LA3021
LA3021
LA3021
Christopher Riley
This module guide was prepared for the University of London by:
u Christopher Riley, LLB, Associate Professor, Durham Law School, University of Durham.
This is one of a series of module guides published by the University. We regret that owing
to pressure of work the author is unable to enter into any correspondence relating to, or
arising from, the guide.
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Company law page i
Contents
Module descriptor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . v
1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
1.1 Company law . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
1.2 Approaching your study . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
Notes
Company law page v
Module descriptor
GENERAL INFORMATION
Module title
Company law
Module code
LA3021
Module level
6
Enquiries
The Undergraduate Laws Programme courses are run in collaboration with the
University of London. Enquiries may be made via the Student Advice Centre at:
https://sid.london.ac.uk
Credit
30
Module prerequisite
None
Company law is a vital module for anyone intending to operate in a commercial field.
The syllabus centres on the way the law regulates companies and the facilities that
company law offers, such as limited liability and transferability of shares, as well as
corresponding burdens such as duties of disclosure and compliance with statutory
procedures.
MODULE AIM
The module aims to introduce students to the nature, and the regulation, of the
modern business company. It will enable students to understand what is distinctive
about the company, the advantages it enjoys as a way of running a business and the
policy issues that its existence raises. Students should come to understand some
of the central concepts relevant to the company, such as limited liability and legal
personality, the competing interests of different groups of individuals who are
affected by a company’s operations, such as its directors, shareholders, creditors and
employees, and the role that the law can play in protecting such individuals.
page vi University of London
1. Explain the main concepts that underpin company law, including separate legal
personality and limited liability;
2. Understand, and critically engage with, the policy issues that arise regarding the
regulation of companies, including the views of different commentators about
those policy issues;
3. Discuss the main principles and rules that seek to regulate and protect different
participants within companies, especially their directors, shareholders and
creditors;
4. Summarise the issues that arise in respect of large, widely owned, public
companies and the strategies that have been developed to ensure such companies
are well governed.
6. Critically analyse and evaluate selected areas of company law and place the policy
issues raised by company law in their social, economic and political contexts;
7. Develop well-reasoned analysis and arguments for the reform of selected areas
of company law, including by engaging critically with the arguments of other
commentators;
8. Critically read case law and other materials and construct answers to questions set;
9. Reflect on their own learning, including identifying areas where their knowledge or
understanding needs improvement and respond appropriately.
MODULE SYLLABUS
(a) The nature of a company’s legal personality and piercing the veil of incorporation.
Incidents of corporate personality. Differences between incorporated and
unincorporated associations. The rule in Salomon v Salomon & Co Ltd and its
development. Tortious liability as an alternative to veil lifting.
(b) The formation of the company. The suitability of the company as a legal vehicle for
different types of business. The registration process, including the memorandum
and articles of association. Pre-incorporation contracts. The duties and liabilities of
promoters.
(c) The relations between the company and outsiders. The decline of the doctrines of
ultra vires and constructive notice. The application of principles of agency law to
companies. The commission of crimes and torts by the company.
(d) The relations between the company and its members and among the members inter
se. The nature of and principles governing the statutory contract between the
company and its members. Different capacities of members and relations between
one member and another. Alteration of the statutory contract and remedies for
breach.
(f) Directors’ duties. The general duties of directors, and the codification of those
duties. Statutory controls on directors, including rules on self-dealing. The
enforcement of directors’ duties, including the rule in Foss v Harbottle and the
statutory derivative claim.
(g) The protection of minority shareholders. The statutory remedies for the protection of
minority shareholders. Shareholders’ personal rights, including under the statutory
contract.
(i) Shares and debentures. Differences between shares and debentures. Registration.
Different classes of shares. Rights of different classes and the variation of share
rights.
(j) Capital. In outline only: the raising, maintenance and reduction of the capital of the
company. Payment of dividends and purchase by the company of its shares.
(k) Winding-up. Types of winding-up. The powers and duties of the liquidator. Actions
against directors of insolvent companies.
Module guide
Module guides are the students’ primary learning resource. The module guide covers
the topics in the syllabus and provides the student with the grounding to complete
the module successfully. The Module Descriptor sets out the learning outcomes that
must be achieved. It also includes the core, essential and further reading, and a series
of activities designed to enable students to test their understanding and develop
relevant skills. The module guide is supplemented each year with the pre-exam
update, made available on the VLE.
u pre-exam updates;
u discussion forums where students can debate and interact with other students;
u quizzes – multiple choice questions with feedback are available for some modules.
u law reports;
Core text
Students should refer to the following core text and specific reading references are
provided for this text in each chapter of the module guide:
¢ Dignam, A. and J. Lowry Company law. (Oxford: Oxford University Press, 2022)
12th edition [ISBN 9780192865359].
ASSESSMENT
Formative assessment is conducted through tasks in the module guide and online
activities. The formative assessment will prepare students to reach the module
learning outcomes tested in the summative assessment.
Please be aware that the format and mode of assessment may need to change in
light of extraordinary events beyond our control, for example, an outbreak such as
the coronavirus (COVID-19) pandemic. In the event of any change, students will be
informed of any new assessment arrangements via the VLE.
Permitted materials
Students are permitted to bring into the examination room the following document:
Contents
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
Introduction
This module guide acts as a focal point for your study of Company law. It will give you
a structure for building up the knowledge and the skills you need to succeed on the
module and will help you to get the most out of the wider reading that you will be
doing. The guide is certainly not a replacement for that reading. Reading the core text
remains essential and looking at the further reading is strongly desirable for those who
want to do well. However, the guide can help you navigate your way through this and
in several ways:
u It can help to give you a structure for the module as a whole and for each individual
topic. If you start your reading on each topic with the guide, you will get a sense of
the key points on each topic and how those points fit together, ensuring you grasp
these first before tackling the detail provided in the textbook.
u It can help you to tackle some of the further reading, both by identifying the key
points to focus on in that reading and by relating those key points to the topics in
the guide and the core text.
Learning outcomes
By the end of this chapter and the relevant readings , you should be able to:
u approach the study of Company law in a systematic way
u understand what the various elements of the module guide are designed to do
u begin your study of Company law with confidence.
Company law 1 Introduction page 3
Although most of you will be new to the subject of company law, you have all
already met some of the building blocks out of which company law is constructed.
Equitable doctrines (such as ‘fiduciary duties’) and the law of tort both form part of
the machinery for regulating companies. Even more significantly, the rules found in
company law can often be supplemented, or even changed, by what those involved
with companies agree between themselves. To be successful, you need to be able
to draw on these earlier areas of your studies and understand how they are being
fashioned and used in the corporate context.
This guide, like most company textbooks, breaks down the subject into a number
of separate topics. Doing so helps to make the subject more manageable and also
gives you a structure for building up your knowledge in an ordered way. However,
it is especially important in company law (and perhaps more than in many other
legal subjects) to see how the topics interlink. The topics are, in a way, like parts of a
machine that do (or should) work together.
Further reading
You will also find further ideas in the following two pieces of reading:
¢ Reisberg, A. ‘Corporate law in the UK after recent reforms: the good, the bad and
the ugly’ (2010) Current Legal Problems 315 (available in LexisLibrary).
your understanding and develop relevant skills. These activities give you a chance
to pause and digest the information you have just covered. 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 and to test your understanding of the area. 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(s) at the end of each chapter. Use the ‘Reflect and
review’ section at the end of each chapter to keep track of your progress.
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 Readings
Core text
¢ Dignam, A. and J. Lowry Company law. (Oxford: Oxford University Press, 2022)
12th edition [ISBN 9780192865359].
This module guide is centred on this textbook. References in the text to ‘Dignam
and Lowry’ are references to this textbook. You may have an earlier edition of this
textbook. You will be able to find the relevant readings for this course by using the
contents list and index of any earlier edition.
It is your core reading and therefore 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.
Further reading
¢ Davies, P.L., S. Worthington and C. Hare Gower: principles of modern company law.
(London: Sweet & Maxwell, 2021) 11th edition [ISBN 9780414088115].
This text is particularly interesting as it fleshes out the interaction of company law
with capital markets and securities regulation.
¢ Worthington, S. and S. Agnew Sealy & Worthington’s text, cases and materials
in company law. (Oxford: Oxford University Press, 2022) 12th edition
[ISBN 9780198830092].
¢ Dignam, A. Hicks & Goo’s cases and materials on company law. (Oxford: Oxford
University Press, 2011) seventh edition [ISBN 9780199564293].
These books place the study of company law in its economic, business and social
context. This makes the cases, statutes and other forms of regulation that make up
company law more accessible and relevant.
Company law 1 Introduction page 5
Three significant books are also drawn to your attention. We don’t 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, 1995) [ISBN 9780198259893].
¢ Cheffins, B.R. Company law: theory, structure and operation. (Oxford: Oxford
University Press, 1997) [ISBN 9780198764694].
Parkinson (1995) examines the corporate law issues surrounding the ‘stakeholder’
debate in the UK (there is more on this in Chapter 14 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 Modern Company Law Review, mentioned
above. His views are therefore important in understanding the CLRSG findings and the
corporate governance provisions in the CA 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 module guide, based around the globalisation of
product and securities markets.
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. A good choice is:
You are currently allowed to bring this book 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 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:
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.
page 6 University of London
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. Have a look at
these as much as you can: doing so 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 Sweet
& Maxwell) and Butterworth’s Company Law Cases (BCLC), 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 Palmer’s Company Law (Sweet & Maxwell)
(available in Westlaw via the Online Library) or Gore-Browne on Companies (Jordan
Publishing) 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.
2 Forms of business organisation
Contents
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
Introduction
In this chapter, we will meet ‘the company’ for the first time. We will see that it is one
‘legal form’ through which a business may be run. There are, however, other legal
forms available for a business, such as the sole tradership or the partnership, and one
of the main purposes of this chapter is to understand what is distinctive about the
company and why so many businesses choose to operate as a company rather than
using one of its alternatives.
The chapter will end by sketching out some of the key events in the life of any
company – events that company law must address. This will give us an overview
of what company law does and provide a helpful map of the journey on which the
remaining chapters in this module guide will take us.
Chapter 1 of Dignam and Lowry is the main reading you need to complete. The whole
chapter is relevant, and you should read it all. But we will also pick out some of the
specific sections from that chapter to read more closely in connection with the
different topics/sections we are addressing.
Learning outcomes
By the end of this chapter and the relevant readings, you should be able to:
u illustrate the differences between the major forms of business organisation in
the UK
u describe the advantages and disadvantages of each form of business
organisation
u explain the different categories of company
u demonstrate the difficulties small businesses have with the company as a form
of business organisation.
Core text
¢ Dignam and Lowry, Chapter 1 ‘Introduction to company law’.
Company law 2 Forms of business organisation page 9
The law offers a choice between a number of different legal forms. The company is
one of those forms and, predictably, it is the one we are going to focus on. However,
to understand better what is distinctive about the company, it is useful to begin by
considering two of the alternative legal forms you could adopt to run your business
– namely, as a sole trader and through a partnership. The important thing, when
considering these different legal forms, is to think about how (and, especially, how
well) they deal with some of the key issues that you would face when running your
business. So, what are those key issues?
u You will probably need to raise capital (money) from others. You could do this
either by convincing others to lend to your business, or by persuading others to
invest in your business as ‘co-owners’.
u There is always the risk that your business will turn out to be a failure. If it does fail,
and the business does not have enough money to satisfy all the debts and liabilities
that have been incurred, who will bear these losses?
u Because there may be a number of different people involved with your business,
there will need to be what Dignam and Lowry call ‘an organizational structure’ –
rules about who makes which decisions concerning the business and how those
decisions are to be taken.
Activity 2.1
Maria is fluent in English and Spanish, and has a degree in engineering. She decides
to set up a business, operating from her home, translating engineering documents
between Spanish and English. Maria will need very little additional capital, since she
already owns much of the equipment the business will need. Maria’s brother, Luis,
has agreed to lend Maria £5,000 to get the business established but Maria does not
want him interfering in the business.
If Maria runs her business as a sole trader:
a. What formalities will she need to comply with in order to create her sole
tradership?
c. What will be Luis’s position in the business – will he be able to make any
decisions?
page 10 University of London
The most obvious difference between the partnership and the sole trader is that, for
a partnership to exist, there must be at least two people who own the business. The
Partnership Act 1890 sets out the main rules governing unlimited partnerships and
s.1 defines a partnership as ‘the relationship which subsists between persons carrying
on a business in common with a view of profit’. However, in many other respects, a
partnership is very similar to, and has similar advantages and disadvantages to, a sole
tradership.
For this module, you do not need to know partnership law in any detail. However,
you do need to understand the main advantages, and disadvantages, of operating
a business as a partnership compared to as a company. So, read Dignam and Lowry,
Sections 1.3–1.6, and then complete the activity that follows.
ACTIVITY 2.2
Imagine that Maria (from Activity 2.1) has been successfully running her translation
business for three years. Recently, her brother Luis has been taking an increased
role in her business. He has been carrying out lots of administration tasks and has
also been translating documents written in French or German (being fluent in both
languages). Maria has been paying him for the work he has undertaken, but Luis
is now demanding a greater say in the running of the business and a share in its
profits.
Advise Maria of the advantages, and disadvantages, of running her business in
partnership with Luis.
The companies we are focusing on in this module are created according to the
procedure set out in the Companies Act 2006. This simple procedure involves
‘registering’ some paperwork with the ‘Registrar of Companies’, based at Companies
House. (Companies House is a public body and, effectively, part of the Department for
Business, Energy and Industrial Strategy.) We will have a look at this process a bit more
in Chapter 3.
Because the companies we are focusing on are created by this registration process,
such companies are called ‘registered companies’. Today, almost all UK companies are
registered companies. However, it is worth noting that there are some other sorts of
company, apart from registered companies, in the UK. They include what are known
as ‘chartered companies’ and ‘statutory companies’. The process for creating these
is rather more complex than the simple registration process under the Companies
Act 2006 and these non-registered companies are rarely used. We will not look at
them further on this module (and from now on, when we refer to ‘a company’, we will
always mean a registered company).
describe the different types quickly – and then explain some of the distinctions. First, a
registered company can be either ‘limited’ or ‘unlimited’. Almost all companies in the
UK are created as limited. Next, limited companies can be either ‘limited by shares’,
or ‘limited by guarantee’. Finally, companies that are limited by shares can be either
private companies (limited by shares) or public companies (limited by shares). In the
UK, there are now nearly 4 million companies. In fact, about 95 per cent of these are
private companies limited by shares; the other types of registered company are all
much rarer.
All companies have one feature in common – a feature that distinguishes them from a
sole trader or an ordinary partnership. A company has its own ‘legal personality’ – it is
treated as being a ‘legal person’, separate from the persons who created the company
and become its owners or its managers. This feature is examined in more detail
in Chapter 4. For now, note that it means, in law, the company itself can, say, own
property, or enter into contracts.
What does it mean to say the company is ‘limited’? For companies that are ‘limited’,
the members of the company (we usually call these members ‘shareholders’ when the
company is limited by shares) are not themselves liable for the debts incurred by the
company. If the company is unable to pay its debts (because its liabilities exceed its
assets), the members cannot be made to put more money into the company to make
up the shortfall.
Activity 2.3
Can you find out the difference between a company limited by shares and a
company limited by guarantee? Can you think why most ‘for profit’ businesses do
not operate as companies limited by guarantee?
Finally, what is the difference between a public (limited) company and a private
(limited) company? Dignam and Lowry explore the difference in more detail (Sections
1.14–1.16); look at that again once you have finished this chapter of the guide. But for
now, we can summarise the differences as follows. First, a public company can offer
its shares to the public at large but a private company cannot. So, a public company
that is raising more capital by selling more shares in itself can offer those shares to
anyone. Related to this point, if a company wants to sell its shares through the London
Stock Exchange, it must become ‘listed’ on that exchange to do so. And only public
companies can become listed in this way. When a private company is selling shares
in itself, it must effectively find buyers ‘privately’ (say, by offering them to its existing
shareholders, or perhaps their wealthy friends, relatives, or business contacts).
Second, public companies are often seen as more prestigious, and more trustworthy,
than private companies.
However, if public companies enjoy these advantages, why do not all businesses
operate as public, rather than as private, companies? The answer lies in the third major
difference between private and public companies. Public companies are subject to a
lot more regulation than private companies. This is partly why they are seen as more
trustworthy – the extra regulation makes it more difficult for those running public
companies to misbehave. However, complying with this extra regulation takes time
and costs money. Since most private companies do not need to raise large amounts of
capital by offering their shares to the world at large, those private companies are quite
content to continue operating as less intensely regulated (but also perhaps somewhat
less ‘prestigious’) private companies.
Activity 2.4
Return to the facts of Activity 2.2. Maria and Luis’s business has grown substantially
in the past year. They have, so far, been able themselves to provide the capital
the business needs but they anticipate that in the next year they will need to find
another investor willing to provide about £50,000 of additional capital. They have
also grown concerned about their potential liability should the business suddenly
fail. And Luis has told Maria that, while he is currently very happy to be involved in
the business, he is already starting to think about his retirement and may want to
leave the business in the next few years.
a. If Maria and Luis decide to change their legal form from a partnership to a
company, how might that affect their roles in the business?
b. Would operating through a company reduce the risks they face should the
business fail?
c. Will operating through a company make it easier to raise more capital in the
future?
d. If they operate through a company, will that make any difference to Luis leaving
the business in the future?
In some areas of corporate regulation, the Government has chosen not to introduce
statutory rules but instead to rely more on what has come to be called ‘soft law’. Such
soft law includes ‘codes of practice’, which may set out recommendations for how
companies should behave, or how they should be managed but that do not apply legal
penalties to a company that fails to follow such recommendations. The UK Corporate
Governance Code, which we will look at in Chapter 14, is a good example of such a
code.
Finally, it is important to understand that shareholders are free to agree some of the
rules for themselves. On some matters (for example, the size of the board of directors)
company law is simply silent, leaving shareholders to draw up their own rule. In
other cases, there is a legal rule (such as the rule for the ‘quorum’ for a shareholders’
meeting) but the rule is not ‘mandatory’ – it is merely a ‘default rule’ that the
shareholders can change by agreement.
One important source of such contractual rules that shareholders can choose for
themselves is the company’s constitution. All companies must have a constitution,
and this document must be submitted when the company is being formed; see
Dignam and Lowry, Sections 1.10– 1.13 for a brief introduction. The constitution of a
company is usually referred to as its ‘articles of association’. It contains rules about the
running of the company – such as who makes management decisions, how meetings
of shareholders, or directors, are to be held and so on. Those forming a company can
draft their own articles but, if they do not, there are ‘model articles’ that are supplied
by the state, by statutory instrument, and which apply ‘by default’. Most companies
(and especially private companies) adopt the model articles either without any
changes, or with a few minor alterations. Because of this, you will need to be familiar
with the most important provisions of the model articles; they can be found in your
recommended statute book.
Company law 2 Forms of business organisation page 13
The essential point is that a lot of company law assumes that in every company there
will be a ‘split’ between ‘ownership and control’ – that the company will be owned by
its shareholders but actually managed by others on their behalf. On this assumption,
company law insists that every company must have, in addition to the shareholders
who own it, directors who will be running the company. Company law then creates
lots of rules to give effect to this presumed split – rules about which decisions must
be made by shareholders and which by directors, rules about the duties of directors
when they make decisions and so on. However, although in large companies there is
likely to be a split between ownership and control, in smaller companies the same
people will probably both own the company and want to manage it.
This is an important issue and it is covered by Dignam and Lowry in Sections 1.18–
1.26. So, have another look at that reading. It will give you further ideas about how
company law may still be poorly designed, in some respects, for the smaller company.
It describes some of the ways that company law has already been changed to address
some of these difficulties – in particular, by making the ‘private company’ less heavily
regulated and therefore somewhat better suited to the needs of the small business.
We will come back to this issue in the activity in Section 2.7, where there is also
guidance on some useful further reading.
First, there will need to be rules about how Maria and Luis actually form their company.
These rules are addressed briefly in Chapter 3.
Second, we already know that, by forming the company, Maria and Luis will create a
separate legal personality (explored in a bit more detail in Chapter 4). While there are
good reasons for allowing entrepreneurs such as Maria and Luis to create companies,
it is also true that the company, and the separate legal personality and limited liability
it offers, can be misused in ways that harm others. Unsurprisingly, then, company
law has a number of rules in place to try to prevent, or limit, such misuse. Chapter 5
focuses on some of these.
Third, because companies usually need money to operate, there will need to be rules
addressing how companies raise ‘capital’. Some of the capital may be raised from
shareholders (‘equity capital’) and some may be raised from creditors (‘loan capital’).
Chapters 6 and 7 look at how company law deals with these two areas.
Fourth, the company will have to be managed and company law must provide rules
dealing with this. Chapter 9 looks at the role of directors in managing the company,
while Chapter 10 considers the important issue of the duties that company law
imposes on directors. If those duties are to work well, then there must be some means
of enforcing them. Chapter 11 focuses on this issue of enforcement.
Fifth, while Maria and Luis may get on well together now, it is, unfortunately, common
for the relationship between shareholders to deteriorate during the lifetime of a
company. This is especially true in smaller companies, where there are often tensions
page 14 University of London
between ‘majority’ and ‘minority’ shareholders. Chapters 8 and 12 will examine this
problem in greater detail. They will help you to see why minority shareholders can
be vulnerable – especially in smaller companies – and how company law offers some
protection. Chapter 8 focuses on the rules that are found in the company’s own
constitution. It shows how these rules can, in theory, be enforced by each individual
shareholder but also explains why, unfortunately, these rules often provide only
limited protection for minorities. Chapter 12 then turns to look at two very important
statutory provisions that have, at least in certain types of company, provided a much
more effective form of protection for minorities.
Sixth, suppose that Maria and Luis’s company proved spectacularly successful. Over
time, it might grow from a fairly small, private company with just two shareholders
into a much larger business, operated through a public company with hundreds
or perhaps even thousands of shareholders. It would be managed by professional
executives. Such large, public companies seem to raise a number of different
regulatory problems. These are often discussed under the label of ‘corporate
governance’, a very topical area of the module, since it involves large public
companies that are often in the public eye. Chapter 14 introduces you to this subject.
Finally, suppose that, rather than growing ever larger, Maria and Luis’s company begins
to struggle financially. The end result of that struggle might be that the company
becomes insolvent and is ‘wound up’. Chapter 15 will look at this end-state of affairs,
considering briefly how a winding up happens and some of its implications for those
who have been running the company.
Activity 2.5
Read the article: Freedman, J. ‘Small businesses and the corporate form: burden or
privilege?’ (1994) 57 Modern Law Review 555–84 (available in JSTOR via the Online
Library). Then, answer the following questions:
i. Looking at Section B of the article, what did Freedman’s research discover
were the main reasons why the owners of small businesses choose to run their
businesses through a company?
ii. The Introduction of the article argues for a reduction in the regulation applied
to small companies but argues there should be a greater reduction in ‘internal’
regulation than in ‘external’ regulation. Can you explain this distinction and the
reasons Freedman gives for making this distinction?
iii. Finally, again looking at the Introduction, Freedman argues against a more
‘radical’ reform involving the creation of a new form of company specifically for
the small business. Why?
No feedback provided.
Summary
You should now understand what it means to say that the company is a ‘legal form’
or a ‘legal vehicle’ for running a business. You should understand how the company
compares to other legal forms (sole tradership and partnership) in terms of how it
deals with the risks of running a business, with the need to raise capital and with the
‘organisational’ (decision-making) structure of the business.
You should also now be aware that there are still concerns that the company may not
be ideally designed for smaller businesses. The reading from Dignam and Lowry should
have shown you some of the company’s shortcomings in this respect and the further
reading from Freedman’s article should have helped you consider these issues more
Company law 2 Forms of business organisation page 15
deeply. If you have done all the suggested reading from this chapter and have tried the
activities above, have a go at the sample examination question to test your knowledge
further.
Further reading
¢ Freedman, J. ‘Small businesses and the corporate form: burden or privilege?’
(1994) 57 MLR 555–84.
First, you could note the various advantages which a company has, as a legal vehicle,
for running a business:
u First, because the company has its own separate legal personality, that personality
continues, notwithstanding changes in the human beings behind the company. So,
the departure of a shareholder does not terminate the company.
u Second, the shareholders benefit from limited liability. This is good for those who
originally create the company. It will also make it easier for the company to raise
more capital in the future – potential investors will be more likely to buy shares
in the company because they know they will also enjoy the protection of limited
liability.
u Because the shareholders have limited liability, they are happy for the company
to take on more risky projects. If the project fails, the investor may not get their
investment back but the rest of their wealth will be safe. Since business often
involves taking on risky ventures whose success cannot be guaranteed, the
company provides a good way of doing so.
u The company can sometimes borrow more than can a sole trader or partnership.
It can do so because it can provide a form of ‘security’ that a sole trader, or an
unlimited partnership, cannot, namely a ‘floating charge’. This is addressed further
in Chapter 6.
u There is some evidence that the public thinks that any company (and even a
private one) is more ‘solid’ and prestigious than a partnership or sole tradership.
u Companies may sometimes enjoy tax advantages (we will not look further at the
taxation of companies in this module).
You could also demonstrate further reading around the subject by noting how the
Freedman study gives us more evidence of why many entrepreneurs choose to run
their businesses through companies.
Second, you might then note some of the shortcomings of the company as a vehicle
for smaller businesses. You could draw on what you have read in Dignam and Lowry,
and the further reading (especially the article by Freedman). In particular, show
how the company has historically been more heavily regulated and how a lot of this
regulation arises because of an assumption that there will be a separation between
‘ownership and control’. You could then explain why this separation may not exist in
the smaller business.
Third, you could then turn to how company law has addressed such problems. You
might explain how the law makes available both a public company and a private
company, with the latter being intended to better fulfil the needs of smaller
page 16 University of London
businesses. You could then discuss some of the ways in which the rules applicable
to private companies have been relaxed and made more appropriate for smaller
companies. You have already met some of the ideas that are relevant here, such as
the Government’s emphasis on a ‘think small first’ approach when it enacted the
Companies Act 2006. But, as we go through the module, you will meet lots of other
examples of ways in which the rules for smaller, private companies differ from those
for larger, and public, companies – in the areas of capital, in relation to directors, the
model articles, minority shareholder protection, and so on. So, you should be able to
keep adding to your answer to this question as you learn more.
Company law 2 Forms of business organisation page 17
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.
If you ticked ‘need to revise first’, which sections of the chapter are you going to
revise?
Must Revision
revise done
Notes
3 Company formation, promoters and
pre-incorporation contracts
Contents
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
3.2 Promoters . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
Introduction
By now, you should understand what a company is and why those running a business
may wish to do so through a company. We noted in Chapter 2 that the sort of
companies we are interested in are called ‘registered companies’ because they are
created by ‘registering’ certain documents with the Registrar of Companies. In this
chapter, we will say a bit more about the practical process of registering a company.
We will also look at the legal position of the person forming a company – what the
law calls the ‘promoter’. And we will finish by considering the problem of so-called
pre‑incorporation contracts (contracts made supposedly on behalf of a company, but
before the company has actually been created).
Learning outcomes
By the end of this chapter and the relevant readings, you should be able to:
u understand how a company is created in the UK
u explain when a person will be treated as a promoter
u understand why promoters have been subject to legal duties
u describe the issues arising from pre-incorporation contracts
u assess the impact of s.51 CA 2006 on pre-incorporation contracts and the liability
of promoters.
Core text
¢ Dignam and Lowry, Chapter 4 ‘Promoters and pre-incorporation contracts’.
Cases
¢ Phonogram Ltd v Lane [1982] QB 938
The documents can be sent by post but this costs a little more (about £40) and it can
take up to 10 days before registration is complete. Unsurprisingly, one can now also
form the company ‘online’; this is cheaper (£12) and quicker (about 24 hours).
Activity 3.1
Go to the website for Companies House and look at the pages which are designed to
help those who wish to form a new company. Think: how helpful are these pages?
www.gov.uk/topic/company-registration-filing/starting-company
No feedback provided.
The essential point to grasp about the UK registration process is that the Government
has tried to make it as easy as possible to create a company as a way of encouraging
enterprise. We can see this in the low cost and the speed with which companies can
be created. It is also evident in how the law deals with a company’s constitution.
We mentioned this document in Chapter 2. The constitution (also called the ‘articles of
association’) contains the ‘internal’ rules governing some aspects of the running of the
company, such as how meetings will be held. All companies must have a constitution.
As we noted, those forming a company can, if they want, draft their own constitution.
However, they might not understand all the issues that a well-drafted constitution
would address. They could, of course, ask their lawyers to draft it for them but this
would add significantly to the cost of creating the company. Company law tries to
help by providing ‘model constitutions’ (there is one version for private companies
and a different version for public companies). Those forming a company can adopt
the relevant model, free of charge. Indeed, they are deemed to have done so unless
they submit their own constitution instead – so that the relevant model constitution
represents a set of ‘default rules’ – i.e. rules that apply unless they are excluded.
Activity 3.2
Maria and Luis would like your advice about whether there are any practical
disadvantages, or any risks, in taking over a ‘shelf company’ and using that to run
their business. Based just on your knowledge of what a company is, can you think of
any disadvantages or any risks?
page 22 University of London
3.2 Promoters
Core text
¢ Dignam and Lowry, Sections 4.1–4.6
The CA 2006 does not define the term promoter. However, the judges have, on
occasions, framed tests for determining whether a person’s activities relate to the
promotion of a company. The classic statement in this regard was made by Cockburn
CJ in Twycross v Grant (1876–77) 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…
The definition is broad and deliberately so. The law was imposing legal duties on
promoters and it wanted to ensure that these duties would apply to all of those
who were sufficiently closely involved in setting a company going. Adopting a broad
definition of ‘promoter’ was necessary to ensure the legal duties would catch all those
who were performing this role, whatever label they might give themselves. (When
we turn to look at directors, we will see the same sort of cat-and-mouse game in play.
Directors, like promoters, are also subject to legal duties. Company law also has a
broad definition of a director – found in s.250 of the Companies Act 2006 – to ensure
these directors’ duties also apply to a wide group of people.)
Today, these legal duties (and therefore the definition of a promoter too) have become
much less important in practice. In the 19th century, it was more common for a new
company to be created as a means of immediately cheating its shareholders. Someone
might form a company simply so that they could sell to it some property they owned
and for far more than its true value. The company would in turn raise the capital
needed to buy the promoter’s property at this over-inflated price by selling shares in
itself, often to investors who would enquire little into the company’s future prospects
(and especially if they were caught up in the irrational frenzy of some periodic share-
buying craze). To prevent people forming and using companies to unload their own
property onto an unsuspecting public, fiduciary duties were imposed on ‘promoters’.
You can look – just quickly – at these duties in Dignam and Lowry (Sections 4.7–4.13).
Get a sense of what these duties say but you do not need to know them in detail. The
important point is that this misuse of companies by ‘promoters’ has become much
less common. This is largely because the law has in any case tightened up generally on
the rules governing the sale of shares to the public. We will look at this later in Chapter
6. This tightening of the rules on ‘public offerings’ of shares does not only apply to
the misuse of companies by promoters. The public-offerings rules would also apply,
for example, if the directors of a long-established company were selling a new block
of the company’s shares to the public. But the tightening up of the rules on public
offerings has stopped promoters misusing a company in the way described above.
This, in turn, has made the legal duties that apply specifically to promoters much less
important in practice.
The common law position was amended, to some extent, by s.9(2) of the European
Communities Act 1972 but the current position is now found in s.51 CA 2006. It is this
provision that you need to understand.
Three points are important. First, under s.51, the company itself still cannot be liable
for a contract made before the company was formed. Second, s.51 provides for the
person who makes the contract to be personally liable. Third, this personal liability
is another ‘default’ rule. In other words, it can be excluded by ‘an agreement to the
contrary’. 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 that the promoter will not be personally liable.
In Braymist Ltd v Wise Finance Co Ltd [2002] 1 BCLC 415 a different issue was before the
Court of Appeal, namely whether a person acting as agent of an unformed company
could enforce a pre-incorporation contract under s.51. It was held that ordinarily they
could do so (unless the contract was inconsistent with their being able to do so).
We should note, finally, that the risk of promoters becoming personally liable has in
recent years diminished. It is now much quicker to form a company, so that impatient
promoters are at less risk of rushing into contracts while waiting for the days to pass
before their company is finally created. A shelf company can be acquired immediately
if the promoter needs, say, to sign up quickly for some deal for the company, or lose
the chance forever. However, promoters do still need to be aware of the dangers.
Activity 3.3
Read Phonogram Ltd v Lane [1982] QB 938 and Braymist Ltd v Wise Finance Co Ltd
[2002] 1 BCLC 415.
Re-read Dignam and Lowry, Sections 4.14–4.21. What is the policy underlying s.51 CA
2006?
Summary
Section 51 of the CA 2006 is really designed to protect third parties contracting
with promoters. It does this by providing, in a clear way, that the promoter will
be personally liable under the contract. However, if the promoter and the third
party agree that the promoter will not be personally liable, then that liability can
be excluded. But Phonogram continues this policy of protecting the third party by
insisting that any such agreement to exclude the promoter’s personal liability must be
‘express’.
page 24 University of London
Further reading
¢ Green, N. ‘Security of transaction after Phonogram’ (1984) MLR 671.
¢ Worthington, S. Sealy & Worthington’s text, cases and materials in company law.
(Oxford: Oxford University Press, 2016) 11th edition [ISBN 9780198722052].
Question 1 ‘UK company law is poorly designed to meet the needs of small
businesses.’
Discuss.
Question 2 In August 2020, scientists working for Cells plc developed a new type of
battery. In September 2020, Cells incorporated a subsidiary, Subvolta Ltd, to make
the battery. A week before Subvolta was incorporated, Roberta, a director of Cells,
signed a lease for a factory that Subvolta was to occupy, adding the words ‘signed
for Subvolta Ltd and without personal liability’ above her signature.
u Will Roberta be personally liable in respect of the lease she signed?
Question 2 This is an extract from a larger question. For this part of the question, you
need to discuss Roberta’s liability, taking into account the rules on pre-incorporation
contracts. So:
u Explain how ordinarily a person who enters into a contract as agent for a company
is not personally liable for that contract – only the company is liable, as the agent’s
principal.
u Describe how s.51 provides that Roberta will therefore be personally liable under
the agreement (the lease) that she has signed.
u Explain that this default rule of ‘personal liability’ for Roberta can be excluded by
‘an agreement to the contrary’.
u Apply this to the facts: provided that the court accepts that the words preceding
Roberta’s signature amount to an ‘express agreement to the contrary’, then
Roberta will not be personally liable.
Company law 3 Company formation, promoters and pre-incorporation contracts page 25
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.
If you ticked ‘need to revise first’, which sections of the chapter are you going to
revise?
Must Revision
revise done
3.2 Promoters
Notes
4 Legal personality and limited liability
Contents
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28
Introduction
In this chapter we explore two concepts that we met briefly in Chapter 2 and which
are fundamental to companies and to company law. They are, first, corporate legal
personality and, second, limited liability. It is essential that you take time here to
understand fully these concepts.
Learning outcomes
By the end of this chapter and the relevant readings, you should be able to:
u explain what is meant by ‘corporate legal personality’ and ‘limited liability’
u illustrate the key consequences of corporate legal personality
u understand the wider benefits, and costs, of limited liability.
Core text
¢ Dignam and Lowry, Chapter 2 ‘Corporate personality and limited liability’.
Cases
¢ Salomon v Salomon & Co [1897] AC 22
¢ Barings plc (In Liquidation) v Coopers & Lybrand (No.4) [2002] 2 BCLC 364
However, things did not go well for the leather business and before long the company
was placed in insolvent liquidation (i.e. it had too little money to pay its debts). A
liquidator was appointed to ‘wind up’ the company (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 15). The liquidator alleged that the company
was a sham and a mere ‘alias’ or agent for Salomon and that 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.
u 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
Activity 4.1
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 Salomon.
b. What are the key principles that we can draw from the case?
c. Should Salomon have been liable for the debts of the company?
4.3.1 Macaura
The principle in Salomon is best illustrated by examining some of the key cases that
followed after. Have a look at Dignam and Lowry, Sections 2.27–2.31 for these cases.
In Macaura v Northern Assurance Co [1925] AC 619, for example, the court held that,
while a shareholder owns shares in the company, the shareholder has no property
interest in the assets that belong to the company itself. So, a shareholder can sell their
shares to someone but a shareholder cannot sell the machines, land, vehicles and so
on that belong to the company itself. Only the company can sell its property. Equally, a
shareholder cannot (as Macaura tried to do in this case) take out an insurance policy,
in his own name, in respect of property owned by the company; the company must
itself insure its own property.
Note that, although a company owns its own property (the property it has acquired),
that does not mean a company has to own all the property it uses. It could, of course,
lease or hire from other people some of the things it needs for its business and
could choose to lease or hire property owned by, say, its shareholder. Although a
person cannot lease property to themself (they cannot be both lessor and lessee), a
shareholder who owns, say, a warehouse can lease that warehouse to a company in
which they own all the shares, because they, and their company, will each be separate
legal persons. The case of Lee (see Section 4.3.2 of the module guide) illustrates how
a company can enter into contractual relationships with its own shareholders in this
way.
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 cannot 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, Shaker v Al-Bedrawi [2003] 2 WLR 922 and Hashem v
Shayif [2008] EWHC 2380 (Fam)).
4.3.2 Lee
In Lee v Lee’s Air Farming [1961] AC 12, Lee incorporated a company, Lee’s Air Farming
Ltd, in August 1954 in which he owned all the shares. Lee was also the sole ‘Governing
Director’ for life and was employed by his company as the company’s chief pilot.
In March 1956, while Lee was working, the company plane he was flying stalled and
crashed. Lee was killed in the crash, leaving a widow and four infant children.
Lee’s widow claimed compensation for his death. Her entitlement to that
compensation depended on whether her husband was ‘a worker’ and that in turn
depended on whether he was employed by the company. For Lee to be employed by
the company, the company (as employer) would have to be seen as a person separate
from Lee (as employee); the same person cannot be both the employer and the
employee. The case was appealed to the Privy Council in London. It found that:
Company law 4 Legal personality and limited liability page 31
u the company and Lee were distinct legal entities and therefore capable of entering
into legal relations with one another
u as such they had entered into a contractual relationship for him to be employed as
the chief pilot of the company
u 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.
Activity 4.2
Re-read Dignam and Lowry, Sections 2.2–2.12 and 2.32–2.45. Then, read Macaura v
Northern Assurance Co [1925] AC 619 and Lee v Lee’s Air Farming [1961] AC 12 carefully
and make sure you understand the principles that each case is following.
Activity 4.3
We saw above how a company can indeed own property but how it can also
choose to hire or rent some of the property it uses and can do so even from its own
shareholder(s). Imagine that you have been running a business as a sole trader.
The business uses some premises, that you own. Like Salomon, you have decided
to incorporate your business. However, you are unsure whether to transfer the
premises to the company you are forming, or instead to retain ownership of these
premises and merely to rent them to the company. What advantages would there
be in your keeping ownership of the premises? Would there be any disadvantages?
This alone does not ensure that shareholders will not lose out. Remember that, if a
company becomes insolvent, usually a liquidator will be appointed to ‘wind up’ the
company. Since the company is insolvent, it will have more liabilities than assets. If the
shareholders could still be forced to put more money into the company to make up
this difference (between what the company owns and what it owes) the shareholders
would eventually have to pay for the debts of their company.
Is limited liability a good thing? Does it have good economic consequences? This is a
very important question. You should begin by looking at Dignam and Lowry, Sections
3.49–3.56. Then, there are two excellent articles you should look at to understand the
benefits of limited liability in more detail (see directly below and Essential reading in
Section 4.4.1).
Essential reading
¢ Easterbrook, F.H. and D.R. Fischel ‘Limited liability and the corporation’ (1985) 52
The University of Chicago Law Review 89 (available in JSTOR via the Online Library).
