lOMoARcPSD|14024421

Company law

Alan Dignam
John Lowry
Chris Riley
 lOMoARcPSD|14024421

This module guide was prepared for the University of London by:

u Alan Dignam, BA, (TCD), PhD (DCU), Professor of Corporate Law, Queen Mary,
University of London

and

u John Lowry, Cheng Yu Tung Visiting Professor, Faculty of Law, Hong Kong University,
and Emeritus Professor, Faculty of Laws, University College London.

The 2016, 2017, 2018, 2019 and 2020 updates were prepared by:

u Chris Riley, LLB, Associate Professor, Durham Law School, University of Durham.

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

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COMPANY LAW PAGE 1

Contents
2 Forms of business organisation .................................................................................................. 4
2.1 The sole trader .................................................................................................................................. 4
2.2 The partnership ................................................................................................................................. 5
2.3 The company ..................................................................................................................................... 5
2.4 Some general problems with the corporate form ............................................................................ 8
3 The nature of legal personality ................................................................................................ 12
3.1 Corporate personality ..................................................................................................................... 12
3.2 Salomon v Salomon & Co ................................................................................................................ 12
3.3 Other cases illustrating the Salomon principle ............................................................................... 13
3.4 Limited liability ................................................................................................................................ 14
4 Lifting the veil of incorporation................................................................................................ 15
4.1 Legislative intervention ................................................................................................................... 15
4.2 Judicial veil lifting ............................................................................................................................ 16
4.3 Actions in tort.................................................................................................................................. 20
5 Company formation, promoters and pre-incorporation contracts ............................................. 22
5.1 Determining who is a promoter ...................................................................................................... 22
5.2 The fiduciary position of promoters ............................................................................................... 23
5.3 Duties and liabilities ........................................................................................................................ 23
5.4 Pre-incorporation contracts ............................................................................................................ 24
5.5 Freedom of establishment .............................................................................................................. 25
6 Raising capital: equity ............................................................................................................. 26
6.1 Private and public companies ......................................................................................................... 26
6.2 Raising money from the public ....................................................................................................... 28
6.3 Insider dealing ................................................................................................................................. 30
6.4 Regulating takeovers....................................................................................................................... 31
7 Raising capital: debentures ...................................................................................................... 33
7.1 Debentures...................................................................................................................................... 33
7.2 Company charges ............................................................................................................................ 34
7.3 Priority............................................................................................................................................. 38
7.4 Avoidance of floating charges ......................................................................................................... 39
8 Capital .................................................................................................................................... 39
8.1 Overview – the maintenance of capital doctrine ........................................................................... 40
8.2 Raising capital: shares may not be issued at a discount ................................................................. 40
8.3 Returning funds to shareholders .................................................................................................... 41
8.4 Prohibition on public companies assisting in the acquisition of their own shares ......................... 46
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9 Dealing with insiders: the articles of association and shareholders’ agreements ....................... 50
9.2 The articles of association ............................................................................................................... 51
9.3 The contract of membership .......................................................................................................... 53
9.4 Shareholders’ agreements .............................................................................................................. 56
9.5 Altering the articles ......................................................................................................................... 56
10 Class rights ............................................................................................................................ 58
10.1 Shares and class rights .................................................................................................................. 58
10.2 Classes of shares ........................................................................................................................... 59
10.3 Variation of class rights ................................................................................................................. 60
11 Majority rule and wrongs against the company ...................................................................... 63
11.1 The rule in Foss v Harbottle – the proper claimant rule ............................................................... 63
11.2 Forms of action ............................................................................................................................. 65
11.3 Derivative claims: introduction ..................................................................................................... 68
11.4 A short excursion into the former common law ........................................................................... 69
11.5 The statutory procedure: Part 11 of the CA 2006......................................................................... 71
11.6 The proceedings, costs and remedies........................................................................................... 74
12 Statutory minority protection ................................................................................................ 75
12.1 Winding up on the ‘just and equitable’ ground ............................................................................ 75
12.2 Unfair prejudice – s.994 CA 2006.................................................................................................. 77
13 Dealing with outsiders: ultra vires and other attribution issues............................................... 82
13.1 The objects clause problem .......................................................................................................... 83
13.2 Reforming ultra vires .................................................................................................................... 84
13.3 Other attribution issues ................................................................................................................ 87
14 The management of the company .......................................................................................... 89
14.1 Directors........................................................................................................................................ 90
14.2 Categories of director ................................................................................................................... 93
14.3 Disqualification of directors .......................................................................................................... 95
15 Directors’ duties .................................................................................................................... 99
15.1 Directors’ duties .......................................................................................................................... 100
15.2 The restatement of directors’ duties: Part 10 of the CA 2006.................................................... 102
15.3 Relief from liability ...................................................................................................................... 118
15.4 Specific statutory duties.............................................................................................................. 119
16 Corporate governance ......................................................................................................... 120
16.1 Introducing corporate governance ............................................................................................. 120
16.2 The shareholder–stakeholder debate in the UK ......................................................................... 122
16.3 UK corporate governance developments ................................................................................... 123
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17 Liquidating the company ..................................................................................................... 129

17.1 Liquidating the company ............................................................................................................ 130
17.2 The liquidator .............................................................................................................................. 131
17.3 Directors of insolvent companies ............................................................................................... 134
17.4 Reform ........................................................................................................................................ 134
COMPANY LAW PAGE 4

2 Forms of business organisation

Introduction

Companies are the dominant form of business association in the UK. They are not, however, the only
form of business association. Sole traders and partnerships also exist as specific legal forms of
business. In this chapter we explore the place of the company within the various legal forms of
business organisation available in the UK in order to provide some insight as to how the company
has come to be the dominant form. In doing so we will consider the various forms of business
organisation from the point of view of their ability to raise capital (money), their ability to minimise
risk and their ability to provide some sort of clear organisational structure. We will also explore
some of the general problems that the corporate form poses for businesses.

In general this subject is not a course in the detailed procedural aspects of company law. Having said
that, in this chapter, more than any other in the guide, we will touch upon procedural matters as
they arise. This is because key aspects of the procedural nature of setting up a company are very
useful for understanding later chapters such as Chapter 5: ‘Company formation, promoters and pre-
incorporation contracts’ and Chapter 9: ‘Dealing with insiders’. Some of you may find this procedural
detail off- putting, but bear with it and complete the activities. It will pay dividends in the later
chapters.

Learning outcomes

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

2.1 The sole trader

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

Advantages

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

Disadvantages

• It is not a particularly useful business form for raising capital (money). For most sole traders
the capital will be provided by personal savings or a bank loan.
• Unlimited liability – the most important point to note in terms of comparing this form to the
company is that there is no difference between the sole trading business and the sole trader
himself. The profits of the business belong to the sole trader but so do the losses. As a result
he has personal liability for all the debts of the business. If the business collapses owing
money (an insolvent liquidation – see Chapter 17) then those owed money by the company
(its creditors) can go after the personal assets of the sole trader (e.g. his car or house) in
order to get their money back.
COMPANY LAW PAGE 5

2.2 The partnership

The second legal vehicle to consider is a partnership. In the UK, there are different types of
partnership. Here, we are considering a ‘general’, or ‘unlimited’, partnership, which is governed by
the Partnership Act 1890. Partnerships are very flexible legal business forms. While we are more
familiar with complex partnerships such as law firms or accountancy firms, partnerships can also be
very simple affairs. Section 1 of the Partnership Act 1890 defines a partnership as ‘the relationship
which subsists between persons carrying on a business in common with a view of profit’. This is a
very broad category and sometimes causes problems (see disadvantages below).

Advantages

• It facilitates investment as it allows two or more people to pool their resources. The
maximum number of partners allowable is, since 2002, unlimited. Prior to that it was 20
unless you were a professional firm – solicitors, accountants etc.
• If you are aware of the problems the Partnership Act can cause (see disadvantages below)
then you can draft a partnership agreement to vary these terms of the
• Act and provide an accurate reflection of your intentions when entering the partnership. The
partnership agreement can therefore be used to provide a very flexible organisational
structure although this usually involves having to pay for legal advice.

Disadvantages

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

2.3 The company

A company is formed by applying to the registrar of companies, providing a constitution (essentially

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

2.3.1 Categories of company

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

Differences between public and private companies limited by shares

• Before 1992 you needed two shareholders to form a private company limited by shares. The
Twelfth EC Company Law Directive (89/667) changed this requirement. Similarly, until the
Companies Act 2006 (CA 2006) was enacted, you still needed two shareholders to form a
public limited company. Now, under the CA 2006, both private and public companies can be
formed with a single shareholder (although of course many have lots of shareholders).
• In private companies investment comes either from the founding members in the form of
personal savings or from a bank loan. Private companies are prohibited from raising capital
from the general public.
• Public companies, on the other hand, are formed specifically to raise large amounts of
money from the general public.
• Private companies can restrict their membership to those the directors approve of or insist
that those who wish to leave the company first offer their shares to the other members.
Public companies could also do this but, as their aim is to raise money from the general
public, a restriction on the sale of shares would not encourage the general public to invest.
• Public companies have a minimum capital requirement of £50,000 (s.763 CA 2006). That
capital requirement does not have to be fully paid – it just needs one quarter of the £50,000
to be paid and an ability to call on the members for the remaining amount. Private
companies have no real minimum capital requirements. For example a private company can
have an authorised share capital of £1 subdivided into shares of 1p each. Because public
companies raise capital from the general public there is a raft of extra regulations that
affects their activities. This is discussed extensively in Chapter 6 on raising equity.
• Public companies are generally subject to a lot more regulation than private companies. For
example, public companies must have at least two directors; private companies need have
only one. Public companies must have a ‘company secretary’. Private companies can choose
whether or not to have one.
• Private companies can also adopt a more streamlined procedure for passing shareholder
resolutions. Instead of having to pass resolutions at a meeting at which shareholders are
physically present, Part 13 of the CA 2006 allows most resolutions, in private companies, to
be passed ‘in writing’.

