcourt, 1932; revised edition, 1968) (New Brunswick, NJ; London: Transaction Publishers, paperback edition 1991 [ISBN 0887388876]). Dodd, E. For whom are corporate managers trustees?, [1932] Harvard Law Review 1145. Berle, A. For whom are corporate managers trustees: a note, [1932] Harvard Law Review 1365. Dignam, A. and M. Galanis, The Globalization of Corporate Governance. (Ashgate, 2009) xxiv and p.458. Jensen, M. and W. Meckling Theory of the firm: managerial behaviour, agency costs, and ownership structure, [1976] 3 Journal of Financial Economics, 305. Coffee, J. The rise of dispersed ownership: the roles of law and the state in the separation of ownership and control, [2001] Yale LJ 1, pp.2529.

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Parkinson, J.E. Corporate power and responsibility: issues in the theory of company law. (Oxford: Oxford University Clarendon Press, 1993) [ISBN 0198259891]. Cheffins, B.R. Company Law: Theory and Structure. (Oxford: Oxford University Press, 1997) [ISBN 0198764693]. Wedderburn, K.W. The social responsibilities of companies, [1982] Melbourne University LR 1. Wedderburn, K.W. Companies and employees: common law or social dimension?, [1993] LQR 220. Wheeler, S. (ed.) A Reader on the Law of the Business Enterprise. (Oxford: Oxford University Press, 1995) [ISBN 0198764693]. Riley, C.A. Controlling corporate management: UK and US initiatives, [1994] LS 244. Pettet, B. Towards a competitive company law, [1998] Co Law 134. Dignam, A. A principled approach to self-regulation? The report of the Hampel Committee on Corporate Governance, [1998] Co Law 140. Dignam, A. and M. Galanis Australia inside/out: the corporate governance system of the Australian listed market, [2004] Melbourne University Law Review Vol 28 (December, 2004), No 3, pp.623653. Finch, V. Board performance and Cadbury on corporate governance, [1992] JBL 581.

Sample examination questions


[t]here should be no confusion (of which there is evidence) of the duties which Mr. Ford conceives that he and the stockholders owe to the general public and the duties which in law he and his co-directors owe to protesting, minority stockholders. A business corporation is organised and carried on primarily for the profit of the stockholders. The powers of the directors are to be employed for that end. The discretion of directors is to be exercised in the choice of means to attain the end and does not extend to a change in the end itself, to the reduction of profits or to the nondistribution of profits among stockholders in order to devote them to other purposes. Dodge v Ford Motor Company (1919) 204 Mich 459; 170 NW 668. If this statement is applied to the UK would it remain true?

Advice on answering the question


Establish that traditionally UK company law has been focused on the shareholders. You could also qualify this by stating that the courts have also allowed directors quite a lot of discretion which indirectly allows stakeholders to benefit. Discuss the stakeholder debate generally. Discuss the CLRSGs report on corporate governance matters, the reformulation of directors duties in the CA 2006 and the controversy surrounding the introduction and repeal of OFR. Remember to apply your findings to the question you have been asked.

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Reflect and review


Look through the points listed below. Are you ready to move on to the next chapter? Ready to move on = I am satisfied that I have sufficient understanding of the principles outlined in this chapter to enable me to go on to the next chapter. Need to revise first = There are one or two areas I am unsure about and need to revise before I go on to the next chapter. Need to study again = I found many or all of the principles outlined in this chapter very difficult and need to go over them again before I move on.
Ready to move on I can describe the main historical periods in the development of the modern company. I can explain the various corporate theories that influence the corporate governance debate. I can illustrate the current trends in corporate governance writing. I can form your own view of what the main purpose of a company should be. Need to revise first Need to study again

If you ticked need to revise first, which sections of the chapter are you going to revise?
Must revise 16.1 16.2 Introducing corporate governance The debate in the UK Revision done

17 Liquidating the company

Contents
17.1 17.2 17.3 17.4 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 196

Liquidating the company . . . . . . . . . . . . . . . . . . . . . . . . 197 The liquidator . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 199 Directors of insolvent companies . . . . . . . . . . . . . . . . . . . . 201 Reform . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 201 Reflect and review . . . . . . . . . . . . . . . . . . . . . . . . . . . 203

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Introduction
In this chapter we consider the various ways in which a company can be wound up. A principal anxiety of the law is to ensure the most equitable treatment possible of all the creditors. You will have noted from previous chapters that many key issues of company law come to the fore during the liquidation process. You should revise Chapter 7: Raising capital: debentures and Chapter 15: Directors duties before embarking on the material below.

Learning outcomes
By the end of this chapter and the relevant readings, you should be able to:
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explain the ways in which a company may be wound up describe the powers and duties of the liquidator describe the order in which creditors are paid discuss the liabilities of directors of insolvent companies.

Essential reading

Dignam and Lowry, Chapter 17: Corporate rescue and liquidations.

Cases

Re London and Paris Banking Corp (1874) LR 19 Eq 444 Measures Bros Ltd v Measures [1910] 1 Ch 336 Silkstone and Haigh Moore Coal Co v Edey [1900] 1 Ch 167 Stead, Hazel & Co v Cooper [1933] 1 KB 840 Coutts & Co v Stock [2000] 1 BCLC 183 Re J Leslie Engineers Co Ltd [1976] 1 WLR 292 Re Produce Marketing Consortium Ltd [1989] BCLC 520.

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17.1 Liquidating the company


The Insolvency Act 1986 (IA 1986) is the principal statute we are concerned with in relation to liquidations. There are three principal ways in which a companys existence can be brought to an end (i.e. dissolved).
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The members may decide to wind up the company even though it is flourishing this is termed voluntary winding up. The creditors may force the dissolution of a company where it is insolvent (i.e. it cannot pay its debts) this is termed compulsory winding up. It is in the public interest to wind up a company.

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17.1.1 Voluntary winding up


Although the company may be viable its founders might nevertheless decide to dissolve it because, for example, they wish to retire or its original purpose has come to an end. Section 84(1) of the IA 1986 provides for three situations in which the company may be voluntarily wound up. 1. When the period, if any, fixed for the duration of the company by the articles expires, or the event, if any, occurs which the articles provide will result in the company being dissolved, and the general meeting has passed a resolution requiring it to be wound up voluntarily (this category is rare nowadays). 2. If the company resolves by special resolution that it be wound up voluntarily. 3. If the company resolves by extraordinary resolution to the effect that it cannot by reason of its liabilities continue its business and that it is advisable to wind up (this will result in a creditors winding up). A creditors voluntary winding up differs from the first two categories as it requires the creditors be notified and hold a meeting (s.98(1)). At that meeting the creditors may appoint a liquidator who will take priority over any liquidator appointed by the general meeting (s.100). For the first two categories of voluntary winding up the law is concerned to ensure that creditors are not left unpaid. As a result s.89 IA 1986 requires the directors to make a declaration of solvency before the voluntary winding up can commence. Creditors in all three categories may also form a liquidation committee to liaise with the liquidator (s.141). A copy of the winding up resolution must be sent to the Registrar of Companies within 15 days (s.84(3) IA 1986 and s.30 CA 2006). The general meeting also appoints a liquidator who takes control of the company for the purpose of realising its assets, meeting its liabilities and distributing any surplus left over to the shareholders (ss.91 and 107 IA 1986). Once the liquidator has completed this task and has sent to the Registrar of Companies his final account and return under s.94 (members voluntary winding up) or s.106 (creditors voluntary winding up), the Registrar shall then register them. Three months after the registration of the return the company is deemed to be dissolved (s.201).