These authors suggest that limited liability gives at least three important economic
benefits.
So, read Easterbrook and Fischel’s article to understand more fully how important
limited liability is, especially in ensuring the growth of large companies with
thousands of small, but largely sleeping, investors.
Activity 4.4
Easterbrook and Fischel show how important limited liability has been in ensuring
the growth of large companies with thousands of small, but largely sleeping,
investors. However, is limited liability so important for the shareholders of a small
company with just one or two shareholders – like Salomon’s ‘one-man’ company?
Do the three benefits of limited liability mentioned above apply to small limited
liability companies like his?
Essential reading
¢ Kraakman, R. and H. Hansmann ‘The essential role of organizational law’ (2000)
110(3) The Yale Law Journal 387 (available in JSTOR via the Online Library).
Hansmann and Kraakman argue that the separate personality enjoyed by companies
does, in some ways, work to the advantage of a company’s creditors. True, the
company’s creditors cannot take the personal assets of the shareholders. However,
the company’s creditors do get the assets of the company, ahead of the personal
creditors of the shareholders. If the shareholders, in their personal lives, are spending
too freely and running up substantial personal debts, their creditors can only seize
the shareholders’ personal assets; they cannot take the assets of the company. This
allows creditors of the company to lend to the company without being concerned
about the wealth, and the behaviour, of the shareholders. A creditor who lends
to a sole trader, for example, is concerned not only with whether the sole trader’s
business is flourishing but also with the personal spending habits of the sole trader:
are they visiting the casino a little too frequently and amassing a mountain of personal
creditors?
Company law 4 Legal personality and limited liability page 33
Note also that (most) creditors are not compelled to lend to companies. They choose
to do so – hopefully knowing of the risks involved and negotiating for a rate of interest
(or some other arrangement, such as the taking of some security from the company)
that compensates them for any increased risk they are taking.
These are important points and, in showing the economic advantages of limited
liability, they help to explain why limited liability companies have flourished in
modern economies. But this is not to say that limited liability and the corporate form
cannot sometimes be abused, or may not sometimes transfer losses to creditors in
ways that appear unfair. Limits to limited liability itself are sometimes necessary.
Chapter 5 will introduce us to some of the ways the law seeks to control the abuse of
limited liability and the corporate form.
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 you do not, then take some
time to think about it and, when you are ready, come back and re-read Dignam and
Lowry, Sections 2.2–2.12. 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). Finally, you also need to
understand that how far the law encourages, or controls, limited liability depends on
the benefits it gives and the way it can be abused. The articles discussed above will
give you a deeper understanding of those issues.
Further reading
¢ Ireland, P. et al. ‘The conceptual foundations of modern company law’ (1987) 14
JLS 149–65.
¢ Pettit, B. ‘Limited liability – a principle for the 21st century’ (1995) CLP 124.
¢ Grantham, R.B. and E.F. Rickett ‘The bootmaker’s 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 9781901362831].
Go through the facts of Salomon with particular emphasis on the aspects of the case
that might appear to be scandalous (e.g. Salomon’s evasion of personal liability for the
debts of his one-man company and his overvaluation of the business).
Discuss whether a ‘tidal wave of irresponsibility’ was unleashed into the business
community. By allowing one-man businesses like his to operate as companies, was the
law not extending further the benefits of limited liability? You might discuss here the
benefits of limited liability, as identified by authors such as Easterbrook and Fischel,
but should also consider whether all these benefits really applied to a small company
like Salomon’s. Does the decision really promote ‘irresponsibility’? You might focus
here on the idea that it allows small companies to escape from responsibility towards
their creditors. Here, you could bring in the work of Hansmann and Kraakman, noting
how creditors can lose out from limited liability, but also how they gain.
Company law 4 Legal personality and limited liability page 35
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.
If you ticked ‘need to revise first’, which sections of the chapter are you going to
revise?
Must Revision
revise done
Notes
5 Lifting the veil of incorporation
Contents
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38
Introduction
As we observed in Chapter 4, the application of the Salomon principle is generally
beneficial for shareholders and has wider economic benefits. However, the Salomon
principle, and the limited liability it facilitates, can be abused. In the UK, both
Parliament and the courts have intervened to control such abuse. This intervention
can take many different forms. Sometimes, for example, the law may continue to
treat the company as a separate legal person but might also impose personal liability
on individuals connected with the company, such as its directors or its shareholders.
At other times, the law may choose to ignore the company’s own legal personality
completely and then work out what rights and liabilities people have as if the
company did not exist at all. We shall refer to all these types of intervention as ‘lifting
the veil of incorporation’. (Some people have suggested that the term lifting the veil
should be used only where the company’s separate existence is being ignored. Strictly
speaking, this is probably true. However, since many writers do use this term in a
rather wider and ‘catch all’ way, that is how it will be used in this chapter too.)
Learning outcomes
By the end of this chapter and the relevant readings, you should be able to:
u describe the situations where legislation will allow the veil of incorporation to
be lifted
u explain the main categories of veil lifting applied by the courts
u explain how actions in tort may be brought against directors or shareholders.
Core text
¢ Dignam and Lowry, Chapter 3 ‘Lifting the veil’.
Cases
¢ Gilford Motor Company Ltd v Horne [1933] Ch 935
¢ Anglo German Breweries Ltd (in liquidation) v Chelsea Corp Inc [2012] EWHC 1481 (Ch)
Additional cases
¢ Re Todd Ltd [1990] BCLC 454
¢ Standard Chartered Bank v Pakistan National Shipping Corp (No.2) [2003] 1 AC 959
¢ National Dock Labour Board v Pinn & Wheeler Ltd [1989] BCLC 647
In practice, it has been very difficult to prove this intention in court and few successful
actions have been brought. In consequence, a new and additional provision was
introduced in s.214 of the Insolvency Act 1986. This covered the lesser offence of
‘wrongful trading’, which it was hoped would be easier to establish than s.213.
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 they do, they risk
having to contribute to the assets 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.
Activity 5.1
a. How effectively do ss.213 and 214 of the Insolvency Act 1986 protect creditors?
b. ‘Neither section 213 nor section 214 Insolvency Act 1986 amounts to an exception
to a company’s legal personality or to the principle of limited liability.’ Discuss.
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.
Before we look at when courts will do these things, it is important to step back
and think about the significance of this ‘division of labour’ between the courts and
Parliament in controlling the misuse of companies. When Parliament introduces
provisions like, say, s.214 Insolvency Act 1986, the scope of the potential liability that
directors face is set down with reasonable clarity and certainty in the statute. Directors
can learn in advance what is expected of them (although they may of course need
to take advice from their lawyers) and can then adjust their behaviour accordingly.
Moreover, it is Parliament – an elected body – that is deciding when a limit should be
placed on the protection of limited liability and so when directors can be made to
contribute personally to the company’s assets.
When judges decide to lift the veil, however, these qualities of statutory provisions
often do not apply. It may be much more difficult for directors, shareholders and
creditors (or even their lawyers) to work out what a large and complex body of case
law is saying about when the courts will lift the veil. If new grounds for veil-lifting
Company law 5 Lifting the veil of incorporation page 41
can be invented by the courts on a case-by-case basis, such rules cannot easily be
discovered in advance; there is inevitably an element of ‘surprise’ when the law is
being developed by the courts. Moreover, some would argue that it is wrong for
judges, who are not elected, to decide important questions of public policy, such as
the balance between limited liability and creditor protection.
On the other hand, there are some advantages in allowing judges to decide these
matters. Parliament cannot always foresee novel situations where companies may be
being abused to harm creditors. There will often therefore be gaps and loopholes in
legislative provisions. Giving judges the power to withhold the benefits of corporate
personality and limited liability, on a case-by-case basis, as new, unanticipated,
situations come before the court can give the law a degree of flexibility that is
essential if it is to remain effective. While judges may not have been elected, they can
draw on a wealth of experience of addressing the misuse of companies.
These observations remind us that there is often a tension between the desire for
certainty and predictability, and the need for flexibility. The history of the UK courts’
approach to veil-lifting demonstrates this tension very clearly. Over time, the UK
judiciary has varied a great deal in its willingness to lift the veil. In some periods,
courts have taken a more interventionist approach and been much readier to ignore
a company’s separate legal personality in order to ensure flexibility and to achieve
more just outcomes. At other times, the pendulum has swung the other way, with
the occasions when the veil can be lifted being restricted to a much narrower set of
circumstances. You can explore these different judicial attitudes in Dignam and Lowry,
Sections 3.10–3.35.
The current UK approach is very much at the more restricted end of the spectrum. We
will see this in the two most important recent cases in this area: Adams and Prest. We
turn to those cases now.
Cape Industries plc was an English registered company. It was the ‘parent’ company
in a corporate group that operated throughout the world, mining, processing and
selling asbestos. At this point, we need to pause to understand what a corporate
group is. So far, we have imagined that shareholders are always human beings but
a shareholder could be another company. One company, in other words, could own
shares in another. Where the shareholding company owns enough shares to control
the company it owns, we would call it a ‘parent company’. We would call the company
it owns its ‘subsidiary’ and call the collection of parent and subsidiaries a ‘corporate
group’. However, just as Salomon & Co Ltd is a separate person from its (human)
shareholder, Salomon, so a subsidiary company is a separate legal person from its
(parent company) shareholder.
To return to Adams v Cape. The asbestos that the Cape group produced and sold caused
horrific injuries to many people. A number of workers in the USA, who had suffered
asbestos-related injuries as a result of their employment, brought proceedings in tort,
in the US courts, against (inter alia) Cape Industries plc. These workers, represented
by Adams, had not actually been employed by any company within the Cape Group.
Nevertheless, they argued that the Cape group had supplied the asbestos that caused
their injuries. They claimed that Cape Industries plc, as the parent of the Cape group,
had accordingly breached a duty of care it owed to them and was thus liable to them
in tort. As a matter of tort law, Cape Industries plc might, or might not, have had a
defence against those claims. However, Cape Industries plc chose not to defend them
and Adams was accordingly given judgment, by default.
page 42 University of London
Having secured this default judgment in the USA, Adams now had to ‘enforce’ it
against Cape Industries plc. Because Cape Industry’s assets were in England, Adams
needed to get the English courts to enforce, in England, the US judgment he had
been given. The English courts would only do this if one or other of two conditions
were met. The first condition was if Cape Industries plc had participated in the US
proceedings. But as we have seen, it had deliberately chosen not to do so. (This now
explains Cape Industries’ apparent capitulation in the USA, allowing Adams to win
so easily, by default.) The alternative condition was if Cape Industries plc was itself
‘present’ in the USA.
So, Adams had to try to persuade the English courts that Cape Industries plc was
indeed ‘present’ in the USA. But the difficulty was that this parent company did not,
itself, operate in the USA. Nevertheless, some of the subsidiaries that Cape Industries
plc owned did have a physical presence there. Adams, therefore, sought to persuade
the English courts that Cape Industries plc, the parent, should be treated as present
in the USA by virtue of its subsidiaries’ presence there. To do so, he would need to
persuade the English court to depart from the normal rule of company law – that a
shareholder (including a parent company shareholder) is legally separate from the
company they (or it) owns.
The Court of Appeal rejected Adams’ arguments. That was clearly unfortunate for
Adams but what matters for us, as company lawyers, is what the Court said about the
grounds when the veil can be lifted.
First, the Court declared that the veil cannot be lifted just because a judge believes
that it would be ‘in the interests of justice’ to do so. The ‘interests of justice’ seems to
be too uncertain and unpredictable a ground on which to lift the veil.
Second, the Court decided that the mere fact that a group of companies constituted
a ‘single economic unit’ was also insufficient to allow the veil to be lifted. To explain
this a little more: it is often argued that, while the different companies that make up a
corporate group may, in law, each be treated as separate legal entities, the commercial
reality is often very different. Economically, the group might be run as if it were one
large business, with assets moved around from company to company within the group
in whatever way maximises the value of the group as a whole. Accordingly, it might
be argued, the law should reflect this economic and commercial reality, and be ready
to ignore the separation between the different companies making up the group. This
‘single economic unit’ argument had been accepted in some earlier cases, such as
DHN Ltd v Tower Hamlets [1976] 1 WLR 852. However, such willingness to disregard the
normal legal consequences of creating separate companies and instead to follow the
‘economic realities’ was never universally approved and, only two years after DHN, the
House of Lords, in Woolfson v Strathclyde RC [1978] SLT 159, specifically disapproved of
DHN. In this respect, the Court in Adams followed the decision in Woolfson. The Court
decided that simply being members of a single economic unit would not result in
veil-lifting unless either some statute, or some contractual document, required two
or more companies in a group to be treated, legally, as one entity. (Tax statutes, for
example, may sometimes require members of a group of companies to be treated as
one single entity for some tax purposes.)
In rejecting these two grounds for veil-lifting, 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.
Having rejected the ‘justice’ ground and the ‘single economic entity’ ground (in the
absence of some relevant statutory or contractual provision) when did the Court in
Adams say the veil could be lifted?
Company law 5 Lifting the veil of incorporation page 43
The Court of Appeal recognised that there was one well-established ground on which
the veil could be lifted, namely where a company was a ‘mere façade concealing the
true facts’. The court noted some earlier cases where this ‘façade’ ground had been
established and tried to identify what the crucial facts were in these cases that led to
the companies being categorised as ‘mere façades’. One such case was Gilford Motor
Company Ltd v Horne [1933] Ch 935. Horne was a former employee of Gilford. As an
employee, he had agreed with Gilford not to solicit its customers (if, for example, he
set up his own business in competition with Gilford later). Horne then left his job with
Gilford and wanted to set up his own business and to solicit its customers – the very
thing he had already promised not to do. To get around that promise, he formed a
company to operate his new business and then argued that it was the company – and
not him, Horne – that was now soliciting Gilford’s customers. The court found that the
company was merely a front for Horne and issued an injunction against both him and
the company, even though the company itself had never signed any covenant not to
solicit Gilford’s customers.
Another similar case was Jones v Lipman [1962] 1 WLR 832. Lipman had entered into a
contract with Jones for the sale of land. 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 façade or
front for Lipman and granted an order for specific performance.
The Court in Adams said these cases showed that a company would be considered
a mere façade where it was being used to enable someone to avoid a pre-existing
obligation (i.e. an obligation that they had already incurred themselves). When the
Court then applied this test to Cape, it held that Cape had not used any of its subsidiary
or related companies to avoid any pre-existing obligation that Cape already had.
Instead, Cape had used other companies only to shield itself from liabilities that might
be incurred in the future. Although that might make the company morally culpable,
there was nothing legally wrong in doing this and using other companies to shield
Cape from future liabilities did not make those companies mere façades.
Having decided that Cape’s subsidiaries were not ‘mere façades’, the Court finally
considered another way that Cape might be treated as present in the USA. This was if
Cape’s subsidiary, that was present in the USA, was treated as Cape’s ‘agent’. This was a
straightforward application of agency principle. If the subsidiary was Cape’s 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 day-to-day control of Cape and with no general power to bind the
parent. Therefore Cape could not be present in the USA through its subsidiary agent.
Adams therefore narrows the situations where the veil of incorporation is in effect
lifted to three situations:
u Where the company is a mere façade (for other examples of where a company was
held to be a façade, see Anglo German Breweries Ltd (in liquidation) v Chelsea Corp Inc
[2012] EWHC 1481 (Ch) and Trustor AB v Smallbone [2002] BCC 795)
The Court of Appeal’s judgment in Adams laid down reasonably clear and restrictive
grounds for veil-lifting. And, with a few exceptions, later courts have largely followed,
and affirmed, the Adams approach. One such exception is Creasey v Breachwood Motors
Ltd [1992] BCC 638 but that case was in turn overruled by Ord v Belhaven Pubs Ltd [1998]
2 BCLC 447. Other exceptions include Ratiu v Conway (2006) 1 All ER 571 and Samengo-
Turner v J&H Marsh & McLennan (Services) Ltd (2007) 2 All ER (Comm) 813.
However, the general approach has been to follow Adams, and two decisions of the
Supreme Court have strongly affirmed its principles: see VTB Capital plc v Nutritek
International Corp [2013] UKSC 5 and Petrodel Resources Ltd v Prest [2013] UKSC 34.
page 44 University of London
Petrodel is the more important of these two cases. In Petrodel, Lord Sumption
distinguished between what he referred to as the ‘evasion’ principle and the
‘concealment’ principle. The veil could be pierced, he argued, only on the evasion
principle – where the controller of a company was using that company to evade an
obligation that the controller already had. However, for the veil to be pierced, it was
not necessary that the company that was being used in this way had been formed to
enable an obligation to be evaded. It was sufficient simply that it was now being used
to enable its controller to escape their obligation.
By the concealment principle, Lord Sumption referred to the court’s ability to see
through someone’s attempt to hide their behaviour. There are, of course, many ways
in which a person might conceal their actions. Lord Sumption was noting that using a
company was one such way. In Lord Sumption’s view, the court always has the power
to see through such a use and, in doing so, identify what someone is really doing. The
court does not need to pierce the veil to do this: the court can simply get to the ‘truth’
of a person’s behaviour. If, for example, I decide to blackmail someone and make my
victim pay the money I demand over to a company I own, the court can still regard me
as a blackmailer and receiver of that money, even though I have used a company to try
to conceal my receipt.
Activity 5.2
Read Dignam and Lowry, Chapter 3, paras 3.10–3.35 then write a short answer
considering the following statement.
‘The Court of Appeal’s decision in Adams takes an overly cautious approach to veil
lifting which does little to serve the interests of justice.’
Second, a rather different justification for extending liability for corporate torts
has been offered by writers who have argued that doing so would have some good
Company law 5 Lifting the veil of incorporation page 45
economic consequences. The article by Hansmann and Kraakman, in the Further
reading, is an example of such a justification. Its authors are concerned with ensuring
that companies are encouraged to spend optimally on safety precautions. If only
companies can be held liable for the accidents they cause, then companies may well
choose to underspend on safety. They will be tempted to do so because the company
can, by declaring insolvency, effectively avoid compensating others for the injuries
the company causes. For these authors, there is a strong case for holding shareholders
liable where the company cannot compensate those it has injured because this threat
to shareholders will encourage those running companies to operate more safely to
avoid accidents in the first place. We have only sketched out the barest details of the
authors’ more detailed and complex arguments, which you should try to read and
understand for yourselves.
Employees
Starting first with employees, if a person commits a tort in the course of working for a
company, they will often be liable under the law of tort for the injuries they cause. The
fact that they were working for a company at the time will not prevent that personal,
tortious, liability. Alice, our bus driver, who negligently injures you, will be personally
liable for her tort. The fact she was working for a limited company at the time will not
prevent her being liable.
Directors
Does the same apply to directors? The answer seems to be that sometimes they can
be liable in tort, and sometimes they cannot, but identifying exactly when seems more
difficult.
It certainly seems to be the case that someone who happens to be a director, but
commits a tort while doing things outside of their role as a director, may well be liable
in tort in the same way as other non-directorial employees can be liable. So, returning
to Miranda’s Marvellous Bus Company Ltd, suppose that Alice, our bus driver, also
happens to be a director of the company. When she is driving the bus, she is not then
really acting in her capacity as a director. She could be personally liable in tort for
those she injures when driving the bus and the fact she happens also to be a director
would not prevent such liability.
However, the courts often seem reluctant to hold directors liable for the harm that
their actions cause to others. We can see this reluctance in two cases. The first is
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. In
this case, the Court of Appeal did in fact find the director liable but, to do so, it
distinguished between acts undertaken by the director as a director and other acts of
the director. The court said that:
The important implication here is that directors should not be held liable for doing
things that only directors can do, namely when they are ‘exercising control’ over the
company through board meetings.
The second case is Williams v Natural Life Health Foods Ltd [1998] 2 All ER 577. In this
case, a director of a company prepared certain financial projections that were then
sent to a third party. In reliance on those projections, the third party entered into a
contractual relationship with the company. The financial projections were misleading,
page 46 University of London
having been prepared negligently by the director. The third party sought to sue the
director for the tort of negligent misstatement. The House of Lords, however, was
reluctant to expose directors to personal liability, in tort, for statements made on
behalf of their companies. It avoided doing so by focusing on the fact that the tort of
negligent misstatement always requires the claimant to show that there has been an
‘assumption of responsibility’ by the defendant – this is an element of the tort itself
(whoever is being sued). The House of Lords held that this element of the tort meant
that, when a director was being sued, the director must be shown to have assumed
personal responsibility for the truth of the statement made to the claimant. There was
no evidence in the present case that there had been any personal dealings that could
have conveyed to the claimant that the director was prepared to assume personal
responsibility for the accuracy of the statements that were made.
Note, however, that where the tortious action that is being brought does not contain,
as an element of that tortious action, an ‘assumption of responsibility’, then there will
be no need to show that the director has personally assumed such responsibility. So,
suppose that a director sought to reassure a potential creditor, telling the creditor that
the company was in good financial health. Suppose that the director knew this was not
the case, so that their statement was not merely negligent but fraudulent. Suppose
also that the director was then sued by the creditor for the tort of ‘deceit’ (i.e. alleging
that the misstatement was made fraudulently, rather than merely negligently). It is
not an element of an action for deceit (against anyone) that the claimant must show
‘an assumption of responsibility’. Accordingly, even if it happened to be a director
who was sued, there would be no need to show that the director personally assumed
any responsibility for the truth of their statement (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.)
Shareholders
Finally, we can turn to the position of shareholders. In principle, a shareholder who
commits a tort in relation to a company can be liable and the fact that they happen
to be a shareholder will not prevent that liability. So, if Alice, our bus driver, happened
to be a shareholder, she could be liable for her negligent bus driving, regardless of the
fact she happened also to own shares in the company.
As we shall see now, the first case to answer these questions – Chandler – suggested
that parent companies might indeed, in some circumstances, be liable for their
omissions, where they had failed to ensure their subsidiaries operated safely. But later
cases seem to have retreated from this position, suggesting shareholders (including
parent companies) will usually be liable only for their active misfeasance.
So, starting with Chandler v Cape plc [2012] EWCA Civ 525, the Court of Appeal decided
the shareholder could be liable, if the shareholder owed a duty of care to those who
were injured. The Court found this duty of care could indeed exist but only for one
particular type of shareholder, namely a parent company and only then if a number of
factors were present. These factors were:
u that the parent itself operated in ‘the same industry as the subsidiary’;
u that the parent did know, or ought to have known, as much about health and
safety as did the subsidiary;
u that the parent knew or ought to have known that the subsidiary’s operations were
unsafe; and
Company law 5 Lifting the veil of incorporation page 47
u the subsidiary or the employee were relying on the parent to safeguard the
employee’s health and safety.
So, Chandler imposed a duty of care on a parent company to ensure that its
subsidiaries were operating safely. The four factors mentioned above indicated when a
parent would be under this duty to ensure its subsidiaries were operating in this way.
It is worth pausing here to remember that tort law generally does not impose liability
for omissions. Making (parent) companies liable in this way represented a significant
new liability situation for tort law.
More importantly still, it now appears that a parent will be liable only where it is
itself guilty of some active misfeasance. In AAA v Unilever plc [2018] EWCA Civ 1532 the
Court suggested the parent would typically owe a duty of care to those injured by a
subsidiary’s negligence only if either of the two following situations existed:
a. where the parent had in substance taken over the management of the subsidiary’s
activity, which led to the injury; or
b. where the parent had taken over the management of the particular activity of the
subsidiary, which caused the injury.
This approach has been confirmed by the Supreme Court in Vedanta Resources plc v
Lungowe [2019] UKSC 20 and in Okpabi v Royal Dutch Shell plc [2021] UKSC 3. In the latter
case, the Supreme Court ruled that ‘ordinary tort principles’ apply to the claim that
a parent company owes a duty of care to someone injured by its subsidiary. On this
basis, parent companies will ordinarily be liable only for their active misfeasance –
only where they sufficiently ‘take over, intervene in, control, supervise or advise the
management of’ those subsidiary activities which have caused harm to others.
Activity 5.3
Imagine that you are advising Parent plc, the parent company of a UK-based
multinational corporation. Many of its subsidiaries operate overseas and often
have high accident rates, cause lots of pollution in their neighbourhoods, and so on.
Although Parent is well aware of these facts, it has always chosen a very ‘hands-off’
approach to its subsidiaries, refusing to interfere with their operations. You have
been asked to advise the parent’s board on whether Parent plc could be held liable
for its subsidiaries’ behaviour.
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 to enable someone to evade their existing
obligations (as, for example, in 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 that has been redressed by the restrictive case of Adams.
Adams has been affirmed by recent Supreme Court decisions, such as VTB Capital and
Prest v Petrodel Resources Ltd.
Faced with the difficulty of lifting the veil, some claimants have sought to use claims
in tort as an alternative. This strategy was successful in the important case of Chandler,
where the employees of a subsidiary company were able to establish that its parent
company owed them a direct duty of care, which the parent had breached when it
page 48 University of London
failed to stop its subsidiary operating in an unsafe way that injured the employees.
But there has been a retreat from this judicial approach in later cases, such as Unilever,
Vedanta and Okpabi, which have insisted that parents will be liable only for their active
misfeasance.
Further reading
¢ Crowe, J. ‘Does control make a difference? The moral foundations of shareholder
liability for corporate wrongs’ (2012) 75 Modern Law Rev 159.
¢ Gallagher, L. and P. Zeigler ‘Lifting the corporate veil in the pursuit of justice’
(1990) JBL 292.
¢ Lowry, J.P. and R. Edmunds ‘Holding the tension between Salomon and the
personal liability of directors’ (1998) Can Bar Rev 467.
¢ Davies and Worthington, Chapter 8 ‘Limited liability and lifting the veil at
common law’ and Chapter 9 ‘Personal liability for abuses of limited liability’.
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 director’s 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 With regard to the first statement, whether this is accurate depends
on what is meant by the parent ‘being in control of its subsidiary’. So far as the law
is concerned, parent companies are only liable, in tort, where they have intervened
sufficiently in the activities of the subsidiary so that the parent has caused the harm
that has been suffered (see, for example, Vedanta Resources and Okpabi). Only this
active misfeasance by the parent will make it liable in tort. The statement suggests,
however, that a parent that is merely ‘in control’ of its subsidiary will automatically be
liable. In one sense, all parent companies ‘control’ their subsidiaries, in that they will
own enough shares to be able to make the subsidiary do whatever the parent wants.
But that does not mean the parent is actually exercising this (‘potential’) control. Many
parents could, but choose not to, exercise that much control; they do not constantly
interfere in the activities of their subsidiaries. If they are not interfering, then they will
be unlikely to be held liable in tort for accidents that occur in the subsidiary.
With regard to the second statement, this is clearly incorrect. Parent companies,
whether they exercise control or not, are separate legal entities from their subsidiaries
and not liable for the subsidiaries, contractual debts. The courts will not lift the veil on
the single economic entity ground: Adams v Cape Industries plc.
page 50 University of London
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.
If you ticked ‘need to revise first’, which sections of the chapter are you going to
revise?
Must Revision
revise done
Contents
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52
Introduction
Companies can raise the money they need to fund their activities in a number of ways.
The two ways we will consider are, first, by selling shares in themselves and, second,
by borrowing money. The term ‘equity capital’ is often used to refer to the money a
company raises by selling shares in itself, whereas ‘loan capital’ is used to describe the
money a company gets by borrowing. Those who buy shares become shareholders of
the company, while those who lend to the company become the company’s creditors.
In this chapter, we are focusing on how the law regulates these two ways of raising
capital. We begin with the process of raising equity capital. Here, as we shall see, the
intensity of the law’s regulation varies depending on whether the shares are being
sold to the public at large. For smaller companies, shares will initially be sold to those
who are forming the company and, if more equity capital is raised later, this will also
often be provided by the existing shareholders, rather than by selling new shares
to the general public. In these situations, the law’s protection is fairly limited, since
those buying shares will likely already be familiar with the company or can quite
easily become so. However, as companies grow, they may sometimes decide to raise
more capital by selling shares to the general public. Such sales are much more heavily
regulated. However, the regulation of public offerings of shares is a specialised and
quite technical area of law and you are only expected to know a basic outline of it for
this module.
Compared to the raising of equity capital, there is generally rather less regulation
attached to a company’s raising of loan capital. Much of the regulation that does
exist (such as the control of misrepresentation by the borrower) is not peculiar to
companies. However, one aspect of the regulation that is worth addressing, but
again only in outline for this module, is the process of giving security for loans that
the company is raising. Companies will often be asked to give a ‘floating charge’ as
security, and we shall focus on some of the consequences of their doing so.
Learning outcomes
By the end of this chapter and the relevant readings , you should be able to:
u identify the issues surrounding the raising of equity capital
u understand in outline how the law regulates the selling of shares to the general
public
u describe the nature of fixed and floating charges and the distinction between
them
u understand how the distinction between fixed and floating charges applies to
book debts and the significance of this distinction for the company’s creditors.
Core text
¢ Dignam and Lowry, Chapter 5 ‘Raising capital: equity and its consequences’
(Sections 5.1–5.8) and Chapter 6 ‘Raising capital: debentures: fixed and floating
charges’ (Sections 6.1–6.26).
Cases
¢ Re Yorkshire Woolcombers Association [1903] 2 Ch 284.
¢ National Westminster Bank plc v Spectrum Plus Ltd [2005] UKHL 41.
Additional cases
¢ Re Harmony Care Homes Ltd [2009] EWHC 1961.
Of course, the existing shareholders may not want, or be able to afford, to exercise this
right. It may be intended that one or more of the existing shareholders will increase
their investment relative to that of the other shareholders, so that they alone will buy
the new shares. Or it may be agreed that the shares will be sold to a new investor who
is joining the company. The right of pre-emption in s.561 can, therefore, be waived by
the existing shareholders and the right can also be excluded by the articles of a private
company.
Activity 6.1
From what you have learnt so far in this module, why in your opinion does the law
prevent private companies from raising share capital from the public at large?
We can now turn to look at how the law deals with capital raising by public companies.
As our feedback to Activity 6.1 suggests, the heavier regulation that applies generally
to public companies makes them a safer vehicle for raising large amounts of capital.
But when a public company is making a general offer to the public at large to invest
in it, more layers of regulation are added to ensure that those taking up the offer are
protected.
Often, when a public company wishes to raise large amounts of capital, it will do
so through a stock exchange (and for a UK company, that would typically mean the
London Stock Exchange). 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 are known as listed shares or securities.
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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. But 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, professional
management funds who are investing funds on behalf of individuals and, increasingly,
the investment vehicles of foreign states, which are usually referred to as ‘sovereign
wealth funds’.
A company that seeks a listing on the LSE must comply with the Listing Rules, which
are extensive and onerous. These rules are issued, and enforced, by the UK’s Financial
Conduct Authority (FCA). The FCA is designated as the UK Listing Authority and
therefore is the main regulatory body for the LSE’s capital markets. The Listing Rules
are designed to ensure that companies that are admitted for listing already have
a solid financial track record and disclose to investors enough information about
the company’s financial performance to enable investors or their advisors to make
informed investment decisions.
When the company’s shares are to be sold to the public (and, of course, often the
purpose of obtaining the listing will be to enable this to happen), then a prospectus
(the document issued to the public inviting them to invest in the shares) submitted
to, and approved by, the FCA is required. Moreover, once a company has achieved a
listing it continues to be subject to a number of continuing obligations, also found in
the Listing Rules, 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, a listed company must also publish
a preliminary statement of its annual results. Directors of listed companies must
also produce a ‘strategic report’ covering the development and performance of the
business, which identifies the principal risks and uncertainties ahead (see Chapter 10
on the link between this report and the directors’ duty under s.172 CA 2006 and
Chapter 14 on the social reporting requirements for companies).
Activity 6.2
What is the listing regime trying to achieve by emphasising disclosure before and
after listing?
No feedback provided.
Summary
The disclosure rules aim to ensure that those who choose to invest in a company can
work out the value of the shares they are purchasing. The rules also make the capital
market work more ‘efficiently’: in other words, they make it easier for companies
that are run more successfully, and produce a better return on capital, to raise more
investment.
Company law 6 Raising capital: equity and loans page 55
Further reading
¢ Dignam and Lowry, Sections 5.9–5.19. (There is more detail in these sections than
you need for this module, but have a quick look through them to get a better
idea of how sales of shares to the public at large are regulated.)
Activity 6.3
Suppose Maria and Luis, whom we met in earlier chapters, decided to invest,
respectively, £100,000 and £50,000 into the company they have set up to run their
business. They are wondering whether they should each invest the whole of this
amount as share capital, or whether they should each lend the company some of
this money. How would you advise them?
Fixed charges
A company may grant a fixed charge to a creditor over some particular piece of
property that the company already owns, 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 company’s (the chargor’s) 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 chargor’s 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 (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 chargee’s permission.
• 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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Because, as we have seen, fixed charges provide greater protection for the charge
holder than a floating charge, it is unsurprising that lenders who are taking security
have, in the past, tried to ensure that the security concerned will be treated as a fixed
charge, rather than as a floating charge. It may be thought that the type of charge
being created will be clear from the wording of the charge itself, but this is not in
fact the case. The courts have decided that the nature of the charge depends on its
substance, not on the label given to it in the charge.
The most important feature that distinguishes a floating charge from a fixed one
is that, under the former, the company will retain control over the asset charged,
including the right to dispose of it in the ordinary course of business. 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’.
interest. But will a charge over such an asset be a fixed or floating charge? The charge
itself will probably have been drafted by the charge holder (the bank) and might
well say that it is a fixed charge, since this is clearly preferable for the bank, for all the
reasons set out above. However, the charge will usually allow the company to retain
‘control’ over the charged asset (the book debts) in the sense that, as each debt is paid
to the company by a customer, the company will be free to use that money for its own
business.
The nature of a charge over book debts was resolved by the 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 charge
stated that the security was a specific charge over all present and future book debts
and other debts. It also prohibited Spectrum 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, however, specify any restrictions on the company’s
operation of the account.
Spectrum’s 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 company’s book debts and their proceeds. The House
of Lords held that, although it is possible to create a fixed charge over book debts
and their proceeds, 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 (i.e. an account that the company would not then be free to draw monies
out of). In practice, companies will be very reluctant to lose control over payments
that they are receiving from their customers. Accordingly, charges over book debts,
that allow the company to retain control over those debts, will usually be floating
charges, rather than fixed ones. The practical, and important, consequence of this is
that, if a company becomes insolvent, the book debts due to the company will not be
taken entirely by, say, the company’s bank, under a fixed charge but instead will be
subject only to a floating charge and subject to the priorities noted above. Some of the
proceeds of these charges will be used for preferential creditors, or for the company’s
unsecured creditors (see Chapter 15 of this guide).
For a case in which a lender did, unusually, have sufficient control over the book debts
that had been charged by a borrower for that charge to be a fixed one, see Re Harmony
Care Homes Ltd [2009] EWHC 1961.
Activity 6.4
Buildflare Ltd, which operates from rented premises and owns few assets, provides
specialist advice to property developers. It has recently been experiencing cash-
flow problems. Although it has managed to increase turnover, its clients are proving
very slow to pay for the services they have received from the company. Buildflare
currently has an unsecured overdraft of £10,000 from National First Bank plc.
National First Bank has agreed to increase this to £50,000 to enable it to survive its
cash-flow problems but wants to ensure it has some security from Buildflare for the
overdraft.
Advise National First Bank.
Accordingly, you might begin by noting the different types of capital a company can
raise – equity (share) capital, and loan capital. You might address each in turn. With
regard to equity capital, you might note how companies are helped in their raising of
capital by the principle of ‘limited liability’. Shareholders will not be personally liable
for the debts of the company; this makes it easier to entice someone to become a
shareholder in a company (and, especially, to become a ‘sleeping investor’) than it is to
entice someone to become an unlimited partner in a partnership.
Note how raising capital involves issues regarding the treatment of existing
shareholders and of those buying the shares, and note the rules on ‘pre-emption
rights’ regarding the former. You might then consider how the law protects buyers.
It would be important here to explain how it is really only public companies that can
raise large amounts of public capital; in that sense, the private company is a less useful
vehicle for raising lots of equity capital. You should show some understanding, in
outline, of how the law regulates public offerings, especially through the Listing Rules.
Does all this regulation help, or hinder, public companies to raise lots of capital? On
the one hand, such regulation is demanding and can be expensive to comply with. But
it makes public companies, and especially listed companies, much more trustworthy
and this is essential if the public is going to be prepared to take the risk of investing.
Regarding loan capital, you might note that the principle of limited liability might
seem to make it more difficult for companies to persuade creditors to lend to a
company. But explain how the giving of security by companies can help reassure
larger lenders. Discuss how easy it is for companies to create security for their
creditors, distinguishing between fixed and floating charges. You might note that only
companies (and LLPs) can create floating charges – sole traders and ordinary partners
cannot do so. This can give companies ‘an edge’ in raising loan capital too, especially
from banks, but this comparative advantage is lessened by the disadvantages of
floating charges. Finally, note how ‘personal guarantees’ are also common, especially
in smaller or younger companies, and these again help companies raise loans,
especially from banks (but only by denying those giving the personal guarantee some
of the benefits of limited liability).
Company law 6 Raising capital: equity and loans page 59
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.
If you ticked ‘need to revise first’, which sections of the chapter are you going to
revise?
Must Revision
revise done
Notes
7 Maintaining the company’s capital
Contents
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62
Introduction
In this chapter we are focusing on the share capital of a company. The main issue
we are looking at concerns the capital maintenance doctrine. This doctrine aims to
ensure that shareholders pay the price for their shares in money or money’s worth
and that the company’s capital is not illegally returned to them. This is another area
of company law that can be technically complex. As you look through this area, bear
in mind the learning outcomes, below. These focus on understanding the purposes
behind the law’s rules and being able to discuss whether the rules are achieving their
purposes.
Learning outcomes
By the end of this chapter and the relevant readings, you should be able to:
u explain the objectives of the doctrine of maintenance of capital
u state the rule proscribing shares being issued at a discount
u describe the rules relating to dividend payments
u describe the procedure for reducing capital
u explain the regime governing financial assistance for the purchase of shares.
Core text
¢ Dignam and Lowry, Chapter 7 ‘Share capital’.
Cases
¢ Bairstow v Queens Moat Houses plc [2001] 2 BCLC 531
Additional cases
¢ Precision Dippings Ltd v Precision Dippings Marketing Ltd [1986] Ch 447.
Company law 7 Maintaining the company’s capital page 63
As always, it is useful to keep in mind whom the law is trying to protect through these
various rules. Primarily, the law is trying to protect a company’s creditors. The greater
the amount of share capital a company has raised, and the more this capital must be
preserved within the company, the greater the creditors’ chances of being paid if the
company has to be liquidated. Remember that, on insolvency, shareholders only get
their capital back after all creditors have been paid. In this sense, then, share capital
acts as a ‘buffer’, providing funds that will be used to pay creditors first.
However, while the rules we are looking at here are mainly intended to protect
creditors, they can also protect the company’s own shareholders to some extent. For
example, if a company returns share capital to some members, but not others, this
may be a way not of preventing creditors being paid but rather of ensuring that some
shareholders do better than others.
Although, as we shall see, the law ‘protects’ this share capital, it is important to
understand that share capital does not take the form of a pot of money (or money in
a bank account) that the company must never touch. Suppose that a company, X Co
Ltd, raises £1 million of share capital (by selling one million shares, of £1 each, to its
shareholders). X Co Ltd will use its share capital to run its business – to buy assets and
stock, to pay its workers and so on. These uses of its share capital are lawful. If X Co
Ltd’s business is successful, then it will generate profits and the value of its assets will
rise above the £1 million of share capital it raised. But if the business is unsuccessful,
the capital it raised will be depleted, as it is used to finance this unprofitable trading.
The capital maintenance rules that we are looking at in this chapter do not prevent
the company’s share capital becoming depleted through trading in this way but they
do try to prevent other ways in which the company might try to return capital to
shareholders.