Limited liability

One of the most obvious differences between the company and other forms of business organisation
is that the members of both private and public companies have limited liability. This means that the
COMPANY LAW PAGE 7

members of the company are only liable for the amount unpaid on their shares and not for the debts
of the company. We will explore how this operates in some detail in the next chapter. In order to
warn those who might deal with a company that the members have limited liability the word
‘limited’ or ‘Ltd’ must appear after a private company’s name or ‘plc’ after a public company (ss.58
and 59 CA 2006).

2.3.2 The constitution of the company

As part of the registration procedure both public and private companies must provide a constitution
which sets out the powers of the company and allocates them to the company’s organs, usually the
general meeting and the board of directors. This constitution historically consisted of two
documents: the memorandum of association and the articles of association. The CA 2006 requires
just a single document that replaces the current constitution (see s.18 CA 2006). The memorandum
still exists as a separate document as part of the registration requirements under the 2006 Act (see
Chapters 9 and 13).

The memorandum

Prior to the CA 2006, the memorandum was a fairly substantial document which those forming a
company needed to prepare. It contained a lot of information, including details of the company’s
share capital, its registered office and the ‘objects’ of the company (see below). The CA 2006
changed this. Now, most of this information is contained either in the company’s articles of
association, or in the application form that must be submitted to register the company. Now, the
memorandum only needs to state:

• that the ‘subscribers’ (i.e. those forming the company) wish to form a company; and
• if the company is to have a share capital, that each subscriber agrees to take at least one
share in the company.

At least one person must ‘subscribe’ to the memorandum (this used to mean they had to ‘sign’ it;
now they need only ‘authenticate’ it). In essence, they agree to take some shares or share in the
company and become its first shareholders.

Share capital in public and private companies

Until the CA 2006, the memorandum had to include quite a lot of details about the company’s share
capital. Now, less information is required, and the information that must be sent is put not in the
memorandum itself, but only in a separate form, known as ‘the statement of capital and initial
shareholdings’. That form must say how many shares the subscribers are taking and the ‘nominal’
value of those shares (that is their ‘face’ value, rather than the actual amount the subscribers are
paying for them).

It used to be the case that companies had to fix, and state in their memorandum, an ‘authorised’
amount of capital. This was the maximum amount of share capital the company could raise
(although the figure could be increased later). It is no longer necessary for companies to have an
authorised share capital (but a company that was formed before the CA 2006 came into force would
have declared what its authorised capital was, and such companies are still limited to that amount
unless they either increase it, or remove the limit entirely). Shares can be fully paid, partly paid or
even unpaid. With partly and unpaid shares, the shareholder can be called upon to pay for them at a
later date. Shares may be also be paid for in goods and services and not necessarily in cash.

We will discuss share capital extensively in Chapter 8.

COMPANY LAW PAGE 8

The articles of association

The articles of association are a set of rules for running the company. They set out the heart of any
company’s organisational structure by allocating power between the board of directors (the main
management organ) and the general meeting (the main shareholder organ). Those forming a
company can provide their own articles but, if they do not, there are ‘model articles’ that are
supplied by the state, by statutory instrument, and these will apply ‘by default’. Prior to 2009, the
same set of model articles was made available for both public and private companies. It was known
as ‘Table A’. From October 2009 onwards, different model articles are available for private, and for
public, companies, and they are now (rather unimaginatively) known simply as ‘the Model Articles’.
Most companies (and especially private companies) tend to adopt the Model Articles either without
any changes, or with a few minor alterations.

A company can alter its articles. A resolution to do so must be passed by a ‘special resolution’ of the
shareholders (s.21 CA 2006). Such a resolution requires a 75 per cent majority of votes cast.
Additionally s.168 CA 2006 gives members the right to remove a director for any reason whatsoever
by simple majority. Therefore, while the board is the primary management organ, the membership
of the board is subject to the continuing approval of the shareholders in general meeting. As noted
above, one clause that used to have to appear in a company’s memorandum was its ‘objects clause’.
This was a statement of the objects (i.e. the activities) the company was being set up to pursue.
Now, companies can choose whether to have any statement of their objects, but if they decide to do
so, such a clause must now to be put in the company’s articles, rather than its memorandum. We
shall examine the legal consequences of either including, or not including, such a clause in Chapter
13, when we consider the so-called ultra vires doctrine.

Advantages

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

Disadvantages

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

2.4 Some general problems with the corporate form

The dominance of the corporation as the preferred mechanism for organising a business in the UK
has thrown up some important problems for company law. The problems stem from the ‘one size
fits all’ nature of the corporate form. While there is a distinction between public and private
registered companies, that distinction masks the fact that the basic legal model provided for public
and private companies is very similar. As a result the statutory framework has historically applied to
COMPANY LAW PAGE 9

one-person private companies and large public companies as if they were similar in nature. The
problem is that they are not.

The key difficulty arises because the statutory model assumes a separation of ownership from
control. That is, it assumes that the investors are residual controllers exercising control once a year
at the annual general meeting (AGM) and that the day-to-day management of the business is carried
out by professional managers (directors). For large companies this is the case but for the vast
majority of companies in the UK this separation of ownership from control does not exist (see
Chapter 14).

To illustrate this we need to examine how, for both a large and a small company, company law
presumes the ownership and control system within the statutory model operates.

2.4.1 A large company

• The general meeting meets once a year (this is the annual general meeting or AGM)
primarily to elect the directors to the board.
• The directors will be a mix of professional managers (executive directors) and independent
outsiders (non-executive directors); see Chapter 14.
• The executive directors will normally have a small shareholding but not usually a significant
one.
• The shareholders are also provided with an annual report from the directors outlining the
performance of the company over the past year and the prospects for the future (like a sort
of report card on their performance). At the heart of the report are the accounts certified by
the auditor (an independent accountant who checks over the accounts prepared by the
directors).
• In between AGMs the directors run the company with little involvement by the
shareholders.
• In a large company the board of directors will be more like a policy body which sets the
direction the company goes in, but the actual implementation of that direction will be
carried out by the company’s employees.
• The directors in carrying out their function stand in a fiduciary relationship with the
company. They therefore owe a duty to act bona fides (in good faith) in the interests of the
company (this generally means the shareholders’ interests) and not for any other purpose
(such as self-enrichment – see Chapter 15).
• The employees who are authorised to carry out the company’s business are the company’s
agents and therefore the company will be bound by their actions (see Chapter 13).

2.4.2 A small company

The same company law model applies to a small company but with significant differences in effect.

• The shareholders and directors will often be the same people.

• The same people will also be the only employees of the company.
• There is no separation of ownership from control, the shareholders are the managers and
therefore most of the statutory assumptions about the company’s organisational structure
will not hold.

These differences (in effect the requirements for meetings and accounts), which are based on a
presumption of the managers being different people from the
COMPANY LAW PAGE 10

shareholders, became a burden for small companies. As a result, over many years, UK company law
was modified in an attempt to reduce some of the requirements and burdens on private companies.
The CA 2006 continued this process, under the slogan of ‘Think Small First’ (see below).

2.4.3 The Freedman study

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

Advantages

• Prestige. The small businesses surveyed considered that one of the major advantages (in fact
possibly the only advantage) of forming a company was that it conferred prestige, legitimacy
and credibility on the venture.
• Limited liability. The ability of those who are behind the company to walk away from the
company’s debts. However for small businesses this was potentially negated by the practice
of banks requiring the shareholders to provide guarantees for bank loans (a common source
of finance among small businesses). Thus any debts owed to the banks could be reclaimed
from the personal assets of the shareholders if the company was in insolvent liquidation.

Disadvantages

• Burdensome regulatory requirements (meetings, accounts, etc.).

• Expensive as they had to pay for professional advice to deal with the regulatory
requirements.

Solutions

Historically company law has not ignored this problem. Many changes were made, even before the
CA 2006 was enacted. For example, the CA 1985 allowed private companies to adopt what it called
‘the elective regime’, in s.379A. This allowed private companies to have simpler and less
burdensome rules governing:

• shareholder meetings
• timing of meetings
• laying of accounts.

However, these concessions were largely seen as insufficient. The CLRSG (the body that was in
charge of developing proposals for what would become the CA 2006) recommended, in its Final
Report (Modern Company Law for a Competitive Economy: Final Report (2001), Chapters 2 and 4)
that more statutory requirements be simplified for small businesses, covering:

• decision-making
• accounts
• audit
• constitutional structure
• dispute resolution.

The CLRSG also recommended that legislation on private companies should be made easier to
understand. In particular, there should be a clear statement of the duties of directors. As we shall
see, many of these recommendations were followed, and the CA 2006 does quite a lot to simplify
the law for private companies.
COMPANY LAW PAGE 11

But concerns still remain that company law is too burdensome for the smaller company and the
effort to reduce the ‘regulatory burden’ continues. In recent years, the UK Government has carried
out a number of public consultations to discover whether further relaxations in the law for private
companies are appropriate. And in 2015, it enacted the Small Business, Enterprise and Employment
Act which reduced the amount of information that must be ‘filed’ with the Registrar of Companies.

Minority issues

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

These situations are worse in private companies where the minority shareholder often needs board
approval for the sale of shares to an outsider or must offer the shares to the other members first. If
the other members are obstructive then this pre-emption process can leave the minority
shareholders trapped. Of course the fact that the majority holder is behaving badly will make it
difficult to find a buyer willing to put themselves into a similarly weak position. One limited source of
protection that has long been available to minority shareholders is that they are allowed (in some
cases at least) to enforce any personal rights they enjoy under the company’s constitution (see
Chapters 11 and 12). However, for reasons which will be explored later, that protection is often
ineffective for a minority, especially where the minority’s complaint relates to misbehaviour by the
company’s directors (see Chapters 14 and 15). Eventually, a statutory remedy was introduced in
s.459 CA 1985 and is now contained in s.994 CA 2006 to make it easier for shareholders to bring an
action.

Summary

The importance of this chapter is that it forms a context within which we can place the company and
its success as a business form. The sole trader may be a suitable approach for informal one-person
ventures, where the capital is mostly provided by the sole trader’s savings or a bank loan. It is
unsuitable for larger organisational or investment purposes.

