COMPANY LAW NOTES

 CHAPTER 1: INTRODUCTION TO COMPANY LAW IN KENYA

 

1.       BUSINESS STRUCTURES

·       The four principal business structures under the Companies Act 2015 are: the sole proprietorship; the partnership; the limited liability partnership; and the company

·       Sole proprietorships are the most common business structure and involve little formality, but the liability of a sole proprietor is personal and unlimited

·       Where two or more persons wish to conduct business together, they may form a partnership. Such partnerships are subject to greater regulation than sole proprietorships, but less regulation than limited liability partnerships and companies. The liability of the partners is personal and unlimited

·       Limited liability partnerships (LLP’s) were created largely to be a suitable business vehicle for large professional firms, and in many respects, they closely resemble companies

·       Public companies are so called because they can offer to sell their shares to the public at large, while private companies cannot offer to sell their shares to the public at large. There are also other notable differences between public and private companies

·       Both LLP’s and companies are created via a process called incorporation, and are thus known as incorporated business structures or ‘bodies corporate’ – the other two business structures (sole proprietorships and ordinary partnerships) are not created via incorporation and so are known as unincorporated business structures

·       A person wishing to engage in some form of business activity will need to do so via one of the business structures identified above, with each providing different advantages and disadvantages

 

2.       SOLE PROPRIETORSHIP

·       The simplest and most popular business structure is the sole proprietorship, and a sole proprietor is simply a single natural person carrying on some form of business activity on his own account

·       Whilst a sole proprietor will be carried on by an individual for that individual’s benefit, sole proprietorships can take on

employees (although the vast majority do not)

·       The key points are: the sole proprietorship is not incorporated, and the sole proprietor does not carry on business in partnership with anyone else

·       Sole proprietorships will come in two forms:

(i)            Sole practitioners – this is where the sole proprietor is a professional, e.g. an accountant, an advocate, etc.

(ii)            Sole trader – this is where the sole proprietor is not a professional

·       There is no separation between a sole proprietor and his business, and the sole proprietorships do not have corporate personality. Accordingly, the sole proprietor owns all of the assets of the business and is entitled to all the profit that the business generates

 

2.1        FORMATION AND REGULATION

·       Commencing a business as a sole proprietor is extremely straightforward and involved much less formality than creating an LLP or a company

·       All that an individual needs to do in order to commence business as a sole proprietor is to register himself with the Registrar

·       Requirements for registering as a Sole Proprietor in Kenya are:

(i)            Unique business name – your business has to be unique and not an imitation of another business name;

(ii)            Nature and business or company must be stated clearly (and specifically)

(iii)            Having a specific physical and postal address, and contact information of the sole proprietor

(iv)            Names of the business owner and all other partners involved in the business, as well as other details such as: nationality, age, gender, location of residence, copy of identification documents, additional business occupation passport photos, copies of KRA PIN Certificates and signed B2N Forms

 

2.2        FINANCE

·       In terms of raising finance, sole proprietorships are at a disadvantage when compared to other business structures

·       E.g. partnerships can raise finance by admitting new partners and companies can raise finance by selling shares, however, neither of these options is available to a sole proprietor (who wishes to remain as such)

·       To raise finance, sole proprietors must either invest their own money into the business (and risk losing it should the business fail) or obtain a loan

·       However, given that many sole proprietorships are small affairs, banks are ordinarily cautious when lending money and obtaining large amounts of debt capital or usually impossible

 

2.3        LIABILITY

·       The principle disadvantage of carrying on business as a sole proprietor is that the liability of the sole proprietorship is

personal and unlimited

·       Whereas partnerships and companies can be limited, it is impossible to create a limited sole proprietorship. Accordingly, the sole proprietor’s assets (including personal assets such as his house, car and bank accounts) can be seized and sold in order to satisfy the debts and liabilities of the sole proprietorship

·       If the sole proprietorship’s debts and liabilities exceed the assets, then the sole proprietor will likely be declared bankrupt

 

3.       COMPANY

·       Section 3(1) Companies Act 2015 (‘CA 2015’) defines a company as ‘a company formed and registered under this Act or an existing company’

·       A registered company is a legal, juristic person, capable of owning land and other property, and entitled to enter into contracts, sue and be sued, have a bank account in its own name, owe money and be a creditor to others

·       A registered company is liable for torts and crimes committed by its servants and agents of the company, and is distinct and separate from its founders and members

·       In legal theory, a company denotes an association of persons for some common object or objects, who contribute money

or money’s worth into a common stock and who employ it for some common purpose

·       There are three fundamental legal concepts pertinent to companies:

o   The concept of legal personality (i.e. corporate personality);

o   The capacity to create legal binding relations; and

o   The concept of limited liability

 

3.1    FUNDAMENTAL CONCEPTS

3.1.1       LEGAL PERSONALITY (CORPORATE PERSONALITY)

·       Legal personality means that the law recognises certain persons as having certain legal rights and duties which can be enforced through the courts. Apart from human beings, the law also affords this legal personality to corporations

·       A corporation is an artificial person created by law, and once it comes into being it is treated by law as a person in its own right, and is independent from the individual members who compose it

·       Corporate personality thus encompasses the capacity of a corporation to have a name of its own, to sue and be sued, to have the right to purchase/sell/lease/mortgage its property in its own name, etc.

·       In addition, property cannot be taken away from a corporation without the due process of the law

 

3.1.2       LEGAL BINDING RELATIONS

·       The validity of a business transaction rests almost entirely on the status of the parties and on their legal capacity to crea te a relationship attended to by legal consequences

·       Accordingly, to attract legal intervention in any case, recognition as a body corporate is vital – i.e. to engage in any legal

process as a party to a transaction depends on one’s status and recognition as a legal person

·       Therefore, legal personality is a fundamental ingredient of capacity, without which a person cannot enter into a binding contract

·       Institutions that enjoy corporate personality, separate from the members who formed it, are:

o   Companies registered under the Companies Act (i.e. incorporated entities/corporations)

o   Statutory corporations established by Acts of Parliament

o   Chartered companies

·       On the other hand, there are institutions that do not have legal personality and do not attract recognition as legal entities due to the fact that they advance interests of a social rather than commercial nature, e.g. societies, guilds, NGOs, etc.

·       Due to the fact that these institutions lack the status of a body corporate, they cannot be liable for contractual debts and obligations incurred by officers on their behalf, whether or not they purport to act for and on behalf of the members

·       Liability vests in actual officers who act on behalf of members or who have been given express authority by members to carry out certain acts, e.g. in the case of societies: they are an unincorporated association (though registered and regulated by statute), and so do not enjoy recognition as legal entities and are not conferred with corporate personality. Thus, they may transact business in their own name, but the members are jointly and severally liable to account for the society’s debts and obligations without any limitation

 

3.1.3       LIMITED LIABILITY

·       Liability is the extent to which a person can be made to account by law – i.e. he can be made accountable either for the full amount of his debts or else pay towards that debt only to a certain limit and not beyond it

·       In the context of company law, liability may be limited either by shares or by guarantee:

o   Section 6(2) CA 2015: in a company limited by shares, the liability of the members of the company is taken to be limited to any amount unpaid on the shares held by that member

o   Section 7(1)(b) CA 2015: in a company limited by guarantee, the liability of the members is limited to the amount that they undertake, within the articles of association, to contribute to the company in the event of its liquidation

·       Note: nearly all statutory rules embodied in CA 2015 are for the protection of the company’s creditors and investors (who

are ordinarily the members)

 

3.2                     INCORPORATION OF A COMPANY

·       Sole proprietorships and ordinary partnerships can be brought into existence very easily and with minimal state involvement

·       Conversely, companies (and LLPs) are brought into existence at the discretion of the state via a formal process known as ‘incorporation’ à the word ‘incorporation’ is used because successful incorporation brings into existence a ‘corporation’ (Section 18, 19 CA 2015)

·       There are three principal methods by which a company can be incorporated:

o   Incorporation by an Act of Parliament;

o   Incorporation by an Executive Order; or

o   Incorporation by registration

·       The provisions of the CA 2015 generally apply only to companies incorporated by registration (known as registered companies), although they can be extended to cover unregistered companies (i.e. state corporations)

·       The vast majority of companies in Kenya, however, are registered

 

3.2.1     INCORPORATION BY ACT OF PARLIAMENT

·       Parliament can create a company by passing an Act of Parliament

·       E.g. the Kenya Railway Corporation Act (Cap. 397) gave rise to the Kenya Railway Corporation

 

3.2.2  INCORPORATION BY EXECUTIVE ORDER

·       A company can be created by an Executive Order (Section 3 of the State Corporations Act)

·       E.g. in March 2013, the LAPSSET Corridor Development Authority (LCDA) was established through the Presidential Order Kenya Gazette Supplement No. 52, Legal Notice N. 58, The LAPPSET Corridor Development Authority Order 2013

·       This was established to coordinate, plan and manage the implementation of the Lamu Port – South Sudan – Ethiopia Transport Corridor

 

3.2.3  INCORPORATION BY REGISTRATION

·       There are three generally recognised corporate personalities: companies, chartered corporations and statutory companies

·       Although they all have corporate personalities, the procedure in forming them varies

·       The procedure in incorporation of a company is generally as follows:

(i)       Determine whether you are incorporating a public or a private company

(ii)     Determine whether you will be incorporating a limited or unlimited company

(iii)    If your company is limited, determine whether your company will be limited by shares or by guarantee

(iv)    Choose a name for your company

§  The chosen name must be reserved at the company’s registry

§  This involves writing to the Registrar of Companies asking that a search be run on the name to confirm that a company with the same name does not already exist, and if so, asking that the name be reserved for use as a company name

§  The Registrar checks if the name sought is desirable, and once this is confirmed, the reservation remains in force for a period of 30 days

§  This period can be extended for a further 30 days, during which time no other company may be registered in that name

(v)     Develop the Memorandum and Articles of Association

§  The MEMARTS are the founding document and provide the basis for the whole corporate structure

§  This is the document in which the promoters express inter alia their desire to be formed into a company with a specific name and objects

§  The MEMARTS are the primary document which set up the company constitution and its objects – as the founding document, it determines the nature and scope of the company

§  The Articles play a subordinate role to the Memorandum – they contain the rules and regulations b which the company’s internal affairs are governed, e.g. how shares and share capital are to be allotted, how company meetings are to be conducted, how directors are appointed, etc.

 

3.2.3.1    PREPARATION OF THE MEMARTS

·       Before preparing the MEMARTS, the draftsman will need to obtain the following information from the promoters:

(i)       The nature of the business

(ii)     The amount of the nominal capital and the denomination of the shares into which it is to be divided

§  These details will need to be stated in the MEMARTS

§  For the articles, the drafter will also require to know if the shares are all to be of one class, and if not, what special rights are to be attached to each class

(iii)    Any other special requirements which deviate from the normal, as exemplified by the appropriate table

·       The MEMARTS should be printed in the English language and should provide for the following:

o   The name of the company with ‘limited’ as the last word of the name

o   The registered office of the company (to be situated in Kenya)

o   The objects of the company

o   The liability of the members of the company (i.e. unlimited)

o   The share capital of the company and how the same is divided up)

·       Moreover, the memorandum should be dated and signed by each subscriber. Opposite the signatures of the subscribers, the memorandum should state the subscribers’ full name, his occupation, full address and for further clarity it is important to indicate their national identity numbers and PIN numbers

·       The signatures must be witnessed by at least one witness who should state his occupation and postal address à witnessing is best done by an advocate

 

3.2.3.2    EFFECT OF THE MEMARTS

·       The MEMARTS form a contract which is binding on members of the company

·       Action to enforce this contract must be brought in the name of the company, except where a personal right is infringed

·       The MEMARTS bind the company and each of the members as if they had been signed and sealed by each member and contained covenants for the part of each member to observe all their provisions

·       Hickman v Kent [1950]: the MEMARTS provided that any suit between any member and the company should be referred to arbitration. A dispute arose between Hickman and the company, and instead of referring the same to arbitration, he filed an action against the company. The court held that the company was entitled to have the action stayed since the articles amount to a contract between the company and the Plaintiff, one of the terms of which was to refer such matters to arbitration. Justice Ashbury had the following to say à The law is clear and could be reduced to 3 propositions:

(i)       No Article can constitute a contract between the company and a third party;

(ii)     No right merely purporting to be conferred by an article to any person, whether a member or not, in a capacity other than that of a member (for example, a solicitor, promoter or director) can be enforced against the company

(iii)    Articles regulating the right and obligation of the members generally as such do not create rights and obligations between members and the company

 

CASE

HOLDING

Eley v Positive Government Security Life Assurance Company [1876]

The claimant solicitor drafted the defendant company’s articles, which were duly registered. The articles provided that the claimant would act as the company’s solicitor and could not be removed unless he engaged in some form of misconduct. Soon thereafter, the company ceased to employ the claimant and engaged another firm of solicitors. The claimant held that the company had breached the terms of the articles. The claimant’s action failed. The company might very well have breached the articles, but as the claimant was not party to the statutory contract, he could not sue for such a breach

 

3.3    ADVANTAGES OF INCORPORATION

3.3.1       CORPORATE PERSONALITY

·       The primary advantage, from which many other advantages flow, is that the company acquires corporate (or separate, or legal) personality à This means that the company is regarded by the law as a person

·       Whereas humans are classified as natural persons, the company is a legal person and can therefore do many things that humans can

 

3.3.2       LIMITED LIABILITY

·       Since a corporation is a separate person from its members, the members are not liable for its debts – in the absence of provisions to the contrary, the members are completely free from any personal liability

·       In a company limited by shares, the members’ liability is limited to the amount unpaid on shares, whereas in a company limited by shares, the members’ liability is limited to the amount they guaranteed to pay

·       Thus, a corporation is a legal entity, distinct from its members, capable of enjoying rights and being subject to duties which are not the same as those enjoyed or borne by the members

·       Limited liability is a powerful incentive to incorporate, but may not provide substantial benefit to smaller companies in practice, e.g. banks will often require that the directors/members of small companies sign personal guarantees, thereby ensuring that they become personally liable should the company default on the loan

·       Further, limited liability companies pay for limited liability in the form of increased regulation, e.g. disclosure requirements

·       Salomon v Salomon [1987] AC 22: The House of Lords held that there is a complete separation of a company and its members, i.e. ‘either the limited company was a limited entity or it was not. If it was, the business belonged to it and not to Salomon. If it was not, there was no person and nothing at all and it is impossible to say at the same time that there is the company and there is not’. The significance of the case is threefold:

(i)            The decision established the legality of the so-called one-man company;

(ii)            The decision showed that incorporation was as readily available to small private partnerships and sole traders as to the large private company; and

(iii)            It also revealed that it is possible for a trader not merely to limit his liability to the money invested in his enterprise but even to avoid any serious risk to that capital by subscribing for debentures rather than shares

·       It is noteworthy that while limited liability minimises the risk faced by members and so encourages investment in companies, it weakens the position of the company’s creditors who cannot access the personal assets of the members to offset any debts of the company. It is therefore argued that limited liability does not so much minimise the members’ risk, but instead shifts it from them to the company’s creditors

 

3.3.3       CONTRACTUAL CAPACITY

·       As the company is a person, it can enter into contracts with both persons inside and outside the company

·       Lee v Lee’s Air Farming Limited [1961] A.C. 12: Lee’s company was formed with capital of £3000 divided into 3000 £1 shares. Of these shares, Mr. Lee held 2,999 and the remaining one share was held by a third party as his nominee. In his capacity as controlling shareholder, Lee voted himself as company director and Chief Pilot. In the course of his duty as a pilot he was involved in a crash in which he died. His widow brought an action for compensation under the Workman’s

Compensation Act and in this Act, workman was defined as “A person employed under a contract of service” so the issue was whether Mr. Lee was a workman under the Act? The House of Lords held “that it was the logical consequence of the decision in Salomon’s case that Lee and the company were two separate entities capable of entering into contractual relations and the widow was therefore entitled to compensation”

 

3.3.4       HOLDING PROPERTY/OWNERSHIP OF ASSETS

·       Corporate personality enables the property of the association to be distinguishable from that of the members

·       The property of the incorporated entity must be dealt with according to the rules (i.e. memorandum and articles of association) and no individual member can claim any particular asset within that pool of property

 

3.3.5       SUING AND BEING SUED

·       As a legal person, a company can take action in its own name to enforce its legal rights. Conversely, it may be sued for breach of its legal duties (the only restriction being that it must be represented by a lawyer in all these actions)

·       East Africa Roofing Company v Pandit [1954] 27 KLR 96: the court held that a corporation such as a limited liability company cannot appear in person as a legal entity without any visible person and having no pshysical existence it cannot at common law appear by its agent but only by its lawyer (the CA 2015 has not changed this common law rule so as to enable a limited company to appear in court by any of its officers)

 

3.3.6       PERPETUAL SUCCESSION

·       A company can only cease to exist by the same process of law which brought it into existence; otherwise, it is not subject to the death of a natural body

·       Even though the company’s members may change over the years, the company continues in existence

 

3.3.7       TRANSFERABILITY OF SHARES

·       Section 326 CA 2015: ‘the shares or any other interests of a member in a company shall be moveable property transferable in the manner provided by the Articles of Association’

·       Therefore, shares in a company are transferable and upon a transfer being effected, the assignee steps into the shoes of the assignor as a member of the company with the full attendant rights thereto

·       Note: this transferability does not relate to private companies, which companies often have their own rules regarding transfer and sale of shares (contained in the memorandum and articles of association – ‘MEMARTS’)

 

3.3.8       BORROWING FACILITIES

·       In practice, companies can raise capital by borrowing much more easily than the sole trader or partnership

·       This borrowing is enabled by the device of the ‘floating charge’ – it is a charge that ‘floats’ over the assets of a company, from time to time with a certain description, but without preventing the company from using those assets or disposing off those assets in the ordinary course of its business, until an event which causes the charge to become crystallised or fixed

·       This is facilitated by the Chattels Transfers Act which exempts companies from compiling an inventory on the particulars of such charges

 

3.4    DISADVANTAGES OF INCORPORATION

3.4.1       INCREASED FORMALITY, REGULATION AND PUBLICITY

·       Companies are subject to significantly more formality and regulation than unincorporated businesses

·       Setting up a company is a more complex task than setting up a sole proprietorship or an ordinary partnership

·       The increased formality and regulation extend beyond formation, and complex rules can apply throughout the company’s

existence (e.g. the rules relating to the calling and running of general meetings)

·       Directors are also subject to a raft of statutory duties that sole proprietors and partners are not subject to

·       Incorporation also results in a loss of privacy as most companies are required to make certain information (e.g. financial accounts) publicly available throughout their existence

 

3.4.2       CIVIL LIABILITY

·       If a company has been wronged, it can commence legal proceedings to redress that wrong. Similarly, if a company commits a civil wring, it can be sued and made liable to pay compensation

·       In many cases, imposing liability upon the company for civil wrongs of its directors/employees poses no problem, as the company can be made liable via the doctrine of vicarious liability (in the case of tortious liability) or via the law of agen cy (in relation to contractual liability)

·       However, the issue is often more complex as certain civil wrongs require defendants to have a certain level of knowledge that the company, as an entity, will lack for obvious reasons

·       The law’s answer is to use the ‘identification theory’ which states that knowledge of certain persons will be attributed to a company. However, the courts will only attribute to the company the knowledge of persons who constitute the ‘directing will and mind’ of the company (Lennard’s Carrying Company limited v Asiatic Petroleum Company Limited [1915])

·       In many cases, this will be limited to the directors and senior officers of the company, and to persons in management to whom the directors have delegated managerial functions (Tesco Supermarkets Limited v Nattrass [1972])

 

3.4.3       CRIMINAL LIABILITY

·       Just as a company can be found liable for committing a civil wrong, so too can it be found guilty of committing a crime