17.1.2 Compulsory winding up


A compulsory winding up normally occurs where a creditor petitions to have the company wound up because it is unable to pay its debts (s.122(1)(f) IA 1986). There are other grounds for a compulsory winding up but the vast majority fall under this category and so we concentrate on it here. Section 123(1) provides that a company will be deemed to be insolvent:
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if a creditor, to whom a sum exceeding 750 is owed, has served on the company at its registered office a written demand, in the prescribed form, requiring the company to pay the debt and the company has for three weeks thereafter neglected to pay; or

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if an execution or other process issued on judgment in favour of a creditor of the company is returned unsatisfied in whole or in part; or if the court is satisfied that the company is unable to pay its debts as they fall due.

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It should be noted in relation to the third category that a company will be deemed to be insolvent where the value of the companys assets is less than the amount of its liabilities (s.123(2) IA 1986). However, if the debt is disputed on bona fide grounds the court will not allow the petition to proceed. Thus, if a creditor presents a petition in order to pressurise the company into paying a debt, the amount of which is genuinely disputed as being excessive, the court may dismiss the petition with costs (Re London and Paris Banking Corp (1874) LR 19 Eq 444). However, if the petition proceeds a creditor who is owed 750 or more will be entitled to a winding up order although the court may refuse to make an order if the petition is not supported by the majority of creditors (s.195). If the court does make an order to wind up the company it is made in favour of all the creditors, not just the petitioner, and the Official Receiver is appointed as liquidator. At this point, if the Official Receiver finds that the realisable assets of the company are insufficient to cover the expenses of the winding up and that the affairs of the company do not require further investigation, he or she may apply to the Registrar of Companies for the early dissolution of the company. Such an application is then registered by the Registrar and three months after the date of the registration of the notice the company is dissolved. But, if there are sufficient funds to cover the expenses of the liquidation the Official Receiver has the power to summon separate meetings of the companys creditors and contributories for the purpose of choosing a person to be liquidator of the company in his or her place (s.136(4)). Once the liquidator has completed his function (see below), s.205 provides that when he has filed his final returns or the Official Receiver has filed a notice stating that he considers the winding up to be complete, the Registrar of Companies shall register those returns or the notice forthwith. At the end of the period of three months beginning with the day of that registration the company is dissolved (s.205(2)).

17.1.3 Public interest winding up


Under s.124A of the IA 1986 the Secretary of State may present a petition to wind up a company in the public interest if, after a DTI (now BIS) investigation or other official enquiry, it appears that it is expedient in the public interest that a company should be wound up if the court thinks it just and equitable for it to be so (see Re Drivertime Recruitment Ltd [2005] 1 BCLC 305). Insolvency is not a requirement and more usually the company will have been used as a vehicle for defrauding the general public. For example, in Re UK-Euro Group plc [2006] All ER (D) 394 (Jul), ChD, the court granted a petition for the winding up of the company on the ground of public interest under s.124A IA 1986 on the basis that the companys affairs were conducted fraudulently and with a complete lack of commercial probity.

Activity 17.1
Read British Eagle International Airlines Ltd v Compagnie Nationale Air France [1975] 1 WLR 758. What emerges from the British Eagle decision as the overarching purpose of liquidation?

Activity 17.2
Read Finch, V. Corporate Insolvency Law: Perspectives and Principles. (Cambridge: Cambridge University Press, 2009) Chapter 2. [ISBN 9780521701822] What are the objectives of the liquidation regime?

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17.2 The liquidator


17.2.1 The liquidators role and powers
The winding up order terminates the management powers of the companys directors (Measures Bros Ltd v Measures (1910)1 Ch 336). Their powers are transferred to the liquidator, together with their fiduciary duties, and so a liquidator must act in good faith, avoid a conflict of interests and not make a secret profit (Silkstone and Haigh Moore Coal Co v Edey (1900) 1 Ch 167). Section 230(3) of the IA 1986 provides that a liquidator must be a qualified insolvency practitioner. He or she acts in the name of the company and will not, therefore, be liable on contracts entered into on behalf of the company (Stead, Hazel & Co v Cooper [1933] 1 KB 840). The liquidator takes control of the company for the purposes of realising the companys assets and distributing them among the claimants according to their priority. For example, corporate property, which is subject to a fixed charge, must be used first to redeem the secured loan to which the charge relates. Similarly, where a supplier of goods has reserved title until payment, ownership will not have passed to the company and so the liquidator cannot incorporate these goods into the common pool of assets. If there are insufficient assets left over after taking account of any fixed charges together with the preferential debts to satisfy the unsecured creditors, their debts abate equally. The order in which debts are to be satisfied in a liquidation is as follows. 1. All expenses properly incurred in the winding up, including the remuneration of the liquidator. 2. Preferential debts as identified in ss.107, 115, 143 and 156 (e.g. unpaid employees wages). 3. Ordinary debts. 4. Deferred and subordinated debts. (See ss.107 and 115 (voluntary liquidations) and ss.143 and 156 (compulsory liquidations); see also s.175 which is of general application) Any balance remaining is distributed to members in accordance with their entitlements under the companys memorandum and articles. Prior to the Enterprise Act 2002, preferential debts were defined by s.386 IA 1986 as debts listed in Schedule 6. These included: debts owed to the Inland Revenue in respect of PAYE deductions during the previous 12 months but not remitted to the Revenue; debts due to Customs and Excise in respect of six months VAT; debts owed to the Department of Health and Social Security in respect of employers National Insurance contributions; debts owed by way of unpaid wages to employees and former employees for the four-month period before the commencement of the winding up (maximum of 800) together with unpaid holiday pay and outstanding contributions to pension schemes. Corporation tax liabilities which accrue after the commencement of a winding up are a necessary disbursement of the liquidator and are therefore expenses of the winding up payable before preferential debts (Re Toshoku Finance (UK) plc, Kahn v Inland Revenue (2002)). Section 251 of the Enterprise Act 2002 amends s.386 and Schedule 6 to the IA 1986 by abolishing Crown preferential debts (i.e. debts due to the Inland Revenue, Customs and Excise and social security contributions) and adds contributions to occupational pension schemes to the list in Schedule 6 (see above). Section 252 of the Enterprise Act 2002 inserts a new s.176A into the IA 1986, which requires, for the benefit of unsecured creditors, a ring-fenced fund to be created out of the realisations of floating charges. The amount to be transferred to the prescribed fund for transmission to unsecured creditors is calculated according to the following: 50 per cent of the first 10,000 plus 20 per cent of available funds above 10,000 up to a maximum of 600,000. The prescribed fund only applies to floating charges created after 15 September 2003. Unlike a board of directors the liquidator has certain key restrictions on his activities. Section 167 of the IA 1986 divides the liquidators powers into two categories: those that