The partnership is a very good business form which has many advantages over a company,
particularly for small- and medium-sized businesses. However, compared to the company, it is now
used less frequently, and the company in turn has come to dominate.

However the company as a form of business organisation is not without its problems. The company
is designed as an investment vehicle, with limited liability for its shareholders and a clear
organisational structure. It is designed for ventures where there is an effective separation of
ownership from control and is therefore largely unsuitable for the majority of its users, who are
small businesses. In many ways a partnership would be more suitable for an entrepreneur and less
onerous for small businesses generally, especially given that limited liability is rarely a reality for
these types of businesses. However, the continued use of the corporate form by small companies
COMPANY LAW PAGE 12

seems secure given the prestige attached to the tag ‘Ltd’. The CA 2006 has gone some way towards
meeting the needs of small businesses.

3 The nature of legal personality

Introduction

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

Learning outcomes

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

• explain what is meant by ‘corporate legal personality’

• illustrate the key effects of corporate legal personality in relation to liability.

3.1 Corporate personality

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

The history of corporate personality

Corporate legal personality arose from the activities of organisations, such as religious orders and
local authorities, which were granted rights by the government to hold property, sue and be sued in
their own right and not to have to rely on the rights of the members behind the organisation. Over
time the concept began to be applied to commercial ventures with a public interest element, such as
rail building ventures and colonial trading businesses. However, modern company law only began in
the mid- 19th century when a series of Companies Acts were passed which allowed ordinary
individuals to form registered companies with limited liability. The way in which corporate
personality and limited liability link together is best expressed by examining the key cases.

3.2 Salomon v Salomon & Co

It was fairly clear that the mid-19th century Companies Acts intended the virtues of corporate
personality and limited liability to be conferred on medium to large commercial ventures. To ensure
this was the case there was a requirement that there be at least seven members of the company.
This was thought to exclude sole traders and small partnerships from utilising corporate personality.
However, as we will see below in the case of Salomon v Salomon & Co [1897] AC 22, this assumption
proved to be mistaken.

Mr Salomon carried on a business as a leather merchant. In 1892 he formed the company Salomon
& Co Ltd. Mr Salomon, his wife and five of his children held one share each in the company. The
members of the family held the shares for Mr Salomon because the Companies Acts required at that
time that there be seven shareholders. Mr Salomon was also the managing director of the company.
The newly incorporated company purchased the sole trading leather business. The leather business
was valued by Mr Salomon at £39,000. This was not an attempt at a fair valuation; ratherit
represented Mr Salomon’s confidence in the continued success of the business.The price was paid in
£10,000 worth of debentures (a debenture is a written acknowledgement of debt like a mortgage –
COMPANY LAW PAGE 13

see Chapter 7) giving a charge over all the company’s assets (this means the debt is secured over the
company’s assets and Mr Salomon could, if he is not repaid his debt, take the company’s assets and
sell them to get his money back), plus £20,000 in £1 shares and £9,000 cash. Mr Salomon also at this
point paid off all the sole trading business creditors in full. Mr Salomon thus held 20,001 shares in
the company, with his family holding the six remaining shares. He was also, because of the
debenture, a secured creditor.

However, things did not go well for the leather business and within a year Mr Salomon had to sell his
debenture to save the business. This did not have the desired effect and the company was placed in
insolvent liquidation (i.e. it had too little money to pay its debts) and a liquidator was appointed (a
court-appointed official who sells off the remaining assets and distributes the proceeds to those who
are owed money by the company – see Chapter 17). The liquidator alleged that the company was
but a sham and a mere ‘alias’ or agent for Mr Salomon and that Mr Salomon was therefore
personally liable for the debts of the company. The Court of Appeal agreed, finding that the
shareholders had to be a bona fide association who intended to go into business and not just hold
shares to comply with the Companies Acts.

The House of Lords disagreed and found that:

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

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

3.3 Other cases illustrating the Salomon principle

3.3.1 Macaura

The principle in Salomon is best illustrated by examining some of the key cases that followed after.
In Macaura v Northern Assurance Co [1925] AC 619 Mr Macaura owned an estate and some timber.
He agreed to sell all the timber on the estate in return for the entire issued share capital of Irish
Canadian Saw Mills Ltd. The timber, which amounted to almost the entire assets of the company,
was then stored on the estate. On 6 February 1922 Mr Macaura insured the timber in his own name.
Two weeks later a fire destroyed all the timber on the estate. Mr Macaura tried to claim under the
insurance policy. The insurance company refused to pay out arguing that he had no insurable
interest in the timber as the timber belonged to the company. Allegations of fraud were also made
against Mr Macaura but never proven. Eventually in 1925 the issue arrived before the House of
Lords who found that:

• the timber belonged to the company and not Mr Macaura

• Mr Macaura, even though he owned all the shares in the company, had no insurable interest
in the property of the company
• just as corporate personality facilitates limited liability by having the debts belong to the
corporation and not the members, it also means that the company’s assets belong to it and
not to the shareholders.
COMPANY LAW PAGE 14

More modern examples of the Salomon principle and the Macaura problem can be seen in cases
such as Barings plc (In Liquidation) v Coopers & Lybrand (No.4) [2002] 2 BCLC 364. In that case a loss
suffered by a parent company as a result of a loss at its subsidiary (a company in which it held all the
shares) was not actionable by the parent – the subsidiary was the proper plaintiff. In essence you
can’t have it both ways – limited liability has huge advantages for shareholders but it also means
that the company is a separate legal entity with its own property, rights and obligations (see also
Giles v Rhind [2003] 2 WLR 237, Shaker v Al-Bedrawi [2003] 2 WLR 922 and Hashem vShayif [2008]
EWHC 2380 (Fam)).

3.3.2 Lee

Another good illustration is Lee v Lee’s Air Farming [1961] AC 12. Mr Lee incorporated a company,
Lee’s Air Farming Ltd, in August 1954 in which he owned all the shares. Mr Lee was also the sole
‘Governing Director’ for life. Thus, as with Mr Salomon, he was in essence a sole trader who now
operated through a corporation. Mr Lee was also employed as chief pilot of the company. In March,
1956, while Mr Lee was working, the company plane he was flying stalled and crashed. Mr Lee was
killed in the crash leaving a widow and four infant children. The company, as part of its statutory
obligations, had been paying an insurance policy to cover claims brought under the Workers’
Compensation Act. The widow claimed she was entitled to compensation under the Act as the
widow of a ‘worker’. The issue went first to the New Zealand Court of Appeal who found that he was
not a ‘worker’ within the meaning of the Act and so no compensation was payable. The case was
appealed to the Privy Council in London. They found that:

• the company and Mr Lee were distinct legal entities and therefore capable of entering into
legal relations with one another
• as such they had entered into a contractual relationship for him to be employed as the chief
pilot of the company
• he could in his role of Governing Director give himself orders as chief pilot. It was therefore a
master and servant relationship and as such he fitted the definition of ‘worker’ under the
Act. The widow was therefore entitled to compensation.

3.4 Limited liability

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

Summary

There are some key points to take from this chapter. First, it is important at this stage that you grasp
the concept of corporate personality. If at this stage you do not, then take some time to think about
it and when you are ready come back and re-read Dignam and Lowry, Chapter 2, paras 2.2–2.12.
Second, having grasped the concept of corporate personality you also need to understand its
consequences (i.e. the fact that the company can hold its own property and be responsible for its
own debts).
COMPANY LAW PAGE 15

4 Lifting the veil of incorporation

Introduction

As we observed in Chapter 3 the application of the Salomon principle has mostly (remember Mr
Macaura) beneficial effects for shareholders. The price of this benefit is often paid by the company’s
creditors. In most situations this is as intended by the Companies Acts. Sometimes, however, the
legislature and the courts haveintervened where the Salomon principle had the potential to be
abused or has unjust consequences. This ‘intervention’ can take many different forms. Sometimes,
for example, it may involve holding individuals inside the company liable – either to the company
itself, or to a third party who has been injured. And sometimes it may involve simply refusing to
treat a company as a separate legal personality, and working out what rights and liabilities people
have as if the company did not exist at all. We shall refer to all these types of intervention as ‘lifting
the veil of incorporation’. (Some people have suggested that the term ‘lifting the veil’ should be used
only where the company’s separate existence is being ignored. Strictly speaking, this is probably
true. However, since many writers do use this term in a rather wider and ‘catch all’ way, that is how
it will be used in this chapter too.)

Learning outcomes

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

• describe the situations where legislation will allow the veil of incorporation to be lifted
• explain the main categories of veil lifting applied by the courts.

4.1 Legislative intervention

As corporate affairs became more complex and group structures emerged (that is, where a parent
company organises its business through a number of subsidiary companies in which it is usually the
sole shareholder) the Companies Acts began to recognise that treating each company in a group as
separate was misleading. Over time a number of provisions were introduced to recognise this fact.
For example:

• s.399 CA 2006 provides that parent companies have a duty to produce group accounts
• s.409 CA 2006 also requires the parent to provide details of the shares it holds in the
subsidiaries and the subsidiaries’ names and country of activity.

However, it was the possibility of using the corporate form to commit fraud that prompted the
introduction of a number of civil and criminal provisions. These provisions operate to negate the
effect of corporate personality and limited liability in:

• s.993 CA 2006 which provides a not much used criminal offence of fraudulent trading
• ss.213–215 Insolvency Act 1986 which contain the most important statutory provisions.