·       However, in the case of R v ICR Haulage Limited [1944] it was held that a company cannot be imprisoned, i.e. it cannot be found guilty of any crime for which the only punishment is imprisonment (e.g. murder)

·       Where the crime is one that requires mens rea, the courts will utilise the identification theory and attribute mens rea to those who are the directing will and mind of the company

·       Corporate manslaughter is a relaxation of this rule – i.e. courts would only impose liability on the company if the death was the result of the actions and gross negligence of an identifiable member of the directing mind and will of the company

 

3.5    PUBLIC AND PRIVATE COMPANIES

·       The CA 2015 provides for a number of different forms of company, classifiable by reference to certain characteristics:

o   Is the company public or private?

o   Is the liability of the company’s members to be limited or unlimited? – If liability is to be unlimited, then the company must be private. The law does not allow for creation of unlimited public companies (CA 2015, S. 5 & 8)

o   Does the company have share capital or not? – Public companies must have a share capital, but private companies

need not. A limited company that does not have a share capital will be a company ‘limited by guarantee’ (CA 2015,

S. 6 & 7)

·       When creating a company, the promoters are required to state whether the company is to be registered as a private company or as a public company

o   Section 10 CA 2015: A public company is a company limited by shares, or limited by guarantee and having a share capital, whose certificate of incorporation states that it is a public company

o   Section 9 CA 2015: A private company is a company whose MEMARTS restrict a member’s rights to transfer shares, limit the number of members to 50, and prohibit invitations to the public to subscribe for shares; it is not a company limited by guarantee; and, its certificate of incorporation states that is it a private company

 

PUBLIC COMPANY	PRIVATE COMPANY
May offer to sell its shares to the public at large, and to facilitate this end, may list its shares on a stock market. Such companies are known as ‘listed companies’ or ‘quoted companies’	Are not permitted to sell their shares to the public at large, nor can they list their shares on a stock exchange (CA 2015, S. 11)
Required to have an allotted share capital of at least Kshs. 6, 750, 000 (‘minimum authorised capital requirement’ under CA 2015, S. 518)	Can be created with a trivial amount of capital
Can be created with only one member, but must have at least two directors (CA 2015, S. 128)	Can be created with only one member, and can be formed with only one director
Required to appoint a Company Secretary	Only required to appoint a Company Secretary if the paid- up capital is more than Kshs. 5, 000, 000 (but may also do so if they otherwise wish) (CA 2015, S. 243 – 244)
Must add the suffix ‘Plc’ to their name (CA 2015, S. 53)	Must add the suffix ‘Ltd’ to their name (CA 2015, S. 54)

3.6    LIMITED AND UNLIMITED COMPANIES

·       The terms ‘limited’ and ‘unlimited’ do not refer to the company itself, but to the liability of its members

·       It is not clear whether the liability of a public company must be limited (as is the case in the United Kingdom), however, when the promoters decide to form a private company, they will need to decide whether the liability of the company’s members will be limited or unlimited

·       Limited liability:

o   The vast majority of companies are limited liability companies as compared to unlimited companies

o   Where the liability of a company is limited, the form and extent of the limitation will depend upon whether their liability is limited by guarantee or limited by shares

o   Where a company is limited by guarantee, the liability of the members is limited to the amount stated in the statement of guarantee (Insolvency Act 2015, Section 385(3))

o   Where a company is limited by shares, the liability of the company’s members will usually be limited to the amount that is unpaid on their shares (Insolvency Act 2015, Section 385(2)(d)) à members who have fully paid for their shares are generally not liable to contribute any more to the company

·       Unlimited liability:

o   In the United Kingdom, for example, only 0.1% of all companies are unlimited

o   The reason why there are so few unlimited companies is because upon winding up, the liability of the members is personal and unlimited, and so their personal assets (e.g. house, car, bank accounts, etc.) can be seized and sold to satisfy the company’s debts

o   The primary reason a company would choose unlimited liability is that such companies are subject to less regulation than limited companies, and so their affairs can be conducted with less formality and more privacy

o   It is unlikely that the promoters will wish to form an unlimited company if the company is intended to trade, however if the company is merely for holding land or other investments, the absence of limited liability would not matter

 

3.7    PROMOTION OF A COMPANY

·       Persons who wish to create a company may need to undertake various activities in order for the company to be able to commence business (e.g. preparing incorporation documents, hiring or buying business premises, obtaining supplies or operating capital, etc.)

·       Such persons, who usually go on to become the company’s first directors, are known as ‘promoters’ of the company and

their activities are closely regulated by the law

·       Notably, these promoters owe fiduciary and statutory duties to the unformed company notably, e.g. a promoter cannot make a secret profit out of the company’s promotion. In addition, a promoter will usually be personally liable on a contract entered into on behalf of a company if that company has not been incorporated at the time the contract was entered into

 

3.7.1      WHEN WILL A PERSON BE A PROMOTER?

·       The law has not sought to define precisely what a promoter is, as if it did, persons would try take themselves out of the definition in order to avoid regulation

·       However, lack of a definition is problematic, as determining whether a person is a promoter is crucial for several reasons:

o   Promoters owe fiduciary duties to the unformed company;

o   Promoters can be held liable for acts in engaged in on behalf of the unformed company; and

o   While the word ‘promoter’ only appears once in the CA 2015, the common law imposes a number of obligations

on company promoters (especially those of public companies)

·       Accordingly, the court in Whaley Bridge Calico Printing Co. v Green [1880] described a promoter: ‘the term promoter is a term not of law, but of business, usefully summing up in a single word a number of business operations familiar to the commercial world, by which a company is generally brought into existence’

·       Accordingly, the word promoter refers to those persons involved in the formation of the company, but based upon the particular facts of each case

·       However, not all persons involved in the formation of a company will be categorised as promoters, e.g. those involved by virtue of their professional duties (such as advocates or accountants) will not be regarded as promoters (Re Great Wheal Polgooth Co. Limited [1883])

3.7.2      DUTIES OF A PROMOTER

·       A promoter occupies a dominant position in relation to the unformed company and, to prevent that position being abused, the promoter will owe the unformed company a number of duties

·       Two board categories of duties can be identified: fiduciary duties and duties imposed by statute

 

(i)             Fiduciary duties

·       A promoter occupies a fiduciary position in relation to the unformed company

·       Accordingly, the promoter is not permitted to make a profit out of the company’s promotion, unless the nature of the promoter’s interest and the profit made by the promoter is disclosed

o   Should the promoter fail to disclose the profit, the transaction in question will be voidable and can be rescinded by the company à Erlanger v new Sombrero Phosphate Co. [1978]: in this case, the promoters of a company sold a lease to the company at twice the price paid for it without disclosing this fact to the company. It was held that the promoters had breached their duties and that they should have disclosed this fact to the company’s board of directors. Since a promoter owes his duty to a company, in the event of any non-disclosure, the primary remedy is for the company to bring proceedings for rescission of any contract with the promoter, or, recovery of any profits from the promoter

o   If rescission fails to recover the value of the profit, or if the right to rescind is lost, then the promoter can be made to account to the company for the value of the profit (Emma Silver Mining Co. v Grant [1897])

·       For example: if, upon incorporation, a promoter sells to the newly formed company an asset that he acquired during the company’s promotion, he will not be permitted to keep the proceeds of sale, unless he discloses the nature of the interest and the extent of the profit made. However, disclosure will only be valid if the persons to whom it is made are independent (Erlanger v new Sombrero Phosphate Co. [1978])

 

(ii)            Duties imposed by statute

·        In addition to the common law fiduciary duty, promoters are also subject to statutory duties

·       E.g. CA 2015, Section 373 states that a non-cash asset cannot be sold to a public company by a person who is a subscriber to the company’s memorandum, unless the non-cash asset has been independently valued and the members have approved the same (2-year initial period)

 

3.7.3      PRE-INCORPORATION CONTRACTS

·       Prior to incorporation being completed, the promoters of the unformed company will likely need to enter into contractual

agreements with third parties in order to cater for the company’s future needs

·       E.g. the promoters may need to contract with creditors to obtain capital, or they may need to contract for supplies or office premises, or take on employees

·       A company does not have the capacity to enter into such contracts until it is fully incorporated

·       The validity of these contracts has been (through case law) based on determining the intent of the parties as revealed in the contract – a process which proved notoriously difficult and which resulted in a significant confusion in the law (as well as a perception that cases in this area could turn based on complex and technical distinctions) – see: Phonogram Ltd v Lane

·       This confusion is shown by contrasting the two following cases:

o   Kelner v Baxter [1866]: the promoter signed the contract ‘on behalf of’ the unformed company, and it was held that a binding contract existed between the promoter and the third party

o   Newborne v Sensolid (Great Britain) ltd [1954]: the promoter signed the contract using the company’s name and added his own signature underneath. It was held that the contract was between the promoter and the unformed company, and, as the company had no legal capacity, no contract existed

·       Under statute, the general position is that if, before a company has acquired legal personality, action has been carried out in its name, and the company does not assume the obligations arising from such an action, the persons who acted shall – without limited – be jointly and severally liable therefore (unless otherwise agreed)

·       CA 2015, Section 44: ‘a contract that purports to be made by or on behalf of a company at a time when the company has not been formed has effect, subject to any agreement to the contrary, as a contract made with the person purporting to act for the company or as an agent for it, and the person is personally liable on the contract accordingly’

o   The basic effect of this section is to render a promoter personally liable for the pe-incorporation contract

o   This clearly benefits third parties who contract with the promoter, as they will be able to sue the promoter should the terms of the pre-incorporation contract be breached

o   However, the section does not indicate whether or not the third party can be liable to the promoter in the event of the third party failing to honour the contract

o   Braymist Ltd v Wise finance Co Ltd [2002]: it was held that a promoter could sue a third party, but the fact that judicial clarification was required demonstrates a flaw in drafting of the section

·       The courts have clearly stated that a company, once incorporated, cannot ratify or adopt a pre-incorporation contract made on its behalf (Re Northumberland Avenue Hotel Co [1886]) à The only way that a company can take advantage of a pre-incorporation contract is for the promoter and third party to discharge the pre-incorporation contract and the company then to enter into a new contract with the third party in respect of the same subject matter (Howard v Patent Ivory Manufacturing Co (1888)). This process of substituting one contract with another is known as ‘novation’

 

3.7.4      ‘SUBJECT TO ANY AGREEMENT TO THE CONTRARY’

·       The imposition of liability under Section 44 is ‘subject to any agreement to the contrary’, which means that a promoter can avoid liability if he can show that he and the other party to the contract agreed that, upon incorporation, the promoter would be released from liability and the company would enter into a second contract with the other party on the same terms as the first contract (i.e. an agreement to novate the contract was present)

·       The agreement can be express or implied, but the courts will require clear evidence that such an agreement exists ( Bagot Pneumatic Tyre Co v Clipper Pneumatic Tyre Co [1902])

·       In the absence of an express agreement, this will likely be difficult for a promoter to prove. Simply acting as a promoter or agent of an unformed company will not be enough to infer the existence of a contrary agreement (Phonogram Ltd v Lane [1982])

CHAPTER 2: LIFTING THE CORPORATE VEIL

 

·       Upon incorporation, the company becomes a person in its own right and can do many things that a natural person can do

·       Corporate personality was available to unregistered companies, but with the passing of the Joint Stock Companies Act 1844 and the ability to incorporate a company by registration, corporate personality took on a new found importance

·       However, it was not until Salomon v Salomon [1897] that courts appreciated the true significance of corporate personality

o   It recognised that a company could legitimately be set up to shield its members and directors from liability;

o   It implicitly recognised the validity of the ‘one-man company’ (i.e. a company run by one person, with a number

of dormant nominee members) nearly a century before single-person companies could be formally created; and

o   The fact that a person holds shares (even all the shares) is not enough to create a relationship of agency or trusteeship

·       There is no doubt that Salomon is the cornerstone upon which company law is based. However, the ability to set up a company to shield oneself from liability is clearly open to abuse

·       Therefore, both Parliament and the courts have the ability to ignore a court’s corporate personality and impose liability upon those behind the company’s corporate personality

·       This is known as ‘piercing’ or ‘lifting’ the ‘corporate veil’ – referring to the ‘corporate veil’ that hides the company’s

members and directors from liability

 

1.       STATUTE

·       As companies are granted corporate personality by statute, it follows that statute can set aside corporate personality and impose liability on those behind the veil

 

SECTION 519, CA 2015	No trading certificate: if a public company carries on business, or exercises any borrowing powers, prior to being issued with a trading certificate, then the directors can be made personally liable
SECTION     505,                   632, INSOLVENCY ACT 2015	Fraudulent trading: where, in the course of winding up, it appears that the company has been run with an intent to defraud the creditors (known as fraudulent trading), the court may lift the veil and impose personal liability on any persons who were knowing parties to such conduct
SECTION                               506, INSOLVENCY ACT 2015	Wrongful trading: where a company has gone into insolvent liquidation, the directors may be personally liable if they continued trading when they knew, or ought to have known, that there was no reasonable prospect of the company avoiding liquidation

 

2.       COMMON LAW

·       As corporate personality is bestowed by statute, it follows that the courts are reluctant to pierce the veil, as case of Adams v Cape Industries Plc [1990] demonstrates:

o   FACTS: The defendant parent company (Cape) was based in England. A subsidiary of Cape was based in South Africa, where it mined asbestos. The asbestos was sold by other subsidiaries, one of which was based in Illinois, USA. The asbestos was sold to a factory in Texas and a number of the factory’s employees developed asbestos- relates medical conditions. A US court ordered that $15 million be paid in damages, but this could only be enforced against Cape in the UK if the claimants could show that Cape was present in the USA. Accordingly, the claimants argued that Cape was present in the USA through its Illinois subsidiary. For this argument to succeed, the separate personalities of the various companies would need to be ignored

o   HELD: The court refused to lift the veil and held that the US subsidiary was separate and distinct from its UK parent company. Accordingly, Cape was not present in the USA and the judgement of the US court could not be enforced against it. Salomon allowed a parent to use its subsidiaries to avoid liability in this way, and the Court was of the opinion that, on the facts, there were no ground to avoid following Salomon

·       However, as we shall see below, the courts have developed a string of jurisprudence touching on situations where the corporate veil will be lifted

 

2.1    FRAUD, SHAM OR CLOAK

·       The most straightforward and least problematic situation in which courts could pierce the corporate veil was where the company was being used to perpetuate fraud, or the company was a façade or sham

·       A common theme amongst such cases is that the company was used to evade some form of existing contractual provision or obligation (i.e. avoiding an existing liability, not a future liability)

 

CASE	HOLDING
Gilford Motor Company Limited v Horne [1933] Ch 935	The defendant was the managing director of the claimant company. His employment contract provided that, should he leave the company, he would not attempt to solicit any of its customers. His employment was terminated, and his wife set up a rival company which competed directly with the claimant. It was clear that this new company was set up at the defendant’s behest and was under the defendant’s control. The court granted an injunction preventing the defendant (and the new company) from soliciting the claimant’s customers. Lord Hanworth MR stated that the new company was ‘formed as a device, a stratagem, in order to mask the effective carrying on of a business of [the defendant]’ and to avoid the restrictive covenant.
Jones v Lipman [1962]	Lipman entered into a contract to sell property to Jones. Shortly thereafter, Lipman changed his mind. To avoid selling the property to Jones, Lipman transferred the property to a company he owned and controlled and had set up to hold the property. When Jones decided to sue Lipman, Lipman said he did not own the land anymore as it was owned by the company. The court found that Lipman created the company only to avoid existing legal obligations and so it lifted the corporate veil – ‘the defendant company is the creature of the first defendant, a device and sham, a mask which he holds before his face in an attempt to avoid recognition by the eye of equity’.
Antonio Gramsci Shipping Corn v Stepanovs [2011]	The holding developed a number of principles to apply in cases involving companies set up fraudulently: ·       The defendant need not be in sole control of the company in question – where there were a number of wrongdoers, with a common purpose, in control of the company, then liability could be imposed on all, or one, of them ·       The veil would not be pierced simply because the company behaved fraudulently – what must be established is that there was a fraudulent misuse of the company structure ·       The veil will only be pierced when the fraud or wrongdoing in question is within the ordinary business of the company in question ·       A contract entered into by a ‘puppet company’ could be enforced against both the puppet company and the puppeteer, although the puppeteer would not be permitted to enforce the contract on policy grounds
VTB     Capital     Plc     v     Nutritek International Corp [2013]	VTB Capital plc (VTB) lent US$225 million to Russagroprom LLC (RAP), which RAP intended to use to purchase a number of Russian companies from Nutritek. RAP defaulted on the loan. VTB alleged that it was induced into entering into the loan agreement with RAP based on fraudulent misrepresentations made by Nutritek. VTB alleged that representations were made indicating that RAP and Nutritek were not under common control, whereas both companies were, in reality, controlled by Mr Malofeev, a Russian entrepreneur. VTB commenced proceedings against Nutritek, Malofeev and several other companies that were involved, alleging that they were liable for RAP’s breach of contract. In order for this claim to succeed, the corporate personality of RAP would need to be pierced and VTB argued that the veil should be pierced on the ground that Malofeev and his associated companies were using RAP as a puppet company to orchestrate a fraud against VTB. VTB claimed that once the veil was pierced, the defendants would become party to the original loan agreement between VTB and RAP, and so would be liable on it. The Supreme Court refused to pierce the corporate veil. Lord Neuberger stated that, to find the defendants liable on the loan agreement, would involve an extension of

 

	the circumstances in which the veil could be pierced. It would, in effect, result in Malofeev becoming a co-contracting party with RAP under the loan agreement. He refused to do this on the ground that where B and C are the contracting parties and A is not, there is simply no justification for holding A responsible for B’s contractual liabilities to C simply because A controls B and has made misrepresentations about B to induce C to enter into the contract. This could not be said to result in unfairness to C: the law provides redress for C against A, in the form of a cause of action in negligent or fraudulent misrepresentation
Creasy     v   Breachwood  Motors Limited [1993]	Creasy claimed wrongful dismissal from Breachwood Motors. Breachwood Motors, in response, ceased trading and transferred its assets to BW, leaving nothing with which to compensate Creasy. Creasy sought to lift the corporate veil and bring action against BW, as the directors of BW and Breachwood Motors were the same. The court lifted the corporate veil to allow for this.
Adams v Cape Industries [1990]	[TO SHOW that avoiding future liability is permissible]: ‘We do not accept that the corporate veil should be lifted simply because the corporate structure has been used so as to ensure that legal liability (if any) in respect of particular future activities of the group (and correspondingly the risk of enforcement of that liability) will fall on another member of the group rather than the defendant company. Whether or not this is desirable, the right to use a corporate structure in this manner is inherent in our corporate law’

 

2.2    GROUPS OF COMPANIES [SINGLE ECONOMIC UNIT]

·       It is common for larger companies to carry out their functions via a number of smaller subsidiary companies

·       Initially, each subsidiary in a group of companies was regarded as its own ‘single economic unit’ à The Albazero [1977]: the court stated that it was ‘long established and now unchallengeable by judicial decision … that each company in a group of companies … is a separate entity possessed of separate legal rights and liabilities’

·       However, this position was changed by DHN Food Distributors v Tower Hamlets

 

CASE	HOLDING
DHN Food Distributors v Tower hamlets LBC [1976]	DHN was a holding company that included two other wholly owned subsidiaries. One of these subsidiaries owned the land upon which DHN conducted business, with DHN occupying the land as a bare licensee. The land was compulsorily purchased by the defendant, who paid £360,000 compensation to the subsidiary. DHN could not find suitable replacement premises, and went into liquidation. DHN argued that it was entitled to compensation for loss of business, but the law provided that only those with a legal or equitable interest in the land were entitled to such compensation, with a bare license not conferring such an interest. DHN was awarded compensation for loss of business. Lord Denning MR stated that the subsidiaries were ‘bound hand and foot’ to DHN and that ‘the group is virtually the same as a partnership where all three companies are partners’. Accordingly, the three companies were treated as one, with DHN regarded as that one.
Adams v Cape Industries [1990]	[HOWEVER, this decision took a different approach:] Slade LJ held: ‘save in cases which turn on the wording of particular statutes or contracts, the court is not free to disregard the principle of Salomon … 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 normally attach to separate legal entities’.