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may be exercised only with the sanction of the court or the liquidation committee; and those which are exercisable without the need to obtain such sanction. For example, the liquidator must obtain the appropriate sanction before exercising his power to bring or defend proceedings in the name and on behalf of the company and to carry on the business of the company so far as may be necessary for its beneficial winding up (s.167(1)(a), Sch.4, Part II). No such sanction is required, however, for the liquidator to sell company property or to raise money by providing security on company assets (s.167(1) (b), Sch.4, Part III). Although, as we have seen, the liquidators main role is to secure that the companys assets are got in and distributed to the creditors (s.143), he also, along with the court, polices the end of the company to ensure insiders do not take advantage of the companys genuine creditors. As such the liquidator is empowered by s.238 IA 1986 to apply to court to set aside any transactions at an undervalue which may have occurred in the two years preceding the winding up. Sometimes in the lead-up to liquidation the company will attempt to put certain creditors in preferred positions to ensure that they get paid (often the creditors in question are in fact directors of the company who may have personally guaranteed a loan to the company). Section 239 allows the liquidator to apply to court to have such a preferment set aside. Insiders may also enter into extortionate credit arrangements which bind the company. If this occurs within three years of the winding up, s.244 again provides for the liquidator to apply to the court to set the transaction aside. The liquidator in a voluntary solvent liquidation, while he has the same duties of good faith as a liquidator in a compulsory liquidation, has a very different role. In a voluntary solvent liquidation the liquidator simply gathers together the assets, pays the liabilities and distributes any surplus to the members. In a compulsory liquidation the liquidator will also carry out this function but usually without any chance that the asset value will exceed the companys liabilities. Thus the liquidators main function will be to determine the priority in which creditors will receive payment. The liquidator will also police the years immediately before the insolvency for any irregular transactions that might be challengeable.

17.2.2 Post-winding up dispositions of company property


Section 129(2) IA 1986 provides that the winding up of a company by the court is deemed to commence at the time of the presentation of the petition for winding up. Where the company is already in voluntary liquidation, winding up is deemed to commence at the time of the passing of the resolution (s.129(1)). These provisions therefore mean that a winding up order has retroactive effect. The date of the winding up order can become critical in relation to any disposition of company property. This is because s.127 provides that, in a winding up by the court, any disposition of the companys property and any transfer of shares or alteration in the status of the companys members made after the commencement of the winding up is void, unless the court otherwise orders. It is not necessary to apply for a court order because the sanction is applied automatically. Section 127 is aimed at preserving corporate assets for the benefit of the general body of creditors by giving the liquidator power to claw back company property which has been transferred by directors after a petition has been presented and liquidation is imminent (see Coutts & Co v Stock [2000] 1 BCLC 183, Lightman J). Thus, a third party dealing with a company in this situation should apply to the court for a validation order. Otherwise they run the risk that the court will refuse to validate the transaction and will order the property to be transferred back to the company unless the third party acquired it as a bona fide purchaser for value without notice (Re J Leslie Engineers Co Ltd [1976] 1 WLR 292). The courts power to grant its consent to a disposition of property is discretionary.

Activity 17.3
Read Re Grays Inn Construction Co Ltd [1980] 1 WLR 711. What factors should be taken into account by the court when deciding whether to validate a post-winding up disposition of property?

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17.3 Directors of insolvent companies


As a safeguard against possible abuses of power, directors of failed companies face certain restrictions on their activities in the immediate aftermath of an insolvency. Sections 216 and 217 of the IA 1986 prohibit a director of a company that has gone into insolvent liquidation from being involved for five years in the management of a company using either the same name as the insolvent company or a name that is so similar as to suggest an association with it. The objective of this provision is to prevent a director simply registering a new company with a similar name and continuing to trade. (See Re Produce Marketing Consortium Ltd (1989) BCLC 520 in which it was held that the directors failure to keep proper accounts was no defence when determining whether they knew, or ought to have known, that the company was insolvent.) Additionally, directors face the real threat that they may become personally liable for the debts of the company should the civil or criminal penalties for fraudulent and wrongful trading apply. Fraudulent trading under s.213 IA 1986 occurs where any business of the company has been carried on with intent to defraud creditors of the company or creditors of any other person, or for any fraudulent purpose. The possibility of criminal liability for fraudulent trading also arises under s.993 of the CA 2006, the wording of which is virtually identical to s.213 IA. As a result of the linkage between the two sections the courts have set the standard of proof for s.213 very high. This led to the introduction of the easier-to-prove offence of wrongful trading in s.214. This provides that the liquidator must prove that the director in question allowed the company to continue to trade, at some time before the commencement of its winding up, when he or she knew or ought to have concluded that there was no reasonable prospect that the company would avoid going into insolvent liquidation.

17.4 Reform
In Chapter 15 we considered the state of the case law suggesting that directors may owe duties to creditors where the company is insolvent. In this regard you should note s.172(3) of the CA 2006.

Activity 17.4
a. What are the three ways of bringing a companys existence to an end? b. Where a company is wound up voluntarily, can the creditors appoint a liquidator? c. What are the three grounds given in s.123(1) of the Insolvency Act 1986 for deeming a company to be insolvent? d. In an insolvent liquidation, which creditors are given preference over ordinary debts? e. In a voluntary liquidation, what happens to any surplus assets? No feedback provided.

Useful further reading

Finch, V. Corporate insolvency law: perspectives and principles. (Cambridge: Cambridge University Press, 2009) [ISBN 9780521701822. Goode, R.M. Principles of corporate insolvency law. (London: Sweet & Maxwell, 2005) [ISBN 9780421930209]. Report of the Review Committee on Insolvency Law and Practice (Cork Committee Report), Cmnd 8558. Cooke, T.E. and A. Hicks Wrongful trading predicting insolvency, [1993] JBL 338.

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Nolan, R. Less equal than others Maxwell and subordinated unsecured obligations, [1995] JBL 485. Oditah, F. Wrongful trading, [1990] LMCLQ 205. Oditah, F. Assets and the treatment of claims in insolvency, [1992] LQR 459. Wheeler, S. Swelling the assets for distribution in corporate insolvency, [1993] JBL 256.