4.1.1 Insolvency Act, s.213

Section 213 of the Insolvency Act 1986 was designed to deal with situations where the corporate
form was used as a vehicle for fraud. It is known as the ‘fraudulent trading’ provision. If, in the
course of the winding up of a company, it appears to the court that any business of the company has
been carried on with intent to defraud creditors of the company or creditors of any other person, or
for any fraudulent purpose, anyone involved in the carrying out of the business can be called upon
to contribute to the debts of the company. This is most likely to be shareholders or directors but can
also be employees and creditors. In Re Todd Ltd [1990] BCLC 454, for example, a director was found
COMPANY LAW PAGE 16

liable to contribute over £70,000 to the debts of the company because of his activities. There is also
the possibility that criminal liability could follow, with a term of imprisonment as the ultimate
penalty (s.993 CA 2006). While the criminal penalty was intended to act as a strong deterrent to
fraudulent behaviour, it proved to have the unfortunate effect of neutralising the effectiveness of
s.213 as the courts set a very high standard of proof for ‘intent to defraud’ because of the possibility
of a criminal charge also arising. In Re Patrick & Lyon Ltd [1933] Ch 786, this involved proving ‘actual
dishonesty, involving, according to current notions of fair trading among commercial men, real
moral blame’. This standard proved very difficult to obtain in practice and a new provision was
introduced in s.214 of the Insolvency Act 1986 which covered the lesser offence of ‘wrongful
trading’.

4.1.2 Insolvency Act, s.214

Wrongful trading does not require proving an intent to defraud. Rather it simply requires that a
director, at some time before the commencement of the winding up of the company, knew or ought
to have concluded that there was no reasonable prospect that the company would avoid going into
insolvent liquidation, but continued to trade. The section operates on the basis that at some time
before the company entered insolvent liquidation there will have been a point where the directors
knew it was hopeless and the company could not trade out of the situation. The reasonable director
would not at this point continue to trade. If he does continue to trade he risks having to contribute
to the debts of the company under s.214.

In Re Produce Marketing Consortium Ltd (No.2) (1989) 5 BCC 569 over a period of seven years the
company slowly drifted into insolvency. The two directors involved did nothing wrong except that
they did not put the company into liquidation after the point of no return became apparent. They
were therefore liable under s.214 to contribute £75,000 to the debts of the company.

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

Summary

The legislature has always been concerned to minimise the extent to which the Salomon principle
could be used as an instrument of fraud. As a result it introduced the offence of fraudulent trading
now contained in s.213 of the Insolvency Act 1986.

The requirement to prove ‘intent to defraud’ became too difficult in practice because of the
possibility of a criminal offence arising and so the lesser offence of ‘wrongful trading’ was introduced
in order to provide a remedy where directors had behaved negligently rather than fraudulently. Thus
if a director continued to trade in circumstances where a reasonable director would have stopped,
the director concerned will be liable to contribute to the company’s debts under s.214.

4.2 Judicial veil lifting

Veil lifting situations often present the judiciary with difficult choices as to where a loss should lie. As
we observed with the Salomon, Lee and Macaura cases, the consequences of treating the company
COMPANY LAW PAGE 17

as a separate legal entity or not can be extreme. Over time the judiciary have varied in their
attitudes, sometimes holding more strictly to the Salomon principle, and at other times taking a
more interventionist approach and being prepared to lift the veil to try to achieve justice in a
particular situation. In recent years, as we shall see below, they seemed to have very clearly reverted
to a stricter application of Salomon, and been prepared to lift the corporate veil much less
frequently. First, however, let’s look at some of the older cases which should give a flavour of the
types of situations that have arisen and the approach taken by the judiciary over time.

In Gilford Motor Company Ltd v Horne [1933] Ch 935 a former employee who was bound by a
covenant not to solicit customers from his former employers set up a company to do so. He argued
that while he was bound by the covenant the company was not. The court found that the company
was merely a front for Mr Horne and issued an injunction against both him and the company, even
though the company itself had never signed any covenant not to solicit Gilford’s customers.

In Jones v Lipman [1962] 1 WLR 832 Mr Lipman had entered into a contract with Mr Jones for the
sale of land. Mr Lipman then changed his mind and did not want to complete the sale. He formed a
company in order to avoid the transaction and conveyed the land to it instead. He then claimed he
no longer owned the land and could not comply with the contract. The judge found the company
was but a façade or front for Mr Lipman and granted an order for specific performance.

By the 1960s the increasingly sophisticated use of group structures was beginning to cause the
courts some difficulty with the strict application of the Salomon principle. Take, for example, a
situation where Z Ltd (the parent or holding company) owns all the issued share capital in three
other companies – A Ltd, B Ltd and C Ltd. These companies are known as wholly owned subsidiaries
(s.1159(2) CA 2006). Z Ltd controls all three subsidiaries. In economic reality there is just one
business but it is organised through four separate legal personalities. In effect this structure allows
the advantages of limited liability to be availed of by the legal personality of the parent company. As
a result the parent could choose to conduct its more risky or liability-prone activities through A Ltd.
The strict application of the Salomon principle would mean that if things go wrong the assets of Z
Ltd, as a shareholder of A Ltd with limited liability, in theory cannot be touched.

In DHN Ltd v Tower Hamlets [1976] 1 WLR 852 Lord Denning argued that a group of companies was
in reality a single economic entity and should be treated as one. However, this willingness to
disregard the normal legal consequences of creating separate companies, and to follow instead the
‘economic realities’, was not universally approved. And only two years later the House of Lords, in
Woolfson v Strathclyde RC [1978] SLT 159, specifically disapproved of Denning’s views on group
structures, and declared that the veil of incorporation could be lifted only if a company was a façade.

We can now turn to what remains arguably the most significant case in this area, Adams v Cape
Industries plc [1990] 2 WLR 657. This was a decision of the Court of Appeal, and it is important for
two reasons. First, it represents a significant move by the senior judiciary towards introducing more
certainty into the law. The feeling had grown that earlier cases did not identify with enough clarity
and precision when the veil could be lifted. The outcome of each individual case might then depend
too much on the subjective opinion of the particular judge hearing that case. Second, the Court of
Appeal clearly preferred a narrower and more restrictive approach to when the veil could be lifted.

4.2.1 Adams v Cape Industries plc (1990)

Adams is a complex case but, broadly, the following occurred. Until 1979, Cape, an English company,
mined and marketed asbestos. Its worldwide marketing subsidiary was another English company,
named Capasco. Cape also had a US marketing subsidiary incorporated in Illinois, named NAAC. In
COMPANY LAW PAGE 18

1974 in Texas, some 462 people sued Cape, Capasco, NAAC and others for personal injuries arising
from the installation of asbestos in a factory. Cape protested at the time that the Texas court had no
jurisdiction over it but in the end it settled the action. In 1978, NAAC was closed down by Cape and
other subsidiaries were formed with the express purpose of reorganising the business in the US to
minimise Cape’s presence there, in respect of taxation and other liabilities. Between 1978 and 1979,
Mr Adams, and many other claimants, commenced a number of further actions against Cape and
Capasco. Cape and Capasco did not settle these actions, but nor did they defend the actions in the
American courts. As a result, Adams and the other claimants got ‘default judgments’, in the US,
against Cape and Capasco.

In 1979 Cape sold its asbestos mining and marketing business and therefore had no assets in the US.
As a result, Adams, if he were to get any money out of Cape, would have to enforce his US judgment
in the UK, and through the UK courts. That is where Cape’s assets were located. The UK courts would
only do this, however, if either Cape had taken part in the US proceedings (which it had not) or if
Cape was itself ‘present’ in the US. Cape argued that it was not itself present there. It pointed out
that Cape itself did not own property, or carry on any business, in the US. All property in the US, and
all activities there, were owned and carried on only by subsidiary or related companies, but these
were separate legal entities. Their presence in the US did not make Cape present in the US.

It was in order to try to show that Cape was in fact present in the US that Mr Adams sought to lift
the corporate veil. The argument was essentially that the separation between Cape, and these other
group companies, should be ignored. The presence of the other companies in the US would then
make Cape present. Notice that he was doing this not in order to establish that Cape was liable to
him. Liability had already been established, in the US, by default. The legal question was not: is Cape
liable? It was only: is Cape present in the US?

The Court of Appeal held in favour of Cape. That was clearly unfortunate for Mr Adams, but what
matters for us, as company lawyers, is what the court said about the grounds when the veil can be
lifted. First, the court declared that the veil cannot be lifted just because a judge believes that it
would be ‘in the interests of justice’ to do so. The ‘interests of justice’ is too vague and unpredictable
a ground on which to lift the veil. Second, the court decided that the mere fact that a group of
companies constituted a ‘single economic unit’ was also not itself sufficient to allow the veil to be
lifted. In this respect, the court clearly followed the decision in Woolfson (above). The court decided
that where, in previous decisions (such as DHN, above), the veil had apparently been lifted on this
ground, this had in fact happened not merely because a group of companies constituted a single
economic unit, but rather because there also existed some statute, or some contractual document
which, on a proper interpretation of its terms, required two or more companies in a group to be
treated as one entity.

In rejecting these two grounds for veil lifting, the court concluded that:

save in cases which turn on the wording of particular statutes or contracts, the court is not free to
disregard the principle of Salomon v Salomon & Co Ltd [1897] AC 22 merely because it considers that
justice so requires. Our law, for better or worse, recognises the creation of subsidiary companies,
which though in one sense the creatures of their parent companies, will nevertheless under the
general law fall to be treated as separate legal entities with all the rights and liabilities which would
normally attach to separate legal entities.

The Court of Appeal did recognise that there was one well-established exception to the Salomon
principle, namely where a company was a ‘mere façade concealing the true facts’. The case of Jones
COMPANY LAW PAGE 19

v Lipman (1962) above is the classic example. But the Court of Appeal was aware that this ground
was potentially rather open-ended, and itself lacked ‘predictability’. It therefore sought to define
this ground with more certainty, suggesting that a company would be considered a mere façade
where it was being used to enable someone to avoid a pre-existing obligation (i.e. an obligation that
they had already incurred themselves). When the court then applied this test to Cape, it held that
Cape had not used any of its subsidiary or related companies to avoid any pre-existing obligation
which Cape already had. Instead, Cape had used other companies only to shield itself from liabilities
which might be incurred in the future. And although that might make the company morally culpable
there was nothing legally wrong in doing this, and using other companies to shield Cape from future
liabilities did not make those companies mere façades.