2.3    AGENCY

·       A relationship of agency usually arises where one person (known as the principal) appoints another person (known as the agent) to act on his behalf

·       Where two parties are involved in an agency relationship, the principal is normally legally responsible for the acts of his agent – in the corporate context, a relationship of agency can arise in two situations:

(i)            The company could be regarded as an agent of a member à i.e. the member, as principal, is responsible for the acts of the company (i.e. the company’s corporate personality is ignored and the member made liable). However, Salomon emphatically stated that the mere fact of incorporation does not cause a relationship of agency to be created between a company and its members, although an agency relationship can arise between a member and the company based on the particular facts of a case (Gramophone & Typewriter Ltd v Stanley)

(ii)            Where two companies are in an agency relationship, the principal (normally the parent or holding company) can be liable for the acts of its agent (normally, a subsidiary company). In effect, the corporate personality of the subsidiary is ignored and the parent company is made liable for the subsidiary’s acts

 

CASE

HOLDING

Smith,     Stone     and     Knight     v Birmingham Corporation

The claimant company purchased a business, and set up a new subsidiary company to run this business. However, the claimant never transferred ownership of the business to the newly created subsidiary. The land upon which the subsidiary conducted business was compulsorily purchased by the defendant, who planned to pay compensation to the subsidiary for loss of business. The claimant contended that it was entitled to the compensation. The court held that the subsidiary was the agent of the claimant and therefore, the corporate personality of the subsidiary was ignored and the claimant obtained the compensation. The crucial factor was that the newly acquired business and the land on which it operated still belonged to the claimant.

 

2.4    JUSTICE OR CONVENIENCE [TORT]

·       The final ground for lifting of the corporate veil is where justice of the case demands so – however, the courts have consistently held that justice is not a ground to lift the corporate veil

·       This is unfortunate for victims of tort (‘involuntary creditors’), therefore, courts have developed a way to hold companies

accountable for tortious harm to individuals

 

CASE

HOLDING

Chandler v Cape Plc [2012]

Chandler worked for Cape products, a subsidiary of Cape Industries. He was exposed to asbestos and later he developed asbestosis, however, by the time he was diagnosed the subsidiary had closed down and so there was no one to sue. Chandler therefore elected to sue the parent company, but the parent company said that they were not to blame for any illness faced by the employee due to the actions of the company’s subsidiary (even the insurance did not cover employees of the subsidiaries). The court agreed later that cape industries was liable, but it only agreed that it was liable on the ground that cape industries had a duty of care to the employees of its subsidiaries à (this is not a veil lifting case, it is a case where the parent company is held accountable on the basis of the duty of care, i.e. the court found an inventive way to hold the parent company liable)

 

3.       THE NEED/DESIRABILITY FOR CORPORATE STRUCTURES

(i)            To take advantage of integrated finance: assets and liabilities are passed from one company to another in the group, and this obscures the true financial position of each company

(ii)            Enhances anonymity of beneficial owners: people who have a lot of money do not like people to know where their money is/where their money comes from, and so they create corporate vehicles which are interconnected in order to obscure the trail of their money

(iii)            For management, avoidance or evasion of tax obligations: “tax heavens” are jurisdictions which have very low regimes of tax, or in some cases no taxes at all

o   Many Multi National Corporations have their holding companies or entities registered in those jurisdictions (it is very difficult to trace money in these jurisdictions)

o   This makes it is possible to manage tax liabilities or reduce tax liabilities by organising your corporate group in such a way which reduces the profits you are earning in any particular jurisdiction

(iv)            Regulatory arbitrage: different jurisdictions have different regulations, and sometimes companies will try to avoid jurisdictions which have higher regulations by setting up an office in a country with lower regulatory hurdles/standards

(v)            Avoiding creditors by concealing or shielding assets: for instance – if someone is suing you in jurisdiction X and you realise that you are in trouble then it may be a good idea to move your assets to jurisdiction Y, and this is done by forming a corporate entity in jurisdiction Y

(vi)            Limiting exposure to/avoiding tortious liability: principle that one cannot be liable for the actions of another à if you are going to carry out risky activities then you want to do so in a manner that will shield you from the damages that may occur in the process. Since each company in a corporate entity is only liable for itself, it may be possible to escape liability

(vii)            Compliance with domestic laws: sometimes corporate groups are enforced upon companies by domestic laws, e.g. in Zimbabwe any company that invests in the country cannot have 100% ownership in the company; the most they can have is 49%, and 51% is to be owned by locals. Thus, you have to formulate mechanisms which would enable you to retain ownership and control in the company (e.g. you may create phantom organisation in Zimbabwe that is owned 51% by locals, but that 51% is controlled by external forces)

(viii)            Facilitating illicit activities such as bribery, corruption or money laundering

CHAPTER 3: THE CONSTITUTION OF A COMPANY

 

·       A company’s constitution consists primarily of the articles of association, agreements, and resolutions affecting the company

·       The CA 2015 has significantly reduced the importance of the Memorandum of Association, and the Articles of Association now form the company’s principal constitutional document

·       The constitution forms a statutory contract between the company and its members, and between the members themselves. However, only those provisions relating to membership rights will constitute terms of the statutory contract

·       While ordinarily an act outside the scope of a company’s objects clause would be ultra vires, companies incorporated under the CA 2015 have unrestricted objects by default (CA 2015, Section 28)

·       A company can alter its articles by passing a special resolution, however, statute and common law restrict a company’s

ability to alter its articles

·       The CA 2015 does not seek to exhaustively regulate the internal affairs of the company, much is left to the companies themselves – accordingly, a company’s constitution aims to set out the powers, rights and obligations of the company’s members and directors, and also to lay down certain processes regarding how the company is to be run

 

1.       EVOLUTION OF THE CORPORATE CONSTITUTION

·       The CA 2015 has altered significantly the form and content of the corporate constitution:

o   Prior to 2015, a company’s constitution consisted of the Memorandum of Association & Articles of Association

o   After 2015, a company’s constitution includes the company’s Articles of Association & any resolutions and agreements affecting the company’s constitution

·       Prior to the CA 2015, the Memorandum was of fundamental importance and formed one of the two principal documents that formed a company’s constitution (however, its importance was reduced to simplify company formation and make it easier to discover the constitutional workings of a company)

·       Under the CA 2015, the memorandum creates a ‘historical screenshot’ by indicating the company’s state of affairs at the

time it was created. Section 12, CA 2015 provides that the memorandum must state that the subscribers:

a.        Wish to form a company under the Act; and

b.       Agree to become members of the company and, in the case of a company with a share capital, to take at least one share each

·       Currently, the company’s Articles of Association (‘articles’) form its principal constitutional document – they tend to regulate the internal workings of a company and regulate issues such as balance of power between members and directors, conduct of general meetings, issues pertaining to shares and distribution of assets, etc.

·       Every company must have a set of articles (Section 13, 20, Companies Act 2015) and promoters are free to draft their own articles that suit the needs of their particular business requirements à however, drafting articles is complex and technical, accordingly the CA 2015 has provided a set of model articles that companies may adopt if they so choose

o   Companies incorporated under the repealed CA will not be governed by the new model articles, but can adopt them if they so choose

o   Where promoters of a limited company do not submit their own articles upon registration, the applicable model

articles will form the company’s articles (Section 20, CA 2015)

o   Even if the promoters do register their own articles, the relevant model articles will still form part of the

company’s articles, unless the registered articles modify or exclude them (Section 21, CA 2015)

·       Should a dispute arise, the courts may be required to interpret the provisions of the articles in order to resolve the dispute

·       Holmes v Keyes [1959]: the articles of association of the company should be regarded as a business document and should be construed so as to give them reasonable business efficacy

·       Thompson v Goblin Hill Hotels Limited [2011]: the words of the articles are not to be given their plan and obvious meaning if such an interpretation would produce a commercial absurdity

 

2.       RESOLUTIONS AND AGREEMENTS AFFECTING THE COMPANY’S CONSTITUTION

·       Certain resolutions and agreements form part of, and affect, the company’s constitution (Section 27, CA 2015)

·       However, the list of such resolutions and agreements is much wider than this definition suggests and appears to go beyond

agreements and resolutions that affect a company’s constitution directly, e.g. special resolutions often form part of the

company’s constitution even though special resolutions ordinarily involve decisions with no bearing on the company’s

constitution

 

3.       THE CONSTITUTION AS A CONTRACT

·       Re Tavarone Mining Company (Pitchard’s Case) (1873): the company’s articles form a contract between a company and its

members, and between the members themselves

·       Section 30(1), CA 2015: 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

·       Accordingly, the company’s constitution forms the ‘statutory contract’ and imposes obligations upon:

o   The company when dealing with its members;

o   The members when dealing with the company; and

o   The members when dealing with one another

·       This statutory contract differs from a standard contract in several important ways and is not subject to certain standard contractual rules

 

	STANDARD CONTRACT	STATUTORY CONTRACT – SECTION 30
Derives binding force from?	The agreement between the parties	From Section 30 of the Companies Act 2015
Alteration of terms against a             party’s wishes?	The terms of a standard contract cannot usually be altered against the wishes of the parties	As the articles can be altered by passing a special resolution, the majority can alter the terms of the statutory contract against the wishes of the minority
Enforcement by     a         third party?	Generally, third parties cannot enforce a standard contract (save for in particular, pre-defined circumstances)	Third parties cannot enforce the statutory contract, i.e. privity of contract – third parties cannot enforce the provisions of the constitution
Action                   for breach                     of contract?	If any term of a standard contract is breached, it can give rise to an action for breach of contract	Only those terms of the constitution that relate to membership rights can form the basis for an action for breach of the statutory contract
Rectification of contract?	The courts may be willing to rectify a standard contract if it fails to give effect to the parties’ intentions, or if it contains a mistake	The courts will not rectify the statutory contract if it fails to give effect to the parties’ intentions, or if it contains a mistake (Scottv Frank F Scott ltd [1940])
Defeasible on certain grounds?	Standard contracts can be defeated on the grounds of mistake, misrepresentation, duress or undue influence	The statutory contract cannot be defeated on the grounds of mistake, misrepresentation, duress or undue influence (Bratton Seymour Service Co Ltd v Oxborough [1992])

 

3.1    CONTRACT BETWEEN THE COMPANY AND ITS MEMBERS

·       As the constitution forms a contract between the company and its members, it follows that both parties can enforce compliance with the terms of the constitution against the other

 

 

CASE

HOLDING

Hickman v Kent or Roney Marsh Sheepbreeders’ Association [1915]

The articles of the defendant company provided that any dispute between it and a member should be referred to arbitration before any legal proceedings were initiated. The defendant purported to expel one of its members (the claimant) from its organisation but, instead of referring the dispute to arbitration, the claimant petitioned the High Court for an injunction restraining his expulsion. Held: the articles formed a contract between the company and its members. The company was therefore permitted to enforce the term of the articles and require disputes to be referred to arbitration. The High Court stayed the legal proceedings initiated by the claimant, and the claimant was subsequently expelled.

 

Pender v Lushington [1877]	The company’s articles provided that its members would have one vote for every ten shares, up to a maximum of 100 votes. Consequently, members with over 1,000 shares would not have voting power commensurate to their shares. To avoid this, members with over 1,000 shares transferred some of their excess shares to several nominees (including the claimant), thereby unlocking the votes within them. The company’s chairman (the defendant) refused to accept the nominees’ votes and the claimant alleged that his votes were improperly rejected. Held: the claimant’s action succeeded. The shares were properly transferred and registered to the nominees, so refusing to accept their votes constituted a breach of the articles
Bisgood v Henderson’s Transvaal Estates Ltd [1908]	Held: the purpose of the constitution is to define the position of the shareholder as shareholder, and not to bind him in his capacity as an individual à it follows that only the terms of the constitution that relate to membership rights will form part of the statutory contract
Beattie v E and F Beattie Ltd [1938]	The company’s articles provided that any disputes between it and its members should be referred to arbitration. A director (who was also a member) was alleged to have improperly drawn a salary without the authorization of the company or its members. The company therefore initiated legal proceedings to recover this payment. The director alleged that, because he was a member, the article provision applied and the dispute should be referred to arbitration. He therefore sought to enforce the provision of the constitution. Held: the director was relying on the articles in his capacity as a director, not in his capacity as a member. Accordingly, the director could not enforce the relevant provision of the articles and the legal proceedings were permitted to go ahead. Accordingly, provisions of the constitution that relate to the rights of directors will not normally form part of the statutory contract

 

3.2    CONTRACT BETWEEN THE MEMBERS THEMSELVES

·       Just as the constitution forms a contract between the company and its members, so too does it form a contract amongst the members themselves

·       Accordingly, a breach of the statutory contract by a member can be enforced by another member, providing that the provision breached concerns a membership right

 

 

CASE

HOLDING

Rayfield v Hands [1960]

The company’s articles provided that, if a member wished to sell his shares, he should inform the directors, who would then purchase the shares between them. The claimant wishes to sell his shares and so notified the defendant directors, who then refused to purchase the claimant’s shares. The directors were all members, and so the claimant sought an order requiring the directors to purchase his shares. Held: the directors should purchase the claimant’s shares. As the company was a quasi-partnership, the article provision affected the directors in their capacity as members and accordingly concerned a membership right

 

4.       THE CAPACITY OF A COMPANY

·       As the company is a legal person, it can enter into contracts in much the same way as natural persons can

·       However, historically, the company’s ability to enter into contracts was subject to a significant limitation à Prior to the passing of the CA 2015, all companies were required to state in their Memoranda the objects or purposes for which the company was set up (this is known as the ‘objects clause’). The objects clause serves to limit the contractual capacity of the company and if a company entered into a contract that was outside the scope of its objects clause, the company would be acting ultra vires (‘beyond one’s powers’) and the contract would be void ab initio (Ashbury Railway Carriage and Iron Co Ltd v Riche [1875])

·       This restriction on a company’s capacity was introduced to protect persons who provided a company with capital, on the expectation that the company would pursue the lines of business for which it was set up and would not expend capital on frolics outside the company’s stated purposes

·       The problem was that the rules relating to ultra vires were overly complex, technical, and vague and served to harm third parties who had innocently contracted with the company. Accordingly, successive amendments to the Companies Act have weakened the ultra vires doctrine

 

5.       ABOLITION OF THE OBJECTS CLAUSE

·       The requirement of an object’s clause has been abolished by the CA 2015 (although companies can still include an objects clause if they so wish) and such companies will accordingly have unrestricted objects (Section 28, CA 2015)

·       For such companies, the ultra vires doctrine will be of little relevance as the company’s contractual capacity will not be

limited, and this is the default position for companies incorporated under the CA 2015

·       Companies incorporated under previous Companies Acts will still have an objects clause, but the companies can delete the objects clause by passing a special resolution to that effect, and in doing so, acquiring unrestricted capacity (Section 22, CA 2015)

 

6.       INCLUSION/RETENTION OF THE OBJECTS CLAUSE

·       The objects clause and the doctrine of ultra vires are still relevant in two instances:

(i)            Although companies incorporated under the CA 2015 do not need to include an objects clause in their articles, they may do so if they wish. It is anticipated that very few companies incorporated under the CA 2015 will include an objects clause

(ii)            Companies incorporated under prior Companies Acts may decide not to, or may neglect to, remove their objects clause. As regards such companies, the objects clause will serve to limit the directors’ authority and the ultra vires doctrine will still be of relevance. Although, it is noteworthy that this doctrine has lost a lot of its force

·       Historically, if a company entered into an ultra vires contract, then that contract would be rendered void ab initio. Unfortunately, this served to harm the innocent third party who contracted with the company and who often had no idea of the scope of the company’s objects clause

·       This has been remedied by Section 33, CA 2015, which provides 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

·       It may be the case that a transaction is within the capacity of the company, but the director who caused the company to enter into the transaction had no authority to do so. In such a case, the issue is not one of corporate capacity, but of directors’ authority. Again, the Act seeks to protect third parties, with Section 34(1), CA 2015 stating that, ‘in favour of a person dealing with a company in good faith, the power of the directors to bind the company, or authorize others to do so, is deemed to be free of any limitation under the company’s constitution’

·       The resultant effect of Section 33 and 34(1), CA 2015 is that if a company or director enters into an ultra vires contract with a third party, then the contract cannot be attacked on the ground that it is ultra vires à Therefore, from the point of view of a third party, the ultra vires doctrine is of little relevance, which is why it is often stated that the CA 2015 abolishes ultra vires externally, because it is of little concern to external third parties.

·       However, whilst the CA 2015 may have rendered the ultra vires doctrine largely irrelevant to persons outside the company, it remains relevant to persons inside the company for two reasons:

(i)            If a member of a company discovers that the company is about to enter into an ultra vires transaction, the member has a personal right to petition the court for an order preventing the company from entering into the transaction (this right arises from the statutory contract that exists between a company and its members. However, this right only arises if a legal obligation has yet to arise (Section 34(4), CA 2015) – the right is lost once the company has entered into the contract. In practice, most members will only become aware of a contract once the company has entered into it, and so this right will be of little use

(ii)            Where the directors of a company cause the company to enter into an ultra vires transaction, or where the directors exceed the authority bestowed upon them by the constitution, then they will likely be in breach of the statutory duty to act in accordance with the company’s constitution (Section 142(a), CA 2015 – ‘Duty to act within the company’s powers’)

·       NOTE:

o   As the constitution forms a contract between the company and its members, acting ultra vires might place the company in breach of the statutory contract created by Section 30, CA 2015

o   As acting ultra vires can amount to breach of duty, the members may be able to bring a derivative claim on behalf of the company against the directors who have acted ultra vires (‘the derivative claim’)

o   If the company acts ultra vires because it has become impossible for it to fulfil the purposes for which it was set up, it

may be wound up on just and equitable grounds (‘the petition for winding up’)

 

7.       ALTERATION OF ARTICLES

·       As a company, or the market in which it operates, evolves, it may become necessary for it to alter its articles

·       Section 22, CA 2015 provides that a company may amend its articles by passing a special resolution (and in certain cases the courts may also have power to amend the articles)

·       However, this ability is not limitless – both common law and statute have imposed limitations on alteration of articles

 

7.1    STATUTORY RESTRICTIONS

·       The ability to alter the articles is limited by the provisions of the Companies Acts (Allen v Gold Reefs of West Africa Limited [1900])

·       Section 23, CA 2015: a member is not bound by any change in the articles made after he became a member, if the effect of the change is to require him to take or subscribe for more shares than the amount he had at the date of alteration, unless he expressly agrees in writing to the change

·       Section 78, CA 2015: in certain situations, statute empowers the court to prohibit a company from altering its articles

without the court’s permission – e.g. where members of a public company object to re-registering it as private

 

7.2    COMMON LAW RESTRICTIONS

 

 

 

 

CASE	HOLDING
Allen v Gold Reefs of West Africa Limited [1900]	Held: the power to alter articles must ‘like all other powers, be exercised subject to those general principles of law and equity which are applicable to all powers conferred on majorities and enabling them to bind minorities. It must be exercised, not only in the manner required by law, but also bona fide for the benefit of the company as a whole’
Shuttleworth v Cox Brothers & Company (Maidenhead) Limited [1927]	The company’s articles provided that its directors (one of whom was the claimant) would hold office for as long as they wished, unless they became disqualified by virtue of one of six specified events. The claimant engaged in a financial irregularity, but it did not fall within one of the six specified events. The other directors therefore used their shares to pass a special resolution altering the articles by adding a seventh event, namely that a director must resign if all the other directors required him to. Following the alteration, the claimant’s co- directors demanded his resignation. The claimant challenged the alteration. Held: The test imposed by Lindley MR is predominantly subjective, meaning that if the majority shareholders honestly believed that the alteration was for the company’s benefit as a whole, then the alteration would be valid, even if the court disagrees with the majority’s assessment. On this basis, the Court held that the alteration was valid, as the other directors did believe that it was for the company’s benefit. The Court did, however, impose an objective requirement, namely that an alteration would not be valid if ‘no reasonable man could consider it for the benefit of the company’