Sample examination question


In 1996, Helen, then aged 24, qualified as a chartered accountant. In 1997 she formed Pear Ltd and its whollyowned subsidiary, Sub Ltd. Helen holds all the shares in Pear except one, which is held by a nominee for her. Pear Ltd holds all the shares in Sub Ltd, except one, which is similarly held by a nominee for Pear Ltd. Helen is the only director of both companies and neither company has filed any accounts with the Registrar for the last three years. Other than her shares in Pear Ltd, Helen has virtually no assets. Since 1997 Pear Ltd has made telephone answering machines and has flourished so that it now has assets of over 1 million and employs 40 people. Sub Ltd however, is mainly engaged in supplying Pear Ltd with components and is not run primarily with a view to making a profit on its own, although for the first two years, 1998 and 1999, Sub Ltd made profits of 8,000 and 3,000 respectively. However in 2000 it made a loss of 38,000; in 2001 a loss of 23,000 and in 2002 a loss of 11,000. In September 2001 Big Bank plc was pressing for a reduction of Sub Ltds overdraft of 40,000. Helen then paid 20,000 of her own money into the account, taking in return a debenture from Sub Ltd for 20,000 and a floating charge to secure both that 20,000 and an earlier loan by her to the company of 15,000. On 2 April 2003 a creditor presented a petition for the winding up of Sub Ltd and a winding up order was made on 14 May 2003. The assets of Sub Ltd fall short of its liabilities by 60,000. Advise Helen as to her potential liabilities, if any, and her position generally.

Advice on answering this question


You will need to address the following issues.
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Section 245 IA 1986, whereby the liquidator of an insolvent company can avoid floating charges (see Chapter 7 of this guide). Whether or not Helen is liable for wrongful trading see IA 1985, s.214. Particular reference should be made to Re Produce Marketing Consortium (No 2). You will need to discuss Salomon v Salomon [1897] AC 22 and Adams v Cape Industries plc [1990] 2 WLR 657 (see Chapters 3 and 4) in order to explain that a parent company (Pear Ltd) is not liable for the debts of its subsidiary (Sub Ltd). However, if Pear Ltd is a shadow director of Sub Ltd (see Chapter 14 of this guide and particularly Secretary of State for Trade and Industry v Deverall [2001] Ch 340), the assets of Pear Ltd may be liquidated to meet the claims against Sub Ltd. Whether Helen can be disqualified as a director under the Company Directors Disqualification Act 1986 (see Chapter 14). Particular reference should be made to the degree of culpability required before the court will disqualify a director. In Re Lo-Line Electric Motors Ltd [1988] Ch 477 Sir Nicholas Browne-Wilkinson V-C said that while ordinary commercial misjudgment is not in itself sufficient to establish unfitness, conduct which displays a lack of commercial probity or conduct which is grossly negligent or displays total incompetence would be sufficient to justify disqualification.

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Reflect and review


Look through the points listed below. Are you ready to start revising this guide? Ready to move on = I am satisfied that I have sufficient understanding of the principles outlined in this chapter to enable me to go on to revise the whole subject. Need to revise first = There are one or two areas in this chapter I am unsure about and need to revise before I go on to wider revision. Need to study again = I found many or all of the principles outlined in this chapter very difficult and need to go over them again before I move on.
Ready to move on I can explain the ways in which a company may be wound up. I can describe the powers and duties of the liquidator. I can describe the order in which creditors are paid. I can discuss the liabilities of directors of insolvent companies. Need to revise first Need to study again

If you ticked need to revise first, which sections of the chapter are you going to revise?
Must revise 17.1 17.2 17.3 17.4 Liquidating the company The liquidator Directors of insolvent companies Reform Revision done

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Notes

Feedback to activities

Contents

Chapter 2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 207 Chapter 3 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 207 Chapter 4 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 208 Chapter 5 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 208 Chapter 6 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 209 Chapter 7 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 210 Chapter 8 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 211 Chapter 9 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 211 Chapter 10 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Chapter 11 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Chapter 12 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Chapter 13 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Chapter 14 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Chapter 15 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Chapter 16 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Chapter 17 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 212 213 213 214 215 216 218 218

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Company Law Feedback to activities

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Chapter 2
Activity 2.1
No feedback provided.

Activity 2.2
No feedback provided.

Activity 2.3
No feedback provided.

Activity 2.4
No feedback provided.

Activity 2.5
Small businesses seem to have been particularly ill-served by the corporate form. At the heart of this has been the difference between company laws presumption that the shareholders do not exercise day-to-day control of the business and the reality in a small business that shareholders often do exercise day-to-day control. The elective regime in the CA 1985 and Table A did try to simplify matters, but from the 1994 Freedman study we know that the only real advantage perceived by small businesses from forming a company was the legitimacy it conferred on the business. The reform process leading to the Companies Act 2006 identified this as a significant problem and the 2006 Act attempts to redress this imbalance by removing the presumption that ownership is separated from control in order to make the corporate form a better model for small businesses.

Chapter 3
Activity 3.1
a. Mr Salomons personal liability for the debts of the business had changed completely from unlimited liability as a sole trader to limited liability as a shareholder in the company. Not only was Mr Salomon not liable for the debts of the company but he had also, as managing director of the company granted himself a secured charge over all the companys assets. As a result if the company failed not only would Mr Salomon have no liability for the debts of the company but whatever assets were left would be claimed by him to pay off the companys debt to him. b. There is really one central principle we can draw and two minor ones. The central principle is that the company is a separate legal personality from its members and therefore legally liable for its debts. This brings us to the minor principles. The first being that once the technicalities of the Companies Act are complied with, a oneperson company can have the benefits of corporate legal personality and limited liability. The second is that debentures can be used effectively to further shield investors from losses. c. This is really a matter of your own personal opinion. It is useful, however, to work out what you think about this issue as it will help you deal with other areas of company law where the Salomon decision has implications.

Activity 3.2
The key point here for your further understanding is that a share is in no way a representation of the fractional value of the companys property. The company as a separate legal entity owns its own property and there is no legal connection between a share in the company and the companys property. That is the case even where (as in Macaura and Lee) the shareholder owns all the shares. Shareholders generally

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benefit from this (although not Mr Macaura) because it facilitates limited liability as the company also owns its own debts (see also Woolfson v Strathclyde Regional Council [1978] SC 90).

Chapter 4
Activity 4.1
No feedback provided.

Activity 4.2
You will have noted from your reading that from the 1960s until the 1990s there was little consistency in the way the senior judiciary approached difficult cases where veil lifting was an option. In 1985 the Court of Appeal in Re a Company [1985] BCLC 37, Ch.D could draw on cases such as Wallersteiner v Moir [1974] 1 WLR 991 to argue that the court can use its power to lift the corporate veil if it is necessary to achieve justice, irrespective of the legal efficacy of the corporate structure under consideration. Equally, four years later the Court of Appeal in National Dock Labour Board v Pinn & Wheeler Ltd [1989] BCLC 647 could draw on cases such as Woolfson v Strathclyde RC [1978] SLT 159 to argue for a strict interpretation of the Salomon principle. In short there was little consistency or certainty in a very important area of company law. This, it seems, is what the Court of Appeal seeks to address in Adams by narrowing the categories of veil lifting and eliminating any concept of veil lifting in the interests of justice. Instead, narrow categories have been created which are somewhat elusive. It does indeed seem an overly cautious approach which does little to serve the interests of justice. However there are suggestions in cases such as Ratiu v Conway (2006) 1 All ER 571 that the courts are becoming a bit more flexible in their interpretation of veil lifting issues.