The court then finally considered the ‘agency’ argument. This was a straightforward application of
agency principle. If the subsidiary was Cape’s agent and acting within its actual or apparent
authority, then the actions of the subsidiary would bind the parent. The court found that the
subsidiaries were independent businesses free from the day- to-day control of Cape and with no
general power to bind the parent. Therefore Cape could not be present in the US through its
subsidiary agent.

Adams therefore narrows the situations where the veil of incorporation is in effect lifted to three
situations:

• where the court is interpreting a statute or document

• where the company is a mere façade (for other examples of where a company was held to
be a façade, see Anglo German Breweries Ltd (in liquidation) v Chelsea Corp Inc [2012]
EWHC 1481 (Ch) and Trustor AB v Smallbone [2002] BCC 795)
• where the subsidiary is an agent of the company.

The Court of Appeal’s judgment in Adams laid down reasonably clear, and clearly restrictive, grounds
for veil lifting. And, with a few exceptions, later courts have largely followed, and affirmed, the
Adams approach. One such exception is Creasey v Breachwood Motors Ltd [1992] BCC 638, but that
case was in turn overruled by Ord v Belhaven Pubs Ltd [1998] 2 BCLC 447. Other exceptions include
Ratiu v Conway (2006) 1 All ER 571 and Samengo-Turner v J&H Marsh & McLennan (Services) Ltd
(2007) 2 All ER (Comm) 813.

However, the general approach has been to follow Adams, and two recent decisions of the Supreme
Court have strongly affirmed its principles: see VTB Capital plc v Nutritek International Corp [2013]
UKSC 5, and Petrodel Resources Ltd v Prest [2013] UKSC 34. Petrodel is the more important of these
two cases. In Petrodel, Lord Sumption distinguished between what he referred to as the ‘evasion’
principle, and the ‘concealment’ principle. The veil could be pierced, he argued, only on the evasion
principle – where the controller of a company was using that company to evade an obligation which
the controller already had. However, for the veil to be pierced, it was not necessary that the
company which was being used in this way had been formed to enable an obligation to be evaded. It
was sufficient simply that it was now being used to enable its controller to escape their obligation.

By the concealment principle, Lord Sumption referred to the court’s ability to see through
someone’s attempt to hide their behaviour. There are, of course, many ways in which a person
might conceal their actions. Lord Sumption was noting that using a company was one such way. In
Lord Sumption’s view, the court always has the power to see through such a use, and in doing so
identify what someone is really doing. The court does not need to pierce the veil to do this: the court
can simply get to the ‘truth’ of a person’s behaviour. If, for example, I decide to blackmail someone,
COMPANY LAW PAGE 20

and make my victim pay the money I demand over to a company I own, the court can still regard me
as a blackmailer and receiver of that money, even though I have used a company to try to conceal
my receipt.

4.3 Actions in tort

Actions in tort against those involved in the running of a company provide another means of
avoiding the Salomon principle. If a person commits a tort in the course of acting for a company,
they will often be liable under the law of tort for the injuries they cause. The fact that they were
acting for a company at the time will not prevent that personal, tortious, liability. A bus driver who
negligently injures a pedestrian will be personally liable for that tort, notwithstanding they were
employed by a bus company (the bus company will be vicariously liable, too).

Does the same apply to directors, when the actions and decisions they take as directors harm
others? The position is less straightforward. One situation in which this might arise is where the
manager, acting on behalf of the company, misleads a third party. This was the situation in Williams
v Natural Life Health Foods Ltd [1998] 2 All ER 577. There the House of Lords emphasised the
Salomon principle in the context of a negligent misstatement claim. The managing director of
Natural Life Health Foods Ltd (NLHF) was also its majority shareholder. The company’s business was
selling franchises to run retail health food shops. One such franchise had been sold to the claimant
on the basis of a brochure which included detailed financial projections. The managing director had
provided much of the information for the brochure. The claimant had not dealt with the managing
director but only with an employee of NLHF. The claimant entered into a franchise agreement with
NLHF but the franchised shop ceased trading after losing a substantial amount of money. He
subsequently brought an action against NLHF for losses suffered as a result of negligent information
contained in the brochure. NLHF subsequently ceased to trade and was dissolved. The claimant then
continued the action against the managing director and majority shareholder alone, alleging he had
assumed a personal responsibility towards the claimant.

The House of Lords seemed particularly aware that the effect of this claim was to try to nullify the
protection offered by limited liability. In its judgment the House of Lords considered that a director
or employee of a company could only be personally liable for negligent misstatement if there was
reasonable reliance by the claimant on an assumption of personal responsibility by the director so as
to create a special relationship between them. There was no evidence in the present case that there
had been any personal dealings which could have conveyed to the claimant that the managing
director was prepared to assume personal liability for the franchise agreement (see also Noel v
Poland [2002] Lloyd’s Rep IR 30).

Other recent cases suggest that if the tort is deceit rather than negligence the courts will more
readily allow personal liability to flow to a director or employee. (See Daido Asia Japan Co Ltd v
Rothen [2002] BCC 589 and Standard Chartered Bank v Pakistan National Shipping Corp (No.2)
[2003] 1 AC 959.)

However, directors’ liability in tort has generally proved to be less than settled. In MCA Records Inc v
Charly Records Ltd (No.5) [2003] 1 BCLC 93 a director had authorised a number of infringing acts
under the Copyright Designs and Patent Act 1988. The Court of Appeal in a very detailed
consideration of the issue of directors’ liability in tort, including the Williams case, took a more
relaxed approach to the possibility of liability. The court concluded:

there is no reason why a person who happens to be a director or controlling shareholder of a

company should not be liable with the company as a joint tortfeasor if he is not exercising control
COMPANY LAW PAGE 21

through the constitutional organs of the company and the circumstances are such that he would be
so liable if he were not a director or controlling shareholder.

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

Could shareholders be held liable in tort? Suppose that you own shares in a company that operates
an unsafe work system, as a result of which employees are injured. If you are only a shareholder, it is
quite unlikely you will be taking any of the decisions that led to the unsafe work practices. Your case
is more one of ‘nonfeasance’ (you failed to stop the company operating unsafely) rather than
misfeasance. In the important decision in Chandler v Cape plc [2012] EWCA Civ 525, however, the
Court of Appeal decided that a shareholder could nevertheless be liable, if the shareholder herself
owed a duty of care to those who were injured. The Court found this duty of care would only arise,
however, for parent companies, for injuries caused by their subsidiaries, and then only if several
other conditions were satisfied. These were that the parent itself operated in ‘the same industry as
the subsidiary’, that the parent did know, or ought to have known, as much about health and safety
as did the subsidiary, that the parent knew or ought to have known that the subsidiary’s operations
were unsafe, and the subsidiary or the employee were relying on the parent to safeguard the
employee’s health and safety.

Cases decided after Chandler, however, seem to indicate a growing reluctance on the part of UK
courts to impose a duty of care on parent companies. In Thompson v Renwick Group Ltd [2014]
EWCA Civ 635, for example, the Court of Appeal refused to impose a duty of care on a parent within
a corporate group that acted only as a ‘pure holding company’. The parent, in other words, carried
on no business itself but merely owned the shares in the subsidiary companies, which conducted all
the group’s business. This approach was also followed in Okpabi v Royal Dutch Shell plc [2018] EWCA
Civ 191. Moreover, although Chandler suggested that a parent company might be liable for ‘non-
feasance’ – for its failure to prevent a subsidiary from harming others – it now appears that a parent
will be liable only where it is itself guilty of some active misfeasance. In AAA v Unilever plc [2018]
EWCA Civ 1532, the court suggested the parent would typically owe a duty of care to those injured
by a subsidiary’s negligence only if either of the two following situations existed:

a. where the parent had in substance taken over the management of the subsidiary’s activity, which
led to the injury; or

b. where the parent had taken over the management of the particular activity of the subsidiary,
which caused the injury.

In one respect at least, however, the decision in Chandler has been broadened a little. In Chandler
the duty was expressed only as one owed towards employees. However, in Lungowe v Vedanta
Resources plc [2017] EWCA Civ 1528 the court refused to strike out a claim brought by neighbours of
a subsidiary company. The court noted that while a claim was ‘more likely to succeed’ if brought by
employees, nevertheless, a claim by residents might still be arguable depending on the facts of the
case.

Summary

It is important that you get a solid understanding of the issues facing the judiciary in this area. In
essence the judiciary are being asked to decide who loses out when a business ends. In normal
commercial situations this will be as the Companies Act intends – therefore the burden falls on the
COMPANY LAW PAGE 22

creditors. However if there is a suggestion that the company has been used for fraud or fraud-like
behaviour (e.g. Jones v Lipman) the courts may lift the veil. At various times, however, the Salomon
principle was only a starting point and the courts would lift the veil in a number of situations if the
interests of justice required them to do so. This led to great uncertainty which has been redressed by
the restrictive case of Adams. Adams has been affirmed by recent Supreme Court decisions, such as
VTB Capital and Prest v Petrodel Resources Ltd.

Faced with the difficulty of lifting the veil, some claimants have sought to use claims in tort as an
alternative. This strategy was successful in the important case of Chandler, where the employees of
a subsidiary company were able to establish that its parent company owed them a direct duty of
care, which the parent had breached when it failed to stop its subsidiary operating in an unsafe way
that injured the employees.

5 Company formation, promoters and pre-incorporation contracts

Introduction

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

Learning outcomes

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

• explain when a person will be treated as a promoter

• describe the duties and liabilities of promoters
• describe the issues arising from pre-incorporation contracts
• assess the impact of s.51 CA 2006 on pre-incorporation contracts and the liability of
promoters.

5.1 Determining who is a promoter

A person who takes the necessary steps to form a company is called a ‘promoter’. In Whaley Bridge
Calico Printing Co v Green (1879) 5 QBD 109, Bowen J explained that: ‘the term promoter is a term
not of law, but of business, usefully summing up in a single word a number of business operations
familiar to the commercial world by which a company is generally brought into existence’. The
promotion process generally involves the following activities.

• Registering the company with Companies House.