 

à à it is therefore apparent that a minority shareholder who wishes to challenge an alteration on this ground will face a difficult task, as our system of law is based heavily on the principle of majority rule

Greenhalgh  v  Ardene     Cinemas Limited [1951]

The company’s articles provided that a shareholder could not sell his shares directly to an outsider if an existing shareholder was willing to purchase them. The company’s managing director was also its majority shareholder and he wished to sell his shares to an outsider. Accordingly, in his capacity as majority shareholder, he altered the articles to permit a shareholder to sell his shares to an outsider, without first offering them to an existing shareholder, providing that an ordinary resolution was passed (which would be a certainty given that he was the majority shareholder). A minority shareholder challenged the alteration. Held: The phrase ‘the company as a whole’ meant the shareholders as a body and the court should take the case of a hypothetical member and ask whether the alteration was for his benefit. On this basis, if an outsider was to wish to purchase the shares of a hypothetical member, it might well be in that member’s benefit to sell his shares directly to an outsider. Further, the advantage obtained by the majority shareholder was also obtained by all the other shareholders, so the alteration was not discriminatory. Accordingly, the alteration was deemed valid

CHAPTER 4: MEMBERS AND SHAREHOLDERS

 

·       While the terms ‘member; and ‘shareholder’ tend to be used interchangeably, there is a distinction

·       Members ordinarily exercise their decision-making powers via the passing of resolutions (which are a formal vote), and these could be either ordinary resolutions (simple majority, 50%) or special resolutions (75%)

·       Resolutions are only validly passed if sufficient notice of the meeting at which they are to be tabled is provided and quorum is present (namely, the minimum number of persons required to be present in order to conduct business)

·       Members can appoint a proxy to attend, speak and vote at general meetings on their behalf

·       Members of a company play two vital roles:

(i)            Through the purchase of shares, they contribute capital to the company

(ii)            Through the passing of resolutions, they make decisions à a significant amount of power is placed into the hands of members and numerous key decisions are reserved for them alone

 

1.       MEMBERS v SHAREHOLDERS

·       ‘Member’ and ‘shareholder’ are often used interchangeably, and in the majority of cases, a member will be a shareholder

and vice versa – as the term ‘member’ is wider than the term ‘shareholder’ is it preferable to use the term ‘member’

·       In companies without a share capital will ordinarily have members and not shareholders

·       On the other hand, in companies with a share capital, a purchase of shares will make an individual a shareholder but not automatically a member – Section 92, CA 2015 provides that a person will only become a member once he has agreed to become a member and his name is entered on the register of members

 

2.       RESOLUTIONS

·       The general power to manage the company is usually vested in the directors by the company’s articles

·       Despite this, the CA 2015 and the Insolvency Act place considerable decision-making power in the hands of the members:

(i)            The members can alter the company’s articles;

(ii)            If the company wishes to convert from a public company to a private company, or vice versa, or if an unlimited company wishes to convert to a private limited company, then approval of the members is required;

(iii)            The members can remove a director (or directors) from office;

(iv)            Numerous loans and other transactions involving directors require the approval of members;

(v)            The members can petition the court to have the company wound up

·       This decision-making power is exercised via the passing of resolutions – a resolution is simply a more formal word for ‘vote’

 

2.1 TYPES OF RESOLUTIONS

 

ORDINARY RESOLUTION	SPECIAL RESOLUTION
S. 256(1) CA 2015 – Passed by a simple majority	S. 257(1) CA 2015 – Passed by a majority of not less than seventy five percent
This means that an exact 50% split will mean that the resolution is lost	These tend to be reserved for more important decisions and constitutional changes

 

·       Where the CA 2015 states that a resolution is required without specifying the type, the resolution required will be an ordinary resolution – although the company will be free to specify a higher majority by inserting a provision in the articles to that effect (Section 207(1), CA 2015)

·       Where statute specifies that an ordinary or special resolution is required, the articles cannot alter the majority needed

·       Resolutions of public companies must be passed at a meeting of the members (Section 255(2), CA 2015) while resolutions of private companies can be passed at a meeting or by way of a written resolution (Section 255(1), CA 2015)

 

2.1.1       WRITTEN RESOLUTIONS

·       The passing of formal resolutions at a meeting involves compliance with a body of rules and procedures that can prove burdensome and costly (e.g. for small companies, where the number if members is small, etc.)

·       Accordingly, the CA 2015 allows private companies to pass written resolutions in substitute for resolutions passed at a meeting (except where statute provides that a meeting must be convened, e.g. for removal of directors from office)

·       Written resolutions require the same majorities and have the same force as resolutions passed at meeting (Section 262(4), CA 2015)

·       Where a written resolution is proposed, a copy of the proposed resolution + a statement informing the member how, and by when, to signify an agreement is sent to each member à once a member has signified agreement, it cannot be revoked

·       Accordingly, it is possible for a private company to go its entire existence without having to call a meeting, while public companies must hold at least one general meeting every year that constitutes an AGM (Section 310(1), A 2015)

·       The written resolution procedure is an example of the ‘think small first’ philosophy behind the CA 2015

 

3.       MEETINGS

·       Except where the written resolution procedure is used, the members will exercise their decision-making powers by passing resolutions at meetings, of which there are two types:

 

GENERAL MEETING	CLASS MEETING
All members are entitled to attend general meetings – the majority of meetings, including the Annual General Meeting (AGM), will constitute general meetings	Only a certain class of the members are allowed to attend class meetings
It used to be the case that any meeting that was not an AGM was known as an extraordinary general meeting (but this phrase should no longer be used)	These meetings are reserved for determining the class of certain members with special rights

 

·       Resolutions passed at general meetings are only valid if the procedural requirements are complied with (Section 275, CA 2015), and these usually cannot be excluded by the articles

 

3.1    THE CALLING OF MEETINGS

·       Section 276, CA 2015: the power to call a general meeting is vested in the directors

·       Section 277, CA 2015: however, the members are allowed to request that the directors call a general meeting, provided:

o   The request comes from members representing at least 5% of the company’s paid-up share capital; or

o   For a company without a share capital, members representing at least 10% of the voting rights of the members (this is reduced to 5% if more than 12 months have lapsed since the last general meeting was convened)

·       Section 279, CA 2015: if directors fail to comply with a valid request for a meeting from the members, then those members (or members representing over half of the total voting rights of the company) are granted the power to call a meeting themselves at the expense of the company

·       Section 280, CA 2015: where it is impracticable to call a meeting in accordance with the above provisions, the court may order a meeting to be called

·       Note: the power to call a general meeting may coincide with other areas of the law:

o   E.g. directors are under a statutory duty to use their powers for a proper purpose (‘duty to act within the company’s powers’ and ‘promote the best interests of the company’) and if the directors call a meeting for an improper purpose (or improperly refuse a members’ request for a meeting), a breach of duty may have occurred which may form the basis of a derivative claim

o   Similarly, if the majority shareholders call a meeting in order to adversely affect the minority, the majority’s conduct may be regarded as unfairly prejudicial (‘unfairly prejudicial conduct’)

 

3.2    NOTICE OF MEETINGS

·       Section 284, CA 2015: resolutions passed at a general meeting are only valid if adequate notice of the meeting is provided

to all persons entitled to such notice, namely: all of the company’s directors, members and the auditor

·       Notice must be provided within a sufficient period prior to the meeting

·       The general rule is that notice of a meeting must be provided at least 21 clear days prior to the meeting in the case of an AGM, and 14 days for any other general meeting (Section 281(1) and 281(2), CA 2015)

·       The company’s articles are free to specify a longer notice period (Section 281(3), CA 2015), but cannot specify a shorter notice period (although the members themselves can agree to a shorter notice period)

·       Section 287, CA 2015: if a provision of the CA requires a special notice of a resolution to be given, the resolution is not effective unless notice of the intention to move it has been given to the company at least 28 days before the meeting

 

3.3    QUORUM

·       A general meeting, and any decisions made at it, will only be valid if quorum is present – quorum is the minimum number

of ‘qualifying persons’ required in order to validly conduct business. A ‘qualifying person’ is:

o   A member of the company; or

o   A representative of a corporate member; or

o   A proxy of the member

·       Where a limited company has only one member, that member will constitute quorum (Section 292(1), CA 2015), and in all other cases, two qualifying persons will constitute quorum unless the articles provide otherwise (Section 292(2), CA 2015)

·       If quorum is not present, the meeting is said to be ‘inquorate’ and no business can be conducted at that meeting, save for

appointment of a chairman for the meeting

 

3.4    VOTING

·       Regarding the passing of resolutions at a meeting, there are two methods of voting:

(i)            By a show of hands: each member will have one vote; or

(ii)            By poll: unless the articles so provide, each member will have one vote per share, except where the company has no share capital, in which case each member will have one vote (Section 295, CA 2015)

·       The model articles under the CA 2015 provide that a resolution at a meeting will be decided on a show of hands, unless a poll is demanded in accordance with the articles

·       The members have the right to demand that a vote be taken on poll, but the articles can stipulate that a certain number of members are required in order for such a demand to be valid (the model articles provide that two members are needed to demand a poll, and also the chair of the meeting can demand a poll)

 

3.5    PROXIES

·       Members need not attend a meeting to exercise their voting rights

·       Section 298, CA 2015: members have the right to appoint another person to exercise their right to attend, speak and vote at general meetings – this person is known as a ‘proxy’

·       In large public companies, the appointment of proxies is important as only a small minority of members will actually attend the meetings

 

3.6    UTILITY OF MEETINGS

·       As public companies are required to hold meetings and since the members can only exercise many of their key decision - making powers at such meetings, the general meeting as a forum for shareholder democracy is of fundamental importance

·       In fact, general meetings are the only formal link between the company’s members and the Board

·       Unfortunately, there is widespread dissatisfaction with the utility of general meetings as a forum for shareholder democracy for several reasons:

o   In order for general meetings to provide a forum for shareholder democracy, they need to be well attended. In large public companies, however, meetings tend to be poorly attended

o   In order for general meetings to effectively hold the directors to account, the majority of shares should not be in the hands or control of the directors. In many private companies, the directors will be the members, so general meetings become largely redundant as the directors will own all, or the majority of, the company’s shares. In public companies, many members will appoint one of the directors to act as their proxy, so the directors may have control of a significant proportion of the company’s shares, thereby allowing them to defeat the resolutions of those who might wish to hold them to account

 

3.7    UNANIMOUS CONSENT [DUOMATIC PRINCIPLE]

·       As noted, convening meetings can be a burdensome process. Even the written resolution procedure may appear unnecessary where all the members know they are in agreement on an issue

·       Accordingly, the common law has long provided that if all the members entitled to vote on a matter are in agreement on that matter, then that agreement will be valid even if no meeting was convened and no resolution took place (Baroness Wenlock v The River Dee Co [1883])

·       This rule is known as the Duomatic principle, named after the case of Re Duomatic Ltd [1969], where Buckley J stated that as this rule circumvents rules and procedures relating to meetings and resolutions, it is unsurprising that strict rules and safeguards are in place, including:

o   Nothing less than unanimity will suffice—a member holding 99 per cent of the shares cannot, by himself, take advantage of the Duomatic principle (Re D’Jan of London [1993])

o   The Duomatic principle cannot be used where the decision in question could not have been taken at a meeting (Re New Cedos Engineering Co Ltd [1994])

o   It is likely that decisions that cannot be taken by written resolution (namely the removal of an auditor or director) are not subject to the Duomatic principle

·       An agreement taken by unanimous consent is likely to be classified under the CA 2015 as an agreement that affects the company’s constitution. Accordingly, such agreements may form part of the company’s constitution and may be enforced by the company or its members. It is also likely that such agreements will need to be registered with the Registrar of Companies

 

4.       MEMBERS REMEDIES

·       It is possible that problems may arise where the company or the members are wronged by the actions or omissions of the directors or the majority shareholders – this is problematic because the persons who cause the harm in these situations are also the persons who have standing to obtain redress

·       Without the law’s aid, members – especially minority shareholders – would be left without a remedy. Accordingly, statute provides members with three principal remedies, namely:

(i)            The derivative claim – Part 11, CA 2015;

(ii)            The unfair prejudice remedy – Part 24, CA 2015; and

(iii)            The petition for winding up the company – Section 424, Insolvency Act 2016 (‘IA 2016’)

·       These member remedies are not mutually exclusive and there exists significant overlap between the three

·       It is worth noting that in Fulham Football Club (1987) Limited v Richards [2011], the Court of Appeal stayed an unfair prejudice claim on the ground that the FA Rules (by which the claimant was bound) provided that disputes be referred to arbitration before commencing legal proceedings à the effect that such a clause would have on other member remedies is not yet known, though it was well established that an arbitration clause contained within the articles can form part of the statutory contract

·       In addition, where the constitution of the company has been breached, a member may be able to enforce the provision that was breached or obtain a remedy for breach of contract

 

4.1    THE DERIVATIVE CLAIM

·       If A sustains loss due to the actions of B, then generally only A can sue B to obtain redress – C cannot sue B on A’s behalf

·       As companies have separate corporate personality, this principle applies equally in the corporate context – i.e. if a company sustains loss due to the actions of another, then generally only the company can sue to obtain redress

·       However, the problem arises where a company sustains loss due to the actions of its directors, as powers of the company are usually delegated to the directors – including authority to determine whether or not the company will commence litigation (and clearly, the directors will not agree to initiate litigation against themselves)

 

 

CASE

HOLDING

Foss v Harbottle [1843]

1.       Proper claimant: only the company, and not the members, can commence proceedings for wrongs committed against it. This principle is a corollary of a company’s corporate personality 2.       Internal management: where a company is acting within its powers, the courts will not interfere in matters of internal management, unless the company itself commences proceedings. This principle is a corollary of the courts long-established reluctance to becomes involved in the internal affairs of businesses 3.       Irregularity: where some procedural irregularity is committed, an aggrieved member cannot commence proceedings where the irregularity is one that can be ratified by a simple majority of the members. This principle is a corollary of the principle of majority rule

·       The rule in Foss v Harbottle, however, is not absolute – if it were, wrongs committed by the directors would rarely be the subject of litigation à accordingly, the courts crafted four ‘exceptions’ to the rule, whereby members could commence an action on the company’s behalf (‘exceptions’ because only one of them is actually an exception)

·       Such actions were known as ‘derivative actions’ because the member was bringing an action based on rights derived from the company – reinforced by the fact that, if the action succeeded, the remedy was granted to the company

·       With the creation of the statutory derivative claim, the derivative action was abolished. However, the exceptions enshrined under the previous common law derivative action were as follows:

(i)            Where the act complained of was illegal (Taylor v National Union of Mineworkers [1985]) or ultra vires (Simpson v Westminster Palace Hotel Co [1860]), a member could commence a derivative action;

(ii)            Where the act infringed the personal rights of a member, a derivative action could be brought. Rights breached could include: a failure to provide sufficient notice of general meetings, a failure to pay dividends in accordance with the articles, or the improper rejection of a member’s votes;

(iii)            Where the act complained of could only be done or sanctioned by the passing of a special resolution, a derivative action could be brought (Edwards v Halliwell [1950]); and

(iv)            Where those persons who controlled the company had committed some sort of fraud on the minority

·       Negligence, even gross negligence, would not suffice (Paldives v Jensen [1956]), but where the negligence benefitted those who controlled the company, this would suffice as the negligence would be tainted by impropriety (Daniels v Daniels [1978])

·       The courts would not allow a claim based on fraud on the minority to succeed if it would not serve the interests of justice,

e.g. where independent members indicate that they do not wish the claim to proceed (Smith v Croft (No. 2) [1988])

 

4.1.1       STATUTORY DERIVATIVE CLAIM

·       The statutory derivative claim was introduced as a result of the rules related to derivative actions becoming ‘complicated and unwieldy’ – it can be found in Part XI, CA 2015

·       Part XI does not abolish the rule in Foss v Harbottle – the rule retains much of its force, however, the common law derivative action has been abolished and replaced by the statutory derivative claim

 

	COMMON LAW DERIVATIVE ACTION	STATUTORY DERIVATIVE CLAIM
Status?	The common law derivative action no longer exists	A statutory derivative claim can only be brought under the Companies Act 2015
Source of law?	Case law spanning over 150 years	Governed by Part XI of the Companies Act 2015
Grounds for a claim?	(i)          Illegal/ultra vires acts (ii)          Acts which infringe on personal rights of a member (iii)          Acts requiring a special majority (iv)          Acts which are a fraud on the minority	(i)           Negligence (ii)          Default (iii)           Breach of duty (iv)           Breach of trust
Covers acts/omissions committed by?	Directors or members	Directors only
Claim can be brought by?	A member only	A member, or a person who is not a member, but to             whom         shares             have            been transferred/transmitted by operation of the law
Claim can be brought against?	A director of the company	A direction of the company or another person (or both)
Claim for negligence?	Claim could only be brought if a director benefitted personally	Claim can be brought, irrespective of whether or not a director benefitted personally

 

4.1.2       SCOPE OF THE STATUTORY DERIVATIVE CLAIM

·       Section 238(2), CA 2015 provides that a derivative claim can only be brought under Part XI, CA 2015 or in pursuance of a court order under Section 780, CA 2015 (‘unfairly prejudicial conduct’)

·       Section 238(3), CA 2015 provides that a derivative claim can only arise from an actual or proposed act or omission involving:

o   Default: ‘default’ is a general term used in many pieces of legislation that refers to a failure to perform a legally

obligated act (e.g. to appear in court when required)

o   Negligence: negligence could not found a common law derivative action, unless the wrongdoer gained benefit from the negligent act. This limitation has not been preserved by the CA 2015, leading many directors to fear an increase in the number of derivative claims (however, this increase in claims has not actually occurred)

o   Breach of duty: a derivative claim can accordingly be founded on the basis of a breach of the general duties, as well as any other breach of duty

o   Breach of trust

·       The scope of the statutory derivative claim is, in many respects, wider than the common law derivative action, especially in relation to negligence and breach of duty

·       The persons against whom a derivative claim can be brought have also widened – under the common law, a derivative action could only be brought against a director, but now a derivative claim may be brought against a director or another person (or both) (CA 2015, Section 238(3))

·       In one respect, the derivative claim is narrower, namely the fact that the act or omission must be made by a director –

under the common law, the actions of members could found a derivative action, but this is no longer the case

 

·       NOTE: therefore, the current position is as follows:

o   Where a member has engaged in the wrongful act or omission, a derivative claim cannot be brought à the appropriate remedy will be under Section 780, CA 2015 (unfairly prejudicial conduct)

o   Where the wrongdoer is a director, a remedy may be available under Section 780 OR by way of a derivative claim. However, the derivative claim may ALSO be brought against a member who was involved in the director’s wrongful act or omission

 

4.1.3       PERMISSION FROM THE COURT

·       Section 239(1), CA 2015 provides that a member who brings a derivative claim must apply to the court for permission to continue it, with Sections 239 – 242 establishing a two-stage test for determining whether permission should be granted

a)       First, the member must establish that he has a prima facie case. If the member cannot establish a prima facie

case for permission, the court must dismiss the claim and make any consequential order it considers appropriate

b)       If a prima facie case is established, a hearing will be convened and the company directed to provide evidence

·       The purpose of this process is to screen out weak or unmeritorious claims before the defendant becomes involved (however, establishing a prima facie case is not a very difficult hurdle to overcome)