Activity 4.3
Involuntary creditors (generally, in this context, the victims of personal injury by the company) are in a vulnerable position when it comes to the application of the Salomon principle. Normal creditors have at least a way of calculating the business risk and charging more or monitoring in order to protect themselves. Involuntary creditors cannot do so and so if, for example, a parent company remains protected from the tortious activities of its subsidiary by the Salomon principle, involuntary creditors can suffer badly. Thankfully the courts seem to realise this and draw a subtle distinction between commercial torts (negligent misstatement) where Salomon is strictly applied and personal injury actions where a more flexible approach has been taken (see Lubbe and Others v Cape Industries plc [2000] 1 WLR 1545).

Chapter 5
Activity 5.1
The House of Lords reasoned that Erlanger, as representing the syndicate, had undertaken to act on behalf of the yet unformed company. We saw from the brief extract taken from Lord Cairns LCs speech (para 4.2), that promoters possess considerable power in determining the shape of a new companys management and supervision. Given the vulnerability of companies to abuse by their promoters, the law has responded by holding them subject to the rigour of the core fiduciary duty of loyalty. In effect, this prohibits promoters from placing themselves in a position where their personal interests might conflict with those of the putative company. Thus, although promoters are not prohibited from selling their own property to the company, they can only do so having made full disclosure to an independent board of directors.

Company Law Feedback to activities


The House noted that there is nothing illegal in promoters selling their own property to the company. However, it was stressed that the privilege of promoting a company carries with it certain obligations. Promoters must appoint directors independent of themselves who will be guardians of the companys interests and who will protect the shareholders. It need not be shown that the promoters were activated by fraudulent motives the fiduciary obligation will be broken even if there was no intention to do injustice.

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Activity 5.2
It is important to note that on the facts the promoters did not disclose to an independent board of directors the profit they made on selling property owned by them to the company. Lord Macnaghten, examining the conduct of Gluckstein, against whom the action was brought, stressed that where a person who plays many parts (i.e. being a promoter and then subsequently a director of the company) announces to himself in one character what he has done in another character, this cannot be described as disclosure in its proper sense. Indeed, there was no disclosure to the intended shareholders at all; they were thus victims of a deception. Consequently, where promoters make a secret profit during the promotion process they will be jointly and severally liable to account for that profit to the company.

Activity 5.3
The policy underlying s.51 is to protect third parties who contracted in the belief that they were dealing with registered companies. It makes pre-incorporation contracts legally enforceable as personal contracts with promoters unless their personal liability has been unequivocally excluded. The question of whether the promoter could enforce the contract he is personally liable on has now been resolved by the Court of Appeal.

Chapter 6
Activity 6.1
No feedback provided.

Activity 6.2
No feedback provided.

Activity 6.3
By emphasising continual disclosure by listed companies, before and after listing, the FSA and the LSE wish to achieve a number of aims.
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Where the company is listing for the first time disclosure provides the potential investor with enough information to decide whether to invest or not. Where the company is already listed the disclosure regime is designed to ensure that information is fairly distributed. If this was not the case large shareholders would have greater access to information than small ones.

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Continuous disclosure also minimises the risk of insider dealing.

Activity 6.4
The answer to this question is not as straightforward as it may seem. There are those who believe that insider dealing should be allowed as it enables insiders to send signals about impending actions by companies much quicker than the disclosure regime (see McVea (1995)). However, the prevailing view on why it is illegal is that it is morally reprehensible and has very damaging effects on the investing publics confidence in the marketplace (see Campbell (1996) on why insider dealing is outlawed).

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Chapter 7
Activity 7.1
A floating charge is a creature of equity. It attaches to assets for the time being. The hallmark of a floating charge is that the company can continue to deal with the charged assets in the ordinary way without obtaining the chargees consent (Re Yorkshire Woolcombers Association, Romer LJ). As its name suggests, it floats over the class of assets charged and it will only attach as a fixed charge upon a crystallising event such as a default in making a loan repayment. A fixed charge is a mortgage (legal or equitable) that is generally granted over identifiable assets not commonly traded in the day-to-day operations of the company it attaches to specific assets of the company, for example, land. The holder of a fixed charge will have rights in rem over the assets (see Agnew v Commissioner of Inland Revenue). Fixed chargees rank above floating chargees in respect of their priority in a liquidation (see Chapter 16 of this subject guide). Floating charges may be challenged under the Insolvency Act 1986, s.245 (see section 7.4 of this guide).

Activity 7.2
In Agnew Lord Millett explained that, unlike a floating charge where the company continues to have the freedom to deal with the assets subject to the charge, a fixed charge creates an immediate proprietary interest in the assets in favour of the holder and therefore the company cannot deal with its assets without committing a breach of the terms of the charge. He stressed that the classification of a security as a fixed or floating charge was a matter of substance rather than drafting. If the chargor was free to deal with the charged assets and could withdraw them from the ambit of the charge without the consent of the chargee, then the charge must be viewed as a floating charge. From the chargees perspective, if the charged assets were not under its control, whereby it could prevent their dissipation without its consent, then the charge cannot be viewed as a fixed charge. The critical test was whether the company could continue receiving the book debts and to use them in its business and whether it had the unrestricted right to deal with the proceeds of book debts paid into its bank account. Note that Lord Millett states that Re New Bullas was wrongly decided because the company was left in control of the process by which the book debts were extinguished and replaced by different assets that were not the subject of a fixed charge and were at the free disposal of the company. That was clearly inconsistent with the nature of a fixed charge.

Activity 7.3
Section 874 of the CA 2006 states that certain charges will be void if not registered within 21 days of their creation. Once registered the charge is valid from the date of its creation. This gives rise to a 21-day invisibility period because whenever a person checks the register it cannot be assumed that it is comprehensive because there may be a charge for which the 21-day period is still running. Under the reform proposals put forward by the CLRSG and the Law Commission the 21-day registration rule would be dispensed with altogether. The period between creation and registration would therefore cease to be relevant and, consequently, there would be no period of invisibility. If adopted by the government, registration will no longer be a perfection requirement but becomes a priority point as between competing chargees.

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Chapter 8
Activity 8.1
Lindley LJ stressed that notwithstanding Ooregum, there is no rule preventing a private company purchasing property or services at any price it thinks proper. Thus, provided a company acts honestly, a contract that provides for it to pay for goods or services by fully paid-up shares is valid and binding both on the company and its creditors. Unless the transaction can be attacked on the basis of, for example, fraud, the value of the consideration received by the company in return for its shares cannot be enquired into.