• Entering into pre-incorporation contracts.
• In the case of public companies, issuing a prospectus.
• Appointing directors and finding shareholders wishing to invest in the new company.

The CA 2006 does not define the term promoter. However, the judges have, on occasions, framed
tests for determining whether a person’s activities relate to the promotion of a company. The classic
statement in this regard was made by Cockburn CJ in Twycross v Grant (1876–77) LR 2 CPD 469, who
said that a promoter is:

one who undertakes to form a company with reference to a given project, and to set it going, and
who takes the necessary steps to accomplish that purpose… and so long as the work of formation
continues, those who carry on that work must, I think, retain the character of promoters. Of course,
COMPANY LAW PAGE 23

if a governing body, in the shape of directors, has once been formed, and they take, as I need not say
they may, what remains to be done in the way of forming the company, into their own hands, the
functions of the promoters are at an end.

The definition is necessarily broad so as to prevent persons taking steps to avoid falling within a
more tightly framed proposition in order to avoid the duties borne by promoters. The breadth of the
definition is a legacy of a number of 19th-century cases involving fraudulent schemes being
perpetrated against investors. The judges responded by holding that promoters were ‘fiduciaries’ by
analogy with trustees (see below) and thus subject to a range of duties aimed at ensuring high
standards of behaviour.

5.2 The fiduciary position of promoters

It has long been settled that promoters are fiduciaries.

They stand, in my opinion, undoubtedly in a fiduciary position. They have in their hands the creation
and moulding of the company; they have the power of defining how, and when, and in what shape,
and under what supervision, it shall start into existence and begin to act as a trading corporation.

(Erlanger v New Sombrero Phosphate Co (1878) 3 App Cas 1218, per Lord Cairns LC.)

The term ‘fiduciary’ is best explained by reference to the particular obligations a fiduciary owes to
his or her principal. As we will see in Chapter 15: ‘Directors’ duties’, fiduciary obligations are
obligations owed to a principal to act with loyalty and with good faith. These obligations entail more
than just acting honestly and fairly. Fiduciaries must act solely in the interests of the principal and
must not allow their own self-interests to dictate their behaviour in any way that might conflict with
the principal’s best

5.3 Duties and liabilities

As indicated in the preceding section, the core duty of a promoter is that of loyalty and good faith.
Given the activities of promoters in bringing a company into existence, a process which often
involves acquiring property for the yet unformed corporation, the core duty is translated into a
prohibition against making secret profits from such transactions. The anxiety of the law in this regard
is directed towards addressing the problem of promoters selling property to the company in which
they have a personal interest and from which they make a profit. Promoters are therefore required
to make full disclosure of any such profit to an independent board of directors once the company
comes into existence. Failure to make such disclosure enables the company to bring an action for
rescission.

In Erlanger v New Sombrero Phosphate Co, a syndicate purchased a mine for £55,000. The syndicate
then formed a company and through a nominee sold the mine to it for £100,000 without disclosing
their interest in the contract. The mining operations were fruitless and the shareholders removed
the original directors and the new board successfully brought an action to have the sale rescinded. In
Salomon v Salomon & Co Ltd [1897] AC 22 (see Chapter 3), the House of Lords took the view that if
the board was not independent, disclosure of all material facts should be made to the original
shareholders. But note that in Gluckstein v Barnes [1900] AC 240 the House of Lords refined the duty
further by holding that disclosure to the original shareholders will not be sufficient if they are not
truly independent and the scheme as a whole is designed to defraud the investing public.
COMPANY LAW PAGE 24

As we saw above (Erlanger v New Sombrero Phosphate Co), where full disclosure is not made by the
promoters the contract is voidable at the company’s option. However, the right to rescind will be
lost where:

• the company affirms the contract (Re Cape Breton Co (1885) 29 Ch D 795)
• the company delays in exercising its right to rescind the contract.

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

5.4 Pre-incorporation contracts

Obviously a company does not come into existence until the promoters have completed the
registration requirements and the Registrar of Companies issues a certificate of incorporation. Prior
to this time a company cannot be bound by contracts entered into in its name or on its behalf. In
practice, however, promoters will need to contract with third parties for such things as a lease of
premises, business equipment and connection to utilities so that once the certificate of
incorporation is issued the company can begin trading.

The problem that arises in relation to pre-incorporation contracts is whether promoters can avoid
being personally liable on such contracts notwithstanding that the company did not exist at the time
such contracts were concluded on its behalf. Quite clearly, an agent (the promoter) cannot bind a
non-existent principal (the company) to contracts. The common law addressed the problem by
applying settled principles of contract and agency, but partial reform was implemented by s.9(2) of
the European Communities Act 1972, now found in s.51 CA 2006.

5.4.1 The common law position

It is a fundamental principle of the law of contract that a party must be in existence in order for an
agreement (offer and acceptance) to crystallise into a binding contract. Given that at the time of a
pre-incorporation contract the company does not exist, it becomes a stranger to the contract once it
comes into existence: the privity doctrine operates to prevent rights and liabilities being conferred
or imposed on the company (Kelner v Baxter (1866–67) LR 2 CP 174, see below). The Contracts
(Rights of Third Parties) Act 1999, which allows enforcement of contracts by third parties if the
contract expressly so provides or a term of the contract confers a benefit on the third party, does
not apply to pre-incorporation contracts.

As indicated above, the law of agency takes the view that a person cannot be an agent of a non-
existent principal and so a company cannot acquire rights or obligations under a pre-incorporation
contract. The common law position is illustrated by the decision in Kelner v Baxter. The promoters of
a hotel company entered into a contract on its behalf for the purchase of wine. When the company
formally came into existence it ratified the contract. The wine was consumed but before payment
was made the company went into liquidation. The promoters, as agents, were sued on the contract.
They argued that liability under the contract had passed, by ratification, to the company. It was held,
however, that as the company did not exist at the time of the agreement it would be wholly
inoperative unless it was binding on the promoters personally and a stranger cannot by subsequent
ratification relieve them from that responsibility.

On the other hand, a promoter can avoid personal liability if the company, after incorporation, and
the third party substitute the original pre-incorporation contract with a new contract on similar
COMPANY LAW PAGE 25

terms. Novation, as this is called, may also be inferred by the conduct of the parties such as where
the terms of the original agreementare changed (Re Patent Ivory Manufacturing Co, Howard v
Patent Ivory Manufacturing Co (1888) 38 Ch D 156). However, novation is ineffective if the company
adoptsthe contract due to the mistaken belief that it is bound by it (Re Northumberland Avenue
Hotel Co Ltd (1886) 33 Ch D 16). A promoter can also avoid personal liability on a contract where he
signs the agreement merely to confirm the signature of the company because in so doing he has not
held himself out as either agent or principal. The signature and the contractual document will be a
complete nullity because the company was not in existence (Newborne v Sensolid (Great Britain) Ltd
[1954] 1 QB 45).

As noted above, the common law position has now been modified, as a result of the UK’s
implementation of the First European Community Directive on Company Law, by s.51 CA 2006
(replacing s.36C CA 1985). The provision seeks to protect the third party by making promoters
personally liable when the company, after incorporation, fails to enter into a new contract on similar
terms.

5.4.2 Companies Act 2006, s.51

Section 51(1) provides that:

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

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

5.5 Freedom of establishment

Companies are no longer static entities whose operations are confined to the jurisdiction in which
they were incorporated. In furtherance of the internal market goal, the EC Treaty creates a common
market with free movement of goods, persons, services and capital. Articles 2, 43 and 48 of the EC
Treaty seek to confer a right of establishment on natural persons and companies alike to carry on
business in any Member State. The fundamental requirement is that companies must have been
formed according to the law of a Member State and that they have their registered office, or centre
of administration or principal place of business within the European Community (article 48 EC
Treaty). A Member State which seeks to impede the right of a company registered in another
Member State from carrying on business in its jurisdiction will be held to be acting in breach of its EC
COMPANY LAW PAGE 26

Treaty obligations. For example, in Centros Ltd v Erhversus-og Selkabssyrelsen (Case C-2212/97)
[2002] 2 WLR 1048, the ECJ held that Denmark was in breach of EU law in refusing to allow Centros
Ltd, a private company registered in England, to establish a branch in Denmark, even though
Denmark was in fact its primary operational establishment. The Court rejected the argument of the
Danish authorities that the Danish owners of Centros Ltd had chosen the UK as the state of
incorporation of its undercapitalised company in order to avoid the minimum capital requirements
required under Danish law. The motives of the owners could not be regarded as abusive but were a
consequence of their freedom to incorporate a company in one Member State and set up a
secondary establishment in another.

See Überseering BV v Nordic Construction Co Baumanagement GmbH (Case 208/00) [2002] ECR I–
9919, ECJ and Kamer van Koophandel en Fabrieken voor Amsterdam v Inspire Art Ltd (Case C-
167/01) [2003] ECR I–10155, ECJ. See further, Lowry (2004).

The pan-European business entity, the European Company (SE), which became available in October
2004, will address the concerns of those Member States wishing to regulate under-capitalised
companies operating within their jurisdictions. Further, the draft 14th EC Company Law
Harmonisation Directive aims to facilitate corporate migration. A company will be able to move its
registered office between Member States without having to disrupt its operations by
reincorporating in the host jurisdiction.

Summary

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

6 Raising capital: equity

Introduction

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

Learning outcomes

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

• distinguish between raising capital for public and private companies

• outline the relevant methods of selling shares to the general public
• describe how the listing regime protects investors
• explain the sanctions available where insider dealing has occurred.

6.1 Private and public companies

6.1.1 Restriction on private companies

As we discussed in Chapter 2, companies can be either private or public. A key distinction between
the two types of registered company is that in terms of equity or capital raising the law presumes
that in private companies the investment is largely provided by the founding members, either
COMPANY LAW PAGE 27

through their personal savings or from bank loans, and that in public companies the intention is to
raise large amounts of money from the general public. Private companies usually also restrict the
ability of their shareholders to transfer their shares (see Dignam and Lowry, Chapter 1, para 1.15).
Crucially, private companies are prohibited from raising capital from the general public (s.755 CA
2006). Public companies have no such prohibition and may freely raise capital from the general
public. Sometimes where extremely large amounts of capital are needed, a public company will
choose to raise capital through listing on the stock exchange. The Listing Rules of the London Stock
Exchange (LSE) (the most sophisticated market for raising public funds) require that a company be a
public company.