·       If a prima facie case is established, we move to the second stage, under which the court decides whether or not to grant permission to continue with the claim under Section 241, CA 2015 à Under Section 241(2), CA 2015 the court must refuse permission if it is satisfied that any of the following principles applies:

a)       Where a person acting in accordance with Section 144, CA 2015 (duty to promote the success of the company for the benefit of its members) would not seek to continue the claim

§  Reinforced the fact that a derivative claim must be for the benefit of the company

§  Refusal of permission on this ground is rare à Iesini v Westip Holdings Limited [2009]: the court held that permission would only be refused on this ground if no director acting in accordance with S. 144 would seek to continue the claim

b)       Where the cause of action arises from an act or omission that is yet to occur, or that the said act or omission has been authorised by the company; and

c)       Where the cause of action arises from an act or omission that has already occurred, and that the act or omission was authorised by the company before it occurred or has been ratified by the company since it occurred

·       If none of the above conditions apply, Section 241(3), CA 2015 provides that the court should have regard to the views of the members who have no personal interest in the matter à the company may have perfectly legitimate reasons for not pursuing the claim, e.g. waste of time and expense, and seeking the views of members with no interest in the matter may help the court determine whether or not the claim should go ahead

 

 

CASE

HOLDING

Mission Capital Plc. v Sinclair [2008]

The defendants were two directors, whose service contracts provided that their employment could be immediately terminated if they engaged in unacceptable conduct. The claimant company terminated their employment on the grounds that they failed to submit financial information and failed to meet financial forecasts. The defendants disputed this. The claimant obtained an injunction that excluded the defendants from the claimant’s premises. The defendants, inter alia, brought a derivative claim and sought permission to continue it. Held: Permission to continue the claim was denied. Although the court believed that the defendants were acting in good faith, the court held that a notional director acting in accordance with Section 172 would not seek to continue the claim, as the damage suffered by the company was ‘speculative’. Further, the court held that the defendants were not seeking anything that could not be recovered via a personal claim under Section 994 of the CA 2006

 

4.1.4       THE ‘NO REFLECTIVE LOSS’ PRINCIPLE

·       An act or omission of a director may cause loss to both the company and, in turn, to its members (e.g. an act of negligence by a director causes the company loss, which in turn reduced the profits and so lowers the members dividends/value of their shares)

·       Such act/omission provides the company and its members with a cause of action against the director, i.e. the company and the members may have a personal claim against the director or the members might be able to bring a derivative claim against the director on behalf of the company

·       In these cases, the ability of members to recover certain personal losses is limited by what is called the ‘ no reflective loss principle’ à where the loss sustained by the member is reflective of the loss sustained by the company, then the members will not be permitted to recover those losses that are reflective of the company’s loss, that could properly be recovered by the company itself (i.e. the company will be the proper claimant, as per the first rule in Foss v Harbottle, and its claim trumps that of the members)

 

 

CASE

HOLDING

Prudential Assurance Co. Ltd v Newman Industries Ltd (No. 2) [1982]

The directors had breached their duty by selling an asset of the company to a third party for less than it was worth, thereby causing the company loss. In order for the sale to be valid, the Listing Rules required the consent of the members, which the directors obtained by providing the members with misleading information regarding the sale. The transaction at an undervalue caused a reduction in the value of the company’s shares. The members commenced a personal action against the directors. Held: The members’ claims were ‘misconceived’. The loss suffered by the members was reflective of the loss suffered by the company, which could be recovered by the company by bringing a claim against the directors. In such a case, the company should bring the action and the members would not be permitted to recover the reflective loss.

 

·       The rationale behind this principle is to prevent double recovery

o   If both the company and the members could recover the loss suffered by the company, then the defendant would be forced to pay compensation twice or if the member were allowed to recover his loss at the exclusion of the company, then the company and its creditors would be harmed

o   Johnson v Gore Wood & Company (No. 1) [2002]: ‘justice to the defendant requires the exclusion of one claim or the other; protection of the interests of the company’s creditors requires that it is the company which is allowed to recover to the exclusion of the shareholders’

·       Whilst the no-reflective loss principle may prevent personal claims from succeeding, it will not prevent a member from succeeding in a derivative claim à this is because benefits of a derivative claim go to the company, and so no issue of double recovery arises and the company’s creditors are not adversely affected

·       Thus, the principle applies to any situation where the company and members have a cause of action deriving from the same facts, and not just where the members have a derivative cause of action. It can therefore apply in cases where the wrongdoer was not a director

·       However, the principle will not apply where the defendant’s actions leave the company unable to commence proceedings,

e.g. where the defendant’s actions cause the company such loss that it cannot afford to commence proceedings ( Giles v Rhind [2002])

 

4.2    UNFAIRLY PREJUDICIAL CONDUCT

·       Section 780, CA 2015 allows a member to petition the court for a remedy on the ground that the company’s affairs will be, or are being, or have been, conducted in a manner that is unfairly prejudicial to the interests of the members generally (or some part of the members)

·       This is an extremely useful remedy, especially with the courts’ liberal interpretation of phrases such as ‘unfairly prejudicial’

and ‘interests of members’

 

4.2.1       WHAT ARE THE ‘INTERESTS OF MEMBERS’?

·       The conduct complained of must ‘unfairly prejudice the interests of members’

·       Historically, the courts would only grant a remedy where the petitioner was bringing the claim in his capacity as a member,

e.g. where an employee of a company (who was also a member), was dismissed by the company, the court refused to grant a remedy on the ground that the member had brought his claim in his capacity as an employee and not a member (Re John Rein & Sons (Strucsteel) Limited [2003])

·       Section 780 focuses on the members interests as opposed to their rights (and their interests are much wider than their rights)

·       In particular, in certain companies, the members may agree that the company should be run in a certain manner, but such agreements may never be formalised or inserted into the constitution. In such companies, the courts will not permit the constitution to be relied upon if such reliance unfairly prejudices the interests of members by defeating the ‘legitimate expectations’ (which has since been rephrased to, ‘equitable considerations’ (of the members))

 

 

CASE

HOLDING

O’Neill            v Phillips [1999]

The defendant gave 25 per cent of a company’s shares to the claimant and appointed him as a director. The defendant also retired from the board, leaving the claimant as the de facto managing director. The profits of the company were initially split 75:25 in favour of the defendant, but this was later amended to provide for an equal share. The company experienced financial difficulties and the defendant returned to oversee management. He also claimed to once again be entitled to 75 per cent of the company’s profits. The claimant left the company and commenced an unfair prejudice claim Held: The House held that the defendant had not promised that the claimant would always receive 50 per cent of the profits and, at most, had promised that the claimant would receive 50 per cent of the profits only while he acted as de facto managing director. The defendant had not breached the company’s constitution, nor was there anything giving rise to the equitable considerations of which Lord Hoffmann spoke. Accordingly, the claimant’s action failed.   As for equitable considerations – Lord Hoffman stated: “A member of a company will not ordinarily be entitled to complain of unfairness unless there has been some breach of the terms on which he agreed

 

that the affairs of the company should be conducted. But ... there will be cases in which equitable considerations make it unfair for those conducting the affairs of the company to rely upon their strict legal powers”

Gamlestaden Fastingheter AB  v  Baltic Partners Limited [2007]

Baltic Partners Ltd (‘Baltic’) was set up to operate a joint venture entered into by the claimant and a man named Karlsten. To finance the venture, the claimant made substantial loans to, and purchased a substantial number of shares in, Baltic. However, shortly thereafter, the claimant alleged that Karlsten and Baltic’s directors had improperly removed funds from Baltic. The claimant alleged that this constituted unfairly prejudicial conduct and that Baltic’s directors should account to Baltic for the withdrawals made. At the time of the hearing, Baltic had become insolvent, and so its directors argued that the payment of compensation to Baltic would benefit the claimant in his capacity as a creditor of Baltic, and so the claim should be dismissed Held: The court rejected the directors’ arguments and found for the claimant. Lord Scott stated that, in such cases, the claimant should not be precluded from a remedy simply because the remedy would benefit him as a creditor and not as a member.   This case clearly demonstrates how far the courts will relax the member qua member requirement in order to achieve a just and equitable result. Further, as the claimant was apparently seeking to enforce a right that belonged to Baltic, one would assume that the rule in Foss v Harbottle would prevent the claim. This clearly demonstrates that a principal reason for the creation of the unfair prejudice remedy was to outflank the rule in Foss v Harbottle where fairness requires.

 

·       What O’Neill establishes is that, in the majority of cases, the members’ rights and interests will be the same and will be set out in the company’s constitution. In other cases, however, notably those involving quasi-partnership companies, equitable considerations will arise which can widen the members’ interests beyond those found in the constitution

·       The category of equitable considerations is wide and open-ended, however, exclusion from management is a good example and is the issue that arises in most Section 780 cases

 

4.2.2       WHEN IS CONDUCT ‘UNFAIRLY PREJUDICIAL’?

·       Upon determination that the interest is one recognised by Section 780, the next step is determination of whether the

company’s affairs have been run in a way so as to unfairly prejudice that interest

·       The courts have taken an objective approach when determining whether or not the conduct complained of is unfairly prejudicial

·       Accordingly, there is no requirement for the petitioner to come with ‘clean hands’, but unmeritorious conduct on behalf of the petitioner might lead the court to hold that the conduct is not fair or that the remedy granted should be reduced (Re London School of Electronics Limited [1986])

·       Re Saul D Harrison and Sons Plc [1994]: the conduct complained of must be unfair and prejudicial

·       Grace v Biagioli [2005]: the petitioner was a member and director of a company. He was removed from office because he was attempting to set up a rival company. The court held that the conduct complained of (i.e. removing him) was prejudicial, but given the obvious conflict of interests that his actions had created, it was not unfair

·       The courts have repeatedly stated that the words ‘unfairly prejudicial’ are not to be given a narrow, technical meaning,

nor have the courts sought to establish a general test to determine whether or not conduct is unfairly prejudicial

o   Lord Hoffman in O’Neill: the rationale behind this is to ‘free the court from technical considerations of legal right and to confer a wide power to do what appeared just and equitable’

o   What is fair depends on the context of the case, i.e. ‘conduct which is perfectly fair between competing businessmen may not be fair between members of family’

·       Examples of conduct which courts have held capable of being unfairly prejudicial include:

(i)            Non-payment of dividends (Re a Company (No 00370 of 1987) [1988]) or payment of low dividends (Re Sam Weller & Sons Ltd [1990])

(ii)            Exclusion from the management of a quasi-partnership company (Re Ghyll Beck Driving Range Ltd [1993])

(iii)            Serious mismanagement (Re Macro (Ipswich) Ltd [1994]) à Note that the mismanagement must be serious— normal mismanagement will not normally constitute unfairly prejudicial conduct (Re Elgindata Ltd (No 1) [1991])

(iv)            Preventing the members from obtaining the best price for their shares (Re a Company (No 008699 of 1985) [1986])

(v)            The payment of excessive remuneration to the directors (Re Cumana Ltd [1986])

(vi)            Improper transfer of assets (Re London School of Electronics Ltd [1986])

 

4.2.3       REMEDIES

·       Where a Section 780 petition is successful, the court has considerable remedial flexibility in that it can make ‘such order as it thinks fit for giving relief in respect of the matters complained of’ (Section 782(1), CA 2015)

·       Section 782(2), CA 2015 provides a non-exhaustive list of examples of orders that the court could make, including:

(i)            An order regulating the conduct of the company’s affairs in the future (e.g. depriving a director of certain powers);

(ii)            An order requiring the company to refrain from doing an act, or to perform an act that it has failed to perform;

(iii)            An order requiring the company not to make any changes to its articles without the court’s permission;

(iv)            An order requiring the petitioner’s shares to be purchased by the company or by another member

·       A Section 780 petition is not subject to a limitation period but, as the granting of relief under Section 782 is discretionary, the court may refuse to grant a remedy where a significant period of time has elapsed between the conduct complained of and the petition being brought

 

4.3    THE PETITION FOR WINDING UP

·       Perhaps the most extreme remedy available to an aggrieved member is to petition the court for an order winding up the company – this remedy is available under Section 393(1), IA 2015

·       The two principal circumstances in which a winding up may be ordered are:

(i)            Where the company passes a special resolution resolving that the company should be wound up (Section 393(1)(b), IA 2015). However, this remedy will be of little use to a minority shareholder

(ii)            Where the court is of the opinion that it is just and equitable to do so (Section 429(1)(g), IA 2015). A single member can petition the court under this section, so it is a potentially significant remedy

 

4.3.1      WHEN WILL A COURT ORDER A WINDING UP?

·       The words ‘just and equitable’ are broad terms and the courts have not sought to exhaustively define when a winding up will be ordered. Despite this, certain instances can be identified where courts are more likely to order a winding up:

(i)            Where the company is fraudulently promoted (Re London and County Coal Co [1886]) or is set up for a fraudulent purpose (Re Walter Jacob Limited [1989])

(ii)            Where the company is deadlocked (i.e. where management or the members are divided and refuse to be reconciled) and is unable to make any decisions (Re Yenidje Tobacco Company Limited [1916])

(iii)            Where the company’s objects clause indicates that it has been formed for a specific purpose (this is known as the company’s ‘substratum’) and it becomes impossible to fulfil this purpose (Re German Date Coffee Company [1882])

à with the introduction of default unrestricted objects, cases involving loss of substratum will lessen significantly over time

(iv)            Where the directors display a lack of probity (i.e. honesty or decency) (Loch v John Blackwood Limited [1924]) à

note: mere negligence or inefficiency will not suffice

CHAPTER 5: DIRECTORS

 

1.       INTRODUCTION

·       A company may be run by persons who call themselves ‘governors’ or ‘managers’ and, increasingly, persons not involved

in management at Board level are called ‘Directors’

·       Section 3, CA 2015 defines a ‘director’ as follows: In relation to a body corporate, a director includes:

a)       Any person occupying the position of a director of the body (by whatever name the person is called); and

b)       Any person in accordance with whose directions or instructions (not being advice given in a professional capacity) the directors of the body are accustomed to act

·       A director can be a natural or legal person, but every company must have at least one director who is a natural person (Section 129(1), CA 2015)

·       The broad definition of ‘director’ will cover those who have been validly appointed to the office of director (known as de jure (‘in law’) directors), but will also cover persons who have not been validly appointed, but who act as directors (known as de facto (‘in fact’) directors). De facto directors, although not validly appointed, are therefore directors under the Act and subject to the relevant provisions (‘Directors’ duties’)

·       A person who has neither been appointed a director, nor acts as a director, may be treated as a director if he is ‘a person in accordance with whose directions or instructions the directors of the company are accustomed to act’, other than where that advice is given in a professional capacity à such a person is known as a ‘shadow director’.

 

2.       APPOINTMENT OF DIRECTORS

·       Section 128, CA 2015: every private company must have at least one director and every public company must have at least two directors à The proposed directors of the company will become its directors officially upon incorporation

·       Thereafter, the power to appoint directors is a matter for the articles, but where the articles are silent on this issue, the power to appoint directors is vested in the members and is usually exercised by passing an ordinary resolution (Worcester Corsetry Limited v Witting [1936])

·       The model articles for private companies limited by shares and the model articles for public companies provide that directors may be appointed by an ordinary resolution of the members, or by a decision of the directors

·       Whilst generally anyone can act as a director, certain types of persons are prohibited by statute from being appointed (e.g.

a minor, or a company’s auditor, cannot be appointed as its director)

 

3.        THE BOARD OF DIRECTORS

·       Collectively, the directors of a company are referred to as the ‘Board’à Much of a company’s power is concentrated in its

Board, which exercises its powers via board meetings (not to be confused with general meetings of the company)

·       The procedures relating to Board meetings are a matter for the company’s articles and decisions of directors are only valid if made at a board meeting, unless all the directors agree to, or acquiesce to, a decision (Charterhouse Investment Trust Ltd v Tempest Diesels Ltd [1986])

·       The law does not require that all the directors must be present at a board meeting, but decisions of board meetings will only be valid if a quorum can be obtained. The model articles set the quorum at two (unless the company is private and only has one director, in which case, it will be one), and decisions taken at a meeting that lacks a quorum (‘inquorate’) are invalid

·       The power to run a company is initially vested in its members. However, in all but the smallest private companies (where the directors and members are usually the same persons), it is impractical for the members to exercise day-to-day control over the company’s affairs. Accordingly, the members’ powers are usually delegated to the company’s directors via the article

·       The directors only have such power as is delegated to them by the members, with most companies having a provision in their articles that delegates the day-to-day control of the company to the directors. In such cases, the power to manage is vested in the directors and the members have no right to interfere with management, unless such power has been reserved for the members via the articles or statute

·       Article 3 of both the model articles for private companies limited by shares and public companies provides that ‘subject to the articles, the directors of the company are responsible for the management of the company’s business, for which purpose they may exercise all the powers of the company’ à this vests considerable power in the directors, but as it is ‘subject to articles’, provisions can be inserted into the articles that affect this balance of power

 

CASE	HOLDING
Automatic Self Cleansing Filter Syndicate Co Ltd v Cuninghame [1906]]	The articles of a company conferred general powers of management upon its directors and provided that they could sell any property of the company on such terms as they deemed fit. The members passed an ordinary resolution resolving to sell the company’s assets and undertakings, but the directors did not believe that such a sale was in the interests of the company and so refused to proceed with the sale. Held: The right to manage the company and the right to determine which property to sell was vested in the directors. Accordingly, the directors were not required to comply with the resolution, unless the articles so provided
Salmon v Quin & Axtens Limited [1909]	The company’s articles conferred general powers of management upon the directors, but such powers were subject to the articles. Article 80 provided that decisions of the directors relating to the acquisition of certain properties would be invalid if two named members were to dissent. The directors decided to acquire such property, but the two named members vetoed the decision. A general meeting was called, and the other members passed an ordinary resolution resolving to acquire the property. The two members who vetoed the decision sought an injunction to restrain the property acquisition. Held: Whilst the directors had a general power of management, it was subject to the articles. Accordingly, the veto exercised by the named members was valid and the company could not override it by passing an ordinary resolution. The House therefore granted an injunction restraining the acquisition

 

·       In both Automatic Self Cleansing and Salmon, ordinary resolutions passed by the members could not affect the powers conferred by the articles, as this would permit the members to indirectly alter the articles by way of an ordinary resolution (when the correct procedure is to go by way of a special resolution)

·       However, whilst general power is vested in the directors, the members retain a specific statutory supervisory power exercisable by passing a special resolution à Article 4(1) of the model articles: ‘Members reserve powers’ states that ‘the members may, by special resolution, direct the directors to take, or refrain from taking, specified action’

·       It is noteworthy that where the directors are unable or unwilling to exercise the powers of management conferred by the articles, then the general powers of management revert back to the members (Barron v Potter [1914])

 

4.       DIRECTORS DUTIES

·       The problem with having such a concentration of power vested in the directors is that they might be tempted to use their

powers to benefit themselves, or to engage in acts that are not in the company’s interests

·       The law aims to discourage such behaviour in several ways, with the principal method being the imposition upon directors of a number of legal duties

·       The common law duties of directors (spanning over a mass amount of case law, making it unclear, inaccessible and out of date) has been abolished and replaced by the new codified directors duties under the Companies Act – the general duties are found in Section 140 – 147, CA 2015 while the law relating to director transactions that require member approval has been re-stated at Sections 155 – 179, CA 2015

·       The CA 2015 refers to the newly codified duties as the ‘general duties’ and provides that they are ‘based on certain common law rules and equitable principles as they apply in relation to directors’ (Section 140(3), CA 2015)

o   This makes clear the fact that codification has not radically altered the content of the duties, but has merely restated them in a more appropriate manner (although notable reforms have been made)

o   The lack of change ensures that the significant and authoritative pre-2015 body of case law that exists will remain relevant—a fact backed up by Section 140(4), CA 2015, which provides that ‘regard shall be had to the corresponding common law rules and equitable principles in interpreting and applying the general duties’  

o   By preserving the remedies already set out in case law, the law remains flexible as the courts can continue to develop existing case law in a way that would not have been possible if the remedies had been set out in statute.