Activity 8.2
Lord Oliver rejected both the trial judges and the Court of Appeals view that larger purpose could embrace avoiding liquidation and preserving the companys goodwill and the advantages of an established business. He noted that purpose is in some contexts a word of wide content and in attaching meaning to it for the purposes of s.153 CA 1985 (now ss.678-682) the mischief against which s.151 (now s.678) seeks to address must be borne in mind. It is therefore necessary to distinguish between a purpose and the reason why a purpose is formed. Larger does not mean more important and reason is not the same as purpose. On the facts of the case, Lord Oliver concluded that the scheme was framed for the best of reasons but to say that the larger purpose of Bradys financial assistance is to be found in the scheme of reorganisation itself is to say only that the larger purpose was the acquisition of the Brady shares on their behalf. Larger purpose cannot be found in the benefits likely to flow from the financial assistance and therefore the acquisition was not a mere incident of the scheme devised to break the deadlock it was the essence of the scheme itself.

Chapter 9
Activity 9.1
a. No feedback provided. b. The articles have historically assumed a situation where there are potentially large numbers of people involved in a business venture. As such it provides a very clear set of rules designed to allocate power between the board and the general meeting, the board having responsibility for the day-to-day running of the company and the general meeting having a supervisory function. This has historically been both a strength and a weakness: a strength in that companies that match the statutory presumption of large numbers of participants can function effectively according to its division of powers; a weakness in that small companies with few participants find its formal division of power inappropriate. The supervisory role of the general meeting has also been diminished in very large companies by shareholder apathy. The separating out of private and public company articles, thus providing appropriate rules, should go some way to resolving this weakness.

Activity 9.2
The s.33 contract is an unusual one but that alone does not explain why enforcing it has been such a complex issue. It seems that all the enforcement issues touch upon a central question in company law. That is, when can an individual member sue in the context of a corporate activity? As we will see in Chapter 11 the general rule in Foss v Harbottle (1843) 2 Hare 461 states that only the company itself can sue to right a wrong to the company. When the judiciary have been deciding on s.33 issues this general principle seems to loom large in their thoughts. As a result, some of the judiciary hold firm to the belief that only the companys organs can enforce the constitution. Others have taken the view that to apply the general rule in Foss v Harbottle is inappropriate in

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the context of s.33 as it would allow the majority to defeat the intention of the section, which is to ensure the constitution is enforceable. Thus the individual shareholders must be allowed to sue to enforce the constitution. While the CLRSG has recognised that shareholders should be able to do so in its recommendations the CA 2006 has done little to change the confusion.

Activity 9.3
a. The key advantage of a shareholders agreement is the certainty of enforcement against the other parties to the agreement. The courts have continually shown that they will enforce such agreements. A shareholder can also identify who he wishes to contract with. For example, if he wishes to contract for other shareholders votes he can identify a shareholder with the right percentage of votes and then enter into an agreement with the other shareholder to exercise his votes in a particular way. It is also private. The disadvantage of a shareholders agreement is that once a party to a shareholders agreement sells his shares, the new owner has no obligations under the shareholders agreement. This is in contrast to the way the s.33 contract operates to bind future shareholders to the companys constitution. Adding the company to the shareholders agreement may also be a disadvantage as there are statutory restrictions on its ability to contract. b. As we have discussed above there are certain restrictions on the shareholders ability to vote. First, alterations of the articles cannot conflict with any statutory provisions. Second, sometimes the courts (particularly where minority shareholders are disadvantaged) will impose equitable restriction on the majority shareholders votes.

Chapter 10
Activity 10.1
A share represents the members financial stake in the company as an association and delimits the extent of the shareholders liability to the company. If the share is partly paid the shareholder owes the company the difference between the price actually paid and its nominal or par value plus any premium (see Chapter 8). In fact, nowadays most shares are fully paid and so the holder has no further liability to contribute to the companys capital in the event of it becoming insolvent. Unlike partners in a partnership, shareholders do not own corporate assets but rather ownership is vested in the company itself: Macaura v Northern Assurance Co Ltd [1925] AC 619.

Activity 10.2
Where rights are annexed to particular shares, such as the right to receive dividends at a specified rate or to receive a return of capital on winding up, they are class rights. Obviously, if a company has issued only one class of shares ordinary shares there are no class rights as such, only shareholder rights. In Cumbrian Newspapers Group Ltd v Cumberland and Westmoreland Herald Newspapers and Printing Co Ltd [1987] Ch 1, Scott J explained that where a companys articles confer special rights on one or more of its members in the capacity of member or shareholder the rights are class rights.

Activity 10.3
The significance of identifying a right as a class right is that it cannot be varied by the company without going through the procedure laid down in ss.630-634 CA 2006. A proposal to vary class rights requires the consent of the class concerned. Class rights therefore have greater protection than a right conferred just by the articles, because the articles of association can be altered by a special resolution of the company (s.21 CA 2006).

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Chapter 11
Activity 11.1
No feedback provided.

Activity 11.2
The judge explained that if the substance of a complaint relates to something that the majority of the company are entitled to do, or if the complaint concerns some irregularity which the majority can legitimately do regularly then there is no point in suing, because ultimately a general meeting will be called at which the majority will get its own way. Mellish LJ went on to add, however, that if the majority abuse their powers and deprive the minority of their membership rights then the minority can sue (see Chapter 9 of this guide and s.33 CA 2006, the statutory contract).

Activity 11.3
No feedback provided.

Activity 11.4
Briefly, the facts were that the company was insolvent due to a former directors breach of certain fiduciary duties not to compete or misuse confidential information. Both duties were also express terms in a shareholders agreement to which the defendant and claimant were parties. Although the company had initiated an action against its former director, the administrative receivers discontinued it when the defendant director applied for a security of costs order (i.e. a court order requiring the company to demonstrate its ability to comply with the courts decision on costs). In effect, the defendant had, by his breach of duty, rendered the company incapable of seeking legal redress against him because it lacked the means to fund the litigation. The claimant sought to recover losses to the value of his shareholding, loss of remuneration and loss of the value of loan stock. The issue for the court was whether these were recoverable by him given the decision in Johnson v Gore Wood & Co. The Court of Appeal, in placing considerable emphasis on the fact that the defendants own wrongdoing had, in effect, disabled the company from suing him for damages, found that this situation had not confronted the House of Lords in Johnson. Given that the duties in question were expressly provided for in the shareholders agreement, it was held that the claimant could pursue his claim for breach of the agreement including his losses in respect of the value of his shareholding. The claims for loss of remuneration and losses of capital and interest in respect of loans made by him to the company did not, in any case, fall within reflective losses. In summary, the decision means that if a company is rendered incapable of suing a wrongdoer by the wrongdoing in question, a shareholder who also has a claim may bring proceedings for his own losses, including losses (termed reflective losses) attributable to the diminution in value of his shares.

Chapter 12
Activity 12.1
The petitioners argued that the majority shareholders who were also the directors had run three companies for their own benefit in that they claimed excessive remuneration while paying low dividends to non-director shareholders. On the facts the court considered that the petitioners had an arguable claim for relief under s.994 and that an order requiring the respondents to purchase the petitioners shares at a fair price to be determined by the court would be more appropriate than destroying the company by ordering its winding up.