Public companies are designed to secure investment from the general public. As such they can
advertise the fact that they are offering shares to the public. In doing so the company must issue a
prospectus giving a detailed and accurate description of the company’s plans (see below). Because
the general public are involved and need to be protected, the initial capital requirements for a public
company are more onerous than for a private one. As we noted in Chapter 2, there is a minimum
capital requirement of £50,000 (s.763 CA 2006). However, the capital requirement may be partly
paid so the company does not actually have to have £50,000; it just needs one-quarter of that to be
‘paid up’, plus the ability to call on the members for the remaining amount (s.586 CA 2006). While
there is no formal limitation on public companies preventing them from transferring shares as
private companies do, it would be highly unusual, given that the aim is to raise money from the
general public, who would be discouraged by such a restriction. In any case, if the public company is
listed on the LSE such restrictions on transfer will be prohibited. Public companies also attract a
higher level of regulation.

6.1.2 Public companies and the public interest

Public companies have a much greater potential to affect the general public than private companies
because of their capital-raising activities. As a result the state has taken a greater interest in investor
protection where public companies are concerned. For example, the CLRSG in its consultation
document Completing The Structure (para 2.73) identified tighter accounting rules, a more onerous
capital maintenance regime and stricter rules for the board of directors as three distinct areas where
public companies were subject to enhanced regulation.

Public companies are not necessarily listed on the stock exchange, but as we noted above, some
public companies may decide to raise capital on the LSE. This involves applying to the LSE and
fulfilling a very strict set of criteria to ensure the business is a sound one. A listing on the stock
exchange is essentially a private contractual arrangement between a public company and the LSE
(itself a listed public company) to gain access to a very sophisticated market for its shares. The public
company, once it gains access to the stock market, is then generally known as a listed company and
its shares as listed shares or securities. The LSE offers the facility of a secondary market, that is, a
place where shares can be traded after they have been issued to shareholders. It also functions as a
capital market for companies to sell new shares to the general public who can then trade them on
the stock exchange. A listing also has the advantage that investors will have greater confidence in
the business if it is within the regulatory ambit of the LSE and investors will be able to sell their
shares easily through the LSE. The shareholders of listed companies tend to be what are called
institutional investors. These institutional investors are made up of pension funds, insurance
companies, professional management funds who are investing funds on behalf of individuals and,
increasingly, the investment vehicles of foreign states, which are usually referred to as ‘Sovereign
Wealth Funds’
COMPANY LAW PAGE 28

Summary

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

6.2 Raising money from the public

While a public company seeking a listing on the LSE must comply with the regulations of the LSE the
company must also choose a way to sell its shares to the general public. This can be done a number
of ways and the following are the most relevant here.

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

6.2.1 The FCA, the FSA and the LSE

The Financial Conduct Authority (FCA) is now the main UK financial services regulator and therefore
the listed market comes within its ambit. Previously, the FCA’s responsibilities were carried out by
the Financial Services Authority (FSA). However, UK financial regulation was substantially overhauled
in the wake of the financial crisis of 2008, and that overhaul involved replacing the FSA with, among
other bodies, the FCA. Until May 2000 the LSE was also the UK’s ‘competent authority for listing’
with responsibility for admitting securities (shares and debentures) to listing, making the Listing
Rules and policing compliance with them. Following enactment of the Financial Services and Markets
Act 2000 (FSMA), which replaced the Financial Services Act 1986, this function was transferred to
the FSA, and subsequently to the FCA, which is now the UK Listing Authority. The LSE is the principal
Recognised Investment Exchange (RIE) for trading securities of UK and foreign companies,
government stocks and options to trade company securities in the UK. Some 1,800 companies
registered in the UK have listed securities.

Once a company has obtained a listing by complying with the listing rules it can only maintain listed
status if it complies with the continuing obligations specified in the listing rules. The LSE’s statutory
obligation to operate an orderly market also obliges it to monitor listed companies on an ongoing
basis. As such the LSE and the FCA have an important co-operative role.

6.2.2 Obligations when listing

While the compliance regulations for companies seeking a listing are complex and voluminous they
broadly cover the availability of past accounts, compliance with a minimum market capitalisation
and a minimum ‘proportion of the shares in public hands’ requirement. The Listing Rules focus
COMPANY LAW PAGE 29

specifically on the information that must be made available to the public by a company when its
shares are being listed. These disclosure requirements operate on the principle that all documents
issued must:

contain all such information as investors and their professional advisers would reasonably require,
and reasonably expect to find there, for the purpose of making an informed assessment of: (a) the
assets and liabilities, financial position, profits and losses, and prospects of the issuer of the
securities; and (b) the rights attaching to those securities. s.80(1) FSMA 2000.

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

6.2.3 Continuing obligations

Once a company has achieved a listing it continues to be subject to a number of obligations to

disclose information necessary to maintain an orderly market and to protect investors. The
continuing obligations require listed companies to publish half-yearly reports on their activities,
together with profits and losses made during the first six months of each financial year. Further, by
way of an additional requirement to the duty to issue full annual accounts and reports, a listed
company must also publish a preliminary statement of the annual results. Directors of listed
companies must also produce a ‘strategic report’ covering the development and performance of the
business which identifies the principal risks and uncertainties ahead (see Chapter 15 on the link
between this report and the directors’ duty under s.172 CA 2006, and Chapter 16 on the social
reporting requirements for companies). The continuing obligations also operate as a means of
preventing insider dealing (see below) as the Listing Rules require a listed company to publish price-
sensitive information (information that may result in substantial movement in the price of its
securities) as quickly as possible. Failure to comply with the listing regime carries the possibility that
the FCA will sanction the company or individuals responsible for the failure. This could lead to a wide
range of criminal and civil sanctions.

On 20 January 2007 a version of the Transparency Directive (2004/109/EC) was implemented for UK
listed companies. Part 43 of the CA 2006 amends Part VI of the FSMA in a number of ways to
implement the requirements of the Directive. It requires companies to produce periodic financial
reports and specifies the minimum content of those reports. It requires major shareholders to
disclose their holdings at certain thresholds. On the implementation of the Directive, responsibility
for the shareholding disclosures was moved from the DTI (now the Department for Business, Energy
and Industrial Strategy (BEIS)) to the FCA. The Directive also requires that companies disclose
information to investors on a fast, non-discriminatory and pan-European basis. Additionally the
Transparency regime provides for criminal and civil penalties for non-compliance.

6.2.4 Reforming the regulatory structure

The CLRSG considered the current regulatory arrangement for public companies in ‘Regulatory and
institutional framework for company law’ (Chapter 12 of Completing the structure). It concluded
after much discussion that it did not ‘see any need for any more extensive redrawing of the
regulatory “map”’ (paras 12.112–113). The Companies Act 2006 did not, as a result, affect the
COMPANY LAW PAGE 30

regulatory structure within which listed companies operate. However, the credit crisis in Autumn
2008 led to a major overhaul of the structure of financial regulation in the UK. The Financial Services
Act 2012 was enacted, introducing major changes to the Financial Services and Markets Act 2000.
The FSA was replaced by two new regulatory bodies. The first was the Prudential Regulation
Authority (PRA), which is a subsidiary of the Bank of England, and is responsible for promoting the
stable and prudent operation of the financial system through regulation of all deposit-taking
institutions, insurers and investment banks.

The other regulatory body we have noted already, namely the FCA. It is responsible for regulation of
conduct in retail, as well as wholesale, financial markets and the infrastructure that supports those
markets. As we have seen, it acts as the UK Listing Authority.

Summary

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

6.3 Insider dealing

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

6.3.1 Criminal sanctions for insider dealing

Part V of the Criminal Justice Act 1993 contains the main criminal provisions specifically on insider
dealing. Section 52(1) states:

[a]n individual who has information as an insider is guilty of insider dealing if, in the circumstances
mentioned in subsection (3) (that is, it is a regulated market and the insider deals himself as a
professional or through a professional intermediary), he deals in securities that are price-affected
securities in relation to the information.

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

6.3.2 The civil sanction regime

The criminal provisions against insider dealing, described in 6.3.1, have not proved terribly effective.
Enforcement has been problematic, partly because of the criminal burden of proof that must be
satisfied. Moreover, there are other ways, besides insider dealing, through which share markets may
COMPANY LAW PAGE 31

be manipulated or distorted. This might be done, for example, by releasing false information to the
market in order to affect share prices.

Because of these problems with the criminal ‘insider dealing’ regime, UK law has been extended to
cover ‘market abuse’ more generally. The legislation imposes a range of penalties on those engaging
in market abuse, including civil penalties and statements of censure.

Market abuse was first regulated by the Financial Services and Markets Act 2000 (FSMA). Section
123 of the FSMA empowers the FCA to impose penalties for market abuse. However, much of the
detail of the regulation here is not to be found in the FSMA itself. Some is contained in regulations
that have been made under the FSMA (the Financial Services and Markets Act 2000 (Market Abuse)
Regulations 2005 (SI 2005/381) and 2016 (SI 2016/680). And many of the relevant rules are now
found in an EU regulation that was introduced in 2014, namely the Market Abuse Regulation
(Regulation 596/2014/EU) (MAR). MAR is complex, and it makes many changes to the fine details of
the regulation of market abuse. Fortunately, you do not need to learn this in detail.

What counts as ‘market abuse’ is now defined by MAR. Essentially, it covers two types of behaviour:
insider dealing and ‘market manipulation’. To qualify as market abuse, the behaviour must not only
fall into one of these two categories, but must also relate to trading in ‘financial instruments’ on
certain specified markets. The financial instruments that are covered include shares in a company,
while the markets that are covered include the London Stock Exchange’s Main Market. The fact that
the regulation of market abuse is limited to trading on formal markets shows that the purpose of the
regulation is not so much about ensuring fairness in individual transactions, but rather about
protecting the integrity of the market as a whole.