Nevertheless, the capital maintenance rules must strike a balance. The more restrictive
the rules are, the more they will protect creditors. However, more restrictive rules will
be more expensive for companies to comply with and might stop companies doing
things that are commercially good for the company. As we shall see, the CA 2006
took a large step towards relaxing the rules, at least so far as private companies are
concerned.
One way this is achieved is by the rule that was first established in Ooregum Gold Mining
Company v Roper [1892] AC 125, and is now codified in s.552 of the CA 2006. This rule
says that shares may not be issued at a discount to their nominal value. The nominal
value is essentially the ‘face’ value of the shares. So, if you agree to buy, say, 1,000
shares of £1 each in X Co Ltd, then the shares have a nominal value of £1 and you must
agree to pay at least this for each share you buy, and so to pay at least £1,000 in total
for your investment. You cannot agree with the company that you will only pay £0.50
for each £1 share.
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Note, however, that the rule does not require that the share is paid for in full when it
is issued. You must agree to pay £1 per share but it might also be agreed that you will
only pay, say, £0.50 today and will pay the balance later when asked to do so. Thus,
a company might have 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). The fact that some shareholders may not have paid the
company in full for the shares they have purchased should not really disadvantage
creditors, since those shareholders can be forced to pay the balance in due course and
will be made to do so by the liquidator if the company becomes insolvent. In any case,
shares are now rarely issued as partly paid.
One potential limitation on the effectiveness of the ‘no-discount’ rule is that the
consideration paid for a share does not have to be in money; the price could be paid
in, say, goods or services. So while, in the example above, you must agree to pay
£1,000 for the shares you are buying, you might make this payment by transferring
to the company some property you own, or by doing some work for the company,
in circumstances where the value you put on the property or the work is arguably
unrealistically high. 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 to their nominal value was not open to challenge.
Because of the scope this gives for abuse, public companies must now satisfy strict
statutory requirements where the consideration for shares is other than money
(the decision in Re Wragg now 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.
7.3.1 Dividends
Part 23 of the CA 2006 codifies the common law by stipulating 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 company’s net assets below the value of its share capital. So, in our example in
Section 7.1, if X Co Ltd does operate profitably, these profits can be distributed to
shareholders as dividends. But if no profits are made, X Co Ltd cannot pay dividends
because it would have to be using some of that £1,000,000 share capital it raised to do
so.
A dividend paid in breach of this rule is unlawful and ultra vires. Both directors and
shareholders can incur liability for such an unlawful payment. So, a director who
knew (or ought to have known) that the payment amounted to a breach is liable to
repay all the dividends wrongly paid and not just the difference between the unlawful
dividend and what could have been paid lawfully: Bairstow v Queens Moat Houses plc
[2001] 2 BCLC 531. Similarly, 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).
First, a company that has issued partly paid shares could either reduce, or wholly
extinguish, the outstanding liability on those shares. Suppose that X Co Ltd sold a
million £1 shares but the purchasers only paid £0.75 to X Co Ltd for each share at the
time of the purchase, leaving £0.25 outstanding. X Co Ltd would have raised only
£750,000 when the shares were sold and might now decide this amount of capital
is sufficient. It might therefore wish to cancel the outstanding amount due on each
share. Doing this would not result in any immediate loss of capital to the company – it
would still have £750,000. However, it would mean that X Co Ltd would not in future
be able to demand the amount still outstanding on those shares and, to that extent, its
creditors would be worse off if X Co Ltd then got into financial difficulties.
Second, a company might want to cancel share capital that is no longer represented
by the assets of the company. Imagine now that X Co Ltd did raise £1 million of share
capital (all the shares were paid for in full) and it then used this money to buy a factory
worth £1 million. At this time, the company’s legal share capital is represented by a
physical asset that is worth as much as the share capital. But suppose the value of this
factory falls, so it is worth only £400,000. X Co Ltd’s legal share capital, on paper, is
still £1 million but this is no longer represented by ‘real’ assets of that value. (The same
situation could arise if X Co Ltd’s value has fallen because of unprofitable trading.) X
Co Ltd might want to reduce the stated value of its share capital from £1 million to
£400,000 to reflect the company’s true value, based on the assets it owns. Now, on the
one hand, making this change does not make the company any less valuable. It merely
makes the company’s legal share capital correspond to what the company actually
owns and is worth. In that sense, X Co Ltd’s creditors are no worse off immediately
after the capital is reduced than they were before. However, the effect of the change
would be to permit X Co Ltd to start paying dividends to shareholders again sooner
(essentially, if the capital were not reduced, the company would not be able to pay
dividends until enough profits had been earned, and retained, by the company to
restore its real value to £1 million). So, again, the effect of permitting this reduction
will be to favour shareholders at the expense of creditors.
Third, a company may decide it simply has more capital than it needs, and wants to
return some of this to each shareholder. Suppose again X Co Ltd had sold a million £1
shares, fully paid, to its shareholders. Initially, the company thought it would need
£1,000,000 of capital for its business. However, it is now clear that £800,000 will be
page 66 University of London
amply sufficient. X Co Ltd might wish to return some of this unneeded capital to its
shareholders, say by returning £0.20 per share. In contrast to the first two ways of
reducing share capital noted above, this third way would result in an immediate loss
of real value to the company; it will have less capital immediately after the reduction.
If share capital is reduced in any of these three ways, then creditors will be left worse
off – at least in the sense that there may be a greater risk in the future that they will
not be paid. However, there may also be good commercial reasons for allowing
the reductions to be made. We noted before that the law must find a reasonable
balance between, on the one hand, protecting creditors and, on the other, permitting
companies to achieve sensible commercial arrangements without, especially for
smaller companies, imposing an excessive amount of regulation. We can see all these
things very clearly in how the Companies Act 2006 now permits capital reductions in
the situations described above.
So, s.641 creates two alternative procedures for companies to reduce their capital
in the situations set out above. Both procedures require a special resolution from
shareholders to effect the reduction. However, they differ in terms of the additional
requirements that are imposed to protect creditors. So, one procedure is much less
heavily regulated but is available only for private limited companies. Such companies
may reduce their capital by passing a special resolution and also having the directors
issue a ‘solvency statement’ (see below). The important point here is that, under this
private companies regime, there is no need for any (expensive) court order permitting
the reduction. The other procedure is available for any limited company. Again, a
special resolution is needed but this must be confirmed by the court. This provides
greater protection for creditors but will be slower and more expensive. Because it is
available for any company, a private company could also use it but would be unlikely
to do so. We can now say a little more about each of these two procedures.
Activity 7.1
Does the simplified procedure for a capital reduction for private companies provide
adequate protection for creditors?
So far, we have focused on how the court will, when deciding whether to confirm
the reduction, protect creditors but issues of the shareholder protection may also
arise. The end result of the reduction will often be that some shares will be cancelled
or at least reduced in value. This can affect different shareholders in different ways;
those with shares being cancelled will, clearly, be affected differently than those
Company law 7 Maintaining the company’s capital page 67
whose shares are not cancelled. The requirement to pass a special resolution for the
reduction already provides a procedural safeguard for shareholders but, of course, a
shareholder with only, say, 25 per cent of the shares, who feels the reduction is going
to treat them unfairly, would not be able to block the resolution.
So, when deciding whether to exercise its discretion to approve the reduction, the
court will also consider whether the proposal strikes a fair balance between the
interests of the different classes of shareholder in the company. You might find it
useful here to take a quick look at what we mean by a ‘class’ of shareholders – in
Section 8.5 of this guide. 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 a shareholder’s class rights (see Chapter 8)
it may be possible to disapply this prima facie approach. In Re Chatterley-Whitfield
Collieries Ltd [1948] 2 All ER 593 the company’s 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 company’s 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
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.
Before explaining these rules, we need to distinguish between the two situations
that these exceptions cover. The first involves a redemption of shares – i.e. where a
company is acquiring shares that were issued as redeemable – so that the terms on
which the shares can be redeemed will have been set out at the time the shares were
issued. The second situation is where shares (which were not issued as redeemable)
are nevertheless now being purchased by the company. In this purchase situation, the
terms on which the shares are to be purchased will not have been previously settled:
these terms will now need to be agreed as part of the purchase process.
Finally, as you look at the rules governing these situations, it is also useful to keep
separate the issue of the procedure for making a redemption or a purchase and the
issue of how the company can pay for the shares being redeemed or purchased. So,
below, we start with procedure and then turn to financing the acquisition.
Shares may not be redeemed unless they are fully paid. Where the directors are
authorised to determine the terms, conditions and manner of redemption, they must do
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so before the shares are allotted and such details must be specified in any statement of
capital that the company is required to file (s.685(3)).
Activity 7.2
‘The redemption of redeemable shares poses no risk to shareholders, and therefore
is subject to very few constraints.’ Do you agree?
The procedural rules governing the purchase differ according to whether the purchase
is a market purchase or an off-market purchase. A market purchase is, essentially, a
purchase of shares that are traded on a recognised investment exchange, such as
the Main Market of the London Stock Exchange. Any other purchase is an off-market
purchase. So, if a listed company were purchasing some of its shares, this would be a
market purchase. But if a private company were doing so, it would be an off-market
purchase. The rules that apply to off-market purchases are much stricter than those
that apply to market purchases. So, this is one situation where the (procedural) rules
are stricter for private than public companies. For off-market purchases, a contract
must be prepared in advance of the purchase, made available for inspection by
shareholders and it must be approved by ordinary resolution. Those whose shares are
being purchased cannot vote on that resolution.
Activity 7.3
Why do you think company law’s procedural rules for off-market purchases are
more restrictive than those for market purchases?
u distributable profits; or
u the proceeds of a fresh share issue made for the purpose of financing the purchase
(s.692(2)).
Activity 7.4
Preventing a public company using capital, and forcing it to use one of the above
two sources of finance, should protect creditors. Explain why.
Private companies, by contrast, are sometimes permitted to use capital to pay for the
shares being redeemed or purchased. We will see in a moment how a private company
can do so and the various safeguards that apply. But first, note that for ‘small’ buy-
backs, a private company is permitted to pay for the acquisition out of capital, without
complying with any such safeguards (see s.692 CA 2006). A small buy-back is one
where the amount paid does not exceed (the lower of) £15,000 or 5 per cent of the
company’s share capital. This small buy-back regime was introduced as another move
towards deregulation, to give private companies an easy, unregulated way of making
small purchases out of capital.
Small buy-backs aside, private companies can still use capital, under s.709 CA 2006, but
doing so is subject to a number of quite technical rules. They include:
Company law 7 Maintaining the company’s capital page 69
u Even private companies must use up any distributable profits, or the proceeds of a
fresh issue, to pay for the shares being acquired before the company is allowed to
use its capital.
u The directors are required to make another ‘solvency statement’, specifying that
the directors, having made a full enquiry, are of the opinion that the company
currently is, and will for 12 months be, able to pay its debts in full (s.714). The
auditors must confirm the directors’ opinion.
u Any creditor may apply to court under s.721 within five weeks of the resolution for
an order preventing the payment (s.719).
But what is wrong with a company giving financial assistance for the purchase of its
shares anyway? Why does it need regulating at all? Regulating financial assistance
is often seen as necessary to protect creditors – in the same way as other capital
maintenance rules are justified. But if we look at the examples of financial assistance
mentioned above, we can see that not all of these necessarily threaten creditors’
interests. A loan does not deplete a company’s net assets because, although funds
leave the company, their loss is matched in the company’s accounts by the debt to the
company that is thereby created. Likewise, if the company pays a fair price for an asset
owned by the intended purchaser, the transaction does not leave the company worse
off, even if it gives the intended purchaser the funds they need to buy the shares.
However, there are other concerns about companies giving financial assistance,
beyond the need to maintain capital for creditors. These wider concerns, which mostly
focus on the interests of shareholders, rather than creditors, include:
u giving assistance may be a way of distorting the capital market – to create more
demand for the company’s shares (and thus to raise the share price higher) than
the company’s own financial performance justifies;
u related to the preceding point, it might also be a way for directors to manipulate
the ownership of the company, perhaps to help a friendly investor buy shares
in the company with a view to stopping a hostile predator from building up a
controlling interest.
page 70 University of London
Section 677 (together with s.683(1) and (2)) seek to place some limits on the scope
of what counts as ‘financial assistance’ for the purpose of the prohibition in s.678 by
listing certain forms or ways in which it can arise. Examples include:
However, the list of forms of financial assistance is still a long one and it includes a
residual, and rather catch-all, category in s.677(1)(d), namely:
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.
Activity 7.5
Megacorp plc, a listed company, has £2 million of distributable profits. Rather than
use this money to pay a dividend, Megacorp’s directors are thinking of using the
money either to buy back some of its shares, or to help Investor, who is interested
in buying shares in Megacorp, to do so.
Analyse the legality of the directors’ alternative plans.
The exceptions
Section 678 casts its net very widely. It does not depend on proof of an improper
intention, as noted above. Perfectly proper, sound, commercial arrangements
might fall within the section. This is compounded by the wide definition of financial
assistance, described above. Given this, there is a clear need for exceptions to
be created, which will prevent this prohibition stifling reasonable commercial
transactions.
One exception, that is implicit in what we have said so far, is that the prohibition in
s.678 only applies to public companies. Under the Companies Act 1985, the provision
applied to private companies too but, as part of the ‘think small first’ agenda of CA
2006, it was decided to restrict it to public companies.
Section 681 contains a wide list of ‘unconditional’ exceptions. They are largely
unproblematic because they relate mainly to procedures that are specifically
authorised elsewhere in the Act – for example, to effect a redemption of shares or a
reduction of capital.
Section 682, on the other hand, contains a list of so-called ‘conditional exceptions’.
These 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.
is using distributable profits and if it is using this money to assist employees to buy
shares as part of an employee share scheme, then this conditional exception would
apply to prevent the company breaching s.678.
Finally, we come to two exceptions – or perhaps ‘defences’ is the better word – which
are built into s.678 itself, in s.678(2) and (3). They are called the ‘principal purpose’
and ‘incidental part of a larger purpose’ defences. These two defences are intended
to ensure that the prohibition in s.678 does not also catch genuine commercial
transactions that are in the interests of the company. However, interpreting the
wording of these two defences has proved difficult and challenging, as much for the
courts as for students! In essence, the defences say that financial assistance is not
prohibited:
u 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,
u in either case, provided the financial assistance is given in good faith in the
interests of the company.
Looking at this wording, we can see how it is trying to exclude from the prohibition
transactions that benefit the company and where the giving of financial assistance
is not the real ‘driver’ of the transaction. However, it does this by talking about the
real purpose of the transaction. Unfortunately, identifying ‘purposes’ behind actions
is often problematic. Suppose that the directors of a company passionately believe
that having Investor as a shareholder in the company makes great commercial sense
for the company. Suppose that, to enable this to be achieved, the company lends
Investor money to buy shares. One interpretation of all this would be to say that the
company’s real purpose here is to get Investor as a shareholder of the company. Giving
financial assistance is not the company’s purpose but merely a step towards achieving
the company’s real purpose. But equally, it also seems plausible to say that giving this
financial assistance is precisely the company’s purpose, and the desire to get Investor
as a shareholder is merely the motive behind (the reason why the company adopts)
this purpose.
These difficulties in assessing ‘purpose’ came to the fore in Brady v Brady [1989] AC 755.
The facts were complex. You can discover these from Dignam and Lowry, alongside
a more detailed analysis of the judgment. But the important point is that the court
adopted a narrow interpretation of the ‘principal purpose’ defence, which attempted
to distinguish ‘purpose’ from the reason why a purpose is formed.
That narrow approach has been criticised on the basis that it unduly restricts the
width of the defences and, indeed, makes it very hard to ascertain exactly what sort of
situations would fall within these defences.
Summary
If a company says it has raised a certain amount of share capital, then the law aims to
ensure it has indeed raised that amount and restricts how the shareholders can then
withdraw this capital from the company. These rules are primarily designed to protect
creditors but also aim to ensure fairness as between different shareholders. The rules
are generally much stricter for public than for private companies – another example
of the law’s ‘think small first’ approach. Finally, the law also limits public companies
giving financial assistance to others to buy shares in the company. This restriction,
which can easily threaten reasonable commercial transactions, has led to a number of
difficult, and perhaps unsatisfactory, cases.
page 72 University of London
u Identify which rules require a company to raise the share capital it says it is raising.
u Identify which rules address the maintenance of share capital – those rules that
deal with capital reductions, with companies acquiring their own shares and with
companies giving financial assistance to purchase shares in the company.
u Identify what the purpose of these rules is. Specifically, comment on whether their
purpose is to protect creditors, explaining why creditor protection is necessary.
Also, consider whether creditor protection is the only purpose of the rules – do
they not also aim to protect shareholders too?
u Evaluate whether the rules are effective. There is a lot to say here and you would
probably need to identify the main points that are relevant. These might include:
the fact that there is no minimum capital requirement for private companies;
the fact that the rules have been much relaxed for private companies (excluded
from the financial assistance regime, able to use capital for buy-backs, and so on).
Evaluate the protection afforded by those private company regimes that require
only a ‘solvency statement’.
u Perhaps explain why, while the law is trying to protect creditors (and shareholders),
it cannot exclusively focus on this goal: it must be careful not to prevent genuine
commercial transactions.
page 74 University of London
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.
If you ticked ‘need to revise first’, which sections of the chapter are you going to
revise?
Must Revision
revise done
Contents
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 76
Introduction
In Chapter 2 we touched briefly on the constitution of the company. In this chapter we
will look in more depth at the company’s constitutional structure. We will look at what
sorts of rules companies’ constitutions usually contain and, especially, how these rules
usually deal with the power to manage the company and the rights that shareholders
enjoy inside the company. We will also see how these rules can be enforced by
shareholders and how the constitution can be changed over time.
Learning outcomes
By the end of this chapter and the relevant readings, you should be able to:
u explain the function of the articles of association
u describe how the articles allocate power to directors
u describe the decision-making powers of shareholders
u explain the problems in enforcing the articles
u describe the mechanisms for altering the articles and any restrictions on
alteration
u explain why shareholder agreements have become common.
Core text
¢ Dignam and Lowry, Chapter 8 ‘The constitution of the company: dealing with
insiders’ and Chapter 9 ‘Classes of share and variation of class rights’, Sections
9.1–9.4.
Cases
¢ Salmon v Quin & Axtens Ltd [1909] 1 Ch 311
Additional cases
¢ Pender v Lushington [1877] 6 Ch D 70
As we saw in Chapter 2, when a company is incorporated, its founders can draft their
own articles. This gives those creating a company the freedom to design some of their
own rules. However, in case they do not wish to do that, there are model articles,
provided by the law, which apply by default. Until 2009, there was a single set of
model articles, called Table A, which applied (again by default) to both public and
private companies. For companies formed on or after 1 October 2009, there now exist
separate models, known as the Model Articles for Private Companies Limited by Shares,
and the Model Articles for Public Companies Limited by Shares. These are contained
in the Companies (Model Articles) Regulations 2008. In practice, most companies
(especially private ones) accept the model articles but often with some amendments
and the addition of some extra provisions. Because the models are so widely used,
they do effectively provide the main legislative model for the running of the company.
So you need to be aware of the key provisions the model articles include (in the same
way that you are aware of the most important parts of CA 2006).
Activity 8.1
What do you think is the relationship between a company’s articles and the
provisions of CA 2006?
u Directors – their powers, their appointment and how they make decisions, e.g. at
board meetings (Regs 3–20)
The model articles for public companies are somewhat longer. They address the same
topics as above but sometimes do so in more detail.
(3) Subject to the articles, the directors are responsible for the management of the
company’s business, for which purpose they may exercise all the powers of the
company.
So, Reg.3 makes clear that it is the board, and not the shareholders, that is given the
power to manage the company.
page 78 University of London
Moreover, the board is also given the power (by Reg.30 for private companies – Reg.70
for public companies) 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 first recommends a dividend.
This may not seem a terribly significant power for the board to be given but it matters
a good deal. It determines what happens to the company’s profits and means that
the shareholders cannot get any income from their shareholding unless the directors
allow it.
2. Reg.3 also makes clear that the directors’ general power to run the company
is subject to other articles that empower shareholders to take some other
decisions. So, for example, under Reg.17 (for private companies – Reg.20 for
public companies) shareholders (as well as directors) have the power to appoint
additional directors by ordinary resolution.
3. It is subject to Reg.4. This makes clear that shareholders can always interfere with
the directors’ running of the company but only if the shareholders pass a special
resolution to tell the board to do, or not to do, something.
(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.
u Shareholders alone can remove directors from office – see s.168 CA 2006
u As noted, shareholders can appoint new directors under the model articles Reg.17
(private companies) or Reg.20 (public companies). The board also enjoys this
power
u Sometimes, directors must get shareholder approval before they can exercise their
powers to enter some transactions. Examples include long-service contracts for
directors, and ‘substantial property transactions’ with directors or those connected
with them (see Chapter 10)
u For quoted companies (this means, essentially, companies whose shares are traded
on a Stock Exchange) shareholders must vote on an annual ‘remuneration report’
(identifying the remuneration being paid to directors) – s.439 CA 2006
u Shareholders can always instruct the directors, by special resolution, under Reg.4.
Company law 8 the articles of association and shareholders’ constitutional rights page 79
Activity 8.2
There seems to be an inconsistency in how UK company law deals with the balance
of power between directors and shareholders. On the one hand, the law makes
it very difficult for shareholders merely to override a decision of the directors,
by instructing the directors what to do. On the other hand, the law makes it easy
for shareholders to take the much more draconian step of removing directors
permanently from the board. Discuss.
u Requisitioning a meeting: most general meetings are called by the board. But
sometimes the board may be reluctant to call a meeting – especially if the directors
know that shareholders are going to use the meeting to take decisions that are
hostile to the board. It is important, therefore, that shareholders can demand
that the board calls a meeting. This is referred to as ‘requisitioning a meeting’.
Section 303 permits a shareholder or shareholders with 5 per cent of the votes to
requisition a meeting and that meeting must then be held within, at most, seven
weeks of the date of the shareholder requisition.
u Quorum: the quorum is the minimum number of people who must be present at
the meeting for it to be valid. CA 2006 sets the quorum, by default, at two persons
(s.318). This can be changed by a company’s articles, although the model articles do
not change this.
u The courts’ power to call a meeting: s.306 gives the court the power to order
a general meeting to be held and to specify any rules it wishes about how the
meeting is to be held. This power has been used quite frequently, predominantly to
deal with one particular problem. Imagine a small company, where the majority of
the shares are held by a single individual. If the quorum for shareholder meetings
in the company is set at two persons, then that shareholder will not, alone,
constitute a quorum. They will need at least one of the minority shareholders to
attend. The minority shareholders may, however, refuse to do so, knowing they will
be outvoted by the majority if they attend. Effectively, the minority are seeking to
use the quorum requirement as a means of preventing the majority from passing
resolutions at a meeting. Faced with that strategy, the majority can ask the court to
order a meeting to take place under s.306 at which the quorum will be only one. In
a number of cases, the courts have made such orders: see, for example, Union Music
Ltd v Watson [2003] 1 BCLC 453.
Activity 8.3
Get a copy of the model articles for private companies. Have a look at the different
sections into which it is divided and the key provisions that have been discussed
above.
No feedback provided.
8.2.4 Going beyond the model articles: additional rights for individual
shareholders?
As we have seen, the model articles address the powers which shareholders
collectively enjoy and also say something (alongside CA 2006) about how shareholders
can collectively exercise those powers, through shareholder meetings. Being
empowered to take part in collective decision-making in this way is important and
valuable for each shareholder. However, in practice, its value is rather greater for
majority shareholders and rather more limited for minority ones. We will be looking
in more detail, in Chapter 12, at the topic of ‘majority rule’. But for now, imagine a
two-person company, where one shareholder, Madge, has 75 per cent, and the other
shareholder, Mini, has only 25 per cent of the shares. While Mini may sometimes enjoy
exercising her constitutional powers to take part in collective decision-making, this
will not count for a great deal where she disagrees with Madge and is outvoted by her.
Given Madge’s ability to use her majority power to control the company, Mini may
therefore want the articles also to give her ‘minority’ rights: rights that will protect
Mini against Madge’s domination of the collective decision-making process within the
company.
The model articles contain very few such rights aimed at protecting minorities against
majority power. However, if minorities can bargain for such rights when they are first
agreeing to invest in a company, then they (or their lawyers) can try to insist that the
articles are expanded to include rights that will give them some protection against the
majority.
Activity 8.4
Imagine that you were advising Mini, who intends to buy 25 per cent of the shares
in X Co Ltd. Although she currently gets on well with Madge, who will own the
remainder of the shares, she is conscious that relationships can break down and
that Madge may use her majority power against Mini. Can you think of the sort of
rights that Mini might want to insist on, in case things go badly with Madge?
Summary
The articles of association form a core part of company law as they allocate corporate
power between directors and shareholders, and provide some of the rules for how
those two groups take their respective decisions. Sometimes, the articles might go
further and provide more personal rights for individual shareholders.
The answer is found in s.33 CA 2006. This effectively turns the company’s constitution
(which includes, remember, the articles) into a contract between the company and its
shareholders. So, s.33(1) CA 2006 states:
The provisions of a company’s 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.
Company law 8 the articles of association and shareholders’ constitutional rights page 81
This rather odd statutory contract was introduced in the 19th 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). Thus, when new members join the company by buying shares, s.33 automatically
binds them to observe (and also allows them to enforce) the rules already found in the
constitution. As such, it removes the need to get all the shareholders to enter into a
new contract, covering the terms of the constitution, each time a new member joins
the company.
u The usual remedy the court will give, if proceedings are taken to enforce the
articles, will be an injunction to stop the company (or shareholder) acting in
breach of the articles. Damages will rarely be given.
u The shareholder’s action will usually be brought against the company itself – as the
other party to the contract created by s.33. Although the breach of the articles may
be the result of some action taken by, say, the directors, the shareholder’s contract
is not with them, and so the company, rather than the directors, will be sued.
u Where the directors do act in a way that is inconsistent with the articles (say there
is a provision in the articles that limits the directors’ authority and the directors
act beyond this limit) then the directors may also breach one of the duties that
they owe to the company, namely that in s.171(a) CA 2006; see Chapter 10. However,
this probably adds little to the likelihood of the articles being followed, since
enforcement of this duty is rare; see Chapter 11.
Some earlier cases on this issue suggested that the contract could not be enforced
directly by one shareholder against another. However, in Rayfield v Hands [1960] Ch 1,
Vaisey J considered that there was a contract inter se that was directly enforceable
by one member against another, at least in the sort of company that has come to
be known as a ‘quasi partnership’. This is essentially a small company with a close,
personal relationship between the shareholders.
regardless of the wishes of the majority. Accordingly, the articles can seem like an
effective bulwark against the power of the majority within the company.
Unfortunately, the articles are rather less effective in protecting minorities than
the foregoing might suggest. In this section, we look at three problems that can
undermine their effectiveness.
However, the courts have extended the point in the preceding paragraph by ruling,
in a number of cases, that even shareholders cannot enforce provisions in the articles
that do not really affect them in their capacity as shareholders. So, even if the director
in the preceding paragraph were also a shareholder, it seems that they would still be
unable to enforce the provision in the articles specifying how much they are to be
paid because this provision affects them only as a director and not in their capacity as
a shareholder. An example of a case in which the courts took this restrictive approach
is Eley v Positive Government Security Life Assurance Co (1876) 1 Ex D 20. There, Eley was a
shareholder in the Positive Government company. He also happened to be a solicitor,
and the articles of the company had been drafted (perhaps by Eley himself) to say that
he would be the company’s solicitor. The majority within the company decided that
the company would no longer use Eley as its solicitor and so Eley brought proceedings
to enforce his right, in the articles, to be the company’s solicitor. The court held that
this provision did not affect Eley as a shareholder, only in some other, ‘outsider’,
capacity, and was therefore unenforceable by him, notwithstanding that he was also a
shareholder.
Other cases, including the Hickman case, noted above, and the more recent Globalink
Telecommunications Ltd v Wilmbury Ltd [2003] 1 BCLC 145), have taken the same
restrictive line as Eley. However, the law here is unfortunately not entirely consistent.
A minority of cases do appear to have allowed shareholders to enforce articles that,
arguably, affected them in an outsider/non-shareholder capacity. Salmon v Quin &
Axtens Ltd [1909] 1 Ch 311, in which a shareholder, who was also a director, enjoyed a
power to veto certain decisions at directors’ meetings, is one such case.
A number of academics have tried to reconcile these conflicting cases. Have a look at
Dignam and Lowry, Section 8.35 for more information and relevant reading here. The
inconsistency in the case law could have been resolved when CA 2006 was enacted
but the Government chose not to do so.
One case that illustrates this judicial approach well is MacDougall v Gardiner (1875) 1 Ch
D 13. In that case, the company’s shareholders were split into two factions. MacDougall
(and the other shareholders who sided with him) comprised a smaller number of
people but together they owned a majority of shares. The other faction comprised
a larger group of people but even so they still owned only a minority of shares. A
shareholders’ meeting was taking place, at which the MacDougall faction intended
Company law 8 the articles of association and shareholders’ constitutional rights page 83
to use their majority power to pass some resolutions. Gardiner, the company’s
chairman, was allied to the minority faction. Determined to prevent the passing of
these resolutions, he declared his intention to adjourn the meeting. MacDougall,
predictably, objected and insisted (as the articles allowed him to do) that Gardiner’s
proposal to adjourn the meeting be voted on by the meeting itself. Gardiner agreed
but then took a vote on ‘a show of hands’ about whether the meeting should be
adjourned. Remember, that on a show of hands, each shareholder has only one vote.
Because the anti-MacDougall faction was comprised of more people, the chairman’s
proposal (to adjourn the meeting) was passed. MacDougall now pointed out that the
articles also said that, if a shareholder so requested, the proposal to adjourn should
be taken not by a show of hands, but instead by a ‘poll’. Remember, that on a vote by
poll, each shareholder has, usually, as many votes as the number of shares they own.
Gardiner, however, now refused to follow this rule in the articles and declared the
meeting had already been adjourned.
When MacDougall brought proceedings to enforce the article that entitled him to
insist that the ‘adjournment vote’ be taken by poll, the court refused to intervene.
It held that the breach of this article was merely a wrong done by Gardiner, the
Chairman, to the company itself. If the company wished to do something about this
wrong it had suffered, it could do so. But, crucially, no personal right of MacDougall
had been breached and so he had no right to bring a personal claim.
It remains unclear when the court will refuse to allow a shareholder to enforce a
provision in the articles on the ground that it is merely an ‘internal irregularity’ that
wrongs only the company. One answer has been given by Lord Wedderburn, who tried
to identify which articles would create ‘personal rights’ that a shareholder would
be permitted to enforce and so would not be treated as mere internal irregularities
harming only the company; look at Dignam and Lowry, Section 8.35.
A different answer was given by Baxter, in his article ‘The role of the judge in enforcing
shareholder rights’(1983) 42 Cambridge Law Journal 96. Baxter suggested two situations
where courts might be right to refuse to step in and enforce a breach of the articles.
The first is where the breach is a procedural wrong that does not really make any
practical difference to the minority shareholder’s position. The second is where the
shareholder complaining of the breach has a majority of shares, and does not need the
court’s help to resolve the situation.
Activity 8.5
Can you think of a situation where the articles might be breached but the breach
would make no practical difference to a minority shareholder’s position?
The second problem concerns what is meant by ‘for the benefit of the company as
a whole’. The court noted, in Greenhalgh v Arderne Cinemas Ltd [1951] Ch 286, that
many alterations do not really affect the company itself, as a separate commercial
entity. Instead, they merely adjust the respective rights of the shareholders, with little
impact on the company. The court therefore said that the test should be whether
the alteration was ‘discriminatory’ between the shareholders. However, it seems
that proving the alteration is discriminatory (and, indeed, so discriminatory that no
reasonable shareholder could approve it) is difficult. In Greenhalgh itself, for example,
the court refused to find such discrimination, notwithstanding that the alteration
clearly benefited the majority shareholder and left the minority worse off.
One area where the courts have been somewhat readier to strike down alterations
is where they are being made to enable the shares of a member to be compulsorily
bought from them: see Brown v British Abrasive Wheel Co Ltd [1919] 1 Ch 290 and Dafen
Tinplate Co Ltd v Llannelli Steel [1920] 2 Ch 124. Perhaps changing the articles to allow
for this is seen as simply too great an attack on the fundamental property rights of
a member. However, even in this context the minority is not sure to win; see, for
example, Re Charterhouse Capital Ltd [2014] EWHC 1410 (Ch).
Class rights
A second way in which the right to alter the articles might be restricted is if the
alteration varies the class rights of a shareholder.
The topic of class rights is dealt with, in quite a lot of detail, in Chapter 9 of Dignam and
Lowry. You need to understand two key points. The first is to identify what is meant
by class rights – so that you can understand when a right a shareholder has in the
articles will be treated as a class right. The second is to understand the more restrictive
procedure that must be followed when class rights are being changed.
Very many companies have a simple capital structure, in which all shareholders have
the same rights. It was recognised, however, in Andrews v Gas Meter Co [1897] 1 Ch 361
that a company may issue shares with different rights attaching to them. So, X Co Ltd
might create, say, two classes of share and call these ‘ordinary’ and ‘preference’ shares.
Most of the rights in the articles might still be enjoyed by both the ordinary shares and
the preference shares alike. But the articles would also specify some rights that only
the ordinary shares enjoy (perhaps, say, the right to vote) and some rights that only
the preference shares enjoy (for example, the right to receive a dividend of a certain
proportion of the company’s profits, and in priority to the ordinary shareholders).
In the foregoing example, it would be very clear from the articles that the company
has two classes of share and it would also be very clear what are the class rights that
attach to each of these two classes.
However, sometimes the articles may not expressly refer to there being different
classes of share, nor to there being class rights. Suppose the articles simply said ‘Sarah
Smith shall be entitled to appoint two directors of X Co Ltd so long as she owns at least
10% of the shares’. Would Sarah’s right be a class right?
This issue was addressed in Cumbrian Newspapers Group Ltd v Cumberland and
Westmoreland Herald Newspapers and Printing Co Ltd [1987] Ch 1. It was decided that, to
Company law 8 the articles of association and shareholders’ constitutional rights page 85
be a class right, the right could not be enjoyed by all shareholders; it would have to
be enjoyed by only some subset of members. Moreover, the right would have to be
enjoyed in the capacity of a shareholder; it could not be an outsider right, as discussed
in Section 8.4.1.
However, a right could be a class right even though it was not ‘attached to the
shares’ of the shareholders who enjoyed the right. If the right were ‘attached’ to a
shareholder’s shares, this would mean that it would ‘run’ with those shares if they
were sold, so that the (incoming) purchaser would enjoy the same right as the
(outgoing) vendor. If the class right were not attached but were given to a shareholder
by name in the articles, it could still be a class right (assuming not all shareholders had
that right), even though, if that named shareholder sold their shares, the purchaser
would not enjoy the same right.
Activity 8.6
The articles of X Co Ltd follow the model articles but with two additional
regulations. Reg.54 says that, if any shareholder wishes to sell their shares, they
must offer them first to the other shareholders. Reg.55 says that Pierre shall be
entitled to three votes per share on a resolution to remove him as a director of the
company. Does Pierre have any class rights?
Why, however, does it matter if a right a shareholder enjoys is a class right? It is
because the procedure for changing – ‘varying’ – class rights is restricted. The main
restriction arises from s.630 CA 2006. This says that, if a class right is being varied, then
such variation must first be approved by 75 per cent of the class of shareholders who
enjoy that right, before the variation is then approved by all the shareholders in the
company. In many cases, the class right will be enjoyed by a single shareholder, which
effectively gives that shareholder a veto over any variation.
Note that s.630 is subject to any alternative procedure for variation of class rights that
the company has chosen to put in the company’s articles. So, if the articles require
the variation to be approved by, say, 90 per cent of the votes of shareholders enjoying
the class right, that would take priority over s.630. Note, also, that what counts as
a ‘variation’ of a class right (necessitating the prior approval under s.630) has been
subject to a lot of litigation. Clearly, if the class right is being deleted from the articles,
that will amount to a variation. However, sometimes the proposed alteration to
the articles will apparently leave the class right intact but may adversely affect its
enjoyment. Dignam and Lowry contains more detail here (see Sections 9.20–9.23).
Activity 8.7
The courts seem very reluctant to prevent the alteration of articles on the grounds
they were not passed bona fide for the benefit of the company as a whole. However,
this reluctance hardly matters because minority shareholders can themselves easily
ensure that they can veto alterations they do not agree with. Discuss.
page 86 University of London
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. But it is an unusual
contract in that:
u the courts have not always enforced all its terms; and
The extent of these distinctive features are not always clear or consistently applied
by the courts and this has led to much academic debate about the nature of the
s.33 contract. More practically, it means that shareholders, and especially minority
shareholders, cannot always rely with confidence on the articles protecting them,
especially against the majority. The increasing use of ‘shareholder agreements’,
considered next, is a response to these practical problems.
There are several advantages in putting additional rules that shareholders agree into
a shareholders’ agreement, rather than into the company’s articles. First, such an
agreement would be enforceable under ordinary contract law principles. It would not
suffer from the problems in enforcing the articles that were noted earlier. That would
also mean that the shareholders’ agreement could not be altered unless all the parties
to the agreement consented. Second, the agreement would be private (and therefore,
confidential), whereas the articles are a publicly available document.
The main disadvantage in using a shareholders’ agreement is that its terms would
not bind any new member to the company who was not a party to the agreement
(whereas the articles are automatically binding on new members).
Further reading
¢ Baxter, C.R. ‘The role of the judge in enforcing shareholder rights’ (1983) 42
Cambridge LJ 96.
¢ Davies and Worthington, Chapter 3 ‘Sources of company law and the company’s
constitution’.
¢ Drury, R.R. ‘The relative nature of a shareholder’s 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.
¢ Prentice, G.N. ‘The enforcement of “outsider” rights’ (1980) 1 Company Lawyer 179.
¢ Wedderburn, K.W. ‘Shareholders’ rights and the rule in Foss v Harbottle’ (1957) CLJ 194.
Company law 8 the articles of association and shareholders’ constitutional rights page 87
If a shareholders’ meeting is held, can it pass a resolution instructing the board not
to buy the land? Explain and apply Regs 3 and 4. The board has power to manage;
shareholders can instruct the board (not) to do something but only by passing a
special resolution. Can Alice pass a special resolution? What if Charles does not attend?
What if Charles attends and votes against Alice?
Analyse the pre-emption obligation in Reg.55. If this is not removed, Brian and Charles
can enforce this against Alice, under s.33. If the company is a quasi partnership, they
can probably sue her directly. Can Alice change the articles to remove Reg.55? Explain
the need for a special resolution (s.21) and again whether Alice will have the votes
to achieve this, including if Charles does not attend and vote. Analyse if Brian can
challenge the alteration. Is it a class right for Brian? Can Brian challenge it under the
Allen v Gold Reefs test?
Discuss what Alice could do if Brian tries to exclude her from a shareholders’ meeting.
Explain why excluding her would probably not be dismissed as a ‘mere internal
irregularity’.
Discuss whether Alice can enforce Reg.54 to insist she is paid her director’s salary. Is
this a shareholder right or an outsider right? Apply the relevant case law.
Note: the two sections you are told not to discuss can also be relevant to shareholder
disputes. They will be addressed in Chapter 12 of the module guide. If an examination
question tells you not to examine these in your answer, you must follow that
instruction.
page 88 University of London
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.
If you ticked ‘need to revise first’, which sections of the chapter are you going to
revise?
Must Revision
revise done
Contents
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90
9.1 Directors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 91
Introduction
In Chapter 8 of this guide we saw how most companies, in their constitutions,
empower the board of directors (rather than the shareholders) to manage the
company. This gives directors a powerful position within the company and means we
need to understand more about who directors are and how company law holds them
accountable for the decisions they take. In this chapter, we will say more about how
directors are appointed and removed, how they are paid and the different types of
director that the law recognises. Finally, we will conclude by looking at how people
can be disqualified from acting as directors.