·       As under the common law, the directors owe their duties to the company (section 170(1), CA 2015) and do not generally owe their duties to members, creditors, employees, or anyone else à the result is that generally, only the company itself can commence proceedings to remedy a breach of the directors’ duties, although in some cases the members might be able to commence proceedings via the derivative claim

 

4.1    DUTY TO ACT WITHIN THE COMPANY’S POWERS

·       Section 142, CA 2015: this first general duty is an amalgamation of two prior common law duties, namely:

a)       The duty to act in accordance with the company’s constitution; and

b)       The duty to exercise powers only for the purposes for which they are conferred

·       While the capacity of the company and the powers of the company are predominantly set out in the company’s articles, and the default position is that companies created under the CA 2015 will have unrestricted objects, it is common for companies to impose some form of limitation on the directors’ power and directors who breach such limitations (e.g. by acting ultra vires) will likely breach the duty found in Section 142(a)

·       The second strand of Section 142 is arguably more important, and this strand is based on the common law ‘proper purpose’

doctrine – it provides that directors must exercise their powers only for the purposes for which they are conferred

o   This duty is wide-ranging and applies to all the powers of a director

o   However, much of the case law in this area circles around the directors’ powers to allot shares, or the extent to

which directors can frustrate a takeover bid

·       If the directors’ have acted for the dominant purpose of maintaining themselves in office, manipulating voting power or

benefitting themselves financially, then the duty will likely have been breached

 

 

CASE

HOLDING

Howard Smith Limited v Ampol Petroleum Limited [1974]

The claimant controlled 55 per cent of shares in company X, and wanted to take it over. The defendant made a rival bid which was rejected by X’s majority shareholder, namely the claimant. The directors of X favoured the defendant’s bid, but this bid could not succeed so long as the claimant was the majority shareholder. Accordingly, the directors of X issued a batch of shares and allotted them to the defendant. The purpose of the share issue was (i) to raise capital to purchase a new oil tanker and (ii) to reduce the claimant’s shareholding to 37 per cent, thereby preventing it from rejecting the defendant’s bid. The claimant alleged that the issue of shares was for an improper purpose. Held: Where the directors exercise their powers for several purposes, the court should objectively determine what is the dominant purpose. If the dominant purpose is proper, no breach of duty will occur, even though subservient improper purposes might exist, and vice versa. Applying this, the court held that the dominant purpose of the share issue was to relegate the claimant to the status of minority

 

	shareholder. This was unsurprisingly deemed to be an improper purpose, and so the directors of X had breached their duty to act for a proper purpose
Hogg v Cramphord [1976]]	Where directors act for an improper purpose, such acts are voidable at the company’s instance and the directors in question may be required to compensate the company for any loss sustained. However, both consequences can be avoided if the members ratify the breach of duty

 

4.2    DUTY TO PROMOTE THE SUCCESS OF THE COMPANY

·       Section 143, CA 2015: a director must ‘act in the way he considers, in good faith, would be most likely to promote the success of the company for the benefit of its members as a whole’

·       This is a reformulation of the common law duty to act bona fide in the interests of the company (Re Smith and Fawcett Limited [1972]), and it is arguably the most important general duty and the duty that has undergone the most change as a result of codification

·       The wording of Section 143 clearly indicates that the duty is subjective, meaning that what matters is what the directors honestly believed would promote the success of the company

o   It is not the court’s place to substitute its views for those of the directors. Accordingly, provided that the decision of the directors was honest, it does not matter that it was unreasonable (Extrasure Travel Insurance Ltd v Scattergood [2003])

o   However, there are limits on the subjectivity of the duty. In Hutton v West Cork Rly Co [1883], the court held that if the duty was entirely subjective then ‘you might have a lunatic conducting the affairs of the company, and paying away its money with both hands in a manner perfectly bona fide yet perfectly irrational’

·       Therefore, the courts will closely examine the evidence and try to determine whether or not the directors honestly believed that their actions were aimed at promoting the success of the company for the benefit of its members

·       Where a director’s act or omission causes the company harm, the court will not be easily persuaded that the director honestly believed his actions to be in the company’s interest (Regentcrest Plc v Cohen [2001])

·       Where the evidence does not provide a conclusive answer, the courts will temper the subjective test with an objective examination, but the test still remains primarily subjective

·       In situations where the director has not considered whether his act or omission will promote the success of the company for the benefit of the members, the proper test would be ‘whether an intelligent and honest man in the position of the director of the company concerned could … have reasonably believed that the transaction was for the benefit of the company’ à accordingly, in such a case the test becomes primary objective

·       In cases where the interests of the company and the membership conflict, preference should be given to the interests of the company (however, whether the directors can favour the company over the members as a whole is unclear)

·       A common criticism levelled at the previous common law duty was that it overly prioritized the interests of members and failed to acknowledge the effect that the directors’ actions can have on other constituents, such as employees, creditors or the environment. Therefore, Section 143(1) provides that when directors are considering what would promote the success of the company for the benefit of its members, regard must be had (amongst other things) to:

o   The likely consequences of any decision in the long-term;

o   The interests of the company’s employees;

o   The need to foster the company’s business relationships with suppliers, customers, and others;

o   The impact of the company’s operation on the community and the environment;

o   The desirability of the company maintaining a reputation for high standards of business conduct; and

o   The need to act fairly as between members of the company

·       Where a director acts in a manner that breaches Section 143, that act is voidable at the company’s instance

·       Where the act also causes the company to sustain loss, those directors in breach will be required to indemnify the company for such loss

·       Of course, as the duty is owed to the company, the company will be the proper claimant unless the members can bring a derivative claim. Given the breadth of the duty, it can be difficult for the members to determine whether or not the directors have breached the duty

 

CASE	HOLDING
Mutual Life Insurance Co. of New York v Rank Organisation [1985]	The defendant company issued 20 million shares, half of which were made available, on preferential terms, to existing shareholders. However, existing shareholders in the USA and Canada were excluded from this offer on the ground that to include them would require the company to comply with complex legislation in those countries, which would prove costly and therefore would not be in the company’s interests. The claimant (an organization acting on behalf of a number of the defendant’s American shareholders) objected to the exclusion. Held: The directors of the defendant had exercised their powers in the interest of the company, and so, in favouring the company over some part of the shareholders, had not breached their duty
Item Software (UK) Limited v Fassihi [2004]	The court held that a director who breaches a fiduciary duty will be required to disclose that breach of duty to the company if the duty to act in the interests of the company requires such disclosure
British Midland Tool Limited v Misland International Tooling Limited [2003]	The court held that this obligation extends to disclosing the breaches of fellow directors. In keeping with the subjective nature of this duty, the key factor is whether the director honestly considers that it is in the company’s interest to know about the breach (Fulham Football Club (1987) Ltd v Tigana [2004])
GHLM Trading Ltd. v Maroo [2012]	Newey J went further and stated, obiter, that this duty of disclosure could extend to disclosing matters other than wrongdoing and that disclosure might be justified to a person other than a board member
Tesco Stores Limited v Pook [2003]	A failure to disclose can result in a loss of employment benefits (e.g. share options, or certain employment rights) and may provide a justification for summary dismissal

 

4.3    DUTY TO EXERCISE INDEPENDENT JUDGEMENT

·       Section 144, CA 2015: the third general duty, namely the duty to exercise independent judgment, is a reformulation and encapsulation of the common law duty placed upon directors not to fetter their discretion when exercising their powers

·       However, this duty was not absolute, and the courts recognized that directors could fetter their discretion and bind themselves to act in a certain way if they bona fide believed such an action to be in the interests of the company (Fulham Football Club Ltd v Cabra Estates Plc [1992])

·       This principle has been preserved by Section 144(2)(a), which provides that the duty to exercise independent judgment will not be breached where the directors act ‘in accordance with an agreement duly entered into by the company that restricts the future exercise of discretion by its directors’. Additionally, Section 144(2)(b) provides that the duty will not be breached where the director acts in a way that is authorized by the company’s constitution

·       Any agreement entered into that contravenes Section 144, CA 2015, will be voidable at the company’s instance à Any directors in breach will also be required to account for any gains made and indemnify the company for any losses sustained as a result of the breach

 

4.4    DUTY TO EXERCISE REASONABLE CARE, SKILL AND DILIGENCE

·       Section 145, CA 2015: this places a duty on directors to ‘exercise reasonable care, skill and diligence’

·       The common law had imposed a similar duty on directors long before the CA 2015 was passed (Re City Equitable Fire Insurance Co Ltd [1925]), but the common law duty was heavily subjective and based on the skills and experience that the director actually had. Accordingly, a director with little skill or experience would be subject to an extremely low standard of care (e.g. Re Cardiff Savings Bank [1892]; Re Brazilian Rubber Plantations and Estates Ltd [1911])

·       The effect of the subjective duty was to allow unskilled, inexperienced, and incompetent directors to use their deficiencies as a shield against liability

·       Therefore, the courts added an objective element to the duty and this dual subjective/objective test has now been incorporated into the Section 145 duty à Section 145 now provides that the standard of care, skill, and diligence expected of a director is based on that of 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 actually has

·       The test found in (a) imposes an objective minimum standard of care that will apply to all directors, irrespective of their individual capabilities, i.e. Directors can no longer use their lack of skill or experience as a means of lowering the standard of care

·       However, this standard will take into account the functions of the director, so the standard will likely vary from director to director (e.g. the standard imposed on a director of a small private company will likely differ to the standard imposed on a director of a listed company), thereby providing the courts with a measure of flexibility

·       The test found in (b) imposes a subjective standard that will apply where the director has some special skill, qualification, or ability (e.g. he is a lawyer or an accountant) and will serve to raise the standard expected of the director (there is the argument advanced that such a higher standard might deter such qualified persons from undertaking directorial office for fear of the repercussions)

 

 

CASE

HOLDING

Re Barings Plc (No. 5) [2001]

Barings Bank collapsed in 1995 following the unauthorised trading activities of a trader named Nick Leeson, which resulted in the bank sustaining losses of £827 million. The case concerned three of the bank’s directors who, it was alleged, had made serious errors of management in relation to Leeson’s activities. At first instance, Parker J held that the three directors should be disqualified. The Court of Appeal upheld the disqualifications and it also affirmed principles in relation to the duty of skill and care, namely: ·       Directors have a continuing duty to acquire and maintain a sufficient knowledge and understanding of the company’s business to enable them property discharge their duties; ·       Whilst directors are entitled to delegate particular functions to those below them, and trust their competence and integrity to a reasonable degree, such delegation will not absolve the director of the duty to supervise the discharge of the delegated functions; ·       The extent of the duty, and the question as to whether it has been discharged, must depend on the facts of each particular case, including the director’s role in the company’s management.   I.E.: continuous acquisition of knowledge for discharge of functions; delegation is permissible but with supervision; and, discharge of duty is dependent on the facts of each case.

 

4.5    DUTY TO AVOID CONFLICTS OF INTEREST

·       Section 146, CA 2015: provides that a director of a company shall avoid a situation in which he has, or can have, a direct or indirect interest that conflicts, or may conflict, with the interests of the company

·       Section 146(2), CA 2015 provides that this duty arises in particular to ‘the exploitation of any property, information, the director’s position or opportunity’ and it is irrelevant whether or not the company wishes or is able to take advantage of the property, information or opportunity

·       The fact that the profit made by the director is negligible and also irrelevant (Towers v Premier Waste Management Limited [2011])

·       However, Section 146(3) states that the section does not apply to transactions which have been authorised by other directors

 

 

CASE

HOLDING

Bhullar v Bhullar [2003]

For over 50 years, the families of two brothers (M and S) had run a company that let commercial property. Following an argument, it was decided that the families would part ways. The claimants (M’s family) proposed that the company should not acquire any further properties and the defendants (S’s family) agreed. A director, who was part of the defendants’ family, discovered, by chance and not whilst acting in the course of the company’s business, a piece of property near to a piece of property owned by the company. Through another company that they owned; the

 

defendants acquired this property without informing the claimants. The claimants alleged that the defendants had acted in conflict with the interests of the company. Held: Although the defendants acquired knowledge of the property in a ‘private’ capacity, the opportunity to purchase the property was one that belonged to the company. Whether or not the company could have or would have acquired the property (because it was in the process of being wound up) was irrelevant.

 

·       Under pre-2015 law, the director could disclose the conflict and obtain authorization from the company in general meeting, but companies could provide, in their articles, that disclosure and authorization from the board would be sufficient

·       Under the CA 2015, authorisation works in the following manner:

o   Private companies: authorization from the directors alone will suffice (unless the constitution provides otherwise, as the model articles contain no such prohibition) therefore avoiding the need to organize a general meeting

o   Public companies: the directors can provide authorization, but only if the constitution so provides (the model articles do not contain a provision allowing the directors to authorize a conflict). However, transactions involving more than 10% of the value of the assets of the company must be authorized by members in general meeting (Section 146(5)(b), CA 2015)

·       Where a director fails to obtain valid authorization, any resulting contract is voidable at the company’s instance, provided that the third party involved had notice of the director’s breach (Hely-Hutchinson & Co Ltd v Brayhead Ltd [1968]). In addition, the company can require the director to account for any profit made as a result of the conflict (Aberdeen Railway Co v Blaikie Bros [1854])

·       NOTE: statutory duties are not mutually exclusive, and a single act may breach several duties. In Industrial Development Consultants Ltd v Cooley [1972], the court held that a director who fails to disclose the existence of a conflict may, in addition to breaching a duty involving a conflict of interest, also breach the duty to act in the interests of the company

 

4.6    DUTY NOT TO ACCEPT BENEFITS FROM THIRD PARTIES

·       Section 147, CA 2015: provides that a director must not accept from a third party a benefit conferred by reason of his being a director, or by doing (or not doing) anything as a director

·       As with Section 146, motive is irrelevant, and it will be no defence for the director to argue that he acted in good faith

·       However, the Section 147 duty will not be breached where ‘the acceptance of the benefit cannot reasonably be regarded as likely to give rise to a conflict of interest’. Accordingly, the duty only arises in relation to benefits that are likely to give rise to a conflict of interest

·       The key difference between Section 146 and Section 147 is that a conflict under s 146 can be authorized by the directors, whereas a conflict under s 147 can only be authorized by the members in general meeting (this is not expressly stated, but is a consequence of Section 148(1), CA 2015, which preserves the common law rules relating to authorization). This clearly indicates that the receipt of benefits from third parties constitutes a greater danger to board impartiality than the conflicts of interest

·       Should a director accept an unauthorized third-party benefit, the company can:

o   Rescind the contract and the benefit can be recovered (Shipway v Broadwood [1899]);

o   Instead of recovering the benefit, claim damages in fraud from either the director in breach or the third party; and

o    Summarily dismiss the director (Boston Deep Sea Fishing Co v Ansell [1888])

 

4.7    DUTY TO DECLARE INTEREST IN PROPOSED TRANSACTION OR ARRANGEMENT WITH COMPANY

·       Section 151, CA 2015: if a director of a company is in any way, directly or indirectly, interested in a proposed transaction or arrangement with the company, or in a transaction or arrangement that the company has already entered into, the director shall declare the nature and extent of that interest to:

a)       The other directors; and

b)       If the company is a public company, to the members of the public company within 72 hours

·       Under Section 151(5), CA 2015, the declaration must be made before the company enters into the transaction or arrangement (which is absurd for transactions the company has already entered into). Two points should be noted:

o Like Section 146, the duty under Section 151 only applies to transactions or arrangements likely to give rise to a conflict of interest; and

o   As the duty covers indirect transactions/arrangements, the director does not actually need to be a party to the transaction/arrangement in order for the Section 151 duty to be breached

·       The duty relates to both existing and proposed transactions or arrangements

·       Where a director enters into a transaction in contravention of Section 151, the transaction is voidable at the company’s instance. For existing transactions, it is unlikely the company would void the transaction, but would probably seek other remedies from the director

·       Under Section 151(10), CA 2015, a director who contravenes this section commits an offence and is liable on conviction to a fine not exceeding one million shillings

 

DUTY	DISCLOSURE REQUIRED?	WHEN IS DISCLOSURE REQUIRED?	IS AUTHORISATION REQUIRED?
SECTION 146 – Duty to avoid               conflicts         of interest	The CA 2015 does not expressly require the director to disclose the conflict of interest/benefit. However, as authorisation is required for the transaction, the director will (in practice) need to disclose the existence of the conflict/benefit prior to obtaining authorisation. Further, the courts have made clear that a director should disclose the existence of a conflict/interest in order to comply with the duty to act in the best interests of the company		Private companies: Yes – directors can authorise the interest, provided that the constitution does not prohibit such authorisation   Public companies: Yes – only if the constitution so provides and the amount is below 10% of company asset value
SECTION 147 – Duty not to accept benefits from third parties	N/A	N/A	Yes – the benefit must be authorised by members in a general meeting
SECTION 151 – Duty to declare interest in proposed transaction or arrangement with the company	Private companies: Yes – the director must disclose the nature and extent of the interest to the other directors   Public companies: the director must disclose the nature and interest to the other directors if the amount is above 10% of the company asset value	Disclosure must be made prior to the company entering the transaction or arrangement in accordance with Section 152, and for a public company the disclosure must be made within 72 hours	No, but if the directors do not approve        of                          the transaction/arrangement, they will likely prevent the company from entering into it
SECTION 151 – Duty to declare interest in existing transactions or arrangements with the company	Yes	Disclosure must be made as soon as is reasonably practicable	No

 

5.       TRANSACTIONS REQUIRING APPROVAL OF THE MEMBERS

·       In addition to the general duties, the law imposes more specific ‘duties’ in relation to certain transactions or arrangements

the directors enter into with the company

·       As these transactions are between the company and the director, they could be regarded as specific cases involving a conflict of interest

·       In relation to such transactions or arrangements, compliance with the general duties is insufficient (Section 150(3), CA 2015) and member approval is also required

 

5.1    SERVICE CONTRACTS

·       Historically, directors would try and make it expensive to remove them from office by negotiating lengthy service contracts. E.g., if a company wished to remove a director five years before his service contract is to end, and he was paid Kshs. 2

million per year, the company would have needed to pay the director Kshs. 10 million in compensation for early termination of his contract.