Activity 12.2
The Court of Appeal held that the petitioner was not acting unreasonably in refusing to accept a valuation of his shares by the companys auditor, as provided in the articles,

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given that his shares might be discounted in circumstances where a discount was inappropriate. Balcombe LJ took the view that it would be just and equitable to ignore the articles of association and allow the petition to proceed. The converse of the decision in Virdi is that if an offer to purchase a petitioners shares is fair, the petitioner will be acting unreasonably in seeking a winding up order rather than seeking relief under s.994 CA 2006.

Activity 12.3
a. The evidence of the events giving rise to the claim spans a period of some 40 years. The petitions were brought against two associated companies, Macro (Ipswich) Ltd and Earliba Finance Co Ltd. The petitioners alleged that the conduct of the companies sole director, Mr. Thompson, (T), amounted to mismanagement which unfairly prejudiced their interests as members. At the time of the petition T was 83 years of age. He was described as a patriarchal figure and engaged in serious disagreements with the petitioners. It is noteworthy that of the three petitioners, one was Ts son and the other two were his nephews. Central to the mismanagement allegation was the complaint that Ts laissez faire style of management left the companies vulnerable to the dishonesty and neglect of his employees at Thompsons, an estate agency business which managed a substantial number of rental properties owned by the company. The petitioners alleged that Thompsons employees received secret commissions from builders, the costs of which were passed on to the companies, and that they took key money from new tenants. It was successfully argued that the substantial financial losses suffered were due to Ts mismanagement which unfairly prejudiced the petitioners. b. Arden J stated that the question of whether any conduct was unfairly prejudicial to the interests of the members has to be judged on an objective basis. First it has to be determined whether the action of which the complaint is made is prejudicial to members interests and, second, whether it is unfairly so. c. In granting relief, the court took the view that rather than appoint the petitioners to the board, which they had contended had been their expectation, T would be ordered to purchase his sons shares in Macro and Earliba.

Chapter 13
Activity 13.1
a. This case probably represents the harshest interpretation of the ultra vires doctrine and perhaps illustrates best the danger ultra vires posed to companies. In this case the companys object was to acquire and develop a German patent for producing coffee from dates. The company failed to get the German patent but obtained a Swedish one instead. Despite the fact the company had a thriving business based on the Swedish patent it was wound up by the court because it could not achieve its strictly stated object. b. Re Jon Beauforte and Re Introductions Ltd are further good examples of the problems thrown up by the ultra vires issue and the need for legislative intervention.

Activity 13.2
The statutory reforms have the combined effect of making it easier for companies to change their objects and of providing saving provisions for outsiders. This means that there are very few remaining ultra vires problems. Most of the criticism of the reforms has focused on the complexity of the solutions provided for what seems a relatively simple problem. The CLRSG in its Final Report (July 2001) (para 9.10) recognised this and recommended that any company formed under a new companies act should have unlimited capacity whether or not it chooses to have an objects clause. This was partly implemented in the CA 2006.

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Activity 13.3
No feedback provided.

Activity 13.4
Lord Hoffmann viewed the organic theory of the company as largely unhelpful. Instead he considered that if a rule of law requires the court to determine the act or a state of mind of a person, and that rule was intended to apply to companies as well, the court can construct a special rule to test whether something can be attributed to the company. For example the court may not be limited to looking at the directing mind and will of the company but rather could also examine the state of mind of the individual responsible for the matter at hand, no matter what level they were at in the company.

Chapter 14
Activity 14.1
Buckley LJ explained that a person who holds all of the shares in a company is not entitled to control its business. Directors are not the servants of shareholders and so they are not bound to obey their directions given as individuals. Nor are directors the agents of shareholders, bound to follow orders given by their principals. But where the articles of association entrust directors with control of the company, such control can only be removed by amending the articles in accordance with the statutory procedure laid down by s.21 CA 2006 which requires a special resolution.

Activity 14.2
a. Article 90 provided that the board shall fix the annual remuneration of the directors subject to the proviso that without the consent of the general meeting such remuneration shall not exceed 100,000. Article 91 went on to confer on the board the power to grant special remuneration, in addition to ordinary remuneration, to any director who serves on any committee or who gives special attention to the business of the company. b. Mr Ward was a member of a committee set up by Guinnesss board of directors to guide the company through a takeover bid it had made for another company, Distillers. He had been paid a fee of 5.2m for his services which had been agreed by the committee. Lord Templeman, construing the language of the articles of association, found that they did not confer on the committee the power to pay remuneration to one of its own members. He said that Article 91 draws a contrast between the board and a committee of the board. The board is expressly authorised to grant special remuneration to any director who serves on any committee. It cannot have been intended that any committee should be able to grant special remuneration to any director, whether a member of the committee or not.

Activity 14.3
In reversing the trial judges finding that the respondents were not shadow directors within the statutory definition, Morritt LJ, having reviewed the case law, laid down five propositions. i. The definition of a shadow director is not to be too narrowly construed given that the purpose of the CDDA 1986 is to protect the public. ii. Although the purpose of the legislation is to identify those, other than professional advisers, with real influence in the corporate affairs of the company, it is not necessary that such influence should be exercised over the whole field of its corporate activities. iii. Whether any particular communication (by words or conduct) from the alleged shadow director is to be classified as a direction or instruction must be objectively ascertained by the court in the light of all the evidence.

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iv. Non-professional advice may come within the statutory description: the proviso excepting advice given in a professional capacity assumes that advice generally is or may be included. The concepts of direction and instruction do not exclude the concept of advice because all three share the common feature of guidance. The critical factor is whether the person has real influence over the companys affairs. v. Although it is sufficient to show that in the face of directions or instructions from the alleged shadow director the properly appointed directors (or some of them) cast themselves in a subservient role or surrendered their respective discretions, this is not necessary in all cases. Such a requirement would be to put a gloss on the statutory requirement that the board are accustomed to act in accordance with such directions or instructions.

Activity 14.4
H, as a non-executive director of the company, was signatory to the companys cheque account. The companys accounts, which H looked to when assessing the companys financial position, were prepared by professional accountants. The company went into liquidation and the Secretary of State applied for an order under s.6 CDDA 1986 on the basis that H had caused the company to operate a policy of not paying Crown monies and had failed to keep himself properly informed of the companys financial position. The grounds of the application were that beginning in June 1995 the company had ceased making National Insurance and PAYE payments. Also, the fact that the company was in arrears of VAT was apparent in the management accounts for February and April 1995. It was alleged by the Secretary of State that H either knew the payments were not being made or ought to have realised they were not being paid because he had not been requested to sign any cheques in respect of such payments. Further, H had signed a number of cheques to pay another directors sons school fees thereby allowing that director to breach his fiduciary duties by misusing company funds for his own personal use. H had questioned the propriety of these payments but had been assured by the accountants that they would be treated as part of that directors remuneration and would be properly reflected in the accounts as such. Notwithstanding the accountants advice H had refused to sign additional cheques for school fees and he had reported these payments to the board. The Secretary of States allegation that H had failed to keep himself properly informed of the companys financial health was rejected. Merely being a signatory to the companys cheques was not sufficient to make the director personally responsible for any policy of not paying Crown monies. H was entitled to rely on the assurances of the accountant that the finances of the company were being properly managed. The court held, taking Hs lack of experience in operating corporate finances together with his non-executive status, that he was entitled to rely on the accountants to prepare the accounts and on their assurances that the finances were being properly run. A cheque signatory is not a Finance director and is therefore not expected to possess such expertise. With respect to the cheques for school fees, H had acted on the advice of the accountant and had reported the payments to the board.