This is one area where what happens in practice can differ considerably between
smaller, typically private, companies and larger, often public, companies. Try to keep
these differences in mind as you work through the issues addressed in this chapter.
Learning outcomes
By the end of this chapter and the relevant readings, you should be able to:
u define the term ‘director’
u explain the role of the board of directors and its relationship with the general
meeting
u describe the various categories of director
u explain the issues regarding remuneration
u describe how the general meeting can remove a director from the board
u explain how directors can be disqualified from holding office.
Core text
¢ Dignam and Lowry, Chapter 13 ‘Corporate management’.
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)
Additional cases
¢ John Shaw & Sons (Salford) Ltd v Shaw [1935] 2 KB 113
9.1 Directors
In practice, the directors of smaller companies will usually be some, or all, of the
company’s shareholders. Apart from those who have agreed to remain ‘sleeping
investors’, the owners of the company will usually expect to be involved in its
management by being appointed directors.
In larger companies, and especially public listed companies, the situation will be
rather different. Directors will usually be appointed because of their expertise
and experience, not because of their ownership of the company. Those appointed
directors may subsequently acquire some shares in the company (often as part of their
remuneration – see below) but share-ownership is a consequence, rather than a cause,
of appointment as a director.
Note that in neither private nor public companies does the law impose any general
qualification requirements on those becoming a director. Those who wish to be
directors do not have to prove, beforehand, that they have the skills, knowledge, or
character to act as such.
Activity 9.1
Those wishing to become directors do not have to prove they are up to the job. But
can you think of any other ways in which company law might deter those who are
incapable of being good directors from taking on the role?
It is worth mentioning briefly here how the courts historically dealt with the balance
of power between the board and shareholders. Until the end of the 19th century,
the shareholders’ meeting had constitutional supremacy. The board of directors
was viewed as the shareholders’ agent and had to act in accordance with decisions
of the general meeting. On this basis, the shareholders remained free to tell the
board what to do, by ordinary resolution. However, by the early 20th century, with
shareholding becoming more dispersed and directors beginning to be appointed
on the basis of professional merit rather than social standing, judges began to treat
the board as enjoying greater autonomy. In Automatic Self-cleansing Filter Syndicate Co
Ltd v Cunninghame [1906] 2 Ch 34, for example, the court interpreted a constitutional
provision, that was drafted in similar terms to Reg.3 of the model articles, as meaning
that shareholders could not interfere with directors’ decisions by ordinary resolution.
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 we saw in Chapter 8 of this guide, this ‘balance of power’ between the shareholders
and the directors is now made explicit in Regs.3 and 4 of the model articles. The
page 92 University of London
directors are empowered to manage the company (Reg.3). Shareholders can still
interfere (Reg.4) but now only by passing a special resolution (requiring a 75 per cent
majority).
Of course, while directors enjoy the power to manage the company, shareholders do
hold many important residual powers, including the appointment and removal of
directors (see below). Moreover, managerial power will revert to the general meeting
where the board of directors is itself deadlocked and therefore incapable of managing
the company (Barron v Potter [1914] 1 Ch 895).
However, while the board is empowered, by Reg.3, to manage the company, it cannot
shoulder this burden alone. The board cannot, collectively, take all the decisions that
managing a modern company, even a small one, requires, let alone a large enterprise.
Inevitably, then, the board must delegate much of its power to others. Initially,
much of this delegation will be to individual directors who, besides attending board
meetings, will also be responsible for managing areas of the company’s operations.
But the larger the company, the more will these ‘executive’ directors in turn delegate
power further down inside the company, to non-directorial managers, and beyond
them to other lower-level employees. Having inevitably delegated much of its power
in this way, the role of the board of directors, as a collective decision-making body,
becomes increasingly to monitor and supervise how this delegated power is being
exercised. The board’s ability to monitor how well others are managing the company
has become especially important in larger, listed companies and we shall return to this
in Chapter 14.
The company’s first directors will be named on the documentation that is sent to
Companies House to register the company. Thereafter, the model articles allow new
directors to be appointed both by the existing board and by the shareholders by
ordinary resolution (Reg.17 for private companies; Reg.20 for public companies).
In smaller companies, the power of appointment that shareholders enjoy means that
shareholders – and majority shareholders in particular – effectively control the make-
up of the board. The majority can ensure they, or people they want, are appointed.
Although the existing directors can also appoint new directors, if the majority
shareholders do not agree with the board’s choice, the majority can quickly remove
them (under s.168 – see below). It is because the majority effectively control board
appointments that a minority shareholder, who expects to have a say in management
may want to insist a provision is included in the articles allowing them to nominate a
person for appointment as a director.
In larger, public companies things are a little different. Although shareholders can still
appoint by ordinary resolution, it is often more difficult in practice for shareholders,
to identify, and then come together to force the appointment of a director of
their choice. The existing board will tend to take the lead in identifying new board
members and, if the board uses its own power (under Reg.20) to appoint a person it
has identified, it will often be difficult in practice for shareholders who are unhappy
to remove that person (under s.168). The model articles for public companies try to
mitigate the board’s domination of the process for recruiting new board members
through some rather complicated provisions requiring directors appointed by the
board to retire automatically by rotation (see Reg.21). However, in practice, the board’s
powerful position in larger companies means that it is often what has been called
‘self-replicating’.
has taken a rather uncommercial attitude. 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). The model articles (for both private and public companies) do permit
directors to be paid but say only that they shall be entitled to such remuneration as
the directors (collectively) may determine (Reg.18 for private companies and Reg.22
for public companies).
Activity 9.2
Alex requires your advice about an investment she is making. She tells you she is
about to become a shareholder and a director of X Co Ltd, which has model articles
for a private company. It is agreed she can be a director and she expects to play an
active part in running the company. She has been told that the board has always
been generous in the pay it has voted to directors. Given what the articles say,
should she take any further precautions to protect herself?
As you will see from the feedback for Activity 9.2, directors like Alex cannot safely rely
on provisions like Reg.18. It is far safer for them to insist on having a service contract
with the company. Not only would such a contract guarantee the amount they are
paid and be enforceable against the company under ordinary contract law principles
but it might also provide the director with some protection if the company wishes to
remove the director (see below).
The other issue that we will flag up here but deal with more fully in Chapter 14 is
especially significant in public companies. Given that directors have the power
to set their own remuneration, will they misuse this power to award themselves
inflated salaries? The temptation for directors – especially ‘executive directors’ (see
Section 9.2.3) – to vote themselves so-called ‘fat cat’ awards has generated much
debate, although preventing excessive pay has not proved easy. We can note here
three broad strategies that have been adopted to try to control it (which will be
discussed more fully in Chapter 14). One has been to introduce more independence
into the process for setting such pay, by encouraging boards to create ‘remuneration
committees’. A second has been to increase the information that shareholders are
given about their directors’ pay. A third has been to give shareholders more say over
the pay-setting process.
Section 168(1) of the CA 2006 provides that a company may by ordinary resolution
remove a director before the expiration of their period of office, notwithstanding
anything in the articles or in any agreement between the director and the company.
So:
u The shareholders can remove the director immediately, even if the director has
a service contract that, say, specifies a period of notice to which the director is
entitled.
However, there are a number of ways in which directors may still defend themselves
against removal. First, the director concerned is entitled to address the meeting at
which it is proposed to remove them (s.169(2)) and they may also require the company
to circulate, to the shareholders, their representations in writing (s.169(4)). In larger
companies, with more undecided shareholders who might be open to persuasion,
these rights might sometimes allow the director to convince the meeting not to
remove them. In smaller companies, the majority shareholders will probably have
already made up their minds and the director’s arguments, however eloquent, will
make little difference.
page 94 University of London
To try to limit this risk, s.188 provides that any director’s service contract that could
last for over two years must be approved by shareholders. If it is not approved, then it
becomes terminable by merely reasonable notice.
There is a second, and less obvious, way in which shareholders might find it expensive
to remove a director. If the director who is removed is also a shareholder, they might
then bring proceedings under s.994, claiming that their removal ‘unfairly prejudices
their interests’. We look in more detail at s.994 in Chapter 12 of this guide. We will see
that such a claim is quite likely to be successful in smaller companies that are ‘quasi
partnerships’. If successful, the shareholders will still not be prevented from removing
the director but they may well have to buy the director’s shares at a generous price,
adding further to the costs of removal.
The other two categories considered here represent people who, although not
formally appointed, are nevertheless exerting similar power to that exercised by de
jure directors. Accordingly, the law recognises these two additional categories in order
to ensure that they are regulated in the same, or a similar, way to de jure directors.
The idea of a de facto director is already implicit in the definition of a director found
in CA 2006. Section 250 says that the term director ‘includes any person occupying
the position of director, by whatever name called’. So, the term de facto director
represents those people who are ‘occupying the position of a director’, even though
not formally appointed. However, this does beg the question: what must someone
be doing to be considered as ‘occupying the position of director’? There has been a
good deal of case law on this, which you should look at in Dignam and Lowry, Sections
13.17–13.20. Some of the key points are:
u What matters is what the director does, not the label that is attached to them (see
Re Gemma Ltd (in liquidation) [2008] BCC 812.
u Usually, this will require their participation at board meetings and participation as
an equal with other directors (see Secretary of State for Trade and Industry v Hollier
[2006] EWHC 1804 (Ch)).
Activity 9.3
Read Dignam and Lowry, Sections 13.17–13.20 and then answer the following:
X Co Ltd has two de jure directors, A and B.
C is the daughter of the company’s majority shareholder. She regularly attends
board meetings, where she joins in all discussions and usually votes.
D is the company’s solicitor. D often attends board meetings, in order to give advice
to the board but does not vote.
E manages many of the day-to-day operations of the company. On the door of her
office is a nameplate calling her ‘managing director’. However, she only rarely
attends board meetings and, if she does, it is as an observer.
Would C, D or E be considered de facto directors?
If someone is a de facto director, then what is their legal position? Since a de facto
director falls within the definition of a ‘director’ in s.250 CA 2006 (see above), then
all provisions in CA 2006 that apply to ‘directors’ (such as the general duties found in
ss.171–177 CA 2006 – see Chapter 10 of this guide) apply equally to de facto directors.
Wherever CA 2006 refers to ‘director’, this includes a de facto director.
We can now turn to the shadow director. In order to evade the duties to which
directors are subject, a person (such as a large shareholder) might avoid formal
appointment as a director but still tell the board what decisions to take. The concept
of a ‘shadow director’ is intended to capture such people.
u Those who provide professional advice are expressly excluded – but a professional
person may be held to be a shadow director if their conduct amounts to effectively
controlling the company’s affairs (Re Tasbian Ltd (No.3) [1993] BCLC 297).
u 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’ Re Hydrodam (Corby) Ltd [1994] BCC 161); a one-off instance where a person
tells the board what to do would not suffice.
u 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).
page 96 University of London
Activity 9.4
Alice owns 75 per cent and Brian owns 25 per cent of the shares of X Co Ltd. Their
children, Charles and Daphne, are the company’s only directors. Charles chairs
board meetings. Although Brian is no longer a director, he still takes a great interest
in the company’s affairs. He often tells Charles and Daphne what decisions they
should take. Charles always follows those instructions. Daphne, who does not get
on well with her father, always makes up her own mind what to do. Alice rarely
interferes in company matters. However, a month ago, she heard that Charles and
Daphne intended to sell some land the company owned. Alice disagreed strongly
with this. She therefore passed special resolution instructing the board not to sell
the land, under Reg.4 of the company’s articles, and Charles and Daphne complied
with this instruction.
Would either Alice or Brian be shadow directors?
What is the legal position of a shadow? The definition of a ‘director’, in s.251, does not
include someone who is merely a shadow. Accordingly, a provision in, say, CA 2006, or
in the Insolvency Act 1986, that applies to ‘a director’ does not automatically apply to
a shadow. A provision will apply to a shadow only if it expressly says that it also applies
to them. So, for example, s.214(7) Insolvency Act 1986 expressly extends the wrongful
trading provision to include shadow directors.
However, the position with regard to the general duties of directors (found in
ss.171–177 CA 2006 ) is less clear-cut. Section 170(5) CA 2006 provides that ‘[t]he general
duties apply to a shadow director of a company where and to the extent that they
are capable of so applying’. Therefore, when faced with a situation where a shadow
director might have breached one of the duties in those provisions, we must first
ask whether this particular duty is capable of applying to someone who is almost
certainly not attending board meetings but merely hiding in the shadows and telling
the legal directors what to do. Moreover, in Standish v Royal Bank of Scotland plc [2019]
EWHC 3116 the court held that the duties owed by the shadow would depend on the
instructions they gave. A shadow director could not be held liable for conduct that was
unconnected with the instructions being given to the directors.
In general, the law itself does not distinguish between these two categories
of director. The legal duties they owe to the company, for example, are usually
understood to be the same. However, soft law recommendations have focused on
non-executive directors, with many recommendations about the role they should play
in monitoring their executive colleagues. Chapter 14 of this guide explores this issue
further.
Note, again, that the executive/non-executive categories can overlap with the de jure/
de facto categories. So, for example, someone might satisfy the test of being a de facto
director through their attendance at board meetings but might play no role in the
management of the company and so be both a de facto, and non-executive, director.
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 they 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).
u Conviction of an offence
u Fraud
u Unfitness
Dignam and Lowry contains more information about each of these grounds (see
Sections 13.53–13.68). However, you should focus your attention on the unfitness
ground in s.6 CDDA 1986. There are usually over 1,000 disqualifications each year and
the overwhelming majority are 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:
u that the person is or has been a director of a company which has at any time
become insolvent (whether while they were a director or subsequently), and
u that their conduct as a director of that company (either taken alone or taken
together with their conduct as a director of any other company or companies)
makes them unfit to be concerned in the management of a company.
So, this ground applies only to someone who has been a director of a company that
becomes insolvent (although the person may have ceased to be a director by the time
it does so). The minimum period of disqualification is two years and the maximum
period is 15 years (s.6(4)).
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’.
u The extent of the director’s responsibility for any failure by the company to comply
with the numerous accounting and publicity requirements of the CA 2006 (paras 4
and 5).
u The extent of the director’s responsibility for the causes of the company becoming
insolvent (para 6).
u The extent of the director’s 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).
Incompetence or dishonesty?
One of the key issues is whether incompetence by directors does, and should, suffice
to make them ‘unfit’, or whether more egregious conduct – for example, dishonesty or
fraud – is required. Before we look at what the law says, consider the following.
Activity 9.5
Disqualifying a person from being a director, on the grounds of unfitness, has such
serious and punitive consequences that it should be applied only to those who
display dishonesty. Discuss.
Turning now to the law, it does seem that courts are reluctant to disqualify for simple
incompetence alone. In Re Lo-Line Electric Motors Ltd [1988] Ch 477 Browne-Wilkinson
V-C said that, while ordinary commercial misjudgment is not in itself sufficient to
establish unfitness, conduct that displays ‘a lack of commercial probity’ or conduct
that 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; Re AG (Manchester) Ltd
(in liquidation); Official Receiver v Watson [2008] 1 BCLC 32).
According to s.15A(3)(b) CDDA 1986, a compensation order can only be made if:
the conduct for which the person is subject to the [disqualification] order or undertaking has
caused loss to one or more creditors of an insolvent company of which the person has at any
time been a director.
The money will either be paid to the Secretary of State, for the benefit of all or some
creditors, or else will be paid as a contribution to the assets of the company.
Company law 9 The management of the company page 99
Re Noble Vintners Ltd [2019] EWHC 2806 (Ch) is the first case in which the court has used
its new powers, found in ss.15A and 15B, to order a disqualified director to compensate
creditors of the company who have been harmed by the director’s misbehaviour. The
court found that the amount of compensation payable should depend on the loss
suffered by the creditor, the nature of the director’s misbehaviour and whether the
director had already made any other payments in respect of their misbehaviour (for
example, to the company under the wrongful trading regime found in s.214 Insolvency
Act 1986).
Activity 9.6
Explain the differences between removal of a director under s.168 CA 2006 and
disqualification of a director under the CDDA 1986.
Further reading
¢ Axworthy, C.S. ‘Corporate directors – who needs them?’ (1988) 51 MLR 273.
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 Rosa’s 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 8 of
this guide).
Alternatively, the company might choose to issue additional shares in order to defeat
Rosa’s 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 10 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.561–572 CA 2006) this will frustrate the scheme to defeat her weighted voting rights.
Company law 9 The management of the company page 101
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.
If you ticked ‘need to revise first’, which sections of the chapter are you going to
revise?
Must Revision
revise done
9.1 Directors
Notes
10 Directors’ duties
Contents
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 104
Introduction
This chapter looks at the duties of directors, which are now found in Part 10 of the CA
2006. We begin by reminding ourselves why company law needs to impose duties on
directors, and how and why these duties came to be found in CA 2006. We then look
at the content of each duty and conclude by looking at the ability of shareholders to
excuse a breach and (briefly) at the remedies for breach.
Bear in mind that this guide does not contain all the information you need on
this (or any other) topic: it gives you an introduction but, as elsewhere, you must
supplement your reading, especially with the recommended textbook, and with other
recommended materials too. Also, because the duties we are considering here were
based on the directors’ status as ‘fiduciaries’, you may find it useful to remind yourself
of the work you did for Equity and Trusts (see in particular Chapter 17, ‘Breach of
fiduciary duty’, of that module guide).
Learning outcomes
By the end of this chapter and the relevant readings, you should be able to:
u discuss the fiduciary position of directors
u discuss the content and scope of the duties of directors restated in Part 10 of the
CA 2006
u explain the authorisation process
u describe the principal transactions with directors that require the approval of
members
u explain the court’s discretion to relieve directors from liability.
Core text
¢ Dignam and Lowry, Chapter 14 ‘Directors’ duties’.
Cases
¢ Percival v Wright [1902] 2 Ch 421
¢ Fulham Football Club Ltd v Cabra Estates plc [1994] 1 BCLC 363
¢ Extrasure Travel Insurances Ltd v Scattergood [2002] All ER (D) 307 (Jul) (Ch D)
¢ Lexi Holdings plc (in admin) v Luqman [2009] EWCA Civ 117
Additional cases
¢ Thorby v Goldberg (1964) 112 CLR 597
¢ Eclairs Group Ltd v JKX Oil and Gas plc [2015] UKSC 71
Of course, whether the duties fulfil either of these purposes will depend not only on
how well their content is designed – whether they demand the right sort of behaviour
of directors – but also on how well they are enforced, an important issue that is
examined in Chapter 11.
There was a long-running debate over whether these judge-made duties should
be taken out of the tangle of case law reports where they were to be found and
restated in a statute. The joint 1999 report by the Law Commission and the Scottish
page 106 University of London
u providing that it was not exhaustive (i.e. 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).
The Final Report of the Company Law Review Steering Group (CLRSG) accepted the case
for codification for two principal reasons.
u First, directors should know what is expected of them and therefore such a
statement will further the CLR’s objectives of reforming the law so as to achieve
clarity and accessibility.
u 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’.
The restatement of the duties was achieved in Part 10 CA 2006, which sets out seven
‘general’ duties, in ss.171–177.
To try to overcome this weakness, s.170(4) provides that the duties ‘shall be
interpreted and applied in the same way as the common law rules or equitable
principles’ that the duties are restating and that ‘regard shall be had to the
corresponding common law rules and equitable principles in interpreting and
applying the general duties’.
So, when working out what the statutory duties in Part 10 mean, judges must interpret
them by reference to earlier case law. The old case law has a continuing relevance, for
judges and for company law students.
It is important to distinguish the issue we have just addressed – to whom directors owe
their duties – from a separate issue that can be easily confused with it. This concerns
whose interests the duties require directors to protect or consider and therefore the
content of the duties. So, for example, as we will see when we turn to examine the
Company law 10 Directors’ duties page 107
duty found in s.172, there is a long-running debate about whether directors should
have to prioritise the interests of shareholders, or whether directors should be
obliged also to act in the interests of other so-called stakeholders, such as employees,
creditors, consumers and so on. But however the content of the duty is defined (to put
shareholders first, or to balance shareholder and stakeholder interests), the duty is still
one that is owed to (and therefore enforceable by) the company itself.
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 itself, and not to the shareholders.
We will now work through these different duties, picking out some of the most salient
points in respect of each. 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.
It is therefore necessary for directors to comply with every duty that may be triggered
in any given situation.
Activity 10.1
Imagine that you are a company director. You want to comply with your general
duties under CA 2006. Have a quick look at ss.171–177. How well do you think you
would be able to understand what they mean and what they require you to do, or
not do? Are they really ‘accessible’ to you, as a director?
No feedback provided.
Clearly, there is a lot going on in this section and it is necessary to unpack its meaning.
The orthodox understanding is that s.172 remains a ‘shareholder primacy’ rule,
requiring directors to prioritise the interests of the company’s shareholders. They
must manage the company so as to make it ‘successful’, where success is measured in
terms of what will benefit shareholders. Since shareholders are usually understood to
be investing for financial reasons, then ‘success’ will be measured in similarly financial
page 108 University of London
terms – by maximising the company’s profits and the value of the company, since
these in turn will maximise the shareholders’ returns from the company and the value
of their shares.
The matters to which directors must have regard – the interests of employees,
the company’s reputation, its impact on the environment and so on – are then
understood ‘instrumentally’. In other words, directors must think about these
things in order to work out the best way to maximise profits and the value of the
company for the benefit of shareholders. If directors are considering whether to cut
wages, for example, they must consider whether such a cut might result in lower
productivity, more staff turnover, etc. The costs of these things must be taken into
account, alongside the savings for the company in lowering its wage bill. If, overall,
the company (and so shareholders) will lose financially by cutting wages, then the
cut should not be made; but if overall the company is still better off (because the cuts
outweigh all the negative financial implications) then the directors should, according
to s.172, make the cut.
Critics of shareholder primacy acknowledge that this sort of enlightened approach may
often result in companies acting well towards their stakeholders. The more directors
take account of the negative consequences the company will suffer by treating
others badly, the more often they might conclude that the gains from doing so will
be outweighed by the costs. This is probably even more true the further the directors
project their calculations into the future. But critics fear that there will remain too
many cases where the company will gain more from behaving badly than it will lose. For
those supporting a stakeholder approach, directors should be required to respect the
interests of stakeholders as ends in themselves. Directors should treat, say, employees
well regardless of whether this happens to make the company more or less valuable for
its shareholders. Clearly, much more could be said about how directors would determine
what constitutes appropriate treatment (if it is not simply that which best maximises
profits and the value of the company); we return to these matters in Chapter 14.
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 subjective quality of s.172 makes enforcement very difficult, since it is hard to
prove the subjective state of the director’s mind. It is worth considering, however, if
there are limits to this subjectivity. One possibility is that the subjective test in s.172
is ‘qualified’ by a proviso: that directors who believe that some action will promote
the company’s success will nevertheless breach s.172 if ‘no reasonable director’ could
have shared that belief. (This would make the test similar to that applied when courts
review alterations to the articles, as discussed in Chapter 8 of this guide.) This issue is
examined in Dignam and Lowry, at Section 14.28.
Company law 10 Directors’ duties page 109
In any case, as we saw earlier, the different duties in ss.171–177 do apply ‘cumulatively’.
Even if directors who hold entirely unreasonable beliefs about the merits of their
actions are able to avoid liability under s.172, they nevertheless may well be in breach
of s.174, considered in Section 10.2.4.
Activity 10.2
A and B are directors of X Co plc. The company runs a fleet of taxis. A and B want to
replace the company’s petrol vehicles with electric ones. It will be expensive to do
this, and A and B believe that their plan will reduce the company’s profits for the
foreseeable future. However, they believe this is the ‘responsible thing to do’. Some,
but by no means all, of X Co’s shareholders share A and B’s environmental concerns.
Advise A and B if their actions will breach s.172.
The courts have accepted this logic, holding that the directors must prioritise the
interests of creditors when the company is insolvent (or close to insolvency): see,
for example, West Mercia Safetywear Ltd v Dodd [1988] BCLC 250, in which the Court
of Appeal cited with approval the decision of the New South Wales Court of Appeal
in Kinsela v Russell Kinsela Pty Ltd (1986) 10 ACLR 395. Dillon LJ in West Mercia said the
following passage from Street CJ’s judgment in Kinsela was of particular note.
Section 172(3) reflects this judicial development, stating 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. The duty becomes one to prioritise the interests of
creditors as a general class; it is not to prioritise the interests of any specific creditor
above others: see GHLM Trading Ltd v Maroo [2012] EWHC 61 (Ch). See also Re HLC
Environmental Projects Ltd [2013] EWHC 2876 (Ch).
One continuing uncertainty is when exactly directors are obliged, under s.172, to
prioritise the interests of creditors. In Dickinson v NAL Realisations (Staffordshire) Ltd
[2017] EWHC 28 (Ch), the High Court refused to say precisely when this obligation starts
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but noted that it did not arise merely because ‘there is a recognised risk of adverse
events that would lead to insolvency’.
In BTI 2014 LLC v Sequana SA [2019] EWCA Civ 112, the court said the duty to put creditors
first arose when insolvency was ‘more likely than not’.
In Wessely v White [2018] EWHC 1499 (Ch), the court accepted that the duty to prioritise
the interests of creditors was still a ‘subjective one’. If a director does what they
conclude is best for creditors, then they will not be in breach of s.172, even if they are
negligent in reaching that conclusion (although that negligence may mean they are
liable for breach of duty of care and skill under s.174).
The duty to prioritise creditor interests, which s.172 becomes when the company
is insolvent, is very similar to a statutory provision we have met earlier, namely,
that found in s.214 of the Insolvency Act 1986. Recall that this ‘wrongful trading’
provision allows a court to order a director of a company that has gone into insolvent
liquidation to contribute towards the assets of the company, unless the director took
all steps to minimise the loss to creditors once they realised, or should have realised,
insolvency was inevitable. So, under s.214 of IA 1986, directors of inevitably insolvent
companies must also prioritise the protection of creditors (and, in particular, minimise
the losses those creditors will suffer).
Activity 10.3
Read Dickinson v NAL Realisations (Staffordshire) Ltd and BTI 2014 LLC v Sequana SA
and apply them to the following. A and B are directors of Y Co Ltd. The company
is currently solvent but the past two days have brought two pieces of bad news
for the company. Two days ago, the company lost a major contract, which will
substantially reduce turnover. Yesterday, it received a number of letters from
lawyers representing residents who live near one of its factories. They say they will
shortly be commencing legal proceedings for injuries caused by pollution from the
factory. Y Co Ltd has little insurance against such claims.
Y Co Ltd’s directors want to protect the shareholders’ investments by keeping
trading for a while but in the meantime removing most of Y Co’s valuable assets
from the company, to put them beyond the reach of creditors.
If the directors implement their plan, will they breach s.172?
(a) in accordance with an agreement duly entered into by the company that restricts
the future exercise of discretion by its directors, or
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 they will take some
of their decisions. This duty can be seen as an aspect of the duty to promote the
success of the company laid down in s.172. Indeed, some have argued that the duty to
exercise independent judgement is already implicit in the duty to act in good faith to
promote the success of the company and therefore did not really need to be set out
as a separate duty in s.173. But it was decided that it would be clearer, and make the
obligation more explicit, to do so.
Does s.173 apply here? Directors might wish to use s.173 ‘defensively’, as a reason why
the company itself should not be bound by its own earlier contracts. Directors must
always be free, according to s.173, to ‘make up their own minds’ and do what is best
for the company. If a contract made by the company prevents them doing so, then it
should be seen, the directors might argue, as being invalid as a result of s.173.
Unsurprisingly, CA 2006 does not allow this argument to work. If it did work, it would
mean that contracts made by companies would be worthless as soon as the directors
formed the judgement that it would be better for the company not to be bound by its
earlier contract. Section 173(2)(a) stops directors using this argument. It makes clear
that there will be no breach of s.173 merely because directors are acting in accordance
with an earlier contract made by their company.
• 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.
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:
• directors exercising their discretion in a manner which restricts their future conduct;
this is not a breach of duty.
Note that the decision in Fulham predates CA 2006 and seems to go beyond s.173(2)(a).
Section 173(2)(a) applies only to an agreement entered into by the company and says
nothing about contracts made by directors personally. The Fulham decision ensures that
promises made by directors personally, but that restrict the directors’ ability to exercise
their future judgement, will nevertheless be valid, if certain conditions are met.
Activity 10.4
Sarah has recently agreed to invest £100,000 in X Co Ltd. She does not have time to
be a director herself but it is agreed that she can appoint Nigel to the board, who
will ‘look after her interests there’. Nigel knows that Sarah will be telling him how
to vote at board meetings and is worried whether he might breach his duties if he
does as she tells him. Sarah is worried that she herself might become liable if she
controls Nigel too much.
Advise Sarah and Nigel, including whether there is anything that could be done to
protect them.
(b) only exercise powers for the purposes for which they are conferred.
So, this duty has two parts. Part (a) requires directors to respect the company’s own
constitutional rules. We have already seen (Chapter 8 of this guide) that the company
is itself bound by the constitution (as a result of s.33 CA 2006) and that shareholders
have a personal right to enforce it against the company. Section 171(a) adds to that
by also imposing a duty on directors to comply with the constitution. However, note
that this duty (like all other duties) is owed to the company and is enforceable by the
company (not by a shareholder personally).
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’.
Most of the cases dealing with the ‘proper purposes’ aspect of the duty have focused
on one particular power that directors are usually given, namely, the power to issue
further 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
they are blocking a resolution supporting, for example, a takeover bid, then directors
will be seen as using the power for an improper purpose (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’.
Company law 10 Directors’ duties page 113
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 that 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
company’s 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).
See further, Criterion Properties plc v Stratford UK Properties LLC [2004] UKHL 28; West
Coast Capital (Lios) Limited [2008] CSOH 72; Eclairs Group Ltd v JKX Oil and Gas plc [2013]
EWCA Civ 640.
Activity 10.5
Read Lord Wilberforce’s 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.
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.
(1) A director of a company must exercise reasonable care, skill and diligence.
(2) This means the care, skill and diligence that would be exercised by a reasonably
diligent person with—
(a) 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
(b) the general knowledge, skill and experience that the director has.
We shall focus here on three issues that frequently arise when applying s.174.
Suppose we are faced with a case where directors have failed to act, rather than having
acted, but badly. The most common types of omission are where some directors are
failing to monitor and supervise the way others (including their more active fellow
directors) are running the company. They therefore fail to detect, and to prevent, the
harm that others are negligently, or perhaps even fraudulently, causing the company.
Can the inactive director be liable for their failure to act?
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It is now accepted that, while directors are free to delegate to others (both their
fellow directors and others below the board), they must nevertheless continue to
monitor and supervise the performance of these ‘delegates’. These ‘core’ obligations
of monitoring and oversight have been emphasised in many cases: see, for example,
Dorchester Finance Co Ltd v Stebbing [1989] BCLC 498, Lexi Holdings plc (in administration)
v Luqman [2009] EWCA Civ 117 and again in Raithatha v Baig [2017] EWHC 2059 (Ch).
If a director has failed to act, or has acted, but badly, against what standard will their
omission or misconduct be judged? Should a judge apply an ‘objective’ standard,
and compare their performance to how a ‘reasonable’ director would have behaved?
Or, should the judge apply a ‘subjective’ standard, and ask whether the director has
performed as well as they were capable of performing, given their relevant attributes
(such as experience, qualifications, etc.)?
Section 174(2) seems to set out both standards. Section 174(2)(a) seems to require
directors to be judged ‘objectively’, while s.174(2)(b) seems to say that they are to be
judged ‘subjectively’. The possible conflict between these two standards is resolved
as follows. The objective standard forms a minimum that every director must meet.
The subjective standard is applied to those whose attributes allow them to perform to
a higher level. A director who, for example, is young, inexperienced, poorly educated
and lacking any qualifications, will still be judged against the minimum, objective
standard (and even if they are personally incapable of attaining that objective
standard). But a director who has, say, a professional qualification, must perform as
well as may reasonably be expected of someone who is qualified in that way.
Many directors’ decisions are taken ‘under uncertainty’. The directors will lack
complete information about the state of the world at the time they are deciding and
about how the world will look in the future. When directors are deciding whether to
invest substantial amounts of money in, say, developing some new product, they do
not know whether a competitor has already designed a similar but superior product,
whether consumers’ preferences will change next year and so on. Directors’ decisions
are, then, inevitably risky. They could turn out well, or badly, for the company as a
result of factors directors do not know, or cannot fully predict or control.
The difficulty is that, once it is known how these risks played out and whether the
directors’ decisions turned out well, or badly, for the company, a bad outcome might
wrongly be interpreted as conclusive evidence that the directors’ original decision
was incompetent. This is sometimes referred to as ‘hindsight bias’. It is, however,
something that UK judges say they are aware of and try to avoid. To do so, judges
should (and seem to) focus not on the outcome of a decision but instead on the
process by which the directors took the decision. If the process by which the directors
took a decision showed an appropriate level of care and skill, then they should not be
held in breach, even if the outcome of the decision was a poor one for the company.
Relevant process issues might include things like whether the directors spent a
reasonable amount of time making the decision, the information they gathered to
assess the risks faced by the company, the advice they sought from experts, etc.
Activity 10.6
X Ltd has three directors, A, B and C. A is a chartered accountant. B is 16 years old
and has almost no experience of running companies, reading accounts, etc. C is very
busy pursing other business interests and rarely attends X Ltd’s board meetings.
A board meeting of X Ltd is called to discuss the purchase of another business for
£500,000.Only A and B attend the meeting. A reports that she has checked the
business’s accounts, it is profitable and worth the asking price. B says he cannot
understand the accounts, and that he is happy if A is happy. The discussion lasts five
minutes. They vote to purchase the business. Unfortunately, the business turns out
Company law 10 Directors’ duties page 115
The duty in s.175 is framed in the widest terms. Section 175(1) provides that:
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.
Thus, the duty addresses not only actual conflicts of interest but the mere possibility
of a conflict of interest. It requires directors not merely to put the company’s interests
above their own but ‘to avoid situations’ that might create the possibility of a conflict
in the first place. The purpose of the duty is to avoid any temptation directors would
be under if they remained in a situation where there was a conflict between the
director’s, and the company’s, interests. As explained by Lord Herschell in Bray v Ford
[1896] AC 44:
Section 175(2) identifies some specific situations where the duty will apply, namely:
Many of the cases have involved directors taking, for their own benefit, opportunities
that they discovered as directors. The classic case illustrating this is Regal (Hastings) Ltd
v Gulliver [1942] 1 All ER 378, [1967] 2 AC 134. Regal owned a cinema. Its directors wished
to acquire two additional cinemas and then 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 lease to the subsidiary unless
its paid-up capital was increased to £5,000. Here, then, was the relevant ‘opportunity’
– the opportunity to invest in the subsidiary by buying some of its shares. Regal’s
directors decided that Regal was unable to buy more than £2,000 worth of shares. The
directors decided that they themselves (and their associates) would therefore take on
the remaining opportunity to buy £3,000 worth of shares in the subsidiary.
Their doing so allowed Regal to acquire the leases of the other two cinemas.
Subsequently, a purchaser took over Regal, by buying all the shares in Regal, as well
as the shares that the directors (and their associates) owned in the subsidiary. The
directors made a profit on the sale of their shares. The purchasers of Regal installed
a new board of directors and Regal then 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.
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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. Thus, the fact the directors may have acted in good faith, and that Regal
(and its shareholders) may have benefited from the directors’ actions in increasing the
capital of the subsidiary, provided no defence to the directors.
Equally, the fact that the company was unable itself to take on the opportunity to
buy all the shares in the subsidiary was also no defence. This last point is reflected
in the wording of s.175(2) that, as we saw, declares that ‘it is immaterial whether
the company could take advantage of the property, information or opportunity’.
Moreover, the same rule applies where the person offering the opportunity decides
they will not allow the company to have it. 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 that came to Cooley while he was managing director,
and that was of concern to the plaintiffs and relevant for the plaintiffs to know, was
information that it was his duty to pass on to the plaintiffs. It was irrelevant that the
Gas Board would not have contracted with IDC.
Activity 10.7
If a company is unable to take an opportunity for itself, then a director should be
free to take it themself, without breaching s.175.
Do you agree?
Finally, it is also irrelevant that the opportunity the director takes falls outside the
‘existing scope’ of the company’s own business: O’Donnell v Shanahan [2009] EWCA
Civ 751. A director was liable when he made a personal profit from pursuing an
opportunity that he learned about as a director to acquire certain property. The
director’s company had not engaged in property acquisition (its business being
restricted to providing advice and assistance to others).The director was nevertheless
found to have breached the duty.
It is worth noting that some Commonwealth decisions have taken a more forgiving
attitude to directors. Examples of such cases include Peso Silver Mines v Cropper [1966]
58 DLR (2d) 1, Canadian Aero Service Ltd v O’Malley [1973] 40 DLR (3d) 371, both discussed
further in Dignam and Lowry. However, although decisions of Commonwealth courts
can be of ‘persuasive value’, it seems unlikely that UK courts, with their stricter
approach, would be persuaded by them.
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.
Recent decisions have made it clear that the duty to avoid conflicts of interest does
not prevent a director from:
u Taking some (but very limited) preliminary steps to investigate or forward that
intention. But if they wish to take any more substantial steps, then they must either
disclose their intentions to the board, or else resign as a director.
See:
A number of cases have addressed how the duty in s.175 should apply to someone
once they have resigned as a director. These cases seem to establish the following key
points:
u Having resigned, they are then free to compete with the company (although, again,
if they had an employment contract, that might include some restriction on future
competition by the director).
However, there remain restrictions on, say, their taking opportunities or using
information they learnt about while a director.
In IDC v Cooley (mentioned above), the director sought to avoid liability by arguing
that he had resigned by the time he took the opportunity (the contract from the Gas
Board) for himself. The court held that this made no difference: provided he learnt
of the opportunity while he was a director, he would be liable even if he only took
the opportunity after he had resigned. This principle is now found in s.170(2), which
provides that:
However, in practice, courts have sometimes been more forgiving towards directors
who have exploited opportunities, post-resignation, that they discovered while
still a director. It seems that the director will not be held liable if two conditions are
satisfied:
u The resignation must not be motivated by the prospect of taking the opportunity;
and
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See:
Activity 10.8
Anna is one of the directors of Rafters Ltd, which makes small sailing craft. While
Anna was on her summer holiday, relaxing in the hotel bar, she got talking to
another guest, Janet. Janet told Anna that she (Janet) had invented a revolutionary
new design of bicycle and was looking for a company to buy her invention from
her. Having learnt that Anna was a director, Janet asked Anna if Rafters would want
to buy her invention from her. At Rafters’ next board meeting, Anna proposed that
Rafters should purchase Janet’s invention. The other directors of Rafters rejected
the proposal. They felt that it was too risky for Rafters to move into a new product
line (cycles) in which it had no experience. Also Rafters had no spare capital to
embark on a new venture.
Frustrated with the decision, Anna immediately decided she would set up her
own business making Janet’s bicycle. In September, she signed a lease for a factory.
In October she resigned as a director of Rafters. In November, she bought Janet’s
invention from her. In December, she contacted most UK shops that sell bicycles
(some of whose owners she had met while a director of Rafters) to obtain orders for
the new bicycle. Anna’s new business has since proved highly profitable for her.
Did Anna breach s.175?
A major concern expressed by the CLRSG 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 that
stifle entrepreneurial activity (at para 3.26). Section 175(5)(a) therefore implements
the CLRSG’s 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 this (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 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.
Activity 10.9
Read Keay, A. ‘The authorising of directors’ conflicts of interest: getting a balance?’
(2012) 12 (1) J of Corp Law Studies 129 (available in the Online Library).
Make notes on why Keay thinks permitting the board itself to authorise a
director’s conflict of interest under s.175 does not provide sufficient protection for
Company law 10 Directors’ duties page 119
First, 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.
Second, the duty will not be infringed if acceptance of the benefit cannot reasonably be
regarded as likely to give rise to a conflict of interest (s.176(4)).