·       Section 157, CA 2015 has curtailed this practice by providing that a director cannot have a guaranteed term of employment of over two years, unless it has been approved by a resolution of the members à Where Section 157 is breached, the relevant contractual provision will be void and the contract will be deemed to contain a term allowing the company to terminate it at any time by giving reasonable notice (Section 157(8), CA 2015)

 

5.2    SUBSTANTIAL PROPERTY TRANSACTIONS

·       Under the general duties, a director with a conflict of interest can avoid committing a breach of duty if he discloses that interest to the other directors

·       However, where the arrangement constitutes a ‘substantial property transaction’, disclosure alone is insufficient and the company must not enter into the arrangement unless it has first been approved by a resolution of the members, or is conditional upon such approval being obtained (Section 158(1), CA 2015)

·       There are two types of arrangement require such approval:

a)       Where a director of a company, or a person connected with the director, acquires, or is to acquire, a substantial non-cash asset; or

b)       Where the company acquires, or is to acquire, a substantial non-cash asset from such a director or person so connected

·       A ‘non-cash asset’ is any property or interest in property, other than cash, and it will be substantial if its value:

a)       Exceeds ten per cent of the company’s asset value and is more than five million shillings; or

b)       Exceeds ten million shillings. (Section 158(7), CA 2015)

·       A substantial property transaction entered into without member approval is voidable at the company’s instance, unless:

o   Restitution is impossible;

o   The company has been indemnified; or

o   A third party’s rights would be affected (Section 162(1), CA 2015)

·       Additionally, any director or connected person involved in the arrangement will be liable to account for any gains made, and will be liable to indemnify the company for any losses sustained as a result of the arrangement

 

5.3    LOANS, QUASI-LOANS AND CREDIT TRANSACTIONS

·       Under the repealed Companies Act, companies were generally prohibited from making any form of loan to dire ctors, and breach of this prohibition constituted a criminal offence

·       The CA 2015 takes a very different approach that is dependent upon the type of transaction in question:

(i)            Section 164(1): no company can make a loan to a director unless the transaction has been approved by a resolution of the members

(ii)            Section 165: a public company cannot make a quasi-loan to a director unless the transaction has been approved by a resolution of the members à A quasi-loan occurs where a company agrees to pay a sum on behalf of the director, or where it reimburses expenses incurred by another due to the actions of the director

(iii)            Section 166: a public company cannot make a quasi-loan to persons connected to a director unless the transaction has been approved by a resolution of the members

(iv)            Section 167(2): a public company cannot enter into a credit transaction (e.g. hire purchase or conditional sale agreements, the leasing or hiring of goods) with a director unless it has been approved by a resolution of the members

 

6.       PAYMENTS FOR LOSS OF OFFICE

·       Section 180(1), CA 2015: the law requires that the members approve certain voluntary payments made by the company to directors losing office

·       Section 182(1), CA 2015 prescribes that a company cannot make such a payment unless the payment has been approved by a resolution of the members à however, certain payments are excluded from this requirement, e.g. payments not exceeding Kshs. 30,000/= or payments that discharge an existing legal obligation

·       Where approval is not obtained, the recipient holds the payment on trust for the company and the director who authorised the payment is jointly and severally liable to indemnify the company for loss resulting from the payment (Section 187(1))

7.       RELIEF FROM LIABILITY

·       A director who has committed a breach of duty may attempt, or be able, to obtain relief from liability in several ways:

(i)            A director’s service contract or the company’s articles may contain a provision excluding liability for negligence, default, breach of duty, or breach of trust. Such provisions are void (S. 194(2)). Similarly, provisions requiring the company to indemnify the director for losses sustained due to his breach of duty are also generally void (S. 194(3)). However, it is not illegal to obtain insurance against liability for director’s negligence (S. 195)

(ii)            S. 207 puts in place, for the first time, a statutory scheme concerning ratification of acts committed by directors that amount to negligence, default, breach of duty, or breach of trust. Such ratification can serve to prevent a derivative claim from being brought (indeed, S. 241(2)(c) provides that permission to continue a derivative claim will be refused where the act has been ratified). Ratification requires a resolution to be passed, and where it occurs, any cause of action is extinguished. However, acts that cannot be ratified under pre- 2015 law

(iii)            Where an officer of the company is found liable for negligence, default, breach of duty, or breach of trust, then s 763 of the CA 2015 allows a court to grant that officer, either wholly or partly, relief from liability on such terms as it sees fit. An officer of the company can also petition the court for such relief

 

8.       TERMINATION OF OFFICE

·       A director’s term of office may be terminated in numerous ways:

o   The articles may provide that a director’s office will terminate upon the occurrence of a certain specified event,

e.g. where an individual is prohibited from law by being a director;

o   Where the director relinquishes office by giving notice to the company and the company accepts his resignation;

o   Or, where the articles provide for the retirement of directors by rotation (common in public companies)

 

8.1      REMOVAL OF DIRECTORS

·       Section 139(1), CA 2015: a company may, by ordinary resolution at a meeting, remove a director before the expiration of his period of office, notwithstanding anything in any agreement between it and him

·       This section can also be used to remove multiple directors

·       The words ‘at a meeting’ indicate that the written resolution procedure cannot be used

·       While the power granted to members under this section appears extremely substantial, Section 139(6)(a) mitigates its usefulness by stating that removal does not deprive a director of compensation payable as a result of the removal à if the directors’ remuneration is substantial or his service contract lengthy, this compensation may be extremely high

·       In addition, Section 139 should not be construed as derogating from any power to remove a director that exists outside the section, e.g. the articles may contain a provision allowing removal of a Board member via a Board resolution, and the advantage of using a separate Board power is that it will not be subject to the procedural requirements of Section 139

 

8.2      DISQUALIFICATION OF DIRECTORS

·       The CA 2015 also grants the courts power to make orders disqualifying persons from being directors as a sanction for breach of a duty (Section 146(12), CA 2015 sets out the provisions for disqualification)

·       The effect of a Disqualification Order (under Part X, CA 2015) is that the person is disqualified from:

a)       Being or acting as a director or secretary of a company;

b)       Being or acting as a liquidator, provisional liquidator or administrator of a company;

c)       Being or acting as a supervisor of a voluntary arrangement approved by a company; or

d)       In any way, whether directly or indirectly, being concerned in the promotion, formation or management of a company, for such period as may be specified in the order (Section 214(1), CA 2015)

·       The period of disqualification specified in a Disqualification Order begins at the end of 21 days from and including the date of the order, unless the relevant court otherwise orders

 

8.2.1      DISQUALIFICATION ON CONVICTION FOR OFFENCE [S. 215]

·       On convicting a person of an offence relating to the promotion, formation, management, liquidation or administration of a company, the court may make a disqualification order against the person

·       The maximum period of disqualification that can be imposed in a disqualification order made under this section is, if the disqualification order is made by a magistrate's court, five years; and in any other case, fifteen years. The application of this section is not limited to offences under this Act

 

8.2.2      DISQUALIFICATION FOR FRAUD OR BREACH OF DUTY COMMITTED WHILE COMPANY IN LIQUIDATION/ADMINISTRATION [S. 216]

·       This section applies to an officer of the company; a liquidator or provisional liquidator of the company; or if the compan y is under administration — the administrator

·       A court may make a disqualification order against such person if, while the company was under administration or in liquidation, it is satisfied that the person has, been found guilty of fraud in relation to the company; or any breach of duty as the holder of such an office

·       The maximum period that can be imposed in a disqualification order made under this section is fifteen years

 

8.2.3      DISQUALIFICATION ON CONVICTION FOR OFFENCE INVOLVING FAILURE TO LODGE RETURNS/OTHER DOCUMENTS [S. 217]

·       The CA 2015 has now made it an offence to fail to comply with any provision of the Act or the insolvency related laws requiring:

a)       A return, financial statement or other document to be lodged with, or sent to the Registrar; or

b)       A matter to be notified to the Registrar, whether the failure is by the person or any company of which the person is an officer

·       If a person is convicted of an offence to which this section applies, the convicting court may make a disqualification order against the person if, during the five years ending with the date of the conviction, the person has been convicted of no fewer than three such offences

·       The maximum period that can be imposed in a disqualification order made under this section is five years

 

8.2.4      DUTY OF COURT TO DISQUALIFY UNFIT DIRECTORS AND SECRETARIES OF INSOLVENT COMPANIES [S. 218]

·       The CA 2015 has also now given directors statutory responsibility for the proper management of companies

·       A court shall make a disqualification order against a person if satisfied, on an application made to it under Section 219, that the person is or has been a director or secretary of a company that has at any time become insolvent whether while the person was a director or secretary or subsequently; and that the conduct of the person as a director or secretary of that company either taken alone or taken together with the person's conduct as a director or secretary of any other company or companies makes the person unfit to take part in the management of a company

 

8.2.5      APPLICATION TO COURT UNDER SECTION 219

·       If the Attorney General is satisfied that it would be in the public interest for a disqualification order under section 218 to be made against a person the Attorney General; or at the Attorney General’s direction, the Official Receiver, may make an application to a court for such an order

·       Except with the leave of the relevant court, an application for the making of an order under section 218 of a disqualificatio n order against a person may not be made after the expiry of two years from and including the day on which the company of which the person is or has been a director or secretary became insolvent

·       Alternatively, the Attorney General may accept a disqualification undertaking if of the view that it would be in the public interest to do so, instead of applying, or proceeding with an application, for a disqualification order à He must be satisfied that the conditions referred to in Section 218(1) are complied with in relation to a person who has offered to enter into a disqualification undertaking

·       A disqualification undertaking (Section 220, CA 2015) is an undertaking by a person that for a period specified in the undertaking, the person will not, without the leave of a court of competent jurisdiction, act or accept an appointment as a director or secretary of a company; or in any way (whether directly or indirectly) be concerned in the promotion, formation or management of a company; and will not act as a liquidator, provisional liquidator or administrator of a company

·       The maximum period that may be specified in a disqualification undertaking is fifteen years and the minimum period that may be so specified is two years

 

8.2.6      DISQUALIFICATION AFTER INVESTIGATION OF COMPANY UNDER SECTION 221

·       If, as result of a report of an investigation conducted under Part XXX, the Attorney General considers that it would be in the public interest for a disqualification order to be made against a person who is or has been a director or secretary of any company, the Attorney General may apply to the Court for a disqualification order to be made against that person

·       The court may make a disqualification order against a person if, on an application under this section, it is satisfied that the person's conduct in relation to the company makes that person unfit to take part in the management of a company

·       The maximum period that can be imposed in a disqualification order made under this section is fifteen years

CHAPTER 6: CAPITAL & CAPITAL MAINTENANCE

 

·       The two principal types of capital that companies acquire are share capital (capital obtained by selling shares) and debt capital (capital borrowed from others)

·       A new allotment of shares must usually be offered to existing shareholders first

·       Companies are prohibited from allotting shares for less than their nominal value

·       Companies can issue different classes of shares with different class rights, and the law regulates the ability to vary such class rights

·       Public companies are subjected to minimum capital requirements when commencing a business, whereas private companies are not a reduction of share capital is only valid if the strict procedures relating to a reduction of the capital, found in the Companies Act 2015, are complied with

·       Companies are generally prohibited from purchasing their own shares, but the Companies Act 2015 does provide exceptions to this prohibition

·       Private companies are permitted to provide financial assistance to acquire their own shares, while public companies are generally prohibited from providing such assistance (but there are exceptions)

·       Companies can only pay a dividend out of ‘profits available for the purpose’

·       The two principal types of charge are fixed charges and floating charges and, in order to be enforceable, charges need to be registered in accordance with the Companies Act 2015

 

1.       SHARES AND SHARE CAPITAL

·       A share is an item of property known as a ‘thing in action’ – in a legal sense, a ‘thing’ (formally known as a ‘chose’) is simply an item of property other than land, and a thing in action is simply an intangible thing which – being intangible – can only be claimed or enforced by legal action, as opposed to taking possession of it

·       Being intangible, a share has no physical existence, but instead confers a number of rights and liabilities upon its holder, including providing evidence of the existence of a contract between the shareholder and the company (‘the constitution as a contract’)

·       However, share ownership does not give the shareholder a proprietary right over the assets of the company ( Borland’s

Trustee v Steel Bros & Co Ltd [1901]), as the assets belong to the corporate entity

·       The Companies Act 2015 defines ‘shares’ as:

a)       In relation to an undertaking with a share capital, means shares in the share capital of the undertaking;

b)       In relation to an undertaking with capital but no share capital, means rights to share in the capital of the undertaking; and

c)       In relation to an undertaking without capital, means interests: (i) conferring a right to share in the profits, or the liability to contribute to the losses, of the undertaking, or (ii) giving rise to an obligation to contribute to the debts or expenses of the undertaking in the event of a liquidation

 

2.        CLASSIFICATIONS OF SHARE CAPITAL

2.1    NOMINAL VALUE

·       Section 324(3), CA 2015: all shares in a limited company with a share capital are required to have a fixed ‘nominal value’

and failure to attach a nominal value to an allotment of shares will render that allotment void

·       The nominal value is a notional value of a share’s worth but, in reality, it may bear no resemblance to a share’s actual value

à it represents the minimum price for which the share can be allotted and it also helps in determining the liability of a shareholder in the event of the company being liquidated

·       Whilst shares cannot be allotted for less than their nominal value, it is common for shares to be allotted for more than their nominal value and the excess is known as the ‘share premium’ (i.e. the share premium represents the difference between the nominal value and the market value of the share)

 

2.2    AUTHORISED SHARE CAPITAL

·       The concept of authorized share capital has been abolished by the CA 2015 but it is still of relevance

·       Under the CAP 486, companies were required to state in their memoranda the total nominal value of shares that may be allotted by the company, and this value represented the company’s authorized share capital. Accordingly, a company with an authorized share capital of Kshs. 1 million could not allot shares with a combined nominal value of more than KES 1

million. For example, it could allot a million shares with a nominal value of Kshs. 1, or 500,000 shares with a nominal value of Kshs. 2, and so on

·       Companies incorporated under the CA 2015 are not limited in terms of the number of shares they can issue (unless they choose to state an authorized share capital in their memoranda) à However, companies incorporated under the CAP 486 may still have their authorized share capital stated in their memoranda and, as regards such companies, their ability to allot shares will be limited to the amount stated

 

2.3    ISSUED AND UNISSUED SHARE CAPITAL

·       A company’s authorized share capital represents the total nominal value of shares that can be allotted

·       The total nominal value of shares that actually has been allotted is known as the ‘issued share capital’. So, for example, a company that has allotted three million shares that have a nominal value of Kshs. 5 each would have an issued share capital of Kshs. 15 million

·       The difference between a company’s authorized share capital and its issued share capital (i.e. the nominal value of shares

that could still be issued) is known as the ‘unissued share capital’

·       With the abolition of authorized share capital, the concept of unissued share capital has also been abolished, except for those companies that still state in their memoranda their authorized share capital

 

2.4    PAID UP, CALLED UP, AND UNCALLED SHARE CAPITAL

·       Shareholders may not have to pay fully for their shares upon allotment

·       Shares may be partly paid for when allotted, with the remainder to be paid at a later late

·       The combined total of the nominal share capital that has actually been paid is known as the ‘paid up share capital’

·       If shares are partly paid for on allotment, the company can call for the remainder (or part of the remainder) to be paid, or the company might have required payment in instalments and an instalment has become due à the paid-up share capital plus the amount called for or the instalment due is known as the ‘called-up share capital’

·       The difference between the company’s issued share capital and it’s called-up share capital is known as the ‘uncalled share capital’ (i.e. the amount remaining to be called upon by the company)

 

3.       ALLOTMENT AND ISSUANCE OF SHARES

·       There are two principal methods by which a person can become a shareholder in a company:

(i)            He can become a shareholder by purchasing new shares from the company; or

(ii)            As shares are freely transferable items of property (subject to the limitations found in the articles), he can become a shareholder by obtaining shares from an existing shareholder (e.g. through sale, gift, bequest, etc.)

·       Whilst the terms ‘allotment’ and ‘issuance’ are used interchangeably, there is a distinction between the two:

o   Shares are allotted when a person acquires the unconditional right to be included in the company’s register of

members with respect to the shares (Section 3(4), CA 2015)

o   Shares are issued when the person’s name is actually entered into the register of members. From this, it follows

that the issuance of shares takes place after they have been allotted (National Westminster Bank v IRC [1995])

 

3.1    THE POWER TO ALLOT SHARES

·       The CA 2015 lays down strict procedures regarding the allotment of shares

·       Section 327(4) – Section 327(5), CA 2015: any director who knowingly permits or authorizes an unlawful allotment will commit an either way offence, although the allotment itself will remain valid

·       Section 328, CA 2015: where a private company has only one class of share, the power to allot shares is vested in the directors, subject to any limitations found in the articles (the model articles contain no such limitations)

·       Section 329, CA 2015: in all other cases, the directors can only allot shares if they are authorized to do so by the company’s

articles (the model articles do not contain such authorization) or by a resolution of the company

 

TYPE OF COMPANY	POWER TO ISSUE SHARES	PROVISION IN THE ARTICLES
Private company with only one class of shares, that wishes to issue shares of the same class	S. 328 CA 2015: the directors may allot shares of the same class, except to the	A provision in the articles empowering the directors to issue shares is not required, but the articles may limit the

 

	extent that they are prohibited from doing so by the company’s articles	directors’ powers to issue shares (the model articles contain no such limitation)
Any other type of company, namely:	S. 329 CA 2015: the directors will only	The model articles for private companies
	have the power to issue shares if:	limited by shares and the model articles
·   A private   company   with   multiple		for public companies provide that the
classes of shares; ·   A private company with only one class	a) They are authorised to do so by the company’s articles; or	company may issue shares with such rights    or    restrictions             as    may             be
of shares   that   wishes   to   issue   a	b) The members   pass   a   resolution	determined   by    ordinary    resolution.
different class of shares; or ·   A public company	authorising the   directors   to   issue shares	Accordingly, under the model articles, the directors are not authorised to issue
		shares without the passing of an ordinary
		resolution

 

3.2    PRE-EMPTION RIGHTS

·       An inevitable consequence of a new allotment of shares is that the shareholdings of existing shareholders (and consequently, their voting power and the return on their investment) will be diluted

·       The allotment may even cause control of the company to be transferred to a new person

·       To prevent these consequences occurring without shareholder consent, existing shareholders are given a right of pre- emption à i.e. under Section 338(1), CA 2015, any new allotment of shares must first be offered to the existing shareholders

·       If an allotment is made that contravenes the pre-emption rights of existing shareholders, then the allotment will remain valid, but the company and every officer who knowingly authorized the allotment will be liable to compensate the shareholders who would have benefited from the pre-emptive offer

·       Note: in certain circumstances, the shareholders’ pre-emption rights can be limited (e.g. where the shares allotted are bonus shares) or even completely excluded (e.g. where a private company has a provision in its articles excluding pre- emption rights)

 

3.3    PROHIBITION ON ALLOTTING SHARES AT A DISCOUNT

·       Section 356, CA 2015 provides that shares cannot be allotted at a discount (i.e. for less than their nominal value)

·       Any contract that purports to allot shares at a discount is void and, if shares actually are allotted at a discount, the allottee is liable to pay the company an amount equal to the discount including interest. The company and every officer in default also commit an either way offence

·       However, the effectiveness of the prohibition, at least in relation to private companies, is weakened by the fact that shares do not have to be paid for in cash à Section 358, CA 2015 provides that shares can be paid for in ‘money or money’s worth,’ and it is reasonably common for shares to be paid for in goods, property, by providing a service, or by transferring an existing business to the company in return for shares

·       By overvaluing the non-cash consideration, private companies can effectively issue shares at a discount. The courts have stated that they will only interfere where the consideration is manifestly illusory or inadequate (Re Wragg Ltd [1897]). Accordingly, private companies can easily avoid the prohibition should they choose to do so

·       Regarding public companies, the rules are more stringent in two ways:

o   First, public companies cannot accept payment for shares in the form of services (Section 361(1), CA 2015);

o   Second, if a public company allots shares for non- cash consideration, then that consideration must be independently valued by a person eligible for appointment as the company’s auditor. This person must confirm that the value of the non-cash consideration is at least equal to the amount paid up on the shares

 

4.       CLASS OF SHARES

·       Most companies will only have one class of share (known as ‘ordinary shares’) and all the shareholders will have the same

rights

·       However, provided that the articles so authorize (and the model articles do), a company is free to issue different classes of shares that confer different rights upon the holder (e.g. shares with increased or decreased voting rights, or shares with differing nominal values)

·       A common form of share class is the preference share, which usually entitles the holder to some sort of benefit or preference over and above the ordinary shareholders à the exact nature of the preference will vary from company to company, but most preference shares provide their holders with fixed or preferential rights to a dividend, and/or priority claims on the assets of the company upon liquidation

·       The rights attached to differing classes of shares are known as ‘class rights’ and shareholders of one class might attempt to remove the class rights of shareholders of another class (especially if the class rights confer a benefit upon the latter class of shareholders)

·       The CA 2015 provides that a variation of class rights will only be effective if strict formalities are complied with. It is therefore important to know what constitutes a ‘variation’. It is clear that abrogation (abolition) of a right will constitute a variation, but the courts are reluctant to hold that a mere alteration of a right will constitute a variation