Crown monies: National Insurance, PAYE (employees income tax) and VAT (sales tax) are all collected by companies on behalf of the government and paid over at set intervals.

Chapter 15
Activity 15.1
In Coleman v Myers the board of a family company had recommended to the shareholders a takeover offer by a company controlled by one of the defendant directors. The court held that in a small private company where the minority shareholders habitually looked to the directors for advice on matters affecting their interests, a duty of disclosure arose which placed the directors in a fiduciary relationship with the shareholders. Woodhouse J stated that while it is impossible to lay down a general test as to when the fiduciary duty will arise, the following factors will be material to the courts determination: dependence upon information and advice, the existence of a relationship of confidence, the significance of some particular transaction for the parties and the extent of any positive action taken by or on behalf of the director or directors to promote it.

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Activity 15.2
Lord Wilberforce stated that the court should: i. consider the nature and scope of the power whose exercise is in question (in this case, a power to issue shares) ii. identify the limits within which it may properly be exercised iii. identify the substantial purpose for which it was actually exercised iv. having given credit to the bona fide opinion of the directors and accepting their judgment as to matters of management, determine whether the substantial purpose (point iii, above) fell within a legitimate purpose determined according to point ii, above. v. If the substantial purpose is proper, the exercise of the power will not be set aside because some other improper, but merely incidental, purpose was also achieved.

Activity 15.3
In Extrasure the directors had transferred company funds to another company in the group to enable it to pay a creditor who had been pressing for payment. It was held that the directors had acted without any honest belief that the transfer was in the interests of the transferor company. The decision clearly illustrates that where the company is one of a number in a group structure the directors must act bona fide in the interests of that company. This is, after all, a straightforward application of the decision in Salomon (see Chapter 3 of this guide) that each company is a separate legal entity. There may be situations, however, where acting in the interests of the group furthers the interests of the particular company. For example, if a subsidiary company is owed money by its parent company which is in financial difficulty the failure on the part of the directors to take action to recover its debts may be in the interests of the subsidiary if, on balance, it would be adversely affected by the liquidation of the parent company (see Nicholas v Soundcraft Electronics Ltd [1993] BCLC 360).

Activity 15.4
All three of the directors (the executive and the two NEDs) were held liable to make good the companys losses and, while the judge noted the accountancy experience of the NEDs, their professional qualifications were not material to his finding. The court found the NEDs negligent in allowing Stebbings to do as he pleased. You should note Foster Js finding that the NEDs not only failed to exhibit the necessary skill and care in the performance of their duties as directors, but that they failed to perform any duty at all.

Activity 15.5
The directors were liable notwithstanding that:
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the company was financially incapable of purchasing the necessary shares they had used their own money they had acted honestly.

As Lord Russell pointed out, the liability to account for any profit does not depend upon fraud or absence of bona fides, the liability arises from the mere fact of a profit having, in the stated circumstances, been made. The fact that the purchasers of the company in effect got a reduction on the purchase price they had agreed was irrelevant to the issue of liability. The decision illustrates that the liability of directors in this respect is founded upon their trustee-like status thus, like trustees, directors will hold any secret profit (i.e. a profit not disclosed to and ratified by the shareholders) on constructive trust. The new board caused the company to bring the claim against its former directors. As we saw in Chapter 11, the proper claimant rule requires the company to bring proceedings for redress when a wrong has been committed against it.

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Chapter 16
Activity 16.1
This is a good way for you to bring company law to life a bit more by thinking about how various aspects of company law can be categorised. As a general guide, mandatory company law rules, such as minimum capital requirements which override any private agreements between contracting parties, sit easier with concession theory, where state interference is more easily justifiable. Default rules, such as the articles of association which apply in the absence of any agreement to the contrary, and enabling rules, such as the company registration procedure, which provide a framework for private parties to carry out certain functions sit easier with aggregate theory. Additionally the common laws protection of managerial discretion seems to have some resonance with corporate realism. Company law, as you will note, is not in reality dominated by any one theory but is a mix of all three.

Activity 16.2
This is a provocative statement and you must agree or disagree with it. Do not sit on the fence as a strong argument on one side or the other is the only way to deal with it. The statement is interesting given that until recently it was generally agreed that corporate governance had improved. Given the collapse of the financial services sector in the UK and US over the course of 2008-9 corporate governance failure is once more at the top of the reform agenda. While it is true that the committees have been a great export success, with many countries adopting their recommendations, this may not be the success it might have seemed. It now seems that the reason why these recommendations are particularly palatable for the global business community is that they are not particularly onerous. If you have not already read Dignam and Lowry, Chapter 15, please do so now.

Chapter 17
Activity 17.1
The primary purpose of liquidation is to ensure, as far as possible, that all creditors receive fair treatment, so if there is any scheme put in place which prevents this the court will set it aside. Thus, the House of Lords held that the pari passu principle of distribution (by which is meant that the free assets of the company are distributed pro rata among unsecured creditors) is mandatory to the extent that a creditor cannot, by contract, obtain a better position than that which the pari passu principle permits.

Activity 17.2
The objectives of the IA 1986, which implements the recommendations of the Report of the Review Committee on Insolvency Law and Practice (Cork Committee Report, 1982, (Cmnd 8558)), are:
uu uu uu

to maximise the return to creditors where the company cannot be saved to establish a fair system for the ranking of competing claims by creditors to provide a mechanism by which the causes of the companys failure can be identified and those guilty of mismanagement can be made answerable.

The compulsory winding up procedures and the powers of a liquidator and the court to police the winding up seeks to achieve these objectives.

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Activity 17.3
Buckley LJ explained that there may be circumstances where it is beneficial, both to the company and to the unsecured creditors, that the company be allowed to dispose of some of its property after the petition has been presented. However, he stressed that in considering whether to make a validating order the court should ensure that the interests of the unsecured creditors are not prejudiced. Where an application is made in respect of a specific transaction this may be susceptible of positive proof. But, whether or not the company should be permitted to carry on business generally is more speculative and will depend on whether a sale of the business as a going concern will be more beneficial than a break-up realisation of the assets. Buckley LJ concluded by saying that, although the court will be disinclined to consent to any transaction which has the effect of preferring a pre-liquidation creditor, nevertheless the court would be inclined to validate a transaction which would increase, or has increased, the value of the companys assets, or which would preserve, or has preserved, the value of the companys assets from harm which would result from the companys business being paralysed

Activity 17.4
No feedback provided.

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Notes

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