Third, the benefit must be provided by a third party, which means a person other than
the company or its holding company or its subsidiaries. Thus, salary (or other benefits)
paid by the company to the director are excluded.
Fourth, and finally, while s.175(5) provides for board authorisation in respect of conflicts
of interest, this is not the case with this particular duty. (However, shareholders may
authorise the acceptance of benefits by virtue of s.180(4).)
Activity 10.10
A is a director of X Co Ltd. She has recently been working long hours setting up
a major transaction with Y, one of the company’s suppliers. Once the deal is
completed, X Co Ltd pays her a bonus of £50,000 for her work. Y gives a well-paid
job to A’s daughter.
Does A breach s.176?
No feedback given.
Section 177 therefore does regulate these situations but less strictly than the other
no-conflict duties we have looked at so far. It provides that:
Thus, the director’s duty is not to avoid having an interest in a company transaction
but only to declare that interest to the board. Once the board is aware of the director’s
interest, it can then ensure that the company’s interests are protected in the
transaction it is making.
It is important to pause here and understand the different situations to which ss.175 and
177 apply. Section 177 applies only where the company itself is entering into a transaction
(and where the director has an interest in that transaction). Moreover, in this situation
(where the company is entering into a transaction, in which a director is interested)
only s.177 applies; s.175 does not. This is achieved by s175(3), which states 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’.
u The director must declare their interest to the board before the company enters
into the transaction (s.177(4)).
u 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.
u Disclosure must be made to the whole board but not necessarily at a formal board
meeting. 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.
u The director does not need to declare their interest if the board is already aware
of it, or ought to be. This point is significant where the director’s interest arises
because they are transacting with the company. In this situation, it is so obvious
that they, as the other party, are interested in the transaction that the board ought
to be aware of that interest, without their needing to disclose it.
Shareholder approval
So far, we have seen that the interested director must declare their interest to the
board but, once the board is made aware of the conflict, it is then trusted to decide
if it is in the company’s interests to proceed with the transaction. But in a number of
self-dealing situations, the potential conflict of interest is seen as so great that the
requirement of disclosure merely to the board is seen as insufficient protection for
shareholders. Instead, in these situations, shareholders must be informed and they
must approve (by ordinary resolution) the transaction in question.
For which transactions is such shareholder approval required? They are found in Part
10, Chapter 4 of the CA 2006 and include:
We shall only consider here the second situation – substantial property transactions,
addressed in ss.190–196. Some key points are:
u The sections apply where the company is buying from, or selling to, a director a
‘substantial non-cash asset’. Section 191 defines what counts as substantial and it
includes any asset whose value exceeds £100,000.
Company law 10 Directors’ duties page 121
u Because only non-cash assets are covered, payments to directors under their
service contracts (which may of course easily exceed £100,000) are not caught.
u Note that shareholder approval is needed only if the transaction is with a director,
or with someone ‘connected with’ a director. Those who are ‘connected’ with
directors are defined in ss.252–255 (and include spouses, parents, children, etc.).
u Section 195 specifies the consequences for failing to secure shareholder approval.
The transaction is voidable by the company, and a number of different people
(such as the director who is making the contract with the company) can be liable
either for any gains they make or any losses suffered by the company.
In general, subject to some qualifications, the answer is yes. Company law uses two
different terms to describe such shareholder approval.
However, we noted that there are some qualifications and the most important of
these need to be mentioned.
u First, any authorisation (and presumably any ratification too) will be effective only
if the director has made full and frank disclosure to the shareholders (prior to their
voting) about the director’s conduct: Cullen Investments Ltd v Brown [2015] EWHC 473.
The shareholders must know fully what it is they are being asked to authorise or ratify.
u Second, CA 2006 tightened up the process for ratifications (it did not do so for
authorisations and the reason for this inconsistency is unclear). Under s.239(4), a
ratification is effective only if it is passed without counting the votes in favour of
the ratification by the wrongdoing director, or anyone connected with them. Thus,
s.239(4) seeks to ensure that ratifications, at least, must be passed in a somewhat
disinterested way by not allowing the votes of the wrongdoer, or anyone
connected with them, to be counted.
The third qualification is a little more complex and uncertain. At common law, it was
unclear whether all breaches of duty were capable of being authorised/ratified by
shareholders. Two points of view emerged:
u Some academics, drawing on case law in support, argued that some breaches of
duty (which were labelled ‘fraudulent breaches’) were simply beyond the capacity
of shareholders to authorise or ratify. This was true however disinterested the
shareholder vote might be. Because the authorisation/ratification of this class of
breach would be ineffective, the company would always be free, later, to sue the
director for breach. And a shareholder would also be able to bring what was then
known as a ‘derivative action’ (which we will look at in Chapter 11).
u Other academics, again with some case law support, took a different line. They
argued that even fraudulent breaches of duty could be authorised/ratified but
such breaches of duty would have to be authorised/ratified in a very disinterested
page 122 University of London
way (whereas, at common law, non-fraudulent breaches did not have to be). The
wrongdoing director would have to play no part in, and exert no influence over, the
vote of the shareholders.
This lack of clarity in the position regarding ‘fraudulent breaches’ of duty was
exacerbated by another uncertainty in the law: it was not clear which breaches of duty
fell into the category of ‘fraudulent breaches’ in the first place. It seemed to be agreed
that ‘simple negligence’ did not amount to a fraudulent breach (and so was certainly
capable of being authorised or ratified). But beyond that, uncertainty prevailed.
The CA 2006 could have resolved these problems but its drafters chose not to do so.
Section 180(4)(a) simply preserved the (very uncertain) common law rule regarding
which breaches of duty (if any) could not be authorised and s.239(7) preserved the
(equally uncertain) common law rule regarding which breaches of duty (if any) could
not be ratified.
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, in CA 2006, 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 177 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.
u 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)
u An account of profits made by the director (see Regal (Hastings) Ltd v Gulliver)
u 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).
u negligence
u default
u breach of duty
u breach of trust.
u having regard to all the circumstances of the case, he ought fairly to be excused on
such terms as the court thinks fit.
An example of the use of this provision is Re D’Jan of London Ltd. A director 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 company’s 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.
More often, however, the courts have been reluctant to give relief under s.1157.
In Re Duckwari plc (No.2) [1999] Ch 268, 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.
For a further illustration of the courts’ reluctance to give relief under s.1157, see Towers
v Premier Waste Management Ltd [2012] BCC 72. 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.
Can a shadow director rely on s.1157? Instant Access Properties Ltd v Rosser [2018] EWHC
756 (Ch) suggests that, in a roundabout way, such a director can. The court held that a
shadow director ought not to be found to be in breach of duty in the first place where,
had they been a de jure or de facto director, they would have been relieved of liability
under s.1157.
Further reading
¢ Ahern, D. ‘Directors’ duties, dry ink and the accessibility agenda’ (2012) LQR 114.
¢ Conaglen, M. ‘The nature and function of fiduciary loyalty’ (2005) LQR 452.
¢ Davies, P. and J. Rickford ‘An introduction to the new UK Companies Act’ (2008)
ECFR 48.
¢ Developing Directors’ Duties (1999) CfiLR (special edition devoted to the Law
Commission’s report on directors’ duties (Nos 261 and 173) and the DTI’s
fundamental review of core company law).
¢ Edmunds, R. and J. Lowry ‘The continuing value of relief for directors’ breach of
duty’ (2003) MLR 195.
¢ 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.
¢ Keay, A. ‘The duty of directors to take account of creditors’ interests: has it any
role to play?’ (2002) JBL 379.
page 124 University of London
¢ Keay, A. ‘The authorising of directors’ conflicts of interest: getting a balance?’
(2012) 12 J of Corp Law Studies 129.
¢ Lowry, J. ‘The irreducible core of the duty of care, skill and diligence of company
directors: Australian Securities and Investments Commission v Healey’ (2012) 79
MLR 249.
¢ Lowry, J. ‘Regal (Hastings) fifty years on: breaking the bonds of the ancien régime’
(1994) NILQ 1.
¢ Parker, H. ‘Directors’ duties under the Companies Act 2006: clarity or confusion?’
(2013) 13 Journal of Corporate Law Studies 1.
¢ Sealy, L.S. ‘“Bona fides” and “proper purposes” in corporate decisions’ (1989)
Monash Univ LR 265.
¢ White Paper: Modern company law for a competitive economy: developing the
framework (2000) DTI, March.
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 director’s 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 2017 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.
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 Bhullar v Bhullar. The
fact that Arthur was a party to the board’s decision to reject Fred’s offer, together with
the fact that he declined Fred’s personal invitation, might point to the board’s 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 module 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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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.
If you ticked ‘need to revise first’, which sections of the chapter are you going to
revise?
Must Revision
revise done
Contents
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 128
11.1 The rule in Foss v Harbottle: the proper claimant rule . . . . . . . . . . 129
Introduction
If directors’ duties are to work well, there must be a reasonable chance that they will
be enforced. Without enforcement, those duties will be unlikely to deter directors
from misbehaving and will too rarely deliver compensation for the harm the company
has suffered.
One way around that incentive problem would be to allow a shareholder to sue the
director for their own benefit, through a ‘personal action’. We note two barriers that
the law places in front of any shareholder who might be tempted to pursue such an
action.
Finally, we shall link the way the law deals with the enforcement of breaches of duty
to two broader ‘policies’ that underpin much of company law: that disputes should
be resolved inside the company, not inside courtrooms, and that the majority should
get their way. Company law is a subject where it is important to see links between
different topics. Much of this chapter focuses on the quite narrow issue of enforcing
just breaches of duty. Doing so makes understanding that narrow issue more
manageable. But it is important, once you have understand that, to try to see how this
narrow issue fits into these two broader policies.
Learning outcomes
By the end of this chapter and the relevant readings, you should be able to:
u explain the rule in Foss v Harbottle and authority to bring a corporate action
u understand the derivative claim and apply the permission criteria
u evaluate how well derivative claims are working
u explain personal actions against directors
u understand how enforcement of wrongs to the company connects to the policy
of majority rule.
Core text
¢ Dignam and Lowry, Chapter 10 ‘Derivative claims’.
Cases
¢ Foss v Harbottle (1843) 2 Hare 461
¢ Prudential Assurance Co Ltd v Newman Industries Co Ltd (No.2) [1980] 2 All ER 841;
[1982] Ch 204 CA
¢ Re Singh Brothers Contractors (North West Limited) [2013] EWHC 2138 (Ch)
Additional cases
¢ Mumbray v Lapper [2005] EWHC 1152 (Ch)
If a company does choose to sue, we can call that action a ‘corporate action’. If we
looked at the pleadings, we would see the company itself named as the claimant,
and the wrongdoing director(s) would be named as defendant(s). (By the end of this
chapter, you should be able to understand how this corporate action differs both from
what we shall call a derivative claim and from a personal action.)
Who decides if a corporate action should be brought? As with any other decision
about what a company is to do, the decision must be taken by someone with authority
to do so. The case of Breckland Group Holdings Ltd v London and Suffolk Ltd (1988) tells us
that whoever has general authority to manage the company will, therefore, have the
authority to take this particular decision (that the company will, or will not, sue). As
we saw in Chapters 8 and 9 of this guide, it is almost always the board that is generally
empowered to manage a company, and Reg.3 of the model articles adopts this rule.
So, in most companies, whether a breach of duty is enforced via a corporate action
depends on whether the board is willing to sue. Generally, boards are reluctant to
do so. (For a very good discussion of whether the board ought to have the authority
to decide whether the company will, or will not, sue a director, see Kershaw (2012),
pp.589–95.)
Activity 11.1
Why might the board be reluctant to sue one of their colleagues, or even a former
colleague?
Can shareholders (or indeed anyone else) get around the board’s predictable
reluctance to bring a corporate action against a director? In theory, a number of ways
are available.
page 130 University of London
First, when a company is insolvent and being wound up, the liquidator takes over the
board’s management powers (see Chapter 15). One might think that a liquidator would
be much more willing than the previous board of directors to decide that a corporate
action should be brought. However, although this does sometimes happen, liquidators
also seem reluctant to sue – mainly because of concerns about costs.
Second, if the majority of shareholders do not agree with the board’s refusal to sue,
then they might try to do something about it. If 75 per cent or more want a corporate
action to be brought, under the model articles (Reg.4) they could pass a special
resolution instructing the board to sue. If only a simple majority of shareholders (more
than 50 percent, less than 75 per cent) want a corporate action to be brought, then
they could not instruct the board to sue but they could change the board so that it
might have a majority who would then vote for a corporate action. The shareholders
could remove directors who are opposing a corporate action (under s.168) or appoint
more directors who would favour a corporate action (under Reg.17 of the model
articles).
The difficulty with these suggestions (for shareholders to get a corporate action) is
that they are often impractical. In large companies with a separation of ownership
and control (see Chapter 14), it is very difficult for unhappy shareholders to coalesce
and pass even ordinary resolutions against the board, let alone special resolutions
requiring 75 per cent. In smaller companies, the wrongdoing directors are likely to
have significant – and perhaps even majority – shareholdings. Because shareholders
are generally free to vote in their own self-interest, then those director-shareholders
would probably be able to block resolutions designed either to force the board to sue,
or to change the board’s membership to one more likely to sue.
Company law’s way around this impasse is the derivative claim. This is the name
for proceedings brought by one or more shareholders to enforce a claim that
the company itself has. The claim is not brought by the company – and so is not a
corporate action. The pleadings would show the claimant as being the shareholder,
not the company. Nevertheless, the shareholder sues on behalf of the company to
enforce the claim the company itself could have brought for the wrong done to it
(but which the board will not bring as a corporate action). If the derivative claim is
successful, the benefits will go to the company, not the shareholder bringing the
claim. Such proceedings are an exception to Foss, for they allow a shareholder to sue
for a wrong done to the company. Section 11.2 looks at this form of proceedings in
more depth.
UK company law has long permitted such claims. Prior to the CA 2006, however, the
rules governing derivative actions (as they were then known) were found not in the
Companies Acts but instead in case law. These rules were much criticised (consider for
example the views of the Law Commission (see the LCCP No.142 (1996) and the ensuing
Report, No.246 (Cm 3769, 1997)). It was felt that the rules, being buried in case law,
were inaccessible and often unclear. It was also felt that the rules were too restrictive
and made it too difficult for shareholders to succeed in bringing such actions.
The Law Commission did not recommend abandoning the rule in Foss v Harbottle itself
and its general principle that ordinarily a company should be the claimant where the
company had been wronged. It felt the rule itself was sound. Derivative proceedings
should remain an exception to that rule – a procedural device that would enable
individual shareholders to take action for the company, to ensure the company’s rights
were vindicated. But there should be ‘a new derivative procedure with more modern,
flexible and accessible criteria’. This was achieved by introducing a new statutory
Company law 11 Enforcing directors’ duties page 131
‘derivative claim’, in Part 11 CA 2006. The common law derivative action has, therefore,
been almost completely replaced by the new statutory claim. Almost but not entirely;
unfortunately, what are termed ‘multiple derivative actions’ are not covered by the
new statutory provisions of Part 11. A multiple derivative action is one brought by
a shareholder of a parent company in respect of a wrong done to the company’s
subsidiary, or its sub-subsidiary and so on. Such claims must still be brought under
the old common law procedure: see Re Fort Gilkicker Ltd [2013] EWHC 348 (Ch) and
Abouraya v Sigmund [2014] EWHC 277 (Ch).
When a derivative claim is brought, the wrongdoing directors will be the main
defendants. However, the company itself will also be joined as a co-defendant. By
being joined as a defendant to the action, the company can still be bound by the
judgment and can enforce any remedy awarded for its benefit (for example, that the
director must pay compensation to the company).
At common law, the derivative action was available only where there was ‘fraud on the
minority’. It became known, then, as the fraud on the minority exception to Foss.
In this ocean of uncertainty, there was one island of firmer ground. ‘Simple’ negligence
(where the director harms the company by their incompetence and does not themself
benefit at the same time) did not amount to fraud: Pavlides v Jensen [1956] Ch 565.
However, while this gives us at least one welcome bit of certainty, it unfortunately
meant that a derivative action could not be brought against directors who were only
incompetent. This made directors’ duties a rather ineffective means of incentivising
directors to behave with care and skill because the duty that demanded they do so could
not be enforced by a derivative action (and a corporate action, for reasons noted above,
was unlikely).
owning 51 per cent of the shares but might well have such control over the company as
to ensure that no corporate action would ever be taken against them.
In Prudential Assurance Co Ltd v Newman Industries Co Ltd (No.2), the Court of Appeal
adopted a quite narrow definition of wrongdoer control (making it difficult for the
claimant shareholder to prove). And this was taken even further by Knox J in Smith v
Croft (No.2) [1988] Ch 114. On his reasoning, even where the wrongdoers did in fact have
51 per cent or more of the votes (and so seemed clearly to be in control), nevertheless
if the majority of the other ‘innocent’ shareholders wanted, for disinterested reasons,
no action to be taken against the director, then no derivative action should be possible.
The logic of Knox J’s argument was that if a majority of disinterested shareholders were
against action by the company, then the company was being stopped from suing (or
‘controlled’) not by the wrongdoers but by non-wrongdoing shareholders.
Summary
At common law, a shareholder would be permitted to sue on behalf of the company, as
an exception to Foss, in a derivative action but only if they could establish that the wrong
to the company amounted to ‘fraud’, and the company could not itself sue because
it was controlled by the wrongdoer(s). But these conditions were unclear in their
meaning, and restrictively applied. The hope was that the new statutory derivative claim
procedure, in Part 11 CA 2006, would be both clearer and give the individual shareholder
a greater chance of success. We must now see if this has proved to be the case.
It is clear that claims against directors for any breach of the duties they owe to the
company fall within its scope. In this respect, the statutory derivative claim is now
wider than the common law action it replaces. The breach no longer needs to be one
that is considered ‘fraud’ (with all the uncertainty that this carried). On a practical
level, it means that a derivative claim now can be brought for a breach of the duty
to exercise reasonable care, skill and diligence in s.174 CA 2006 (compare the case of
Pavlides v Jensen).
Although most actions will be against a director, s.260(3) also makes clear that a
derivative claim may be brought against, for example, a third party who dishonestly
assists a director’s breach of fiduciary duty.
It is also immaterial whether the cause of action arose before or after the person who
is seeking to bring or continue the derivative claim became a member of the company
(s.260(4)).
Activity 11.2
Do you think those who become shareholders only after a breach of duty has
occurred should be allowed to bring a derivative claim?
Finally, note that CA 2006 does not say that the shareholder bringing the derivative
claim must show that the wrongdoers are in control of the company (recall that
establishing ‘wrongdoer control’ was one of the conditions under the common law
rules). However, it is less clear whether this means this condition no longer applies to
the new statutory claim: see Kershaw, D. ‘The rule in Foss v Harbottle is dead; long live
the rule in Foss v Harbottle’ (2015) Journal of Business Law 274.
derivative claims may lack merit and, from the company’s point of view, may be
more trouble than they are worth. Section 261 tries to address this risk. It states
that, once a derivative claim has been brought, the member must apply to the court
for permission to continue it. The intention is that judges will act as ‘gatekeepers’,
weeding out unmeritorious claims before they cause too many costs and too much
inconvenience for companies, their directors and the courts.
Getting permission to continue involves a two-stage process. The first stage involves
a paper hearing, where the court considers the member’s 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.
Usually, the court does not dismiss the application at the first stage and the
application will then proceed to the second stage, which is a full permission hearing.
Section 263(2) and (3) set out the criteria that the court must take into account when
determining whether to grant permission. In theory, these criteria apply at both stages
described above but it is really at the second (full) stage that the court will work
through them carefully.
The first three criteria, set out in s.263(2), operate as what might be called ‘mandatory
bars’. If any one of these three criteria applies, the court must then refuse its
permission to continue the claim. If none of the three bars applies, then the judge
has a discretion whether or not to grant permission and s.263(3) sets out the criteria
the judge will apply to guide them in exercising that discretion. Judges usually
work through the mandatory bars first, since if any one of them is applicable, the
discretionary factors become irrelevant (since permission will have to be refused).
u a person acting in accordance with s.172 (duty to promote the success of the
company) would not seek to continue the claim; or
If we start with the second and third bars (authorisation or ratification), these seem
only rarely to be raised in cases. Perhaps this is because, where there has been
authorisation or ratification, potential claimants do not bother even starting a
derivative claim, since they would inevitably be refused permission. For a rare example
where a case was begun but where permission was then refused because the breach
of duty had been authorised or ratified, see Re Singh Brothers Contractors (North West
Limited) [2013] EWHC 2138 (Ch).
Remember that the authorisation or ratification must be valid for the bar to apply.
We addressed some of the conditions for an authorisation or ratification to be valid
in Chapter 10 of this guide. You should refer back to that discussion now and then test
your knowledge with the following activity.
Activity 11.3
A owns 51 per cent and B owns 49 per cent of the shares in X Co Ltd. A few weeks
ago, A took a corporate opportunity for himself and profited substantially by doing
so. B is now threatening to bring a derivative claim against A. A is thinking of calling
a shareholders’ meeting to excuse any breach of duty he may have committed but
is not sure if this will be effective. Advise A.
The first of the mandatory bars (whether a person is acting in accordance with s.172,
etc.) often receives much more discussion in the cases. It has sometimes been called
the ‘hypothetical director’ test. The issue the court is really addressing is whether
continuing the claim would be in the best interests of the company: will the company
itself be better off if the claim is allowed to continue to trial, or better off if the claim is
brought to an end immediately through a refusal of permission to continue? In Iesini v
page 134 University of London
Westrip Holdings Ltd [2009] EWHC 2526 (Ch), Lewison J listed the ingredients the judge
should take into account in deciding whether it would be in the company’s interests
to continue, or to stop, the proceedings. These included:
u the impact on the company if it lost the claim and had to pay not only its own costs
but the defendant’s as well
u whether the prosecution of the claim would damage the company in other ways
(e.g. by losing the services of a valuable employee or alienating a key supplier or
customer).
Often, these different ingredients will point in different directions. So, for example, the
claim might be quite strong, for a large amount, against a wealthy defendant director
(suggesting that the company might gain a lot if the claim against the director were
allowed to continue to a trial). Yet the director might be one of the driving forces
behind the company and might be threatening to leave if the claim were allowed
to continue (resulting in considerable damage to the company). Lewison J (in Iesini)
suggested that in such cases the judge should give the benefit of the doubt to the
shareholder and should not refuse permission on this mandatory bar. Permission
under this mandatory bar should be refused only if ‘no reasonable director’ would
think it worth proceeding with the claim – in other words, only if it were very clear that
the company would lose far more than it might hope to gain by continuing the claim.
In ‘giving the benefit of the doubt’ to the shareholder, remember this does not mean
that the shareholder then gets permission. It means only that the ‘hypothetical
director’ bar will not be used to refuse permission. Since that bar will not apply (and
assuming no other bar applies) the judge will then have a discretion and will turn
to the discretionary factors in s.263(3); these factors will determine whether the
shareholder gets permission.
u 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
u whether the shareholder could pursue the action in their own right.
The ‘good faith’ factor seems to refer to whether the claimant is motivated by a desire
to benefit the company, or by some ulterior agenda (such as a personal vendetta
against the director). In most cases, it seems to have been accepted that the claimant
was acting in good faith.
The second factor (the importance that a person acting, etc.) considers the same
issue as the ‘hypothetical director’ bar described above. As a discretionary factor, it
asks the court to try to estimate, very roughly, how much the company might gain, or
lose, from continuing the claim. If the company stands to gain only a small amount,
say, then the court will probably conclude that the hypothetical director would not
Company law 11 Enforcing directors’ duties page 135
consider it very important to continue the claim, making it more likely (although not
certain) that permission will be refused.
The third factor asks the judge to consider whether, if a shareholders’ meeting were
called, an effective ratification might be passed (bearing in mind who would, and
would not, be allowed to vote – see s.239(4)).
The fourth factor (whether ‘the company’ has decided not to pursue the claim) asks
whether the board of directors has decided there should be no corporate action. In
Kleanthous v Paphitis [2011] EWHC 2287 (Ch), the fact that the board had decided not
to sue contributed towards the judge’s decision to refuse permission. The claimant
argued that the directors taking this decision were themselves too close to the
defendant director but the judge responded by saying that the company’s own
directors were better placed than the judge to determine the likely impact on the
company of either continuing, or stopping, the claim.
The final factor (could the shareholder pursue the director’s misbehaviour ‘in their
own right’) needs a little explanation. It is asking whether the claimant shareholder
can bring some action for their own benefit, rather than pursuing the matter as a
derivative claim on behalf of the company. The most obvious way a shareholder
could do this is through the so-called ‘unfair prejudice remedy’, in s.994 CA 2006. This
remedy is the subject of Chapter 12 of this guide. We shall see that it is a very effective
(and often-used) protection for shareholders. Where successful, it usually results in the
shareholder being ‘bought out’ of the company and on quite generous terms. This can
often be a better long-term solution to the breakdown in the relationship between
the claimant shareholder and the other shareholders/directors in the company,
especially in smaller companies. In a number of cases (see, for example, Mission Capital
plc v Sinclair [2008] EWHC 1339 (Ch) and Franbar Holdings v Patel [2008] EWHC 1534 (Ch))
the courts’ perception that s.994 provided a better solution carried a lot of weight in
their refusal of permission.
Activity 11.4
Can you think of any circumstances where it would be better to allow a shareholder
to continue with a derivative claim, rather than telling them to bring s.994
proceedings and exit the company?
Finally, in addition to the factors noted above, s.263(4) adds the requirement 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.
While the rules under Part 11 are undoubtedly clearer, more certain and accessible
than the old common law and now allow shareholders to sue for any breach of duty
(including, significantly, for negligence), shareholders still seem very reluctant to take
advantage of these reforms in the law.
One practical hurdle that confronts a shareholder litigant is the cost of a proposed
action. If the action is allowed to proceed to a trial and the claim is successful (so
that the shareholder/company wins and the director loses), then the director will
typically have to pay both their own costs and the shareholder’s costs. But if the claim
page 136 University of London
goes to trial and is lost, then the shareholder will usually have to pay their own costs,
as well as the costs of the victorious director. This represents a significant risk for a
claimant shareholder. To give them some ‘insurance’, the court may, at the outset, also
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. These indemnities are
sometimes called ‘Wallersteiner orders’, in recognition of the first leading case where
such an indemnity was given (Wallersteiner v Moir (No.2) [1975] 2 QB 273).
Although courts used to make such orders quite frequently, they seem to have
become more cautious about doing so (see, for example, Bhullar v Bhullar [2015] EWHC
1943 (Ch) and Hook v Sumner [2015] EWHC 3820 (Ch). In Bhullar, for example, the court
refused to award an indemnity where it felt that the claimant was using the derivative
claim as a tactic to pressure the majority and that the dispute between the parties was
likely to be settled under s.994 CA 2006 (unfair prejudice proceedings).
Activity 11.5
Can you think of any other reasons why a shareholder might be reluctant to start a
derivative claim?
Shareholders’ reluctance to sue (see the feedback to Activity 11.5) is arguably not
helped by the courts’ own reluctance to give permission to continue claims. Can we
explain that judicial attitude? At least two reasons seem evident:
u Judges feel that deciding whether it will be in the company’s interests to allow
the action to proceed is a commercial/business judgement. It involves assessing
the commercial impacts on the company of pursuing the claim to a trial. Judges,
however, feel they lack the expertise, experience and deep knowledge of the
specific situation any particular company faces to make such judgements. Judges
feel that the company’s own directors are much better placed to make such
judgements, and so tend to defer to them, and their assertion that continuing the
claim will harm the company. This sort of judicial ‘deference’ to the company’s
own directors is arguably evident in cases such as Iesini v Westrip and Kleanthous v
Paphitis.
u Judges feel that s.994 provides a better mechanism for resolving many of these
disputes. But while s.994 may be better for the individual shareholder who is
bought out, it rarely protects the company itself against the harm caused by its
directors’ breach of duty.
Some writers have questioned whether a better way to raise levels of enforcement
of directors’ duties would be to move towards greater public enforcement. For an
interesting look at the Australian approach, see: Keay A. and M. Welsh ‘Enforcing
breaches of directors’ duties by a public body and Antipodean experiences’ (2015) 15
Journal of Corporate Law Studies 255–84.
11.6.1 Introduction
So far, we have considered two forms of action against a director: a corporate action
brought by the company itself (decided on by the board) and a derivative claim
brought by a shareholder on behalf of the company. We now turn to a third form
of action that might be brought against a director, namely, a personal action. We
shall begin by looking at personal actions brought by a shareholder (although, as we
shall see below, such actions might also be brought by other third parties, such as
creditors).
What is ‘personal’ about a personal action? It means that the claimant is suing ‘for
themself’, in two senses. First, they are suing to enforce their own cause of action.
Contrast this with a derivative claim, where the shareholder sues to enforce the
company’s cause of action. Second, they sue for their own benefit: if they win, then
they will receive, say, the compensation that the director is ordered to pay. Again,
Company law 11 Enforcing directors’ duties page 137
contrast this with a derivative claim, where the benefits of a successful action go to
the company. It is this second point that can make the personal claim much more
attractive to a shareholder, compared to a derivative claim, where they see others
free-riding on their hard work in bringing the claim.
Before we look at when shareholders can bring such personal claims, one final
distinction needs to be made. Besides the personal action being considered here
(against a director, for compensation), there are other types of personal actions that
shareholders can bring and it is important to understand the differences between
them. One other type of personal action we met in Chapter 8. Remember that
shareholders can sue to enforce the company’s articles because of the contract that
exists, based on the articles, between each shareholder (personally) and the company.
An action by a shareholder to enforce the articles is a personal one. But it is brought
against the company itself (or, sometimes, against fellow shareholders) and the
remedy sought is usually an injunction, not compensation. Another type of personal
action that shareholders can bring has been mentioned already in this chapter and
is the focus of Chapter 12: an action under s.994 for ‘unfair prejudice’. Again, these
are personal actions by shareholders; the shareholder is complaining that they have
personally suffered ‘unfair prejudice’ and the remedy they seek is usually a personal
one (that their shares be bought from them).
The personal action we are considering now, in this chapter, is different from these
others, in two senses. The first concerns whom the shareholder is suing. The personal
action we are considering now is being brought against a director – neither of the
other personal actions target the director. The second difference concerns the remedy.
The personal action we are considering now seeks compensation for the shareholder,
for the wrong done to them – neither of the other personal actions usually seeks
compensation for past harm.
With those introductory comments behind us, can a shareholder sue a director,
personally, for compensation in this way? To do so, they will need to overcome two
hurdles: they will need to show that they have their own cause of action against the
director and they will need to show that they are not suing for reflective loss. In most
cases, they will be unable to get over one, or even both, of these hurdles. Personal
actions against directors are, then, exceptional and rare.
Do directors owe any duties directly to the shareholders? As we have seen already,
they do not owe the duties found in ss.171–177 CA 2006 to the shareholders; those
duties are owed only to the company. So, shareholders will need to look elsewhere. In
fact, in some situations, directors may incur duties directly to shareholders (alongside
the duties those directors owe to the company under CA 2006). But these situations
are rare and courts seem generally reluctant to burden directors with additional
duties owed directly to shareholders. This reluctance can be seen in cases such as
Percival v Wright [1902] 2 Ch 421.
We might identify three situations where such duties may arise (or, put another
way, three different sources for duties a director might come to owe directly to a
shareholder).
A reflective loss is a loss that is suffered by someone, such as a shareholder, but which
is caused by, and thus reflects, a loss first suffered by the company itself. Suppose
a director makes a negligent decision that loses their company £1 million. If you
own shares in that company, then those shares will probably fall in value as a result.
Likewise, your future dividends may be lower because of the company’s reduced
profits. The reduced value of your shares and the reduced dividends are a loss to you
but a reflective one.
Company law 11 Enforcing directors’ duties page 139
Activity 11.6
Where a director harms a company and causes some reflective losses to its
shareholders, it is much better that the company itself sues the director, and that
the shareholders are prevented from bringing a personal claim against the director
(even if the shareholders have a good cause of action against the director).
Do you agree? Why?
The precise scope of the reflective loss barrier has been subject to much judicial
consideration. In Johnson v Gore Wood & Co [2001] 1 All ER 481, it was held that the
principle applies provided that the company itself has a legal claim in respect of its
loss. However, so long as the company does have a legal claim, the principle will apply,
regardless of whether the company chooses to pursue that claim and regardless of any
practical difficulties that the company might face in doing so (such as if the company
is in severe financial difficulties and therefore practically unable to sue).
Johnson also made clear, however, that the reflective loss principle does not apply to
the extent that a shareholder suffers some loss that is separate and distinct from the
loss suffered by the company. This is really just acknowledging that shareholders may
sometimes suffer non-reflective losses and they, rather obviously, are not covered
by the principle! Suppose, for example, that a director gives negligent advice to a
shareholder in connection with the shareholder’s sale of their shares. Because of this
poor advice, the shareholder sells some of their shares too cheaply and suffers a loss
as a result. The company itself probably suffers no loss as a result of the director’s poor
advice to the shareholder – it will be worth the same after the director has misadvised
the shareholder as it was before they did so. The shareholder alone suffers a loss,
which cannot therefore be ‘reflective’ of a loss first suffered by the company.
That third party would, again, have to establish some direct cause of action against the
director and, just as with shareholders, might often struggle to do so. A creditor, for
example, contracts with the company, not with the director. However, exceptionally,
direct obligations might arise. As before, they could arise in tort. The case of Williams v
Natural Life Health Foods Ltd, which we discussed in Chapter 5, illustrates this. Williams,
a creditor of a (now-insolvent) company, sued its managing director personally, in tort,
alleging negligent misstatement. Similarly direct obligations could arise in contract;
a director might enter into a personal guarantee with the creditor, under which the
director promises to repay the creditor’s loan if the company fails to do so.
If the creditor can establish a cause of action, are they nevertheless still subject to
the reflective loss principle? When the creditor seeks to pursue their cause of action
against the director, will the court tell them that their losses as a creditor (such as the
non-payment of their loan) are merely a reflection of some harm that the director first
caused to the company, and that any claim against the director should be brought by
the company, not the creditor?
Some earlier cases seemed to suggest that the reflective loss principle did indeed apply
to creditors. However, in Sevilleja v Marex Financial Ltd [2020] UKSC 31, the Supreme Court
took the opportunity to reduce the scope of the reflective loss principle. The Court held
that the principle applied only to claims brought by shareholders and had no application
to claims brought by non-shareholders, such as creditors.
Moreover, even in respect of claims brought by shareholders, the court ruled in Marex
that the reflective loss principle applied only to claims by them in their capacity as
shareholders – for a drop in the value of their shares or a diminution in the value of
their dividends. The principle did not apply to claims a shareholder might be really
bringing in some other capacity, say as a creditor, or indeed as a director, of the
company.
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Activity 11.7
A and B are the only shareholders and directors of X Ltd. When the company was
formed, A and B signed an agreement under which each promised the other to
perform the duties they owed the company under ss.171–177 of the Companies
Act 2006. They each have a director’s service contract, entitling them to be paid
£100,000 per year. A also lent the company £200,000. In addition, the company
borrowed £300,000 from Devonshire Bank plc. A and B gave personal guarantees to
Devonshire Bank to repay that loan if the company failed to do so.
In April 2021, B committed a number of serious breaches of her duties under the
Companies Act 2006. As a result, the company lost about £1 million and is now
insolvent. A and B’s shares are worthless. The company cannot pay A or B their
directors’ salaries and cannot repay the loans to A or to Devonshire Bank. The latter
is insisting that A and B personally repay the bank’s loan in accordance with their
personal guarantees.
Will the reflective loss principle prevent any of the following claims:
a. By A against B for the drop in value of her shares?
Summary
For a shareholder to bring a personal claim against a director, they must establish
both that the director owed them a duty personally and that the loss claimed for is
not reflective loss. However, the reflective loss principle does not prevent claims that
someone who happens to be a shareholder is bringing in some capacity other than
as a shareholder. Nor does the principle apply to actions against directors brought by
non-shareholders, such as by creditors.
This could also be true in relation to other wrongdoing within the company that might
not itself amount to a breach of directors’ duties. In Chapter 8 of this guide, addressing
breaches of the articles, we looked at the case of MacDougall v Gardiner (1875) 1 Ch
D 13. In that case, the chairman of a shareholders’ meeting failed to follow the rules
in the company’s articles for the adjournment of the meeting. MacDougall tried to
bring legal proceedings in respect of the chairman’s misconduct. The court, however,
declined to get involved. And to achieve that, the court ruled that the chairman’s
misconduct was a mere internal irregularity and so a wrong only to the company; it
was, therefore, up to the majority within the company to decide what, if anything, the
company would do about the wrong inflicted on it by the chairman.
Company law 11 Enforcing directors’ duties page 141
But why favour these things? We have touched on lots of relevant considerations
already. It reduces the number of cases reaching the courts. It stops the company’s
troubles being aired in public. Although shareholder meetings can sometimes
be fractious affairs, they are less confrontational than litigation, and might give
shareholders a better chance of continuing to work together once the dust has
settled. Judges feel directors or shareholders are probably better placed to decide
what happens in their own company than are judges. And majority rule seems more
democratic.
But the arguments do not all point one way. Minority shareholders can be oppressed
by the majority and sometimes need the court’s help. The derivative claim provides
one sort of help, although, as we have seen, not very effectively. The fact that
individual shareholders can enforce the company’s constitution also gives minorities
some protection, although, as we saw in Chapter 8, that help too is often rather
limited. In Chapter 12, we keep our focus on majority rule and minority protection, and
move on to look at a much more effective regime for protecting minorities.
Summary
When directors breach their duties, enforcement should be by the company itself. But
companies rarely choose to sue. Derivative claims are a mechanism for overcoming
that reluctance. The rules governing such claims are now found in Part 11 CA 2006 and,
central to these rules is the requirement for shareholders to get the court’s permission
to continue the claim, and the criteria the court will apply in deciding whether to
give it. Unfortunately, permission is more often refused than given and that adds to
the disincentives shareholders already face to step forward and take on the burden
of bringing a derivative claim. It would often be more rewarding to a shareholder to
bring a personal claim against the director but company law only allows such claims
very rarely.
Further reading
¢ Armour, J. ‘Derivative actions: a framework for decisions’ (2019) 135 Law
Quarterly Review 412.
¢ Boyle, A.J. ‘The new derivative action’ (1997) 18 Company Lawyer 256.
¢ CLSRG Developing the Framework, para 4.127; Completing the Structure, paras
5.86–5.87; Final Report, para 7.46.
¢ Lord Wedderburn ‘Shareholders’ rights and the rule in Foss v Harbottle’ (1957) CLJ
194 and (1958) CLJ 93.
¢ Riley, C.A. ‘Derivative claims and ratification: time to ditch some baggage’ (2014)
34 Legal Studies 582.
u The first part addressed the derivative claim. You need to explain what this is and
the rules governing such claims, in Part 11 CA 2006. You might note some of the
changes in the new statutory derivative claim, compared to the old common law
action, and how these now make bringing derivative claims easier.
u Address how the claimant must now get permission to continue the claim and
analyse the criteria (in s.263(2) and (3)) that the courts apply in deciding whether or
not to give such permission.
u Mention relevant case law, such as Iesini, Franbar, Kleanthous, Singh, Wishart, etc. to
show how the courts actually apply the statutory criteria – whether, for example,
the courts are interpreting them strictly, or more favourably, towards claimants.
u You should also discuss some of the practical problems undermining the
effectiveness of derivative claims – e.g. the ‘collective action’/‘free-riding’ problem,
the lack of an effective incentive for any individual shareholder to sue, issues over
costs, and so on.
u The second part asks whether the derivative claim should be replaced with
personal actions against directors for breach of their duties. Explain some of the
reasons for UK law’s restrictions on such personal actions – such as avoiding the
‘floodgates’ problem, preventing double liability and double recovery, a fairer
distribution of compensation and creditor protection.
u The third and final part asks whether, under UK company law, such actions are
‘impossible’. You need to explain the two hurdles the shareholder needs to get
over and how difficult it is to do so. Note relevant case law, including Johnson v Gore
Wood; Marex.
page 144 University of London
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.