·       Section 393 – 393, CA 2012: class rights can only be varied if the same is:

(i)            Approved in writing by the holders of three-quarters in nominal value of the issued shares of the class in question;

(ii)            Or, approved by the passing of a special resolution at a meeting of holders of that class of share

 

 

CASE

HOLDING

Re Mackenzie & Co Ltd [1916]

The company issued preference shares with a nominal value of £20 each. These shares entitled their owners to a 4 per cent dividend on the amount paid up and, as the shares were fully paid up, this equated to 80 pence per share. The articles were amended to reduce the nominal value of the preference shares to £12, thereby reducing the dividend to 48 pence per share. Held: The alteration of the articles did not constitute a variation of a class right, as the right remained the same (i.e. 4 per cent of the amount paid up). Providing that the right itself remains the same, the fact that an alteration renders the right less valuable (or even worthless), will prevent the alteration from amounting to a variation

 

5.       MINIMUM CAPITAL REQUIREMENT

·       Private companies with a share capital are not subject to a minimum share capital requirement and can accordingly be set up by issuing Kshs. 1/= to a single shareholder

·       Conversely, a public company cannot conduct business until it has been issued with a trading certificate, and the Registrar of Companies will not issue such a certificate unless he is satisfied that the nominal value if the company’s allotted share capital is not less than Kshs. 6, 750, 000/= (Section 516 – 518, CA 2015)

·       This minimum capital requirement aims to ensure that there is always a minimum level of capital available in order to

satisfy the company’s debts

·       However, it is acknowledged that the minimum capital requirement does little to aid creditors for three reasons:

(i)            The figure of Kshs. 6,750,000/= is too low to offer creditors any real protection;

(ii)            The shares do not need to be fully paid up—only one quarter of the nominal value and the whole of the premium needs be paid up at the time of allotment (Section 362(1), CA 2015), and shares issued at the time of incorporation must be paid for in cash. Thus, a newly formed public company may have only Kshs. 1,687,500/= in cash when it starts business (with the right to call on the shareholders for at least a further Kshs. 5,062,500/=);

(iii)            The authorized minimum is measured at the time the company commences trading, but little account is taken of the fact that it may be reduce once trading commences. If the level of capital does fall below half the company’s called-up capital, then a general meeting must be called to discuss what steps should be taken (Section 4161, CA 2015), but by the time the assets reach this level, it is likely that some form of insolvency procedure will be in place, thereby rendering the general meeting useless. Even if this is not the case, the Act does not require that the meeting take any action

 

6.       CAPITAL MAINTENANCE

·       Having obtained share capital through the selling of shares, the law requires the company to ‘maintain’ the same (no

unauthorised distributions)

·       The rationale behind this is creditor protection – the creditors look to the company’s capital for payment and the less

capital the company has, the greater the risk that the company will default, and the creditors will not be paid

·       At its most basic level, the creditors will expect capital to rise and fall in the course of trading, but will not expect the company to return capital to the shareholders

·       Through a series of rules known collectively as the ‘capital maintenance regime’, the law prohibits capital from being returned to the shareholders (this can be through: the restructuring of share capital, or the acquisition by a company of its own shares)

 

6.1      THE RESTRUCTURING OF SHAPE CAPITAL [PART XV, CA 2015]

·       A company may increase its share capital by: allotting new shares; subdividing existing shares into shares of a smaller nominal value; or, consolidating shares by merging existing shares into shares of a higher nominal value

·       These forms of share capital restructuring do not adversely affect the level of share capital and so creditor interests are not jeopardized

·       However, a reduction of share capital may adversely affect the creditors’ interests, and so is heavily regulated. A reduction of capital will be unlawful unless the procedures found in Sections 407 – 422, CA 2015 are complied with. These sections provide companies with two methods to reduce share capital

·       Note: provided that companies could only reduce capital if their articles so permitted, a special resolution was obtained, and the reduction was approved by the courts. Obtaining court approval proved to be unduly burdensome for many smaller companies

 

6.1.1      SPECIAL RESOLUTION AND COURT CONFIRMATION

·       This method is available to all types of companies

·       Section 407 – 108, CA 2015: provides that a reduction will be valid where the company authorizes the reduction by passing a special resolution and then then applies to the court for an order confirming the reduction

·       Section 417, CA 2015: where a public company wishes to reduce its share capital below the authorized minimum, the Registrar of Companies will not register the reduction unless the company first re-registers as private, or unless the court so directs

 

6.1.2      SPECIAL RESOLUTION SUPPORTED BY SOLVENCY STATEMENT

·       The second method of effecting a reduction is available to private companies only and does not require court approval

·       Section 419(1)(a), 420, CA 2015: a private company can effect a reduction of capital by passing a special resolution authorizing the reduction, supported by a statement of solvency from the directors à this statement must be made no more than 14 days before the resolution is passed evidences the opinion of the directors that:

o   There is no ground on which the company could then be found to be unable to pay its debts, and

o   The company will be able to pay its debts as they fall due during the year immediately following the date of the statement (if the company is to be wound up within 12 months of the statement being made, the directors must be of the opinion that the company will be able to pay its debts in full within 12 months of the winding-up commencing)

·       If this statement is made without reasonable grounds for the opinions expressed within it, every director who is in default commits an offence, although the reduction remains valid

 

6.2      THE ACQUISITION OF OWN SHARES [PART XVI, CA 2015]

·       The common law absolutely prohibited companies from purchasing their own existing shares on the ground that this would involve returning capital to the shareholders (Trevor v Whitworth [1887]) and would therefore reduce the funds available to pay the creditors

·       Section 424, CA 2015 maintains a strict approach by providing that limited companies cannot purchase their own shares, except in accordance with the procedures laid down in the CA 2015

·       If these procedures are not followed, the purported acquisition of shares is void, and the company and every officer of the company in default will commit an offence. A company can purchase its own shares in one of two ways

 

6.2.1      REMEEMABLE SHARES

·       Section 684, CA 2015: a company can purchase shares that it has issued as redeemable shares

·       Redeemable shares offer temporary membership of a company and tend to provide that the shares can be redeemed (i.e. bought back) by the company, usually upon the insistence of the company or the shareholder, or after a stated period has passed

·       To ensure that capital is not reduced, the company must pay for the shares out of its distributable profits, or out of a fresh issue of shares

 

6.2.2      PURCHASE BY A COMPANY OF OWN SHARES

·       Whilst redeemable shares are useful, they are inflexible in so much as the company must decide, prior to issue, that the shares are to be redeemable and the company can only then purchase those redeemable shares

·       What companies wanted was the general ability to purchase any shares (including redeemable shares) and such a power exists under Section 424, CA 2015. Several safeguards exist, including:

o   Only limited companies may purchase their own shares;

o   The shares purchased must be fully paid up; and

o   When purchasing the shares, the company must pay for the shares upon purchase

·       Purchase of the shares must be made from distributable profits, or out of a fresh issue of shares (although there is a specific method whereby private companies can purchase their own shares out of capital)

·       Additional safeguards are provided depending whether or not the purchase is to take place on a recognized investment exchange. Where the purchase is to take place on such an exchange, the additional safeguards imposed by the Act are less extensive as investment exchanges have their own safeguards in place

 

6.2.3      FINANCIAL ASSISTANCE TO ACQUIRE SHARES

·       Historically, companies have been prohibited from providing financial assistance for purchase of their shares on the ground that it would allow a company to manipulate its share price (exceptions were narrow and strictly regulated)

·       However, this restriction hampered innocent and commercially beneficial transactions, especially ones involving private companies. Accordingly, this prohibition has now been abolished for private companies

·       Section 442, CA 2015 still retains the prohibition for public companies – contravention of the same constituted an offence, and an agreement to provide unlawful financial assistance will be voidable

 

7.       DISTRIBUTIONS

·       The pro-member nature of directors’ duties indicates that the principal purpose of most commercial companies is to make a profit

·       Members expect a share of the company’s profits to be distributed to them, usually in the form of a dividend

·       Dividends are the distribution, usually in cash, of profits to the members, usually at a fixed amount per share à accordingly, the more shares a member owns, the greater the dividend he will receive

·       It is important to remember that members do not have a right to a dividend à Burland v Earle [1902]: until a dividend is declared, or a company is wound up, companies are not under a legal obligation to distribute profits to their members

·       However, failure to pay a dividend may amount to unfairly prejudicial conduct or even justify winding up of a company on equitable grounds

 

7.1    PROCESS OF DECLARING A DIVIDEND

7.2    RESTRICTIONS ON DISTRIBUTIONS

·       Section 486(1), CA 2015: provides that companies cannot pay a dividend out of capital – instead, a ‘company may only make a distribution out of profits available for the purpose’, with such profits being defined as the company’s ‘accumulated, realised profits ... less its accumulated, realised losses’ (Section 486(2), CA 2015):

o   The word ‘accumulated’ is included to require companies to include previous years’ losses when determining the profits available for the purpose. The aim of this is to prevent a situation whereby a company has several years’ poor performance and sustains significant losses, but then has a profitable year and pays out a dividend, even though that profitable year has not replaced the losses suffered in previous years

o   The word ‘realised’ is included to prevent companies from paying out a dividend based on estimated profits. Companies used to be able to pay out a dividend based on estimated profits, but if that level of profit were not reached, the shortfall would have to be paid out of capital. Companies are now required to determine profits based on gains and losses that are realized, and what is realized is to be determined using generally accepted accounting principles, with the Financial Reporting Standard 18 providing that profits are realized only when realized in the form of cash or other assets, the cash realization of which can be assessed with reasonable certainty

·       When determining whether or not a distribution is lawful, the courts will focus on the purpose and substance of the transaction, as opposed to its form (e.g. a distribution described as a dividend, but paid out of capital, would be found unlawful, despite the label attached to it)

·       Although an objective approach is favourable, the courts will look at all the facts, including the state of mind of the persons orchestrating the transaction (Progress Property Co Ltd v Moorgarth Group Ltd [2010])

 

7.3    CONSEQUENCES OF UNLAWFUL DISTRIBUTION

·       Section 494(1), 494(2), CA 2015: any shareholder who, at the time of the distribution, knew or had reasonable grounds to believe that the distribution was unlawful, is required to repay it, or part of it, to the company

·       Section 486(3), CA 2015: where directors are concerned, the company, and each officer of the company who is in default, commit an offence and on conviction are each liable to a fine not exceeding one million shillings

·       Under common law, the directors who authorized the distribution are liable to repay the money to the company if they knew or ought to have known that the distribution was unlawful (Re National Funds Assurance Co (No 2) [1878])

·       This is a severe deterrent, as was seen in the case of Bairstow v Queens Moat Houses plc [2001] where the directors were required to pay back an unlawful distribution of £26.7 million, plus an additional £15.2 million in interest

·       If an unlawful distribution is made based on erroneous accounts, the company’s auditor, if negligent in failing to detect the error, will be liable to repay the company the amount of the unlawful distribution (Leeds Estate Building and Investment Co v Shepherd [1887])

 

CHAPTER 7: DEBT CAPITAL

 

·       It may be the case that a company can acquire all the capital it needs through the selling of shares

·       However, in many companies, this will not be the case and the company will need to obtain additional capital by borrowing it from others

·       Such capital is known as ‘debt capital’ or ‘loan capital’ and can be obtained in several ways, e.g. using an overdraft facility, obtaining a loan from the bank, or mortgaging the property of the company

 

1.       DEBENTURES

·       A debenture is a document by which a company creates or acknowledged a debt, whether secured or unsecured à Section 3, CA 2015: a debenture is defined, in relation to a company, as including debenture stock and other securities of a company (whether or not constituting a charge on the assets of the company)

·       Companies can raise significant amounts of debt capital using debenture stocks – these are similar to shares, except that the holder of a debenture stock is a creditor and not a member, and is therefore entitled to interest on the loan (the debenture) but will not receive a dividend

·       A secured loan is one where the loan agreement provides the lender with a claim over the company’s assets, so that if the

company defaults on the loan, the lender can seize the relevant assets and sell them in order to satisfy the debt owed

·       A further benefit of secured loans is that, in the event of the company being liquidated, secured creditors have the right to be paid before the unsecured creditors. Given that insolvent companies will have limited assets, this is an extremely important advantage

 

1.1    DEFINING A DEBENTURE

 

CASE	HOLDING
Levy v Abercorris Slate and Slab Co [1887]	‘Debenture’ is not a term of art, but has been defined to mean simply any document that creates or acknowledges a debt
Lemon v Austin Friars Investment Trust Limited [1926]	It is impossible to give an exhaustive definition of a debenture, but an acknowledgement of indebtedness is its primary feature
Fons Hf v Corporal Limited & Another [2014]	Debentures have the ‘ordinary meaning of an acknowledgement of debt recorded in a written document’ à the word ‘debenture’ has origins in the Latin word for ‘owing’

 

1.2    DEBENTURE AS A SECURITY DOCUMENT

·       In practice, a finance lawyer is most likely to associate the term ‘debenture’ with a document that:

o   Is executed in favour of a creditor;

o   Includes a covenant to pay the creditor; and

o   Grants security over the whole or substantially the whole of a company’s assets

·       Because a debenture in a literal sense is merely an instrument evidencing corporate indebtedness, and might itself be unsecured or irredeemable, many leading textbooks choose to avoid the term altogether, preferring to use the terms ‘mortgage’ or ‘charge’ when referring to instruments that create security interests

·       Typically, a debenture as a security document creates:

o   A fixed charge over the assets of the company which are not disposed of in the ordinary course of business;

o   A floating charge over the rest of the company’s undertaking; and

o   It may also take an assignment by way of security over choses in action and mortgages over specific assets such as real estate or shares

·       A debenture of this nature grants the creditor rights as mortgagee or chargee, e.g. the authority to appoint an administrator or administrative receiver with wide powers to run the company’s business and realise its assets in the event of default on the debenture repayment

 

2.       CHARGES

·       Any form of security where possession of property is not transferred will be classified as a charge

·       The creditor who obtained the charge is called the ‘chargee’ and the borrower who granted the charge is known as the ‘chargor’ or ‘surety’

 

2.1    FIXED CHARGE

·       The simplest form of charge is the fixed charge, so called because it is taken over a fixed, identifiable asset of the company,

e.g. a building, a vehicle, or a piece of machinery

·       Should the debtor company default on the loan, the creditor can look to the charged asset to satisfy the debt, usually by selling it and recovering the proceeds of sale

·       The most straightforward and common example of a fixed charge is a mortgage à the debtor company (the mortgagor) will borrow capital from the creditor (the mortgagee) and the loan will be secured on a fixed asset of the company (e.g. a building). Should the company default on the loan, the creditor can obtain possession of the mortgaged asset and sell it

·       Unless the charge contract provides otherwise, a company can grant multiple fixed charges over a specific asset, with prior charges having priority over subsequent ones (unless the terms of the prior charges provide that subsequent charges can be made that take priority)

·       Fixed charges are advantageous for creditors because:

o   They allow the creditor to take security over a fixed, identifiable asset and ensure that the creditor ranks ahead of all other creditors in the event of the company being liquidated; and

o   It limits the debtor’s ability to deal with the charged asset (however, this created inflexibility for the debtor)

 

2.2    FLOATING CHARGE

·       A more flexible form of charge to the fixed charge was required, leading to the creation of the floating charge

·       There is no legal definition of what amounts to a floating charge, but in Re Yorkshire Woolcombers’ Association Ltd [1903], three defining factors were identified:

o   The charge will be taken over a class of assets (e.g. machinery, raw materials, or even the entire undertaking), as opposed to a specific asset;

o   The class of assets charged is normally constantly changing (e.g. raw materials will be used and replenished); and

o   Floating charges leave the company free to use and deal with those assets

·       This charge ‘floats’ over the charged assets, but is not fixed on them, so the company is free to use and dispose of those

assets

·       The company can even grant fixed charges on the assets over which the charge floats, which may (depending on the terms of the floating charge) rank ahead of the floating charge (Wheatley v Silkstone and Haigh Moor Coal Co [1885])

·       However, the company cannot create a subsequent floating charge over the exact same class of assets as a prior floating charge, unless the first chargee agrees. The company can, however, create subsequent floating charges over part of the assets charged by a prior floating charge and the general rule is that later charges rank behind earlier ones (although the terms of the first charge may provide otherwise)

·       Upon the occurrence of certain events, the charge will cease to float and will become affixed to the charged assets, whereupon the company’s ability to deal with the charged assets will be limited (‘crystallization’). Certain events will always cause a charge to crystallize, including:

o   The company going into liquidation;

o   The appointment of a receiver; and

o   An event that a clause in the security contract specifies as causing automatic crystallisation (‘automatic crystallisation clause’)

 

	FIXED CHARGE	FLOATING CHARGE
Legal or equitable?	Can be legal or equitable	Can be equitable only
Subject matter of charge	Usually taken over specific, identifiable assets	Usually taken over a class of assets or the entire undertaking
Effect     on              the              charged asset(s)?	The ability of the chargor to deal with the charged asset will usually be limited	The chargor will usually be free to deal with the charged assets
Better              suited         for              which areas?	Better suited for assets that the company does not need to deal with or dispose of	Suitable for all types of assets
Priority?	Ranks ahead of all other debts	Ranks behind fixed charge holders, liquidation expenses and preferential creditors

 

Reliant on liquidator?	Not reliant on the liquidator – Fixed charge holders can obtain the charged asset and sell it to satisfy the debt owed	Floating charge holders are reliant on the liquidator to obtain satisfaction of their debt
Set aside by liquidator?	A liquidator has no power to set aside a fixed charge	A liquidator has the power to set aside certain floating charges

 

2.3    DETERMINING THE CLASS OF A CHARGE

·       Identifying whether a particular charge is fixed or floating is not always straightforward and a charge holder may use this ambiguity to his advantage (e.g. by creating a charge with the characteristics of a floating charge, but later arguing that i t is in fact a fixed charge in order to gain priority upon liquidation)

·       Accordingly, the approach the courts use in determining whether a charge is fixed or floating is of crucial importance

 

CASE	HOLDING
Agnew v Commissioner for Inland Revenue [2001]	The process for determining the classification of a charge is two-fold: (i)             The court will look at the charge instrument in order to determine the rights and obligations that the parties intended to grant each other – it is not the task of the court to determine what type of charge the parties intended to create (ii)            The courts will use these rights and obligations to determine, as a matter of law, whether the charge was fixed or floating
Street v Mountford [1985]	Since the courts are not concerned with the type of charge that the parties intended to create, it follows that the courts will not regard the parties’ own classification of the charge as conclusive
Russel Cooke Trust Co. Ltd v Elliott [2007]	The courts will contradict the parties classification of the charge if the rights and obligations imposed by the charge are not consistent with the label that the parties have attached to it à in this case, the High Court held that what was described in the charge instrument as a floating charge was actually a fixed charge
Re Spectrum Plus Limited [2005]	A company obtained an overdraft facility from a bank, with the bank taking what was purported to be a fixed charge over the company’s book debts as security. The charge required that the company could not sell, charge, or assign the book debts without the bank’s consent, and that the proceeds of the book debts were to be paid into the bank account that the company held with the bank. The company was, however, free to draw upon the account, providing that the overdraft facility was not exceeded. The company entered liquidation and, in order to determine the priority of the company’s creditors, the court had to determine whether the charge was fixed or floating Held: The House held that the charge was a floating charge. Lord Scott stated that the key feature of a floating charge was that it grants the chargor (the company) the right to use the charged asset, including removing it from the scope of the charge. As the company could draw from the bank account, the rights granted to the chargor indicated strongly that the charge was a floating charge

 

2.4    REGISTRATION

·       For obvious reasons, prior to providing a company with capital, a potential creditor will want to know of any charges over

the company’s assets

·       Accordingly, successive Companies Acts have long provided for a system of registration of charges