If you ticked ‘need to revise first’, which sections of the chapter are you going to
revise?
Must Revision
revise done
Contents
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 146
12.1 Majority rule and the need for minority protection . . . . . . . . . . . 147
Introduction
In this chapter we turn to the protection of minority shareholders. We begin by
considering why minorities might need some protection, which takes us back to the
idea of majority rule. We will see that allowing a majority of shareholders to decide
what should be done often makes good sense within companies but it does carry risks
for the minority and these risks tend to be most severe in smaller companies. We will
remind ourselves of other areas of company law, already considered in this guide,
that offer a degree of help for minorities but acknowledge that these areas suffer
significant shortcomings and limitations.
That will set the stage to appreciate the far more effective protection afforded by
s.994, especially in ‘quasi-partnership’ companies where the courts are prepared to
identify, and give effect to, informal understandings between the shareholders about
how the company will operate. Finally, we will conclude by considering the alternative
statutory remedy of having the company wound up.
Learning outcomes
By the end of this chapter and the relevant readings, you should be able to:
u understand the benefits, and risks, of majority rule, especially in smaller
companies
u describe the scope of the unfair prejudice remedy
u describe the remedies available under the unfair prejudice provision
u explain the ‘just and equitable’ winding up remedy
u state the main grounds for a just and equitable winding up.
Core text
¢ Dignam and Lowry, Chapter 11 ‘Statutory shareholder remedies’.
Cases
¢ Ebrahimi v Westbourne Galleries Ltd [1973] AC 360
¢ Fulham Football Club (1987) Ltd v Richards [2011] EWCA Civ 855
Additional cases
¢ Re Yenidje Tobacco Co Ltd [1916] 2 Ch 426
¢ Re Home & Office Fire Extinguishers Ltd [2012] EWHC 917 (Ch)
As we suggested briefly at the end of Chapter 11, majority rule has many advantages. To
see these advantages more clearly, it is useful to have in mind what the alternatives to
majority rule might be.
u It looks a more efficient way of resolving disagreements. Meetings are usually quite
quick and cheap – much cheaper than protracted litigation.
u It keeps disputes within the company, avoiding harmful publicity and perhaps the
breakdown of relationships that litigating in front of a judge might create.
u It minimises judicial interference inside companies. Judges fear they are ill-
equipped to resolve business disagreements, which are better addressed by the
people who will have to live with the consequences of the decision – shareholders.
And judges fear a flood of litigation – with four million companies, and lots of
disagreements, judges would struggle to cope.
u It seems more democratic to allow the decision that has more support among
shareholders to prevail. Of course, those who buy more shares usually get more
votes but that too looks appropriate: those with most at stake in the decision
should arguably have more influence.
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However, while majority rule has many advantages, the losing minority that finds itself
outvoted ‘pays the price’ for these, as they see their opinions overridden and must
accept the wishes of the majority. Is this a problem?
In larger companies, arguably much less so. For one thing, in a larger company, with
many shareholders, today’s minority might be in tomorrow’s majority. Over time, a
shareholder might often get their way and being occasionally outvoted will seem
more acceptable. Moreover, if a shareholder starts to find themself too often in the
minority, or is outvoted on a matter that they feel very strongly about, then they may
have a good solution in their own hands. If the company is listed, they can easily sell
their shares and invest elsewhere.
In smaller companies, things can be very different. First, the minority shareholder is
often ‘entrenched’ – in a permanent minority. They are constantly outvoted and lose
out – without, arguably, ever reaping the benefits of majority rule. This is most clearly
the case in, say, a two-person company with a 49 per cent and 51 per cent shareholder.
Moreover, in smaller companies, a minority who finds themself always on the losing
side has no easy way to escape because there is no real ‘market’ for a minority’s shares.
The need for some minority protection against the operation of majority rule is
therefore greatest in smaller companies. In this chapter, we are focusing on the
statutory provision – in s.994 CA 2006 – which now provides the most effective
protection for minorities. However, before doing so, spend a few minutes thinking
about the following activity.
Activity 12.1
What other areas of company law, studied in earlier chapters, provide some
protection for minority shareholders?
A member of a company may apply to the court by petition for an order… on the ground
that the company’s 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.
u the conduct he is complaining about concerns ‘the way the company’s affairs are
being conducted’, or is ‘an act or omission of the company’
u it does so ‘unfairly’
In fact, however, the courts have adopted a flexible and expansive approach towards
this first element. So, while decisions taken by shareholders at general meetings, and
by directors at board meetings, will clearly fall within the definition, actions by them
outside of those ‘organs’ of the company can also count if those actions involve the
conduct of the company’s affairs: Oak Investment Partners XII v Boughtwood [2010] 2
BCLC 459.
One area of shareholder behaviour that has, perhaps surprisingly, been found not to
involve the conduct of the company’s affairs concerns a shareholder’s non-compliance
with a pre-emption agreement. In Graham v Every [2014] EWCA Civ 191, the court held
that failure to comply with a pre-emption obligation might affect the ownership, and
the rights, of shareholders but had nothing to do with the running of the company.
‘Prejudices’
This means, essentially, that the conduct being complained about harms the
petitioner’s interests. Whether there is harm is tested ‘objectively’: Re Saul D Harrison
and Sons plc [1995] 1BCLC 14. So, the mere fact that the petitioner feels harmed will not
suffice, if there is no real damage to their interests. But equally, the petitioner does
not need to show that others were deliberately intending to harm them, or were
motivated by bad faith. The harm that is suffered will often be financial but it need not
be. Being excluded from management, for example, may have no adverse financial
consequences for the petitioner but can still be harmful.
‘Interests’
Perhaps the most important aspect of the s.994 wording concerns the meaning of
‘interests’. What interests does a shareholder have in the company? Identifying these
allows us to say what harmful behaviour a shareholder can object to.
However, the courts have deliberately given the term ‘interests’ a wider scope,
going beyond the shareholder’s legal rights, at least in companies that have come
to be called ‘quasi-partnerships’. In Ebrahimi v Westbourne Galleries, Lord Wilberforce
identified the defining features of such a company:
(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.
page 150 University of London
Interests in a quasi-partnership
The courts have used a variety of different labels to describe the source of the
additional interests, beyond their strict legal rights, which shareholders might enjoy in
a quasi-partnership. So, they have referred to ‘legitimate expectations’, to ‘equitable
considerations’ or ‘equitable constraints’, and so on. But what seems most important
is the shareholders’ own shared understandings or informal agreements about how
the company will be run and the role the shareholders will be able to play within it.
The facts of O’Neill 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 Phillips (P). O’Neill (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 company’s 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 company’s business and would then receive 50 per cent of the profits.
In December 1985 P retired from the board and O became sole director and effectively
the company’s 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 O’s
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 P’s 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 O’s remuneration. P’s 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 P’s decision to revise O’s profit-sharing arrangement considered to be unfair
conduct. O’s entitlement to 50 per cent of the company’s 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.
This emphasis on respecting the parties’ own agreements seems also to be evident
in the case of Fulham Football Club (1987) Ltd v Richards [2011] EWCA Civ 855, where the
court upheld a provision in the company’s articles that obliged a member to refer
disputes to arbitration rather than seeking relief under s.994.
Re Ghyll Beck Driving Range Ltd [1993] BCLC 1126 is an excellent example of a court taking
account of informal understandings. 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 company’s 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
petitioner’s shares on the basis that the affairs of the company had been conducted in
a manner unfairly prejudicial to his interests.
Although the petitioner must be a shareholder in order to bring the action, the
conduct that forms the basis of their complaint need not affect them in their capacity
as a member. For example, exclusion from the management of the company, which is
conduct affecting the petitioner qua director, will suffice.
u 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; Brownlow v GH
Marshall Ltd [2001] BCC 152; Phoenix Office Supplies Ltd v Larvin [2002] EWCA Civ 1740).
u 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).
u 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; Re Tobian Properties Ltd [2012] EWCA Civ 998; Re CF Booth Ltd
[2017] EWHC 457 (Ch)).
u 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).
u 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.
A no-fault divorce?
One point that is implicit in the above is that a petitioner has to prove ‘fault’– in the
sense described above – to succeed under s.994. They must show that their rights have
been infringed, or that the understandings between the shareholders have not been
followed. But the mere fact that the shareholders’ relationship has broken down, and
that they can no longer co-operate together to run the company, does not entitle
the petitioner to relief if they cannot show this is a result of fault in the sense just
described. Lord Hoffmann, in O’Neill, observed that s.994 does not entitle a petitioner
to a no-fault divorce – to be bought out merely because of a faultless breakdown
of relationship. By contrast, such a breakdown might, if sufficiently serious, justify a
winding up order (under s.122(1)(g) Insolvency Act 1986); see Hawkes v Cuddy (No.2)
[2009] EWCA Civ 291.
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12.2.3 Unfairness
Not only must the conduct prejudice (harm) the petitioner’s interests but it must do
so ‘unfairly’. Does this add anything to what we have already said? Often, it will not.
Unfairness will naturally follow from the fact that the company is being run in a way
that goes against the shareholders’ own agreements (perhaps informal) and thereby
harms the petitioner. In this sense, the requirement of fairness has already been built
into the definition of what interests a shareholder can legitimately assert.
u If the petitioner has brought the prejudicial behaviour on themself, by their own
unreasonable conduct. A good example of this is where a petitioner is removed
from the board, in breach of a shared understanding that they would be entitled
to remain a director of the company so long as they owned shares. However, the
removal is a result of the petitioner’s own unreasonable/disruptive behaviour at
board meetings. Although the petitioner’s interests have been harmed, it is not
unfair. For examples of this, see Re RA Noble & Sons (Clothing) Ltd [1983] BCLC 273 and
Waldron v Waldron [2019] EWHC 46 (Ch).
u If the petitioner has been made a reasonable offer for his shares and has
unreasonably refused that offer (see O’Neill v Phillips).
Summary
In Re Saul D Harrison and O’Neill 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 8 of this guide). The House of Lords stressed that the remedy
did not confer on the petitioner a unilateral right to withdraw their 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 12.2
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?
12.2.4 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.
Without prejudice to the generality of subsection (1), the court’s order may:
(d) require the company not to make any, or specified, alterations in its
articles without the leave of the court;
(e) 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 company’s capital
accordingly.
Note the width of the court’s powers under s.996(1) (compare the winding up remedy,
below). The most common remedy sought is the 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. Two important points stand out. First,
the shares must usually be valued by an ‘independent valuer’ (O’Neill v Phillips). The
auditors would usually not be considered independent.
The second point concerns whether the valuation should be ‘pro rata’ or ‘discounted’.
Re Bird Precision Bellows Ltd [1984] Ch 419 reviewed this issue. It was stressed that the
overriding objective was to achieve a fair price and that normally no discount would
be applied. Thus, a 49 per cent shareholding in the company will be valued pro rata,
being worth 49 per cent of whatever the company as a whole is worth. This (generous)
approach was justified on the grounds that the petitioner is an unwilling vendor of
what is, in effect, a partnership share.
One issue that has generated a considerable amount of case law is whether this
presumption in favour of a pro rata valuation should apply to all companies or only to
those companies that are quasi-partnerships. In Irvine v Irvine [2006] EWHC 1875 (Ch),
the High Court had suggested that this pro rata principle would apply only in a quasi-
partnership. In Re Blue Index Ltd [2014] EWHC 2680 (Ch), on the other hand, the court
felt that restricting the pro rata approach to quasi-partnerships was inappropriate
and declared that the pro rata principle would apply in all companies. However, in
Estera Trust (Jersey) Ltd v Singh [2018] EWHC 1715 (Ch), the court suggested, again, that
the pro rata presumption applied only to quasi-partnerships. The law on this point,
then, remains rather uncertain. Even where the pro rata presumption does apply, it
is rebuttable if there are good reasons for applying a discount. If, for example, the
minority shareholder acquired their shares by way of an investment then a discount
may, in the circumstances, be fair so as to reflect the fact that the petitioner has little
control over the company’s management (see the speech of Lord Hoffmann in O’Neill v
Phillips; see also, Profinance Trust SA v Gladstone [2002] 1 BCLC 141, CA).
See also Richardson v Blackmore [2006] BCC 276; Re OC (Transport) Services Ltd [1984]
BCLC 251; Ng v Crabtree [2011] EWHC 1834 (Ch); Re Home & Office Fire Extinguishers Ltd
[2012] EWHC 917 (Ch) and Harborne Road Nominees Ltd v Karvaski [2011] EWHC 2214 (Ch).
Given the range of remedies available under the unfair prejudice provision (see
above) 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 that 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 N’s 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 company’s management was clearly
in breach of that understanding. It was therefore just and equitable to wind up the
company.
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 petitioner’s own misconduct led to the
breakdown in relations relief will be denied.
The following are illustrations of the grounds which will support a petition under
s.122(1)(g).
2. 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).
3. 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). However, in Re Paramount Powders (UK) Ltd [2019] EWCA Civ 1644, the court
held that a petitioner had no automatic right to have a company wound up merely
because there had been a breakdown in mutual trust and confidence between the
Company law 12 Statutory minority protection page 155
members. The court might refuse a winding up in such a case if, for example, the
petitioner were responsible for that breakdown.
Activity 12.3
Read Virdi v Abbey Leisure Ltd [1990] BCC 60.
Why was winding up under s.122(1)(g) IA 1986 considered to be an appropriate
remedy?
Further reading
¢ Boyle, A.J. ‘O’Neill v Phillips: unfair prejudice in the House of Lords’ (2000) 21
Company Lawyer 253–54.
¢ Prentice, D.D. ‘The theory of the firm: minority shareholder oppression: sections
459–461 of the Companies Act 1985’ (1988) OJLS 55.
¢ Reisberg, A. ‘Indemnity costs orders under s.459 petitions’ (2004) Comp Law 116.
¢ Riley, C. ‘Contracting out of company law: s.459 of the Companies Act 1985 and
the role of the courts’ (1992) MLR 782.
page 156 University of London
Until 2022 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 2022 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 Colin’s 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.
Company law 12 Statutory minority protection page 157
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 Wilberforce’s speech in Ebrahimi v Westbourne Galleries Ltd, Lord Hoffmann’s
speech in O’Neill 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 Colin’s
shares (Re Bird Precision Bellows Ltd and O’Neill v Phillips).
page 158 University of London
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.
If you ticked ‘need to revise first’, which sections of the chapter are you going to
revise?
Must Revision
revise done
Contents
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 160
Introduction
We began this module by noting that a company has its own legal personality,
allowing it to act in the real world. We know that the company can enter into
contracts and presumably commit torts and criminal offences too. But if a company is
a fictitious thing, how do we decide when ‘it’ has made a contract, or committed a tort
or a crime?
This is usually referred to as the issue of ‘attribution’ – how to attribute the actions of
natural persons who surround the company (its employees, directors, shareholders)
to the company itself, so that their actions, or even their mental states, become those
of the company.
Knowing how company law deals with this attribution issue enables us to understand
when a company will be liable to an outsider – to someone who alleges that they have
contracted with the company, or that the company has tortiously injured them, or
that the company has committed a criminal offence. It concerns what we might call
the ‘external’ position of the company. But, as we shall see, the external liability of the
company can also have ‘internal’ consequences. Directors, for example, may act in a
way that makes the company liable (externally) to a third party but, in doing so, may
also breach the duties they owe (internally) within the company.
Our focus in this chapter will be mainly on contractual liabilities, where we examine
two problems that arise in deciding whether a company should be bound by a
contract that someone has purported to make on its behalf. The first arises if a
company has chosen to limit the objects it can pursue (which in turn limits the
contracts it has the capacity to make). This first problem is now comparatively rare.
The second problem remains much more significant and concerns who has authority
to make a company enter into a contract.
Having addressed contractual liabilities, we turn briefly at the end of the chapter to
consider the attribution of tortious and criminal liability to companies.
Learning outcomes
By the end of this chapter and the relevant readings, you should be able to:
u explain the objects clause problem and how company law has addressed it
u explain the authority problem, with reference to ‘constitutional limitations’ on
directors’ authority and how company law has addressed it
u explain why attribution in other areas was and is similarly problematic.
Core text
¢ Dignam and Lowry, Chapter 12 ‘The constitution of the company: dealing with
outsiders’.
Cases
¢ Royal British Bank v Turquand [1856] 6 E & B 327
Additional cases
¢ Re German Date Coffee Co [1882] 20 Ch D 169
¢ McNicholas Construction Co Ltd v Customs and Excise Commissioners (2000) STC 553
Why company law chose to require companies to declare, and then stick to, their
objects was unclear. Perhaps it was intended to protect the company’s shareholders,
who might want to ensure the company used their money only for the stated business
(for example, investors who were happy to fund a railway but not, say, a casino).
Perhaps the rule also reflected older ideas that operating as a company was a privilege
granted by the state but a privilege to be given only for a limited activity.
It has, however, taken legislation to address the problem fully. The most far-reaching
change was made in s.31 of CA 2006. This now provides that:
Unless a company’s articles specifically restrict the objects of the company, its objects are
unrestricted.
Thus, the ‘default rule’ is now that a company has unrestricted objects and can
therefore pursue any (lawful) activity it wishes. If a company’s constitution says
nothing about its objects, then they are assumed to be unrestricted. If a company
wishes to restrict its objects, it must do so expressly, by including a restriction (‘this
company’s objects are only as follows …’) in its constitution. Almost all companies
formed under CA 2006 (i.e. since October 2009) will have chosen not to restrict
expressly the company’s objects, and they will therefore avoid the complications that
arise by having an objects clause.
However, a few companies may still have objects clauses, for one of two reasons:
u First, some companies may still want to restrict their objects, as s.31 permits
them to do. The companies most likely to want to do so are perhaps those that
are formed not to make a profit but instead to pursue some social (and perhaps
charitable) purpose. Such a company may want expressly to restrict its objects
to that purpose and have deliberately chosen to include an objects clause in its
constitution to achieve that.
u The second reason is a historical hangover. All companies formed under earlier
Companies Acts (i.e. before October 2009) did have objects clauses in their
constitutions because they had to do so. These older companies can, if they want,
now remove those clauses and most have probably done so. But a few may have
chosen not to do so or, perhaps more likely, may have overlooked the possibility
of doing so. For such companies, their old objects clause now acts as an ‘express
restriction’ on the company’s activities, for the purpose of s.31.
page 162 University of London
In 2015, Alice set up the company MeatFreeTreats Ltd, to make and sell vegetarian
products. The company’s constitution contains a provision, Reg.54, which expressly
limits the company’s objects to buying, making and selling vegetarian products. Alice
has now semi-retired but still owns 30 per cent of the company’s shares and remains a
director. The company has two more directors, both Alice’s children. Her children are
keen to expand the company’s activities and do not really share Alice’s commitment
to vegetarianism. They have recently placed an order, on behalf of the company, to buy
from Sandy a large quantity of meat-based products and have told Sandy that, if these
products sell well, more orders will follow.
External consequences
This refers to the relationship between the company and the third parties with whom
it contracts – with Sandy, in our scenario. At common law, the contract with Sandy
would, because of the company’s restricted objects, have been treated as beyond the
company’s capacity and so ultra vires. As such, the contract would have been void and
unenforceable by either party. Now, however, s.39 CA 2006 treats the contract as valid,
and enforceable, by both parties. Section 39(1) says, bluntly, that:
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 company’s constitution.
The ‘act done’ here is entering into the contract with Sandy and so the validity of that
contract cannot be challenged based on the company’s lack of capacity because of the
objects clause in its articles. Effectively, s.39 abolishes the external consequences of
having a restriction on the company’s objects.
Internal consequences
This refers to the position of shareholders, and of directors, within the company.
Turning now to the position of the directors, remember that the duty in s.171 CA
2006 has two parts, with part (a) requiring directors to ‘act in accordance with
the company’s constitution’. The directors have breached this duty, by making the
company enter into a contract that is outside the company’s objects clause in Reg.54.
However, remember that this duty (like all others) is owed to the company itself. The
breach must be enforced by the company (a ‘corporate action’: see Chapter 11 of this
guide). If the board will not sue, then Alice might consider bringing a derivative claim,
but is probably unlikely to get permission to continue this.
Company law 13 Dealing with outsiders page 163
Summary
For most companies, the ‘objects clause’ problem no longer exists because they
choose not to have an objects clause. Even for the few companies that do retain an
objects clause, s.39 means this clause has, effectively, no external consequences:
contracts that are beyond the company’s objects remain valid. But, internally,
shareholders can enforce the clause to stop future breaches of it by their company,
and directors who make their company act beyond the objects clause breach s.171(a)
CA 2006 (for which their company could, but probably rarely will, sue them).
Activity 13.1
Is there any point in someone like Alice bothering to include an objects clause
in her company’s constitution to reflect the activities she wants her company to
pursue?
Actual authority
Actual authority may either have been expressly conferred on the agent or may be
implied because of the position the agent occupies.
In most companies, the company’s constitution will expressly confer on the board
as a whole the most extensive authority to act on behalf of the company. We saw,
in Chapter 8 of this guide, how Reg.3 of the model articles does just that. The board
may in turn expressly delegate much of the authority that it enjoys further down the
company to individual executive directors. Board minutes would often record these
express delegations. Other employees, below the level of director, may likewise have
(typically more limited) authority expressly delegated to them.
Even where someone has not been expressly given authority, however, they may still
enjoy some implied authority. This is the authority that usually goes with the position
a person occupies. Take, for example, someone acting as the company’s managing
director or, as they are often now called, chief executive. If, for some reason, there
had been no express delegation of authority to that person, still they would enjoy
very extensive implied authority to act for the company because of the position they
occupy. Other executive directors – the human resources director, the finance director,
and so on – will also enjoy substantial authority relevant to their executive positions.
So too for employees below them. A ‘catering manager’ might, by accident or perhaps
even intentionally, not have been given any express authority to purchase foodstuffs,
yet it is implicit in their position that they are empowered to do so.
For a case examining the implied authority that was enjoyed by someone in their roles as
chairman and as managing director, see Hely-Hutchinson v Brayhead Ltd [1967] 3 All ER 98.
page 164 University of London
Apparent authority
Someone who lacks actual authority (whether express, or implied) may nevertheless
enjoy apparent (or, as it is sometimes also called, ostensible) authority. Apparent
authority arises where someone is represented (to a person who reasonably relies
on the representation) as having authority. The representation must be made by
someone who does have authority. So, if I do not have actual authority to act as your
agent, I cannot give myself that authority simply by representing, to a third party, that
I have your authority. You, or someone actually authorised by you, must make the
representation. (See Freeman & Lockyer v Buckhurst Park Properties Ltd [1964] 2 QB 480;
MCI WorldCom International Inc v Primus Telecommunications Inc [2004] 1 BCLC 42.)
We now turn, however, to a particular issue: it arises where rules found in the
company’s constitution expressly limit the authority that person would usually
be assumed to have. An example would be if there were a provision in a company’s
constitution stating that ‘any loan over £50,000 must be approved by shareholders’.
Usually, a third party could rightly assume the board has full authority to make loans.
But the clause in the example imposes a (constitutional) limit on the authority of
the company’s directors. If the directors of the company purported to enter into a
loan agreement with Anybank plc to borrow £100,000, without having the contract
approved by shareholders, then they would seem to lack the authority to do so.
Clearly, the board does not have express authority because, whatever authority has
been delegated, it expressly does not include the power to borrow over £50,000
without shareholder approval. The company might also argue that the board does
not have implied authority either. Although a board, given its position, would usually
enjoy implied authority to enter into any loan, the provision in the constitution seeks
to exclude that usual implied authority a board might have. Now, of course, the third
party might argue it was unaware of the provision in the constitution and so should be
unaffected by it. But by a doctrine known as ‘constructive notice’, those dealing with
a company were treated as knowing the terms of the company’s constitution (which
was a publicly available document) and so deemed to be aware of the limit on the
board’s authority.
To see how company law has dealt with this distinctly company law problem of
constitutional limits on directors’ authority, we will again distinguish between the
‘external’ and the ‘internal’ consequences of such constitutional provisions. Essentially,
we will see the same approach as that mentioned in relation to the objects clause
problem above. The law wants to protect the third party dealing with the company,
and so (almost) abolishes the external effects of these constitutional limitations on
the directors’ authority. But the law retains the internal effects of these constitutional
provisions, in terms of shareholders’ ability to enforce the articles and the duty of
directors to observe the terms of the constitution.
to the way we used it earlier, in Chapters 10 and 11 of this guide. Earlier, we used it to
mean ‘excuse’ a director’s breach of duty. Now, we mean to ‘validate’ a contract that
would otherwise be unauthorised.)
Suppose, however, that the company wishes not to perform the unauthorised
contract. Is there any reason not to apply the usual external consequence – that the
company is not bound by an unauthorised contract – where the lack of authority
arises, specifically, because of a constitutional limit on the authority of the person
who acted for the company? Allowing the company to walk away from the contract
in this situation can seem very harsh on the third party. Take again the example given
above, where the company’s articles require loans over £50,000 to be approved
by shareholders. The third party – Anybank plc – likely assumed the board had the
usual (extensive) implied authority enjoyed by boards. Surely it is unreasonable and
impractical to expect the third party to read the articles in the first place. Even if it had
done so, how was it to know that the shareholders had not in fact approved the loan?
In Royal British Bank v Turquand (1856) 6 E & B 327 Exch Ch, company law made a partial
attempt to soften this harshness. Essentially, it was held that third parties were
entitled to assume that ‘internal procedures’ (such as the obtaining of shareholder
approval, in our example) had been followed. The third party did not need to enquire
into the ‘internal management’ of the company. This has become known as the indoor
management rule.
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 company’s constitution.
Effectively, then, third parties are entitled to assume that the board has full authority
to bind the company, regardless of any constitutional limitations that there might
actually be on the board’s authority. Third parties do not need to go to the trouble
of reading the articles to discover if there are constitutional limits on the board’s
authority, since they will be unaffected by them.
Note that, to be able to rely on s.40(1), the third party must be dealing with the
company ‘in good faith’. Yet this condition will usually be satisfied by the third party,
since s.40(2)(b) says that a person dealing with a company ‘is presumed to have acted
in good faith unless the contrary is proved’ and, moreover, ‘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 company’s constitution’.
So, even if a third party has read the constitution and realises that it deprives the
directors of authority, the third party is still not to be regarded as acting in bad faith
and can therefore still rely on the protection given by s.40.
Activity 13.2
Section 40(1) operates only ‘in favour of a third party’. It cannot be relied on by the
company itself. Why do you think that it is so ‘one-sided’, protecting only the third
party from the external consequences of an unauthorised transaction?
Where the third party is a director of the company (or is ‘connected’ with a director)
then the protection afforded to that third party by s.40 is reduced. Section 40
still applies, to allow the third party to ignore the constitutional limitation on the
directors’ authority but s.41 adds that the contract will still, nevertheless, be voidable
at the instance of the company. So, the director dealing with their company is still
entitled, under s.40, to treat the directors as having unlimited authority and the
contract as therefore valid but the company could nevertheless choose to avoid the
contract. However, if it either fails to do so, or loses the right to do so (remember, the
right to avoid a voidable contract can be lost in some situations) then the director will
benefit from s.40.
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Activity 13.3
Choristers Ltd has model articles, with an additional Reg.54 that says that any
contract over £50,000 must be approved by the directors unanimously. The
company has five directors, including Abeke and Bolade. Recently, Abeke entered
into two contracts with Choristers. The first was to sell some land to the company,
for £60,000. The second was to sell some vehicles to the company for £30,000.
Bolade voted against Choristers entering into each of these contracts but was
outvoted both times.
The board now regrets having made these contracts with Abeke. Is the company
bound?
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.
Turning now to the directors, they must, under s.171(a), act in accordance with
the company’s constitution. If they exceed some constitutional limitation on their
authority, they breach that duty. Section 40(5) notes that directors remain liable for
any such breach, notwithstanding s.40:
This section does not affect any liability incurred by the directors, or any other person, by
reason of the directors’ exceeding their powers.
However, as we also noted before, the duty is owed to the company, so enforcement
action would have to be taken by the company itself, which is unlikely to happen. A
shareholder might perhaps try to enforce the breach through a derivative claim but
gaining permission would probably be difficult. (Often, the company would not have
suffered any obvious loss as a result of the directors’ failure to act in accordance with
the constitution. Given that, the proceedings would likely produce little money for the
company, making a ‘hypothetical director’ unlikely to continue the claim.)
Activity 13.4
Ateef has agreed to buy a 10 per cent shareholding in Traderco Ltd. It is also agreed
she can become a director. However, she knows she will be in a minority at board
meetings and at risk of being outvoted. She is trying to negotiate some additional
protection, therefore. The other shareholders have agreed that the constitution can
be changed to include a term saying that ‘Ateef shall be entitled to veto, at a board
meeting, any transaction for a value exceeding £80,000’.
Explain to her how effectively this will enable her to prevent the company making
large transactions without her approval.
Summary
In principle, companies should only be bound by contracts made for them by those
with authority. Agency law already provides well-developed rules to work out what
Company law 13 Dealing with outsiders page 167
authority agents have, including the implied authority that a third party is entitled to
assume the agent enjoys. In the company context, the main area of difficulty arises
where, tucked away in a company’s constitution, some provision limits the implied
authority that agency law would confer on those directors. If third parties were
caught out by such provisions, it would seem unfair to them and disruptive of normal
commercial relations. Company law has intervened to protect third parties, through
s.40. But constitutional limits on authority still matter ‘internally’: shareholders can
prevent future breaches of them, and directors who ignore them could, in theory at
least, be sued.
The courts originally had some difficulty in dealing with claims alleging torts by
companies. At first, the courts considered that a tort must be ultra vires, for 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, provided they 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.
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 †
Respondeat superior (Latin) –
liable because his action is the very action of the company itself. ‘the superior is responsible’.
This is the doctrine that an
As a result, if one individual can be identified who can be said to be essentially the
employer is responsible for
company’s alter ego and that individual has the required fault, then the fault of that
things done by his or her
individual will be attributed to the company. The attribution of responsibility here is employees as part of their
very different than through vicarious liability in tort, where the company is responsible employment.
for the actions of another. The individual’s 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
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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 company’s
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.
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 company’s action.
Activity 13.5
Read Lord Hoffmann’s 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 court’s 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.
Further reading
¢ Davies and Worthington, Chapter 7 ‘Corporate actions’.
¢ Ferran, E. ‘The reform of the law on corporate capacity and directors’ and
officers’ authority’, Parts 1 and 2 (1992) Company Lawyer 124 and 177.
¢ Poole, J. ‘Abolition of the ultra vires doctrine and agency problems’ (1991) Company
Lawyer 43.
¢ Sullivan, B. ‘Corporate killing – some government proposals’ (2001) Crim L Rev 31.
b. All the directors, apart from Mark, want Realales to buy ‘a wine and cocktail
bar’, which has recently been advertised for sale, for £200,000. Mark is
objecting, saying the acquisition would infringe the company’s basic purpose,
which he believes is to run traditional pubs selling real ale.
c. Last month, Beatrice proposed the company buy a pub in London for
£700,000, from Yvonne. The other directors backed Beatrice and voted for the
acquisition. Mark objected, and told them he was exercising his veto. Despite
Mark’s objection, contracts were exchanged last week to purchase the pub.
The transaction is due to be completed in two weeks. Yvonne knew that Mark
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had vetoed the purchase. Mark has told Beatrice that he will enforce his right
to stop the purchase and will be suing the directors too.
Advise Beatrice.
Explain how your answer to part (c) might differ in these alternative situations:
i. If Yvonne were Beatrice’s mother OR
ii. If Yvonne were now offered a higher price for the pub by Mr Gazumper and
decided she did not wish to complete the sale to Realales.
Company law 13 Dealing with outsiders page 171
b. Realales was formed in 2010. It was not required to have an objects clause. It could
have chosen to include, in its articles, a restriction on its objects. But we are told
the company has model articles. The model articles do not contain any express
restriction on a company’s objects. Realales, then, has unrestricted objects, by
default, under s.31. The proposal to buy the wine and cocktail bar may, as Mark
suggests, go against his view of what the company’s purpose and ethos is but it
does not conflict with any provision in the articles. Mark cannot use s.33 to stop
the purchase on these grounds then. Because the purchase will not infringe the
articles, the directors will not breach s.171(a) if they make the company purchase
the wine and cocktail bar.
c. The first point to make here is that the board lacked authority to purchase the pub,
given Mark’s exercise of his veto. Building on that, you then need to work out the
external and internal consequences.
Externally, although the transaction was unauthorised, s.40 allows the third party,
Yvonne, to ignore the lack of authority, provided she was acting in good faith.
Note the presumption of good faith and consider if Yvonne’s knowledge that Mark
vetoed the purchase prevents her having good faith.
What can Mark do? Explain s.33, allowing him to enforce his veto in Reg.54 but
note s.40(4) that ‘no such proceedings [to enforce the articles] lie in respect of
an act to be done in fulfilment of a legal obligation arising from a previous act of
the company’ (s.40(4)). So, he cannot use s.33 to stop Realales completing the
purchase of Yvonne’s pub if completing the purchase is fulfilling a legal obligation
that the company already has.
Have the directors (Mark aside) breached their duties? Which one? Who must sue
them – can Mark sue them himself if the company will not?
i. If Yvonne were Beatrice’s mother, then the transaction would be with a person
connected to a director. Yvonne still has the protection of s.40 but the contract is
nevertheless voidable. It seems that Realales’ board would not want to exercise the
company’s right to avoid the contract. But could Mark now force them to do so?
The point is not certain but, if he tries to enforce the articles, we probably cannot
say the company already has a ‘legal obligation’ to complete the purchase – and so
Mark is probably then not stopped from using s.33 to enforce Reg.54.
ii. If Yvonne tries to back out, Realales cannot rely on s.40 CA 2006. Usually, this
would not be a problem; Realales could simply ratify the contract with Yvonne. But
remember, it must be ratified by whoever would have had authority initially. So, as
was necessary first time around, it needs a board decision that Mark does not veto.
But since Mark is still opposed, ratification by Realales looks unlikely. If Yvonne
refuses to complete the purchase, Realales may be unable to stop her.
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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.
If you ticked ‘need to revise first’, which sections of the chapter are you going to
revise?
Must Revision
revise done
Contents
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 174
Introduction
This chapter examines a number of issues that are most relevant to larger, public
companies – especially those whose shares are ‘listed’ on the London Stock Exchange.
The issues we shall look at are often discussed under the label of ‘corporate
governance’. Because these larger companies are usually powerful institutions,
employing thousands of workers and dominating the communities in which they
operate, these governance issues are very important, economically and socially. They
can make a real difference to how successful a country’s economy will be and to the
quality of life its citizens will enjoy.
This chapter provides an introduction to, and an overview of, the governance issues
it addresses but, as with other areas of this module, you will need to undertake
further reading to build up a good knowledge and understanding of this area. Bear
in mind too that most of the law we are looking at here should not be new to you.
Large, listed companies are not subject to an entirely different company law regime.
So, this chapter builds on your earlier study of company law and you can use a lot of
your existing knowledge of company law when thinking about, and writing about,
corporate governance. But large, listed, companies do throw up some distinctive
issues and it is these that this chapter examines.
Learning outcomes
By the end of this chapter and the relevant readings, you should be able to:
u discuss the governance issues that larger companies raise
u explain some of the governance mechanisms that have been used to increase
shareholder protection in larger companies
u describe different theories about the nature of the company and their relevance
to the debate about the interests companies should serve
u form your own view of what the main purpose of a company should be.
Core text
¢ Dignam and Lowry, Chapter 15 ‘Corporate governance 1: corporate governance
and corporate theory’ and Chapter 16 ‘Corporate governance 2: the UK corporate
governance debate’.
Company law 14 Corporate governance page 175
Berle and Means’ research focused on the USA but the ownership of UK-listed
companies is seen as having followed a similar pattern, albeit somewhat later than
occurred in the USA. However, note that the development of large companies with
dispersed ownership and a separation of ownership from control has not been
universal. In much of the rest of the world, a class of professional managers running
large companies did develop but this was not accompanied by dispersed ownership.
Rather, founding families, other companies and banks tended to retain, or build up,
controlling stakes in large companies. Thus, outside the UK and the USA, the issue
we shall examine next about accountability to shareholders has not always driven
the debate about corporate governance in the same way. Differences in corporate
governance systems around the world have also become a major and fascinating area
of study (see, for example, Coffee (2001)).
Returning to the UK, why does the separation of ownership and control matter? The
main concern has been that it reduces the accountability of companies’ managers
(their executives) to shareholders. This concern tends to assume that companies
should be run in the interests of shareholders but that this is less likely to happen
if shareholders no longer exercise control over the company. Instead, managers
will probably put their own interests first. They will tend to shirk, get away with
incompetence or line their own pockets at the expense of their shareholders. Such
managerial misbehaviour is usually analysed in terms of the ‘agency costs’ that
managers impose on dispersed, passive shareholders.
Many of the areas of company law that we have looked at already in this module are
equally applicable to large public companies, of course, and some of these already
try to ensure that managers are accountable to shareholders. The most obvious
example, perhaps, are the legal duties imposed on directors. Yet, as we have seen,
those duties are not always as effective as one might hope, not least because of
problems in enforcing them. Boards tend to be reluctant to make their companies sue
and, although derivative claims are meant to provide a way around this problem, they
remain relatively underused in the UK, especially in relation to larger companies.
One important question that arises when mechanisms of the types just described
are being developed is whether they should be made compulsory for all companies,
or whether each company should have a degree of choice in how far it adopts these
mechanisms and how it applies each mechanism to that company’s particular and
distinct circumstances. A second question is whether legal rules should be developed
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in relation to these mechanisms, or whether what is sometimes called ‘soft law’ – such
as codes of practice – should be used instead. The two questions are interconnected in
that, typically, soft law tends to be less compulsory or ‘mandatory’ to preserve greater
choice and flexibility for companies. As we shall see, the governance rules that have
been developed in relation to the three mechanisms we are addressing in Section 14.2
do rely heavily on soft law but are interwoven with some mandatory legal provisions.
We can now turn to the second observation emerging from Berle and Means’ study
of the largest public companies. This switched attention away from the internal
relationship between managers and their dispersed shareholders, and towards the
external relationship between large companies and society as a whole. As companies
have grown larger, they have also become more powerful in their dealings with non-
shareholders – their employees, consumers, suppliers, the local communities in which
they operate, the environment on which our future existence depends and so on.
For the very largest companies, operating multinationally, their power might rival or
even exceed that of some of the states in which they carry out business. This second
observation about large companies has led to a rather different debate about good
corporate governance. Rather than emphasising the need to improve accountability
to shareholders, it questions whether shareholders ought to enjoy the priority that
company law has traditionally given them and whether more needs to be done to
increase the recognition of the interests of a company’s so-called ‘stakeholders’. We
return to these questions in Section 14.3.
The second issue is how to ensure that a company’s executive remuneration packages
are well designed to reward good performance (however that is defined). After all,
if executives are in control of the company, will they not use that control to award
themselves pay packages that excessively reward even poor performance? Efforts here
have focused on three different mechanisms:
u Create more independence in the way the board decides the pay of executive
directors. In particular, boards should delegate decisions on executive pay to
a sub-committee – a ‘remuneration committee’ – composed of independent
‘non-executive directors’. We look further at this idea in Section 14.2.2, as it forms
Company law 14 Corporate governance page 177
part of the larger task of re-engineering boards of directors. As we shall see there,
encouraging companies to develop these ‘remuneration committees’ has largely
been left to soft law, in the form of the UK Corporate Governance Code.
u Increase the amount of information shareholders get about how much executives
are being paid. We have noted this already (in Chapter 8), seeing how quoted
companies must give their shareholders ‘remuneration reports’.
u Give shareholders more ‘say on pay’. Remuneration reports must now be voted on
by shareholders and, since 2013, the shareholders’ vote has been binding (as to the
company’s remuneration policy). The extent to which shareholders make use of
this ‘say on pay’ remains unclear. Some have argued that other stakeholder groups
– and especially a company’s employees – should be given more involvement in
the remuneration machinery, perhaps by having representatives on companies’
remuneration committees. One aspect of the UK Government’s 2016 ‘Corporate
governance reform’ to review corporate governance arrangements in the UK
concerned executive remuneration. The Government was urged by some to
elevate the involvement of employees in setting executive remuneration but it
chose not to do so. Instead, it enacted the Companies (Miscellaneous Reporting)
Regulations 2018, which required quoted companies to reveal the ratio between
the pay of their CEO and the average pay of the company’s UK workforce.
You can read more about the arguments around executive pay (from a critical
perspective).
In terms of board membership, the key idea has been to increase the number of
so-called non-executive directors on company boards. As their name suggests, non-
executives do not manage the company. Instead, they are part-time appointments and
bear the main responsibility for monitoring the executive directors. A key question
then is how we can ensure that NEDs will carry out this monitoring role effectively.
That seems to be partly about ensuring that the right people are chosen to be NEDs
in the first place and that those people then have good incentives to take their work
seriously. We come back to these points below.
Activity 14.1
Would you make a good NED? What sort of person do you think it takes to monitor
the executives of a very large company?
In terms of board structure, the key idea has been for boards to delegate some
aspects of their role to board sub-committees. Doing this should allow both the
board to work more efficiently and free up sub-committees to have a different (and
perhaps still more independent) membership than the board as a whole. The principal
sub-committees that are thought appropriate are those dealing with executive
remuneration, the audit process and the nomination of new directors.
The UKCG Code has quite a long history, stretching back to the work of the Cadbury
Committee in 1992 on the financial aspects of corporate governance. The key
recommendation of the Cadbury Committee was to increase the number of non-
executive directors on the main board. Cadbury also recommended that a committee
structure should be put in place to give greater board control over executive pay, the
audit process and the appointment of directors.
In 2010, the Combined Code was renamed the UK Corporate Governance Code. The
latest version dates from 2018. Responsibility for updating its provisions and for
monitoring how companies are responding to its recommendations now falls on
the FRC (and will pass to ARGA, once it replaces the FRC). It is usually updated every
few years and it applies to companies with a ‘premium listing’ on the London Stock
Exchange.
The 2018 version is rather shorter, and supposedly ‘punchier’, than its predecessors.
There is now a simpler division between:
u The UKCG Code’s 18 principles, which are fairly broad, high-level statements of
good practice, which companies are expected to apply and must explain how they
do so.
u Its 41 more specific ‘provisions’, which are more detailed and precise but
companies may choose not to follow. Where they decide not to do so, they must
explain why.
Despite the change in style of the UKCG Code, its basic philosophy remains the same.
It continues to focus on the structure, composition and role of the board, with an
emphasis on ensuring that boards contain a sufficient proportion (at least half) of
independent non-executive directors who are responsible for monitoring their
executive colleagues. You can access the latest version of the Code.
Strengths
u Many non-executives are also executives of other listed companies, so have a good
understanding of, and experience in, business matters and governance problems.
Weaknesses
u Non-executives can only spare a limited amount of time for the job – typically two
days per month.
u They are inevitably less well informed about the company than its executives.
u They lack strong incentives to perform well (compared to the incentive they are
probably under as an executive director of another company). Being a non-
executive director can be seen as a distraction from one’s ‘real’ job of being an
executive elsewhere.
Company law 14 Corporate governance page 179
u Some have complained that their presence on the board can be ‘divisive’, since the
board is divided into those responsible for leading the company (executives) and
those who are there to police them (non-executives).
With regard to the merits of using a code of practice, rather than hard law, to
implement this governance mechanism, there are a number of weaknesses but also
strengths.
Strengths
u The ‘self-regulatory’ nature of the Code, where the business community has more
input into its drafting, makes companies and directors respond with less hostility
towards rules they have played a part in creating.
u The Code can be written in plain, non-legalistic language, which will be observed in
the spirit and not merely the letter.
Weaknesses
u Companies and/or executives have too much influence over the content of the Code.
Board diversity
Although we have focused on the balance between executive and non-executive
directors, a rather different concern about board composition has also become
prominent in recent years. This has to do with the ‘diversity’ of board members.
The focus has been mainly on the balance between male and female directors. The 2012
version of the Code was changed to include a recommendation that company annual
reports should ‘include a description of the board’s policy on diversity, including
gender, any measurable objectives that it has set for implementing the policy, and
progress on achieving the objectives’. This change to the Code followed on from the
review undertaken by Lord Davies into the proportion of women on company boards.
That review set a goal for the 100 largest quoted companies (known as the FTSE 100) to
have at least 25 per cent female board members by 2015. This target was achieved by
October 2015, with a female board membership of 26 per cent.
Alongside the issue of gender diversity, the ethnic diversity of UK boards has also been
addressed, by the Parker review.
u The Code sets out 12 principles of stewardship, which such organisations are
expected to apply.
u They must also explain, through an annual reporting requirement, how these
principles have been applied.
Activity 14.2
Visit the FRC’s information page on the Stewardship Code. Does it reassure you that
the Code is going to be taken seriously?
No feedback provided.
The first confusion is that shareholder primacists believe that those running
companies should never consider their stakeholders (that stakeholder theorists alone
believe those running companies should consider stakeholders).
In fact, both shareholder primacists and stakeholders believe that directors should
consider stakeholders: their disagreement is about how directors should do so.
For shareholder primacists, the ultimate goal of directors should be to maximise
profits. Directors should think about stakeholder interests but only in order to
Company law 14 Corporate governance page 181
achieve that goal – to work out which decisions will actually maximise profits.
Shareholder primacists, then, believe stakeholder interests should only be a matter
of instrumental concern: something directors take into account in order better
to maximise profits for shareholders. Stakeholder theorists think directors should
approach the interests of stakeholders in a different way – as an end in themselves.
Directors should take decisions that will treat stakeholders well, regardless of whether
this maximises profits, even if it reduces profits.
The second confusion is that shareholder primacists believe that companies should
be free to do anything they want if it will increase profits for their shareholders,
while only stakeholder theorists think that there should be limits on what companies
can do. Again, this is misleading. Shareholder primacists generally do believe there
should be constraints – regulation – on company behaviour. But the real disagreement
concerns the form these constraints should take. Shareholder primacists believe that
legal regulation to improve corporate behaviour should generally take the form of
what we might call ‘external regulation’ – rules that apply to the company itself and
that limit what it can do and the harm it might cause to stakeholders. Tort liability,
environmental protection laws, minimum wage rules, consumer protection laws,
etc., are all examples of this sort of ‘external regulation’. But the law should not,
shareholder primacists argue, abandon the directors’ duty to maximise profits within
the law, or remove the control that shareholders are given within their companies.
Shareholder primacists believe directors should remain free – indeed, be obliged – to
maximise profits but within the constraints that external regulation imposes on how
companies may behave. And shareholders alone should be given control rights to
ensure directors do.
Summary
Shareholder primacists believe directors should pursue profit maximisation and
take account of stakeholder interests only instrumentally. Shareholders alone should
be given rights to control the directors. Stakeholder interests should be protected
through external regulation, that limits what companies can lawfully do. Stakeholder
theorists think that directors should not aim to maximise profits but instead genuinely
to balance the interests of shareholders and stakeholders. And stakeholders – not just
shareholders – should also have control rights within the company.
Fiction/concession theory
These theories were dominant in earlier centuries. They viewed the company as
being a fictitious entity and one that owes its existence to the state’s ‘generosity’. The
company would not exist without a state to create it. States are not obliged to permit
natural persons to create these fictitious entities. If a state does so, that is a concession
on its part. The state is then entitled to set the price that people must pay for the
state’s generosity.
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Corporate realism
The fiction/concession theory of the company became less convincing over time, partly
because of changes in the process for forming companies. As it became increasingly
easy to form a company, it felt unrealistic to see the outcome of this process as a great
concession by the state. Moreover, the view that the company itself was no more than
a legal fiction was also challenged. As companies became increasingly well established,
with a permanence that outlasted the natural persons who came and went, they
seemed like social institutions with a real existence of their own. Different companies
had their own way of acting and their own values and culture. Companies were, to be
sure, affected by the natural persons involved in them but companies also themselves
exerted an influence of their own on those around them.
These ideas underpin the ‘realist’ theory of companies: that a company is a real thing.
The choice a state faces is not whether to create companies but whether to recognise
companies that others create, and which exist already, regardless of whether the state
confers legal recognition on them.
Dodd (1932) was a key proponent of this theory. He used it to argue for companies’
wider responsibilities towards non-shareholders. If companies were real persons, then
they had interests and responsibilities of their own. Companies were not simply a tool
in the hands of shareholders. They had to act as good citizens and their directors were
obliged to ensure they did.
The most influential aggregate theory is what has become known as the nexus of
contracts theory of the company. So, being an aggregate theory, its focus is the
relationship between the individuals who comprise the company. It then proceeds
to analyse these relationships in contractual terms. The individuals who comprise a
company choose, voluntarily, to co-operate together. Each company’s shareholders
choose to invest in it, its creditors to lend to it, its employees to work for it, etc. And
the terms on which they choose to do so are agreed by them.
Merely pointing out that those involved with companies have a contractual
relationship with the company does not immediately tell us whether the law should
favour a shareholder primacy or stakeholding approach. Shareholders and employees,
say, may both have contracts with the companies they invest in, or work for. But
how does that tell us whether the law should allow only shareholders to choose
directors, or whether it should allow employees to do so as well? Or whether the duty
on directors should be to put the interests of one group of contracting individuals
(shareholders) ahead of another group (employees, or consumers, etc.).
One way to address this uncertainty would be to make everyone’s return from the
company depend entirely on how well the company is performing. In good years, all
might do well; in lean years, all might get very little. This would share the risks equally.
The difficulty with this arrangement is that some of those involved with companies
might be very ‘risk averse’. Take employees, for example. They probably depend
on a single company for their livelihood. If that company hit a lean patch and gave
employees (and everyone else) very little, employees might have no other source
of income and struggle to survive. Shareholders, however, might be rather less risk
averse. They might be invested in several companies, so that a lean period in the
fortunes of one might be offset by better times in others. Furthermore, shareholders
might be investing surplus capital and not dependent on the income it produces for
the necessities of life.
Rather than all sharing equally in good and bad times alike, a different arrangement
for dealing with the inevitable uncertainties in each company’s fortune suggests itself.
A priority system could be established. Those less willing to gamble on a company’s
fortunes could receive a pre-determined return, that does not vary according to
the company’s success. This would be safe, if unexciting. But some could act as
‘residual claimants’ – they would receive what is left over after those with their safe,
fixed returns have been paid. In lean years, they would get nothing. In good times,
they would receive far more. This is, of course, the arrangement within companies.
Stakeholders enjoy predetermined, and fairly safe, returns. Shareholders act as
residual claimants, getting the profits (if any) that are left.
It is argued that this arrangement is usually the economically efficient way to cope
with the uncertainties of corporate activity. It allows companies to offer a sufficiently
certain return to stakeholders (employees with agreed wages, creditors with agreed
rates of interest) to persuade them to become involved with companies. It does,
however, leave shareholders in a uniquely risky position, it is argued. They have no
entitlement to any return. If there is no surplus (no profit) left when others have
been paid, shareholders get nothing. How can investors, then, be persuaded to take
on this risky position and buy shares in companies? The answer given is by insisting
that directors must run companies to try to maximise profits for shareholders; and
shareholders must have enough control within the company to ensure directors try to
do so.
Stakeholder criticisms
Needless to say, stakeholders have criticised the foregoing analysis. You can read those
criticisms in more detail in the literature cited below, especially that from Deakin and
from Keay.
Second, the analysis above assumes that stakeholders’ contractual relationships give
them very effective protection, which reassures stakeholders to engage co-operatively
with companies. However, critics question this assumption. Employees’ contracts,
for example, may often give rather limited protection and be difficult to enforce.
Consumers may lack bargaining power. Stakeholders may lack information about the
behaviour of the companies they deal with. If these problems are significant, they
render profit-maximising companies less trustworthy, harming their own financial
performance. Paradoxically, companies that are committed to profit maximisation
may end up less profitable than companies that commit to a stakeholder approach.
Third, while external regulation can address some of these problems – it can provide
more reassurance to stakeholders than their contracts alone – still there are limits
on external regulation too. Regulation often takes time to catch up with the bad
corporate behaviour it is trying to stop. Insolvency can be an effective way of avoiding
regulation. And the power of large corporations enables them to dull efforts to
introduce and enforce effective regulation.
Activity 14.3
Read Dignam and Lowry Chapters 15 and 16 and then consider the following.
‘The UK Corporate Governance Code has been a great success. We know this not
only because of the improvements in UK corporate governance it has brought
about but because similar codes have been adopted by international agencies and
other jurisdictions around the world.’
Do you agree with the above statement? Explain your views.
Further reading
¢ Berle, A. ‘For whom corporate managers are trustees: a note’ (1932) Harvard Law
Review 1365.
¢ Berle, A. and G. Means The modern corporation and private property. (New
Brunswick, NJ; London: Transaction Publishers, paperback edition 1991)
[ISBN 9780887388873].
¢ Coffee, J. ‘The rise of dispersed ownership: the roles of law and the state in the
separation of ownership and control’ (2001) 1 Yale LJ 25–29.
¢ Dodd, E. ‘For whom are corporate managers trustees?’ (1932) Harvard Law
Review 1145.
¢ Finegold, D., G.S. Benson and D. Hecht ‘Corporate boards and company
performance: review of research in light of recent reforms’ (2007) 15 Corp Gov
865.
¢ Jensen, M.C. and W.H. Meckling ‘Theory of the firm: managerial behaviour,
agency costs and ownership structure’ (1976) 3(4) Journal of Financial Economics
305–60.
¢ Parkinson, J.E. Corporate power and responsibility: issues in the theory of company
law. (Oxford: Clarendon Press, 1995) [ISBN 9780198259893].
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Contents
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 188
Introduction
In this chapter we consider the liquidation of companies. The liquidation process
is a part of insolvency law and, potentially, a very large (and quite technical) topic.
However, for this module our focus is much narrower, examining two key issues.
The first is how well the liquidation process protects creditors. We have already
looked at other areas of company law that also aim to protect creditors – such as the
disqualification regime, capital maintenance rules and even, sometimes, directors’
duties. The liquidation of a company is the final stage in a company’s life. Where
liquidation is happening because of the company’s insolvency, as is normally the case,
then creditors’ interests will take priority and the law’s overriding aim is creditor
protection.
The second issue is how liquidation can affect directors. Again, much else in our
module has been looking at the regulation of directors. As the final curtain descends
on a company, often because the company has failed, we would expect directors’ past
behaviour to come under the spotlight again.
Bear in mind that insolvency law includes a number of other mechanisms, in addition
to the liquidation (or ‘winding up’ – both terms mean the same thing) of companies.
Many of these other mechanisms – moratoria, creditor voluntary arrangements, and
administration – focus on trying to rescue companies in financial distress and allowing
them to survive their present financial difficulties. These mechanisms are often a
compromise between protecting creditors and protecting others (such as employees)
who might benefit from the company’s long-term survival. They are beyond the
scope of our module but it is worth remembering that many companies that end up
being liquidated will have already passed, unsuccessfully, through one of these earlier
attempts to save them.
Learning outcomes
By the end of this chapter and the relevant readings, you should be able to:
u explain the ways in which a company may be wound up
u understand how, and how effectively, the liquidation process aims to protect
creditors
u understand the implication of liquidation for the company’s directors.
Core text
¢ Dignam and Lowry, Chapter 17: ‘Corporate rescue and liquidations in outline’.
Cases
¢ Re London and Paris Banking Corp (1874) LR 19 Eq 444
¢ BNY Corporate Trustee Services Ltd v Eurosail-UK 2007-3BL plc [2013] UKSC 28.
Company law 15 Liquidating the company page 189
u The members may collectively decide to wind up the company – this is termed a
voluntary winding up.
u The creditors may force the winding up of a company where it is insolvent (i.e. it
cannot pay its debts) – this is termed compulsory winding up.
u The Secretary of State may seek to have the company wound up where it is in the
public interest.
We might add to these a fourth trigger, namely, where a member seeks to have the
company wound up on the ‘just and equitable ground’, in s.122(1)(g) IA 1986. We noted
this procedure in Chapter 12 and will not consider it further here.
It is easy to confuse ‘liquidation’ and ‘dissolution’. Dissolution is the final act, which
brings the company’s existence to an end (and removes the company from the
register of companies). Liquidation/winding up is the process that must be undertaken
to deal with the company’s assets before the company can be dissolved.
Why would shareholders vote to wind up their own company? There are two main
reasons.
The first is that the company remains solvent but has outlived its usefulness to the
shareholders. They may no longer wish to continue its business, and want to sell off
its assets and recover their own capital. But this happens relatively infrequently; even
where shareholders wish to end their relationship with the company and recover their
capital, it would usually be financially better for them to sell the company itself (i.e.
sell their shares in the company) rather than have the company sell its assets, as part
of a winding up, and then hand the proceeds to the shareholders.
Activity 15.1
Can you think how the facts of the case of Regal Hastings, addressed in Chapter 10 of
the module guide, illustrate this shareholder preference for selling the company,
rather than selling its assets and voluntarily winding up the company?
The second reason members may choose to wind up their own company is where the
company is insolvent and its members want to start the winding up before a creditor
does so. The members may also be the company’s directors (if the company is a small
one) and as directors they will be aware of their potential liability for wrongful trading
if they allow the company to continue trading while insolvent (see below).
These two different reasons for members to voluntarily wind up their company are
reflected in the two very different ways a voluntary winding up can proceed.
u Where the company is solvent, and the directors of the company are prepared
to make a ‘statutory declaration of solvency’ under s.89 of the IA 1986, then the
winding up will proceed as a ‘members’ voluntary winding up’. In that situation,
the members will largely control the winding up process (such as the choice of
liquidator). This member control is seen as appropriate given that creditors are
likely to be paid in full (because the company is solvent).
page 190 University of London
u If the directors are not prepared to make the declaration of solvency, then a
‘creditors’ voluntary winding up’ will ensue. In this case, creditors largely control
the process.
For reasons noted already, members’ voluntary winding ups (used where the company
is solvent) are relatively uncommon. Most voluntary winding ups involve insolvent
companies and proceed as creditors’ voluntary winding ups. In either case, however,
the job of the liquidator is the same: to take control of the company; realise its assets;
settle its liabilities and then distribute any surplus (unlikely in a creditors’ voluntary
winding up) to the shareholders (ss.91 and 107 IA 1986). Thereafter, the company will
be dissolved.
What counts as being ‘insolvent’ or, to use the term which the IA 1986 uses, being
‘unable to pay its debts’? Section 123 offers no fewer than four different ways in which
a creditor can show that the company is unable to pay its debts. The first three are
found in s.123(1) and they are:
u 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. (However, if the debt is disputed on bona fide grounds the court
will not allow the petition to proceed); or
u If the court is satisfied that the company is unable to pay its debts as they fall due.
These three tests all represent what is sometimes called ‘cash flow insolvency’. In
other words, they allow a creditor to show, in one of three different ways, that the
company is currently unable to pay its immediate debts. On each of these three tests, a
company will be considered insolvent if it cannot, in the short term, pay its debts, even
if its long-term assets exceed its long-term liabilities. Allowing companies to be wound
up for cash flow insolvency means that companies with a good long-term future might
nevertheless be wound up if they are facing short-term liquidity problems that are
preventing them paying their current debts.
The fourth test for a company’s inability to pay its debts is found in s.123(2), which
states that a company will be deemed to be insolvent where:
u The value of the company’s assets is less than the amount of its liabilities, taking
into account its contingent and prospective liabilities.
Summary
The IA 1986 adopts a very wide and comprehensive definition of a company’s inability
to pay its debts. Essentially, a company will be considered to be ‘unable to pay its
debts’ if it is either cash flow insolvent or balance sheet insolvent.
Company law 15 Liquidating the company page 191
Activity 15.2
Do you think that a company should have to be both cash flow and balance sheet
insolvent to be deemed ‘unable to pay its debts’ for the purpose of petitioning for
a compulsory winding up? If both conditions had to be satisfied, explain which
creditors would become unable to present a petition.
The wide definition given to insolvency, where either cash flow or balance sheet
insolvency suffices, makes it easier for creditors to present winding up petitions. This
makes the law more protective towards creditors – or at least towards the creditor
who wishes to use liquidation, or the threat of it, to recover their debt. But it can work
to the disadvantage of companies and of other creditors – as Activity 15.2 sought to
demonstrate. It is a particular concern that companies with a sound long-term future
can be subject to winding up proceedings because of short-term cash flow problems.
First, note that some of the rescue procedures (such as administration), that are
beyond the scope of this module, are designed to deal with this problem. Those rescue
procedures include provisions that prevent creditors issuing winding up petitions,
giving companies with short-term financial difficulties a short-term breathing space.
Second, the court may refuse to make an order if the petition is not supported by
the majority of creditors (s.195). So, where one creditor is trying to use liquidation
to benefit themselves but their doing so may leave the body of creditors worse off
overall, the majority can ask the court not to make the winding up order.
Third, in response to the coronavirus pandemic, s.10 of the Corporate Insolvency and
Governance Act 2020 (CIGA 2020) imposed temporary restrictions on compulsory
liquidations. Again, these were designed to avoid a winding up of companies with
short-term problems arising from the coronavirus pandemic but which might recover
and survive once the pandemic is itself under control. These restrictions ended in
the autumn of 2021 but were immediately replaced by a further restriction, added to
Schedule 10 of CIGA 2020.
This prevents the court making a winding up petition on the grounds of a company’s
inability to pay its debts unless the debt or debts owed to the petitioning creditor
amount to £10,000 or more. If the petition is being presented by a group of creditors,
their combined debts must be £10,000 or more. This is a very substantial change in the
law. In the case of many small companies, a single creditor will not be owed £10,000
by the company. Unless they are able to find other creditors to join in their petition,
they will not be able have the company wound up compulsorily. It is unclear whether
this restriction will be permanent, or will be removed as the economy recovers
post-pandemic.
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(s), and the Official Receiver is appointed as liquidator.
Provided that there are sufficient funds to cover the expenses of the liquidation, the
Official Receiver will then summon separate meetings of the company’s creditors
for the purpose of choosing a person to be liquidator of the company in their place
(s.136(4)).
Activity 15.3
Read Finch, V. and D. Milman Corporate insolvency law: perspectives and principles.
(Cambridge: Cambridge University Press, 2017) third edition [ISBN 9781107039919],
Chapter 2 ‘Aims, objectives and benchmarks’ (available on the VLE).
What are the objectives of the liquidation regime?
The liquidator takes control of the company for the purposes of realising the
company’s assets and then distributing them among the claimants according to their
priority (s.143). It is clearly in the interests of creditors that liquidators maximise the
value of the company’s assets. To do so, the liquidator is given extensive powers to
deal with the company and its property (see s.167 of the IA 1986, and Parts 1 to 3 of
Schedule 4 of the IA 1986).
u Suing directors for past breaches of duty (this could be done as a corporate action,
since the liquidator has inherited the managerial powers of the board, including
its authority to decide the company will sue, or be done through ‘misfeasance’
proceedings under s.212 IA 1986, which provides a summary procedure for suing
the director during a winding up).
u Applying to the court to have certain ‘extortionate credit arrangements’ set aside:
s.244 IA 1986.
u Applying to court to invalidate certain floating charges: s.245 IA 1986 (see Chapter 6
of this guide).
u Taking proceedings against directors for wrongful trading (s.214 IA 1986) or against
any person for fraudulent trading (s.213 IA 1986) to secure a ‘contribution to the
assets of the company’ (see further Section 15.3).
1. All expenses properly incurred in the winding up, including the remuneration of
the liquidator.
Company law 15 Liquidating the company page 193
2. Preferential debts as identified in ss.107, 115, 143 and 156 (e.g. some unpaid wages of
employees).
3. Monies due to a floating charge holder, out of the assets covered by the floating
charge (but subject to the rules on ‘ring-fenced funds’, described below).
In the case of a members’ voluntary winding up, where the company is solvent, then
any balance remaining, after all creditors have been paid, is distributed to members in
accordance with their entitlements under the company’s memorandum and articles.
Three points are worth noting about the order in which assets are distributed.
First, where (as is invariably the case in insolvent liquidations) there are insufficient
assets to pay all the unsecured creditors, then those unsecured creditors are paid
proportionately, in accordance with the pari passu principle, that is each should be
paid the same proportion of their debts. This is intended to ensure fairness between
creditors, so that each suffers equally from the company’s insolvency and benefits
equally from its winding up.
Second, while that approach ensures equal treatment among the unsecured creditors,
it does not mean that unsecured creditors and those above them in the list – say floating
charge holders – are treated the same. There have long been complaints that banks are
able to impose floating charges on companies (in a way that ‘ordinary’ small creditors
cannot) and then use their charges to grab most of the company’s assets, leaving very
little for those below. Defenders of this point to freedom of contract and the importance
of floating charges in lowering the cost of borrowing for companies. The price, however,
is paid by unsecured creditors, who often end up with little.
To address this longstanding complaint, s.252 of the Enterprise Act 2002 reduced
somewhat the benefits of having a floating charge by requiring a portion of the
sale proceeds from the assets covered by a floating charge to be ‘ring fenced’ and
then used for ordinary unsecured creditors. So, floating charge holders get less, and
ordinary creditors a little more, from the assets of the company.
Third, to persuade floating charge holders (especially banks) to accept this reform, the
state itself agreed to get less from liquidations. Until 2002, the category of preferential
debts (appearing at number 2 on our priority list) used to be larger, in that it included
some debts owed to the state, such as to the tax authorities. However, as a result of
the Enterprise Act 2002, these ceased to be preferential debts. The state gave up this
advantage it had enjoyed in liquidations. By doing so, the state now typically receives
less on liquidations – floating charge holders benefit from that but effectively pass on
much of this benefit to unsecured creditors lower down the list.
A number of controls aim to ensure they will. First, there are restrictions on who
can take on the role of liquidator. Section 230(3) IA 1986 provides that a liquidator
must be a qualified insolvency practitioner and there are, in turn, regulations on the
qualifications and licence to act that insolvency practitioners must hold.
Second, creditors have significant control over the choice of liquidator in compulsory,
or creditors’ voluntary, liquidations. When creditors’ interests are at stake, in other
words, creditors can determine the choice, making it difficult for the shareholders or
directors of the company to pick a ‘tame’ liquidator who would favour the company’s
former directors.
Third, as we have seen, liquidators owe fiduciary duties to the company during
liquidation.
page 194 University of London
First, their past behaviour is usually more likely to come under the spotlight and action
taken against them in relation to that behaviour, compared to when the company
is in good financial health and still controlled by those directors. Second, directors
may, as a result of being associated with a company that has become insolvent, be
significantly restricted as to their future activities. We will take each in turn.
Finally, remember that directors face the threat that they may be ordered to make
a (substantial) contribution to the assets of the company should they be guilty of
fraudulent or wrongful trading, while fraudulent trading also carries the further risk of
criminal punishment.
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.
Although directors of insolvent companies that are wound up do face greater scrutiny
of their past actions and are a little more exposed to proceedings being taken against
them, we ought not to exaggerate this likelihood. Liquidators remain somewhat
unwilling to bring claims against them, especially for breach of duty or for fraudulent
trading, and actions for wrongful trading have been much fewer than many hoped.
Two further measures have been introduced to try to increase the likelihood of
directors being forced to pay for their misconduct. First, s.246ZD IA1986 now permits
liquidators to assign (and therefore, effectively, to sell) a fraudulent or wrongful
trading action against a director. Thus, a liquidator who decides that they do not want
themselves to bring an action for wrongful trading, might nevertheless choose to
sell and assign the action to a third party, who would then be able to bring the action
instead. In this way, the liquidator gets at least some money for the benefit of the
creditors and the risks associated with bringing the claim fall on the purchasing third
Company law 15 Liquidating the company page 195
party. However, if the action is successful, the benefit will go to the third party (rather
than to the insolvent company for the benefit of all the creditors).
Second, as we saw when considering the regime for disqualification (Chapter 9),
directors who are disqualified and have been found to have caused loss to a creditor of
an insolvent company can now be made subject to a compensation order, under s.15A
of the Company Directors Disqualification Act 1986. Far more directors are disqualified
than are sued by liquidators. If compensation orders under s.15A become widely used
in conjunction with disqualification orders, this will very significantly increase the
chances of directors of insolvent companies being made to pay for past misbehaviour
that harms creditors.
First, ss.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.
The second, and potentially much more wide reaching, restriction arises from the
disqualification regime under the Company Directors Disqualification Act 1986,
mentioned in Section 15.3.1. So, directors of companies that have been wound up
insolvent face the risk of being disqualified (from being involved in the management
of any company) if their behaviour shows them to be ‘unfit’: see Chapter 9.
Summary
We have focused here on the process for liquidating companies, addressing two
key concerns for company law. First, how does the process add to the protection
of creditors? Can creditors easily (and perhaps too easily) force companies into
liquidation? Will the liquidation process maximise the amount that creditors recover
and will that be shared fairly between them? Second, how does the process impact
on directors? Does it increase the chances of action being taken for past misbehaviour
and does it add new grounds for additional liability?
Further reading
¢ Cooke, T.E. and A. Hicks ‘Wrongful trading – predicting insolvency’ (1993) JBL 338.
¢ Oditah, F. ‘Assets and the treatment of claims in insolvency’ (1992) LQR 459.
¢ Report of the Review Committee on insolvency law and practice (Cork Committee
Report), Cmnd 8558.
¢ Van Zwieten, K. Goode on principles of corporate insolvency law. (London: Sweet &
Maxwell, 2018) fifth edition [ISBN 9780414066014].
u Section 245 IA 1986, whereby the liquidator of an insolvent company can avoid
floating charges (see Chapter 6 of this guide).
u 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).
u You will need to discuss Salomon v Salomon [1897] AC 22 and Adams v Cape Industries
plc [1990] 2 WLR 657 (see Chapters 4 and 5) 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 9 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.
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Contents
Chapter 2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 201
Chapter 3 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 203
Chapter 4 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 204
Chapter 5 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 205
Chapter 6 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 207
Chapter 7 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 208
Chapter 8 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 210
Chapter 9 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 212
Chapter 10 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 213
Chapter 11 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 216
Chapter 12 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 218
Chapter 13 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 220
Chapter 14 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 221
Chapter 15 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 222
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Company law Feedback to activities page 201
Chapter 2
Activity 2.1
a. If Maria runs the business as a sole trader, there will be no formalities to create
the sole tradership. Maria simply gets on with running the business. There are
therefore no legal fees to pay to create a sole tradership. This simplicity will also
continue once the business is up and running. There will be no complicated legal
structure to follow about how decisions are to be taken – Maria can simply take
all necessary decisions alone and in whatever way she wants. She will not have
to file lots of information about the business (compare the more onerous ‘filing
requirements’ for companies, later). All this will save Maria time and money, and
will allow her to keep her business affairs more confidential.
b. Maria will herself be liable for the debts of the business – she will personally enter
into contracts with others and she will therefore be personally liable on those
contracts. If the business collapses, those owed money (‘creditors’) can go after
all of Maria’s personal assets (e.g. her car or house) to recover the money owed to
them.
c. With a sole tradership, the capital the sole trader needs must be supplied by the
sole trader – from money they already have, or from loans they obtain, as Maria is
doing from Luis. Luis will be a contractual creditor of Maria and his position will
therefore depend on the terms of his loan agreement with Maria. Typically this
agreement will give Luis no say in how Maria manages the business and Luis’s
returns will be limited to the agreed rate of interest on the loan, regardless of how
profitable the business may be. (Once you have read further and understand the
partnership position, you should be able to see how Luis’s position would differ if
he and Maria were to operate the business together as partners instead.)
Activity 2.2
Advantages
The main advantage of Maria choosing to run her business as a partnership with Luis
is that it would enable her to satisfy Luis’s wishes (his desire for a say in the running
of the business and his desire for a share of the profits). The partnership would be
governed by the terms of the Partnership Act 1890 and by any partnership agreement
they entered into. The Act itself says that each partner is entitled to participate in the
management of the partnership and that profits are to be shared equally. These rules
in the 1890 Act could be changed by the terms of the agreement but they provide a
good starting point for structuring the business in the way Luis wants.
There are other respects in which the partnership is a convenient and attractive legal
form for Maria and Luis to use, if they are to become co-owners of the business.
u There are very few formal legal filing requirements to become a partnership.
u The partnership is generally less heavily regulated than is the company. It offers a
very flexible organisational structure. Although the Partnership Act 1890 provides
many rules about how the partnership will be run, these are only ‘default rules’.
They can be changed by the partners, for example, in a partnership agreement
(although drawing up such an agreement will usually involve paying for legal
advice).
u There are also fewer rules about financial information that must be disclosed for
a partnership, compared to a company. This can reduce the costs of running a
partnership, compared to a company, and it also means the partners enjoy greater
confidentiality.
Disadvantages
The partnership does, however, have some disadvantages, especially when compared
to the company.
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u First, partners do not have limited liability. Like the sole trader, they are personally
liable for the debts incurred by the partnership. Moreover, since each partner has
a large amount of authority to act, one partner can become personally liable for
debts incurred by their fellow partners.
u A partnership does not have ‘perpetual succession’. In theory, the partnership ends
when a partner decides to leave. This can be disruptive and incur expenses.
u A partnership cannot create a ‘floating charge’. You will read about this when you
come to look at the company. But this inability to create a floating charge can
mean that partnerships sometimes find it more difficult than do companies to
borrow money from, say, a bank.
Activity 2.3
A company limited by shares has a ‘share capital’ and raises money for itself by
selling (‘allotting’) shares in itself to investors, who then become members – called
‘shareholders’ – of the company.
A company limited by guarantee does not raise money by selling shares in itself in this
way and therefore does not have a ‘share capital’. It still has members but someone
becomes a member, not by buying shares in the company, but instead simply by
promising to pay to the company a specified amount of money, if asked to do so
in the future. This is the member’s ‘guarantee’ to the company and the amount so
guaranteed is usually very small – say just £1.
There are two things about the ‘guarantee company’ that make it unsuitable for most
for-profit businesses.
u First, such businesses usually need to raise some capital from their investors from
the outset of the company’s operations. That can be achieved in a company limited
by shares – by selling shares to its investors.
Activity 2.4
a. If they run their business through a company, then both Maria and Luis will have
to decide whether they are each going to be shareholders and each going to be
directors. Presumably, they will each become shareholders, since they currently
both own the business as partners and will each want to retain their ownership
stake if the business is run through a company. By each becoming a shareholder,
each will be entitled to a share of the profits earned by the company. If the
company is profitable, then its value will rise and so too will the value of their
shares.
b. Yes – the company itself will be responsible for the debts it incurs. Maria and Luis,
as shareholders, will not be personally responsible for these debts, nor can they
be made to contribute more money to the capital of the company should its debts
exceed its assets. However, if the company wishes to borrow money from a bank,
Company law Feedback to activities page 203
then Maria and Luis may well find that the bank will insist on their entering into
‘personal guarantees’ – whereby they promise the bank that they will personally
repay any loan made to the company if the company fails to do so.
u Companies are subject to a lot more regulation than are sole traders or
partnerships. We explore this point further in Section 2.5.
Activity 2.5
No feedback provided.
Chapter 3
Activity 3.1
No feedback provided.
Activity 3.2
The first disadvantage in taking over a shelf company is that a little work will need to
be done to change the company’s directors and shareholders. The company’s existing
director and shareholder will be some individual from the business that has created
the shelf company. This existing director will retire and Maria and Luis will become
directors in their place. The existing shareholder will transfer their share to Maria or
Luis. The second disadvantage is that some other features of the company may not be
to Maria and Luis’s liking and may also need to be changed. They may want to change
the name of the company to something that reflects the company’s future business,
or their ownership of the company (e.g. ‘Maria and Luis Translation Services Ltd’). They
may also want to change some parts of the constitution.
The risk in taking over a company (rather than forming their own) is that a company
they take over may have already incurred liabilities before they acquire it. Of course,
Maria and Luis, once they become owners of the company, will not be personally liable
in respect of these liabilities. They will be protected by limited liability. Nevertheless,
if they are putting more money into the company, they do not want to discover that
this money will have to be used to satisfy debts incurred by the company before they
acquired it. If they form their own company, however, then they can be sure it is ‘clean’
and debt-free when it comes into existence. Provided that Maria and Luis purchase
their shelf company from a trustworthy supplier, they can be confident the company
will not have incurred any liabilities before they acquire it.
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Activity 3.3
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 (Phonogram). The question of whether the promoter
could enforce the contract that they are personally liable on has now been resolved by
the Court of Appeal (Braymist).
Chapter 4
Activity 4.1
a. Salomon’s 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 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 company’s assets. As a result, if the company failed, not only would Salomon
have no liability for the debts of the company but whatever assets were left would
be claimed by him to pay off the company’s 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 one-
person 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 for you to work out for yourself, taking into account the
Essential reading in Section 4.4. 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 4.2
The key point here for your further understanding is that a share is in no way a
representation of the fractional value of the company’s 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 company’s property. That is the case even where (as
in Macaura and Lee) the shareholder owns most or all of the shares. Shareholders
generally benefit from this (although not Macaura) because it facilitates limited
liability as the company also owns its own debts (see also Woolfson v Strathclyde
Regional Council [1978] SC 90).
Activity 4.3
There are at least two advantages in your keeping ownership of the premises. The first
arises if the company becomes insolvent. If the premises are owned by the company,
then the premises will be available to the company’s creditors. In other words, the
liquidator will sell the premises and the sale proceeds will be used (along with the other
assets of the company) to repay creditors. If you own the premises, this will not happen.
Second, if you own the premises, then any increase in their value belongs to you and
not to the company. This second advantage is less important so long as you own all
the shares in the company. Suppose that the premises in question increase in value
by £100,000. If you own those premises personally, you will capture all that increase
in value. Similarly, even if the premises are owned by the company, if you own all
the company’s shares, then the increase in the value of the premises should in turn
increase the value of the company by £100,000 and the value of your shares in the
company should also increase by the same amount. If, however, you own only, say,
50 per cent of the shares in the company, then when the company’s value increases by
£100,000, your shares should increase by only, roughly, £50,000.
Company law Feedback to activities page 205
So, keeping property in your own name, rather than transferring it to the company, is
especially advantageous if the company has several owners. But in that case, there is
also a disadvantage in keeping the property in your own name too. By not transferring
your property to the company, you will be putting less capital into the company. If
others are transferring more capital into the company, they will expect more shares in
return.
Activity 4.4
It is arguable that only the first benefit mentioned – the reduction of risk faced by
investors – clearly applies to smaller companies, like Salomon’s. Certainly, Salomon was
protected from losing everything when his company became insolvent. His creditors
ending up shouldering some of the losses (their debts were not paid in full).
With regard to the benefit of encouraging ‘sleeping investors’, many small companies
do not have such investors and do not rely on sleeping investors to supply the capital
the company needs. Often, in smaller companies, the shareholders will also be
directors of the company and actively involved in running it.
For similar reasons, smaller companies do not tend to be owned by lots of small,
‘dispersed’ shareholders. There is no ‘active market’ in the shares of such companies.
There was no frequent buying and selling of shares in Salomon’s company, keeping
Salomon ‘on his toes’ about how well he was running the company. While limited
liability might be necessary to allow large companies like Facebook or HSBC plc to
be owned by their many thousands of small shareholders, it was not necessary for
Salomon’s ownership of his business.
Although these can seem to be quite complex economic arguments, they do help to
explain why there was some surprise – and some opposition – to the idea of allowing
small businesses like Salomon’s to operate as companies.
Chapter 5
Activity 5.1
a. Both provisions arguably suffer from some weaknesses. Section 213 requires proof
of ‘dishonesty’ and this has made it difficult to use successfully. To be sure, s.214
tries to address this, by setting the standard of liability rather lower. Those who
are merely ‘negligent’ can become liable under s.214 (if, say, they negligently fail
to realise that insolvency is inevitable, or if they negligently fail to take the right
steps to minimise the loss to the company’s creditors). However, the number of
successful actions brought under s.214 has also been quite limited. Why? Well,
one reason might be financial. Although both provisions are designed to protect
creditors, creditors themselves cannot bring proceedings (they must be brought
by, say, the liquidator). And liquidators are often reluctant to use what little
money remains in the company to fund proceedings. Moreover, if proceedings are
brought, the contribution ordered against the defendant is paid to the company
itself. It is not paid to any particular creditor who has suffered most as a result of
the fraudulent or wrongful trading. (Compare later the position of a creditor who is
able to bring an action in tort against a director or shareholder: any compensation
recovered by such proceedings will go straight to the creditor who brings the
claim.)
Take the company’s separate legal personality. Arguably, these statutory provisions
do not infringe that at all. Neither of the sections asks the court to pretend that the
company does not exist. Quite the contrary: both provisions continue to treat the
company as being a separate legal person. That much is clear from the fact that any
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The position with regard to limited liability is a bit more complex, perhaps. It
depends a little on what we understand ‘limited liability’ to mean. Suppose
we define it as meaning that shareholders cannot be made personally liable to
creditors. Do these sections infringe that meaning of limited liability?
First, it might be argued that both sections tend to be used mainly against
directors, rather than shareholders. However, s.213 does apply to anyone who is
party to fraudulent trading – so, in theory, shareholders could be found liable.
Although s.214 on its face seems to apply only to directors, and not shareholders, in
most smaller companies (to which the section is most relevant), the shareholders
will probably be directors as well. Moreover, s.214 also applies to ‘shadow directors’
and this could cover, say, a parent company in a corporate group that is telling
the board of its subsidiary how the company should be run. (Remember, a parent
company is a shareholder, and perhaps the only shareholder, of its subsidiaries.)
Second, it might be argued that, even if liability is imposed under these sections,
the defendant is still not made liable to a creditor. They are simply ordered to make
a payment to the company. The amount of the payment is not the specific amount
of any debt owed to any creditor. However, these may seem rather technical
points. In more practical terms, defendants are made to put their hands in their
pockets and pay out their own money because their company cannot afford to. In
that more practical sense, those ordered to make payments will feel that they have
lost the protection of limited liability.
Activity 5.2
You will have noted from your reading that, from the 1960s until the 1990s, there
seemed to be 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.
But equally, four years later, in National Dock Labour Board v Pinn & Wheeler Ltd [1989]
BCLC 647, the Court of Appeal could draw on cases such as Woolfson v Strathclyde RC
[1978] SLT 159 to argue for a strict interpretation of the Salomon principle. So, in cases
only a few years apart, the Court of Appeal could come to very different decisions, each
with apparent support from earlier case law. 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 was trying to address in Adams. The Court
of Appeal wanted to achieve two things. First, it wanted to introduce more certainty
and predictability into the law, resolving the inconsistency between the cases, so that
those involved with companies would know with much greater certainty when the
veil would be lifted and a company’s separate legal personality ignored. Second, the
Court of Appeal clearly preferred a narrower and more restrictive approach to when
the veil could be lifted, by narrowing the categories of veil-lifting and eliminating any
concept of veil-lifting on the vague ground of ‘the interests of justice’.
It does indeed seem an overly cautious approach that does little to serve the interests
of justice. It is true that there have, since Adams, been cases – such as Ratiu v Conway
(2006) 1 All ER 571 – that suggested that the courts might be prepared to be a bit more
flexible in their interpretation of veil-lifting issues. However, more recent decisions,
such as VTB Capital plc v Nutritek International Corp [2013] UKSC 5 and Petrodel Resources
Ltd v Prest [2013] UKSC 34, indicate the courts are following the hardline approach of
Adams.
Company law Feedback to activities page 207
Activity 5.3
Could Parent plc be liable for harm caused by its subsidiaries? We might begin by
noting that, in company law, the parent and each subsidiary are treated as separate
legal persons. The starting point then is that each is responsible only for its own
liabilities. If a subsidiary causes an accident that harms someone or damages
someone’s property, only the subsidiary will be liable for such harm.
One way Parent plc might face liability would be if the veil between the subsidiary and
Parent were lifted. However, the grounds for doing this have become much narrower
after Adams v Cape Industries plc. Unless Parent plc were using its subsidiaries to escape
from an existing liability that Parent plc had already incurred, the veil would not be
lifted. But this does not seem to be what has happened in the facts for this activity.
Parent presumably used subsidiaries, not to escape a liability Parent already had, but to
prevent itself becoming liable in the future.
A different way Parent might become liable would be if it itself breached a duty of
care that it owed to those injured by its subsidiaries. But would Parent owe such a
duty of care? Certainly, after Chandler, it was easier to argue that a parent did owe
such a duty. And this duty might require Parent to take steps to ensure its subsidiaries
operated safely. Parent’s hands-off approach could breach this duty. Whether the
four ‘conditions’ laid down in Chandler, for when a duty of care would arise, might
be satisfied in Parent’s case is no longer important, however. As a result of the cases
decided after Chandler – Unilever, Vedanta and Okpabi – we no longer need to apply
these conditions. Instead, we must ask whether Parent is interfering sufficiently in its
subsidiaries so that the Parent can be said to have caused the harm that has resulted.
From what we are told, Parent is not doing so.
Parent, then, seems unlikely to be held liable for its subsidiaries’ accidents – even if
Parent knows about its subsidiaries’ poor safety records and even if it could easily
prevent them.
Chapter 6
Activity 6.1
We have to remember the fundamental distinction between private and public
companies so far as their overall legal treatment is concerned. Private companies are
much less heavily regulated than are public companies. The additional regulation to
which public companies are subject is seen in lots of different areas of company law,
including, for example, the rules on accounts, on auditing, on minimum share capital,
and so on. Company law has created two different legal vehicles – the private company
and the public company. The private company works well for smaller businesses,
which can benefit from a lighter regulatory burden. But that lighter regulation means
investors in private companies are less well protected. The greater regulation imposed
on public companies makes them somewhat safer, from an investment point of view.
Activity 6.2
No feedback provided.
Activity 6.3
This question requires you to think about the differences between share capital and
loan capital. Maria and Luis might be advised to use only a small amount of the money
they are investing to buy shares in the company and to lend it the remainder. Maria
might buy, say, £200 worth of shares and lend the company £99,800 and Luis might
buy £100 worth of shares and lend the company £49,900. In this way the company
would have just £300 of share capital and £149,700 of loans.
There are two advantages in their lending much of the money to the company, rather
than investing it as share capital. First, even while the company is solvent, loans can
be more easily recovered from the company than can equity capital. As we see in
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Chapter 7, companies generally cannot return capital to the shareholders but these
restrictions do not apply where the company is repaying loans borrowed by the
company. Second, if the company is wound up, then equity capital is repaid last and
only after all the money due to creditors has been repaid. Where the company is
insolvent, there will be insufficient to repay all the company’s loans and nothing will
be left to repay the shareholders their equity capital. However, if the shareholders
have lent money to the company, then those shareholders may be repaid some of
those loans. So, if the company is insolvent, Maria and Luis will not get back their £200
and £100 share-capital investments but may get back part of their loans.
Of course, by lending their money they will get fewer shares. This reduction in the
number of shares they own might matter if there were other shareholders who
were investing more equity capital and thereby getting more shares and more votes
and power within the company. But Maria and Luis are the only shareholders. What
matters is not how many shares they each own but what proportion of the total share
capital each has. Maria, by buying £200 worth of shares, compared to Luis’ £100 worth
of shares, ensures she still has two-thirds of the total shares and votes.
Activity 6.4
The bank could take either a fixed charge, or a floating charge, over the assets of the
company. However, we are told that the company in fact has few assets apart, it seems,
from its ‘book debts’, i.e. the amounts due to Buildflare from its own customers. The
bank can take a charge over these debts but, based on Spectrum, this charge will
probably be a floating charge, assuming that Buildflare is allowed to keep control over
the debts by being able to spend money from the account into which the proceeds of
the debts are paid.
The bank should be made aware that a floating charge will provide them with less
security than would a fixed charge. The bank should also be advised that a floating
charge is at risk of being avoided under s.245 Insolvency Act 1986 if insolvency
proceedings are begun against Buildflare within 12 months of the charge’s creation. In
respect of the new money (up to £40,000) that will be lent to the company after the
floating charge is created, the charge cannot be invalidated. However, in respect of
the £10,000 already lent to the company (the existing overdraft), the floating charge
may be invalidated unless the company is still solvent at the date the floating charge is
created.
Chapter 7
Activity 7.1
What protection does the procedure give creditors? The only real protection is the
requirement of a solvency statement. (The requirement of a special resolution by
shareholders gives creditors no protection.)
Explain what the directors must say in the statement. So, the statement essentially
requires directors to say that they are of the opinion that the company is currently
solvent and will remain able to pay its debts for 12 months. It does not require
directors to guarantee that all creditors will be paid, notwithstanding the capital
reduction. Directors could be aware that, beyond 12 months, the company’s
fortunes might take a real turn for the worse but they would still be able to make the
statement.
Also explain the penalty for making an untrue statement – set out in s.643. Directors
who make a solvency statement without having reasonable grounds for the opinions
expressed in it commit an offence for which the penalties may include imprisonment.
Consider if this is likely to deter dishonest directors, or those being ‘economical’ with
the truth about the future risks facing the company.
Finally, given that the protection for creditors is quite limited, is it sufficient? Here,
you need to explain what reductions of capital may be being made by the company
Company law Feedback to activities page 209
(explained in Section 7.3.3 of the module guide). Given that these reductions often only
create a limited risk for creditors in the first place, then perhaps the limited protection
for them in the ‘solvency statement’ requirement is a fair balance. What do you think?
Activity 7.2
It is certainly true that there are very few rules regulating the issuing, or the
redemption, of redeemable shares. Is this, as the question suggests, because such a
redemption poses no risk to shareholders?
Where shares are redeemable, they will have been issued as such, with the conditions
for redemption (when, by whom, and so on) fixed at the time they are issued. In
principle, shareholders will be aware, in advance, that the shares can be redeemed.
A shareholder owning such shares should know they do so and therefore cannot
argue it is unfair that they are later ‘forced out’ of the company when their shares
are redeemed. Likewise, other shareholders cannot really complain that some
shareholder is now able to extract their capital from the company by having their
shares redeemed. So, perhaps it does seem realistic to suggest that shareholders
will (or at least ought to) be aware of all this – and this probably explains the lack of
shareholder protection when shares are redeemed.
Activity 7.3
For a market purchase, the shares will be bought at the price fixed by the market. That
will usually be a reliable guide about what the market thinks those shares are worth
and, to that extent, fair to the company and to the vendor shareholder. The vendor
will get the same price as any other shareholder could have got if they had sold their
shares to an ‘ordinary’ purchaser (rather than selling them back to the company). With
an off-market purchase, there is no market-fixing of the price in this way. The directors
will decide, in agreement with the vendor, what price the company will pay. The
directors might, because of incompetence or dishonesty, pay more than is fair, to the
disadvantage of the company’s other shareholders.
Activity 7.4
If the public company is using profits it could have distributed to shareholders anyway
(as a dividend) then paying that money out to acquire the company’s shares does
not leave creditors any worse off. If the company uses the proceeds of a fresh issue of
shares, the company will retain the same amount of capital (but the identity of some
of its shareholders will change).
Activity 7.5
In relation to the first option, of using the money to buy back some of the company’s
shares, this is probably permissible. The company could purchase its shares, under
s.690 CA 2006 (provided there is no restriction on it doing so under the articles).
Procedurally, it would presumably be a ‘market-purchase’, obviating the need to
comply with the more onerous rules for off-market purchases. And, crucially, although
public companies cannot use capital to finance the purchase, distributable reserves
can be used.
However, in relation to the second option (giving assistance to Investor), if giving the
assistance did result in a drop in Megacorp’s asset value, then this would constitute
financial assistance. It would therefore be caught by s.678. This is true even though
Megacorp’s asset value would have fallen, and lawfully so, had it used the money
instead to buy back its shares, or to pay a dividend to its current shareholders. This
again illustrates that the rules here are driven by more than just the desire to protect
the company’s capital for the benefit of its creditors.
(Note, in the scenario for this activity, there might be other exceptions or defences
that apply to prevent Megacorp’s giving of financial assistance breaching s.678.)
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Chapter 8
Activity 8.1
If there is a conflict between the company’s articles and the CA 2006, then the latter
takes priority, unless the CA 2006 itself makes clear that a provision in CA 2006 can be
varied or excluded by the articles.
So, for example, if X Co Ltd had a provision in its articles saying that ‘directors can
only be removed by special resolution’, or that ‘the directors do not owe any duty of
care, skill and diligence’, neither of these provisions would be valid. They contradict
statutory rules (the first contradicts s.168, the second contradicts s.174), neither of
which expressly permits variation or exclusion; neither says, for example, ‘…subject to
the company’s articles…’.
Activity 8.2
The statement is correct in suggesting that it is, legally, easier to remove a director
than to tell them what to do. Telling them what to do requires a special resolution
(under Reg.4 of the model articles). Removing a director requires only an ordinary
resolution (under s.168 CA 2006).
Activity 8.3
No feedback provided.
Activity 8.4
Mini is probably most interested in three things that she’ll be looking for from her
investment.
The first is a right to some income from the company. To be sure of getting this, she
could try to negotiate for:
u Right to a dividend before Madge (shares with this right might be called
‘preference shares’)
The second is a right to more control over the company than her 25 per cent
shareholding would otherwise give her. To get this, she could try to negotiate for:
The third thing she might want is a right to the return of her capital from the company.
This can be difficult to secure: remember, from Chapter 7, that there are restrictions on
the company itself returning share capital. But she might ask for:
Whether Madge would agree to any of the above will depend on their relative
bargaining power (how much Madge’s company needs Mini’s investment). It is also
likely that the more generous are the individual rights that Mini is given, the more she
will have to pay for the shares.
Activity 8.5
In our Madge and Mini example above, suppose the rule in the articles about who
should chair a shareholders’ meeting (Reg.39 in the model articles) were breached.
Suppose that Madge, at this wrongly chaired meeting, passed an ordinary resolution.
There would be little point in the court intervening to declare the meeting, and the
resolution, invalid because of this breach of Reg.39. Ultimately, with her 75 per cent of
shares, Madge can easily pass any ordinary (and indeed special) resolutions she wants.
To declare this resolution invalid would merely delay matters and add expense, forcing
Madge to redo, properly, something she did slightly improperly first time around.
The same consideration can apply in political elections too. If an electorate votes
clearly for Candidate A, the fact that a few votes for Candidate B were wrongly not
counted seems to make no practical difference to the outcome. (Of course, it would
be very different if the uncounted votes exceeded A’s majority over B.)
Activity 8.6
Reg.54 gives Pierre a right of pre-emption. However, this does not appear to be a class
right. It seems to be enjoyed by all the shareholders in the company; it is not limited to
only a subset of the shareholders.
Reg.55 gives Pierre a right to extra votes (to ‘weighted votes’, as they are sometimes
called) if he is threatened with removal as a director. This right does not seem to be
enjoyed by all shareholders; in fact, it seems only one shareholder (Pierre) has this
right. It would, therefore, be a class right and Pierre would be the only member of the
class with this right.
This right does not, however, seem to be attached to Pierre’s shares. That does not
prevent it being a class right but it does mean that if Pierre sold his shares to you, you
would not benefit from this right to extra votes on a resolution to remove you as a
director. (Incidentally, we know a right giving extra votes on a resolution to remove
someone as a director is valid from the case of Bushell v Faith.)
Activity 8.7
There is no right answer to this question. It requires your own analysis and your own
argument. But your analysis might include the following points:
u Explain how courts gave themselves the power to overturn some alterations, in
Allen v Gold Reefs
u Explain what the Gold Reefs test says and how the courts have developed it into a
qualified subjective test
u Explain what the court said in the Greenhalgh case about the meaning of ‘for the
benefit of the company as a whole’
u Explain how minorities can give themselves the power to veto alterations –
through mechanisms such as class rights and provisions for entrenchment.
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Chapter 9
Activity 9.1
There are two ways it might do so. The first is through disqualification, addressed at
the end of Chapter 9. Those who are unfit to be directors can be disqualified. So, this
does not require a person to prove they will be a good director before taking on the
job but it does prevent those who, on the job, prove they are unfit from continuing to
act in the future. We might call disqualification a form of ‘ex-post’ control.
Second, if directors can be held liable for their mistakes, then this might deter those
who have concerns about their ability from taking on the job. Bear this in mind when
we look at the duty of care and skill in Chapter 10; one of the effects of that duty may
be to encourage potential directors to ‘self-select’.
Activity 9.2
Alex is running a number of risks if she relies on the articles alone to protect her
expectations. The first is that Reg.18 does not guarantee any salary; if she falls out with
the other directors, they may vote to pay her little or nothing for the work she has
done. The second risk is a little more academic but is important to remember. Suppose
the directors did vote to pay her something but then regretted their generosity and
refused to make the payment. Could Alex enforce Reg.18? Here, you need to revise
what we learnt in Chapter 8 about the enforceability of the articles. Shareholders can
generally enforce the articles, based on s.33 CA 2006, but cannot enforce ‘outsider
rights’ that do not benefit them as shareholders. Reg.18 seems to be an outsider right
and so may not be enforceable.
The third risk is that any director can be removed by an ordinary resolution, under
s.168 CA 2006. If Alex is removed, she will be entitled to nothing.
Could Alex do more to protect her position? Yes – she ought to have a service contract
with the company, specifying the salary to which she will be entitled as a director.
Activity 9.3
C seems likely to be a de facto director. By participating in board meetings, she is taking
part in the governance of the company. She appears to do so as an equal, given that
she speaks and votes.
E is also unlikely to be a de facto director. Although she is labelled a director (by the
name plate on her door), this does not decide the matter. What matters is what she
does. She seems to be managing the company but not governing it through board
meeting participation.
Activity 9.4
Brian might be. There is certainly a repeated practice of his telling one of the directors
(Charles) what to do and that director following those instructions. However, does
Charles constitute a ‘governing majority’ of the board? Ordinarily we might think not,
since he is only one half of it. However, he is also the Chairperson of the board. As such,
he would have a casting vote in the event of disagreement with Daphne, giving him
effective control at the board.
Activity 9.5
It is certainly true that disqualification can have very serious consequences. The
disqualification lasts a long time. And it prevents a wide range of conduct, including
merely being involved in the management of a company. This could limit the
disqualified person’s ability to earn a living and might also stifle entrepreneurialism.
Moreover, company law generally is reluctant to hold directors liable for business
misjudgements (see Chapter 10 of this guide); perhaps this same reluctance should
apply in disqualification proceedings too.
But there are counterarguments. CDDA is intended to protect the public; it could be
argued that incompetent directors can cause as much harm as can dishonest ones
and the public needs to be protected from both. While disqualification prevents
involvement with limited companies, it does not stop the person setting up as, say,
a sole trader. If limited liability is a privilege, perhaps it should be restricted to those
who have not proven themselves too incompetent to deserve it.
Activity 9.6
There are a number of important differences:
Private versus public: the removal of directors under s.168 is a ‘private’ regime
operated by shareholders, whereas disqualification under the CDDA is a public regime,
operated by the Insolvency Service, with proceedings brought by the Secretary of
State and requiring a court order (or an undertaking to the court).
Grounds: there is no restriction on the grounds for removal under s.168, so that
shareholders can remove for any reason they choose, whereas disqualification must
be for one of the grounds specified in the CDDA.
Scope: removal under s.168 is limited to the particular company from whose board the
director is removed. When a person is disqualified under the CDDA, they are precluded
from acting in relation to any company.
Chapter 10
Activity 10.1
No feedback provided.
Activity 10.2
There is a risk here that A and B could be in breach of s.172. Although the directors
should have regard to the impact of their decision (to keep, or change, the company’s
vehicle fleet) on the environment, they should be doing this in order to work out
the truly long-term, profit-maximising thing to do. Although the company might,
over the long term, get some benefit from being seen as environmentally more
responsible (more customers might use them, for example, if customers care about
the environment), still, if these benefits do not offset the higher costs of non-petrol
vehicles, then their decision does not seem to promote the success of the company
for the benefit of its members.
But proving that directors realised that the change would reduce profitability overall
might be difficult. The directors might easily say they believed that eventually, over the
very long term, profits would be enhanced, not diminished, by the change.
Does it matter some shareholders might agree with the directors? It would if those
shareholders were prepared to ‘authorise’ the directors’ proposed switch – see later.
page 214 University of London
Activity 10.3
Although the directors’ duty under s.172 is usually to put shareholders first, when the
company is in sufficiently serious financial difficulties, this switches to a duty to put
creditors first. ‘Asset stripping’ would likely breach that creditor-focused switch in
the s.172 duty. The question is whether the company’s financial difficulties are serious
enough to trigger this change in the duty. Although the company is still solvent, this
does not mean the duty may not have switched. The mere fact that the environmental
claim might destroy the company’s solvency does not necessarily mean the company
should now be regarded as insolvent (Dickinson). The question is whether it is more
likely than not that the company will become insolvent (Sequana). That will depend on
a range of considerations, including the likelihood the actions will succeed, the impact
of the loss of the customer, the prospects of finding new customers, etc.
Activity 10.4
If Nigel follows Sarah’s instructions, then he may breach s.173. He will not be exercising
his own judgement. (If he treats Sarah’s ‘instructions’ as just advice about what she
expects but then makes up his own mind what will best promote the success of the
company, then he will not.)
Nigel could perhaps ask for a provision to be put in the constitution authorising him
to act on Sarah’s instructions. This might avoid a breach of s.173 (because of s.173(2)
(b)). However, Nigel would still have to comply with other duties. If, in following Sarah’s
instructions, he does not himself believe the actions she tells him to take will ‘promote
the success of the company for the benefit of its members’, then he may breach s.172.
Equally, if Sarah tells him to do something incompetent, then he may breach s.174
(care and skill) if he does as she tells him. In these cases, the constitutional provision
authorising him to do as Sarah tells him will not prevent those breaches of ss.172 and 174.
Sarah might, perhaps, be in danger of becoming a ‘shadow director’ (under s.251: see
Chapter 9 of this guide). However, remember that to be a shadow, someone must be
instructing a ‘governing majority’ of the board what to do: if Sarah is telling only Nigel
how to act and, if he does not form a majority at board meetings, she will not be a
shadow.
Activity 10.5
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)
(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.
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 10.6
A: it is tempting to assume that the purchase of the business is clear evidence of
incompetence, since it is now losing money. But perhaps this is so only because of
factors, or changed circumstances, that A could not be reasonably expected to have
known. We must not judge her with hindsight and the court would probably not.
Instead, it should focus on process. But in asking if she followed a reasonable process,
it will take account of her professional qualification. She will be judged subjectively.
If the accounts she read would have revealed to a professional accountant problems
in the business, this may evidence her lack of care and skill. The time spent on the
discussion – especially in light of the very large purchase price – might also seem to
show a lack of care.
Company law Feedback to activities page 215
B: will be judged objectively. His youth and lack of experience will not be used to lower
the standard expected of him below that of a reasonable director. He also seems to
have participated in an unreasonably brief process to decide on such a major decision.
Although he might argue he was relying on ‘the expert’ A, still he must exercise
reasonable care to supervise her.
C: seems guilty of omission here. But all directors have a duty to monitor the
performance of their colleagues. Does she fulfil that duty?
Activity 10.7
It can seem unfair to hold directors in breach of s.175 where they take an opportunity
the company is unable to exploit itself, say because its lacks the money to do so (as
in Regal) or because the other party refuses to deal with the company (as in Cooley).
Commonwealth courts have been lenient (e.g. Peso) but UK courts seem stuck in the
strictness of equity’s uncompromising attitude.
Yet might the UK’s rules be justified? One concern has been that judges will struggle
to know if the company is truly unable to exploit the opportunity for itself. The judge
will have to rely a lot on the directors’ own evidence as to whether the company could
take on the opportunity. Judges might perhaps be safer to have a strict rule. This may
sometimes be ‘over-inclusive’ – punishing directors whose companies truly could not
afford to exploit an opportunity. But at least it will not allow guilty directors to mislead
the court with tales of the company’s financial difficulties. A strict rule will incentivise
directors to do all they can to enable the company to take on valuable opportunities; if
directors know they can take an opportunity for themselves, perhaps they will try less
hard to enable the company to get it. Do you agree?
Activity 10.8
Anna here does several different things, each one of which may, or may not, be a
separate breach of s.175. First, she decides to set up in competition. Despite the
broad wording of s.175(1) and (2), merely deciding to compete is not a breach of s.175
(Balston). However, Anna takes steps to advance that intention (signs a lease) without
either resigning or informing the board of her intentions. Per British Midland and the
slightly more relaxed Shepherds Investments, that’s a breach of s.175.
Second, she exploits an opportunity to profit personally (taking the new cycle design).
That seems to breach the broad, catch-all wording of s.175(1) and especially s.175(2).
This conclusion seems to be reinforced by the pre-Act case law, which must be used
to interpret the statutory duties (per s.170(4)). Per Regal, it makes no difference her
company had already rejected the opportunity. Consider if it matters that she learnt of
this opportunity at a social event (Bhullar).
Does it make a difference she resigns before taking this opportunity? Cooley/s.170(2)
suggest not, if the opportunity was discovered while a director (as it was). However,
other cases (Umunna, CMS Dolphin, Foster Bryant) suggest the director may not be liable
if: (i) resignation not motivated by desire to take opportunity; and (ii) opportunity
‘not a maturing business opportunity which company is actively pursuing’. Trans-tag
suggests both conditions must be satisfied for the director to avoid liability. Arguably,
the second condition applies here (given board rejection) but perhaps not the first, so
again, it is unclear if Anna will be liable.
What about Anna’s approaching the shopkeepers? She might be making use of
information learnt while a director, so again s.175 might seem to apply. But Thermascan
suggests she will not be liable for merely using ‘her general fund of knowledge and
information’ acquired while a director (as opposed to confidential information,
trade secrets). It seems unlikely that the information Anna built up about shops, as a
director of Rafters, that she is now using for her cycle sales, would be confidential or
trade secrets.
page 216 University of London
ACTIVITY 10.9
No feedback provided.
ACTIVITY 10.10
No feedback provided.
Chapter 11
Activity 11.1
There could be a number of possible reasons: which do you find convincing?
u Might directors tend to view each other’s behaviour in a positive light and
therefore be less likely to think their colleagues have breached their duties in the
first place?
u Could there be close ties between working colleagues, making some reluctant to
‘turn on’ another colleague?
u Might the board fear that if they cause a colleague to be sued, that colleague will
retaliate by making allegations about the other directors’ conduct (e.g. ‘if I was
behaving so badly as a director, why did you not stop me sooner?’)?
Activity 11.2
Allowing a shareholder to sue for breaches that occurred before they became a
member may give that shareholder a ‘windfall’. By the time they join, the breach may
have already caused the value of the company to fall and the price the shareholder
pays for their shares might be lower to reflect that. If they are then able to sue the
director, derivatively, this may produce a gain for the company and increase the value
of their shares. This might, perhaps, be seen as unfair.
However, the late-coming shareholder would enjoy the same windfall if any other
shareholder brought a derivative claim. The benefits would always be felt first by
the company and then by its current shareholders, regardless of whether they were
shareholders at the time of the breach and suffered a drop in the value of their shares
as a result of the breach.
Activity 11.3
If A tries to ‘excuse’ his breach of duty, which has already occurred, he will be
attempting to ratify that (past) breach. But a ratification is valid only if passed without
counting the votes of the wrongdoer, A (s.239(4)). But if A’s votes are ignored, that will
leave only B’s votes to count, which will be 100 per cent against the resolution to ratify.
Clearly it will not be passed.
If A had called a shareholders’ meeting to approve his actions before taking the
opportunity, he would have been attempting to authorise his future breach of duty.
Then, A would have been entitled to have his votes counted on that resolution to
authorise and, with 51 per cent, the resolution would have been passed, even if B voted
against.
This assumes that the breach was capable of being authorised. There is a debate over
whether some breaches – those that are ‘fraudulent’ – are simply incapable of being
authorised (or ratified) and there is also uncertainty over what counts as a fraudulent
breach in the first place.
Company law Feedback to activities page 217
Activity 11.4
The essential difference between a derivative claim and most proceedings under s.994
is the following. A derivative claim aims to protect the company itself (by enforcing
the director’s breach of duty, producing a remedy, such as damages, for the company).
Most proceedings under s.994 only protect the shareholder who brings them and do
so by getting that shareholder out of the company.
First, there may be some situations where the shareholder bringing the derivative
claim would prefer to remain as a member of the company and fight to protect
the company, rather than leave through s.994. In Wishart v Castlecroft Securities Ltd
[2010] BCC 161, for example, the claimant shareholder feared that if he claimed under
s.994, and were bought out, the value paid for his shares would be very low (because
the company’s main assets were real estate and property prices were low because
of the 2008 financial crisis). He preferred instead to remain a shareholder of the
company and pursue his derivative claim to protect it. The court agreed that, in these
circumstances, that was reasonable.
Second, if the company has other shareholders who have also suffered by the
director’s breach of duty, allowing a derivative claim to proceed will protect the
company and thereby those other shareholders.
Activity 11.5
If a shareholder weighs up the costs and the benefits, to them, of bringing a derivative
claim, they might decide that the costs (to them) exceed the benefits (to them). Their
costs will include:
u the harm suing might cause to the shareholder’s relationship with other
shareholders in the company.
A ‘Wallersteiner order’– if the court is prepared to give one – can help with the financial
costs but the other costs will inevitably be borne by the shareholder who sues.
So, the shareholder who sues incurs most of the costs but gets only some of the
benefits. Our shareholder may calculate that they are better off not suing and hope
that someone else will do so instead. Our shareholder will then be able to ‘free ride’
on the efforts of another shareholder who is willing to sue. But if each shareholder
reasons in this way, all sit back and do nothing. This is often referred to as a ‘collective
action’ problem.
Activity 11.6
There are a number of arguments in support of the statement:
u If the company has lots of shareholders, and each were entitled to bring a personal
claim, this would have a ‘floodgates’ effect. It is better to have a single action –
either by the company (a corporate action) or, at least, on its behalf (a derivative
claim).
u There is a risk of double recovery and of directors being held liable twice. Suppose
a shareholder sues personally, first, and obtains from the director compensation
equal to the drop in the value of their shares. If the company then sues the director,
the company will also be able to recover its own loss. The shareholder, who has
already been compensated, will then get a ‘windfall’ when the value of their shares
rises, while the director will have paid out compensation twice.
page 218 University of London
u If the company is solvent, a single action by the company ensures a fairer
distribution among shareholders of any compensation the director must pay.
Suppose the misbehaving director has enough assets to compensate for only half
of the damage they have caused the company. If we allow each shareholder to sue
personally for their ‘share’ of that loss (the fall in the value of their shares), those
who sue quickly, while the director is still solvent, will recover the full value of
their loss. Those who sue later may receive nothing (once the director has used up
their limited wealth). With a single action by the company, whatever money the
company recovers will benefit all shareholders, in proportion to the shares they
own in the company.
Activity 11.7
As noted, for A to bring a personal claim against B, she must establish, first, that B
owed her some duty personally, which B breached and, secondly, that the loss she is
suing for is not prevented by the ‘reflective loss principle’.
But will the reflective loss principle prevent any of the claims?
a. A’s claim for the drop in value of her shares is prevented by the reflective loss
principle. That loss is a reflective loss. A would be claiming for it as a shareholder.
The company has its own cause of action against B for that loss.
b. These losses are also reflective losses. However, following Sevilleja v Marex Financial
Ltd [2020] UKSC 31, these claims by A will not be prevented by the reflective loss
principle. In respect of her lost salary, A is suing as a director/creditor, not as a
shareholder. In respect of her unpaid loan to the company, A is also suing as a
creditor. The fact that she is also a shareholder does not matter: these losses are
not suffered as a shareholder.
Chapter 12
Activity 12.1
First, we saw in Chapter 8 of this guide that the rules found in the company’s articles
provide some protection. Those terms are given ‘contractual effect’ by s.33 and
can be enforced by each shareholder individually. However, Chapter 8 suggested
this protection is often ineffective. Some provisions (‘outsider rights’) may not be
enforced. Some breaches will be called ‘mere internal irregularities’ and are a wrong
only to the company, not to any individual shareholder, so that only the company
can do anything about the breach (with the majority deciding whether to do so). The
articles can always be altered by the majority.
Second, sometimes company law put restrictions on which shareholders are able to
vote, or how shareholders must vote. Such restrictions are exceptional – so we will
start with the general rules and then mention the limited exceptions.
Company law Feedback to activities page 219
Generally, shareholders are entitled to vote on a resolution even when they are
personally interested in it (if, for example, a director threatened with dismissal owns
shares, they can vote on the resolution to remove them, even though they are clearly
interested in the vote). Moreover, shareholders are generally not required to vote ‘in
the interests of the company’ but can instead ‘vote selfishly’ – i.e. cast their votes in
their own interests: North-West Transportation v Beatty (1887) 12 App Cases 589.
Now two limited exceptions. When shareholders alter the articles, they are supposed
to vote ‘for the benefit of the company as a whole’. And when a breach of duty is being
ratified, some shareholders – the wrongdoer, and those connected with them – are not
allowed to vote (s.239(4)).
Third, derivative claims provide a (weak) form of minority protection. Such claims
do at least allow a minority shareholder to launch proceedings. But if the majority of
shareholders oppose the claim, the minority will probably struggle. If the majority
have authorised the breach, the claim will not be given permission. And if the majority
(but now, without the wrongdoer or those connected to them) ratify the breach,
permission will also be refused.
Activity 12.2
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, Thompson (T), amounted to mismanagement
that unfairly prejudiced their interests as members. At the time of the petition
T was 83 years old. 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 T’s son and the other two were his nephews. Central to
the mismanagement allegation was the complaint that T’s 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 T’s 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 son’s shares in Macro and Earliba.
Activity 12.3
The Court of Appeal held that the petitioner was not acting unreasonably in refusing to
accept a valuation of his shares by the company’s auditor, as provided in the articles,
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 petitioner’s shares
is fair, the petitioner will be acting unreasonably in seeking a winding up order rather
than seeking relief under s.994 CA 2006.
page 220 University of London
Chapter 13
Activity 13.1
Including a restriction on the company’s objects will still have some – internal –
consequences for Alice and so may be worth using to try to ensure the company
remains true to its vegetarian purpose.
So, if Alice remains vigilant about the plans of the other two directors and discovers
that they are planning to make the company enter into a non-vegetarian transaction
in the future, but have not done so yet, then she could go to court and enforce the
objects clause, under s.33. However, if by the time she gets to court, the contract has
already been made, then it will be binding on the company (s.39) and Alice will not be
able to use s.33 to prevent the company performing the contract. Once a contract has
been made, the law protects the third party, and the shareholder’s sensibilities take
second place. It sounds as though Alice, who is semi-retired, might not want to be
checking so constantly on the future plans of her children.
The clause would also be relevant to the duties of her children, as directors. Alice
could remind them that, if they are thinking of making the company rush into binding
non-vegetarian transactions before Alice can stop them, they will still breach their
duties. The risk of doing so might make her children think twice; however, a good
company lawyer who had read Chapter 11 of this guide would probably advise them
that their chances of being sued would be very small.
Activity 13.2
Section 40(1) protects only the third party, and not the company, because the
company does not need to be protected where contracts are unenforceable because
of the lack of authority of the company’s agent. If the company wants to enforce that
contract, despite its agent’s lack of authority, it can simply ratify the contract. The
company has a solution in its own hands to the authority problem. The third party
does not; it needs the law’s protection.
Activity 13.3
In relation to the first (land) contract, this was unauthorised, given Reg.54 of the
company’s constitution and Bolade’s opposition. Abeke can rely on s.40 to have the
contract treated as valid, despite the constitutional limitation on the authority of the
board. However, because the contract is with a director, s.41 also applies, making the
contract still voidable by the company. The company can avoid the land contract.
In relation to the second (vehicles) contract, this was not an unauthorised contract
to begin with. Reg.54 does not apply to this, so the board has the (usual) authority to
make the company enter this contract, even if one director objects. Since the contract
is authorised, its validity does not depend on s.40. Since the validity of the contract
does not depend on s.40, s.41 does not apply.
The important point here is to remember that s.41 only applies to make contracts
(with directors/connected persons) voidable where the contract would be
unauthorised and therefore invalid but for s.40. Most contracts, even with directors,
can be authorised by the board, making s.40 and s.41 irrelevant.
Activity 13.4
As with our advice to Alice (Activity 13.1), including the provision in the articles will
provide Ateef with some but limited protection. If Ateef vetoes a transaction at a
board meeting, then by doing so she denies the other directors the authority to make
the company enter into the vetoed transaction. If the others threaten to ignore the
fact that she has used her veto and make the company enter into the transaction
anyway, she can go to court under s.33 to compel the company not to enter into the
threatened transaction that she has vetoed. (Could it be argued that this power of
veto is not a right she enjoys as a shareholder anyway and so is not in fact enforceable
under s.33? Remind yourself, from Chapter 8, about this problem in enforcing the
articles under s.33 – and remind yourself why Salmon v Quin & Axtens is relevant here.)
Company law Feedback to activities page 221
But if the others move quickly and make the company enter the transaction before
she gets to court, she will effectively lose her right to block it. Once the company has
entered into the transaction, it will be binding on the company, under s.40. She will no
longer be able to prevent it (s.40(4)).
So, as with Alice in Activity 13.1, she will need to be vigilant in regard to the other
directors’ intentions to ignore her veto and will need to move quickly if she wishes to
enforce it.
If the others did ignore it, then they would breach their duties as directors. But Ateef
can probably take little comfort from this: we would have to advise her that she would
have little chance of enforcing that breach.
If she was so angry with the others for ignoring her right of veto, she would probably
have good grounds for a s.994 action (why?).
Activity 13.5
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
What qualities do you think a good NED needs to possess? And do you have them?
Perhaps they include the following:
u Some understanding of business and of the issues that arise in companies that you
need to be looking out for.
u Some NEDs will be monitoring specific areas of management and so might need
specialised expertise – for example, in financial accounting.
u The time and motivation to do a good job – will you be able to spend enough time
acquiring enough information to judge how well the company’s being run?
Activity 14.2
No feedback provided.
Activity 14.3
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 codes 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.
page 222 University of London
Chapter 15
Activity 15.1
In Regal Hastings, the directors could have made Regal sell its assets – its three
cinemas – to the purchaser that they had identified. Next, they would have arranged
for the members to pass a resolution to wind up the now propertyless, but cash-rich,
company. Finally, the liquidator would have distributed that cash to the members. But
instead, the members got their money by selling their shares in Regal to the purchaser,
and Regal continued to exist.
It is worth noting that if the company had been voluntarily wound up, instead of being
sold, probably no action would ever have been taken against the directors for their
alleged breach of duty. In a members’ voluntary winding up, the members (steered by
the directors) would have chosen the liquidator and that liquidator would probably
have been less interested in making Regal, as it was being liquidated, sue its directors.
But the purchaser, as the new owner of Regal, had good reason to make the company
sue its former directors.
Activity 15.2
If both conditions had to be satisfied, some creditors would be prevented from
presenting a petition. Those creditors would fall into one or other of the following two
groups.
First, a short-term creditor of a company that is cash-flow insolvent but that remains
balance-sheet solvent (and so should survive in the long term) would no longer be
able to petition. They would effectively have to be more patient, accepting they
cannot use, or threaten, liquidation, even though they are not being paid in the short
term. Would this be fair to them?
Activity 15.3
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:
The compulsory winding up procedures and the powers of a liquidator and the court
to police the winding up seek to achieve these objectives.