The principal penalty for market abuse is a fine, which can be imposed on any person who has
engaged in market abuse or has required or encouraged any other person to do the same. In
addition, the FCA may censure those who have engaged in market abuse, and the Secretary of State
may also apply to the court for a restitution order in favour of those injured by the market abuse.
However, the FSMA makes no provision for an individual shareholder who has suffered a loss as a
result of breach of the market abuse provisions described above to bring proceedings to recover
such loss.

Summary

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

6.4 Regulating takeovers

One of the consequences of listing on the LSE is that the shares of the company can be easily bought
and sold. This also means that the entire listed shareholding can be bought in the listed marketplace,
thus effecting a takeover of the company.

Strangely, given the importance of this area, the Companies Act contains relatively few provisions on
the regulation of takeovers.

• Section 219 CA 2006 contains disclosure requirements for directors’ salaries.

COMPANY LAW PAGE 32

• The Transparency Directive requires anyone acquiring a 3 per cent holding in a company to
disclose their interest to the company and again every time their interest increases or
decreases by 1 per cent.
• Section 979 CA 2006 governs post-takeover compulsory purchase of a dissenting minority.

Additionally, ss.895–901 CA 2006 and s.110 Insolvency Act 1986 allow effective takeovers of
companies in crisis and liquidation. The conduct of the takeover itself, which is of greatest concern
to shareholders and companies, is left to the self- regulatory system to govern.

Since 1968 the conduct of takeovers has been governed by the Panel on Takeovers and Mergers (the
Panel). The Panel administers the rules on takeovers called the City Code on Takeovers and Mergers
(the Code). The Panel and the Code aim to achieve equality of treatment and opportunity for all
shareholders in a takeover bid. The Code, while flexible, emphasises a number of general principles.
These are:

• equality of treatment and opportunity for all shareholders in takeover bids

• adequate information and advice to enable shareholders to assess the merits of the offer
• no action which might frustrate an offer is taken by a target company during the offer period
without shareholders being allowed to vote on it
• the maintenance of fair and orderly markets in the shares of the companies concerned
throughout the period of the offer.

Until the CA 2006 the Panel was a non-statutory body but its decisions were subject to judicial
review because of the public nature of its regulatory role (see R v Panel on Takeovers and Mergers
ex p Datafin (1987) QB 815). However, the courts would only hear the review after the takeover was
complete, thus eliminating the use of the courts in a tatical sense during the progress of a takeover
bid. Prior to 2006 the Panel had no formal power to sanction but was held in great respect by the
financial services sector. As a result the Panel had a number of actions it could take. First, the Panel
could issue critical statements about the conduct of a bid which would alert shareholders to
irregularities. Second, the Panel’s role was recognised by the FSA (as it was then called), the various
self-regulatory bodies licensed by the FSA and the professional bodies. This means that the Panel
could pass the matter to these bodies requesting a sanction. For example, a listed company that did
not follow the Code could have the LSE remove or suspend its listing and the company’s professional
advisers could have disciplinary proceedings brought against them by their professional body. The
FSA might also have withdrawn its investment authorisation (see below) from any person who is the
subject of an adverse ruling of the Panel.

6.4.1 The reform of takeovers

The reform of takeovers in the EU has been a subject of much discussion since 1989 when the
European Commission put forward a draft directive on European takeovers. Unfortunately there are
very different views on takeovers within the EU member states and for more than a decade no
progress was made. Eventually in 2001 political agreement was reached on a text of the Draft
Directive by the Council of Ministers but it was rejected by the European Parliament. In April 2004 a
much compromised Directive was eventually agreed (Directive 2004/25/EC of the European
Parliament and of the Council of 21 April 2004 on Takeover Bids).

The Directive requires the establishment of a statutory body which would oversee statutory
takeover provisions. The CA 2006 Part 28, as a result, converted the self- regulating Panel (s 942 CA
2006) into just such a statutory body to oversee takeovers in the United Kingdom on 6 April 2007.
Under the Takeover Directive reforms, the Panel now has its own range of sanctions contained in
COMPANY LAW PAGE 33

ss.952-956 CA 2006. Thus the Panel now has formal powers to issue statements of censure, issue
directions, refer conduct to other regulatory bodies, order compensation to be paid for breach of
the code and refer a matter for enforcement by the court.

This means that the Panel can take action itself or pass the matter to other regulators requesting a
sanction. For example, a listed company that does not follow the Code could face:

• the LSE removing or suspending its listing

• disciplinary proceedings being brought against the company’s professional advisers by their
professional body.

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

7 Raising capital: debentures

Introduction

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

Learning outcomes

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

• explain what is meant by the term debenture

• describe the nature of fixed and floating charges and the distinction between them
• explain what is meant by book debts and outline the debate surrounding the issue of
granting a fixed charge over them
• outline the priority of charges and the statutory registration scheme
• describe and assess the proposals for reform.

7.1 Debentures

Put simply, a debenture is the document that evidences, or acknowledges, the company’s debt (Levy
v Abercorris Slate and Slab Co (1887) 36 Ch D 215, per Chitty J; see also Knightsbridge Estates Trust v
Byrne [1940] AC 613). The definition provided by s.738 CA 2006 is far from helpful: ‘…“debenture”
includes debenture stock, bonds and any other securities of a company, whether constituting a
charge on the assets of the company or not’. Thus a mortgage of freehold property by a company
falls within the statutory definition as it is a security and a charge on its assets. A charge or security
interest is a right in rem created by a grant or declaration of trust which, if fixed, implies a restriction
on the debtor’s dominion over the asset(s) in question (Goode (2003)).

Debenture stock is money borrowed from a number of different lenders on the same terms. Such
lenders form a ‘class’ who usually have their rights set out in a trust deed. The trustee, often a bank,
represents their interests as a whole. The trust deed will generally set out the following terms.
COMPANY LAW PAGE 34

• The obligation to pay the principal sum with interest.

• The security, if any, that is given for the loan.
• The events that will trigger the enforcing of the security.

7.2 Company charges

Creditors will often require security from a borrower before lending money, so that in the event of a
default on repayment the creditor can enforce the security interest. By requiring security from a
debtor-company the creditor seeks to ensure priority over the general body of creditors should the
company be wound up.

The granting of security by a company does not mean that the title to the secured asset passes to
the creditor. Instead it creates an encumbrance on the property. The creditor gets a right to have
the security made available by an order of the court (National Provincial Bank v Charnley [1924] 1 KB
431, Atkin LJ). For companies, the most common species of charges given as security interests are
fixed and floating charges.

7.2.1 Fixed and floating charges

Fixed charges

A company may grant a fixed charge to a creditor over certain property such as a warehouse. Such a
charge is similar to a mortgage in that the rights of the creditor (the chargee) attach immediately to
the property and the company’s (the chargor’s) power to deal with the asset is restricted. In Agnew
v Commissioner of Inland Revenue [2001] 2 AC 710 Lord Millett stated that:

A fixed charge gives the holder of the charge an immediate proprietary interest in the assets subject
to the charge which binds all those into whose hands the assets may come with notice of the charge.

Floating charges

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

A floating charge converts to a fixed charge over the assets within its scope upon the occurrence of a
‘crystallising’ event such as a default on repayment or the winding up of the company.

The impact of liquidation

The distinction between a fixed and floating charge assumes critical importance if the company goes
into liquidation (see Chapter 17) because of the ranking of chargees against the general body of
creditors. In Re Yorkshire Woolcombers Association [1903] 2 Ch 284, Romer LJ listed the following
distinguishing features of a floating charge.

• It is a charge on a class of assets of a company present and future.

COMPANY LAW PAGE 35

• That class is one which, in the ordinary course of the business of the company, would be
changing from time to time.
• By the charge it is contemplated that, until some future step is taken by or on behalf of
those interested in the charge, the company may carry on its business in the ordinary way as
far as concerns the particular class [charged].

In determining whether a charge is fixed or floating the courts will look to the substance of the
matter irrespective of what description the parties use to categorise it. In this regard Lord Millett
explained, in Agnew v Commissioner of Inland Revenue, that:

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

Lord Millett noted that Romer LJ’s third distinguishing feature (see above) is the classic hallmark of a
floating charge. More recently, in National Westminster Bank plc v Spectrum Plus Ltd [2005] UKHL
41, Lord Phillips MR explained that:

Initially it was not difficult to distinguish between a fixed and a floating charge. A fixed charge arose
where the chargor agreed that he would no longer have the right of free disposal of the assets
charged, but that they should stand as security for the discharge of obligations owed to the chargee.
A floating charge was normally granted by a company which wished to be free to acquire and
dispose of assets in the normal course of its business, but nonetheless to make its assets available as
security to the chargee in priority to other creditors should it cease to trade. The hallmark of the
floating charge was the agreement that the chargor should be free to dispose of his assets in the
normal course of business unless and until the chargee intervened. Up to that moment the charge
‘floated’.

In Arthur D Little Ltd v Ableco Finance LLC [2002] 2 BCLC 799 the chargor, Arthur D Little Ltd,
guaranteed the liabilities of its two parent companies to Ableco by creating a charge, described as a
first fixed charge, over its shareholding in a subsidiary company,

CCL. The chargor company retained both its voting and dividend rights with respect to the shares
until default. The company’s administrator argued that it was a floating charge. It was held, applying
Lord Millett’s reasoning in Agnew, that whether or not the charge was fixed or floating is a question
of law and the particular charge in issue was fixed. It did not float over a body of fluctuating assets
and, notwithstanding the company’s voting and dividend rights, it could not deal with the asset in
the ordinary course of business: the company could not dispose of, or otherwise deal with, the
shares. The asset was therefore under the control of the chargee.

In Queens Moat Houses plc v Capita IRG Trustees Ltd [2004] EWHC 868, it was held that the
existence of a right unilaterally to require a chargee to release property from a charge did not render
what is otherwise a fixed charge a floating charge.
COMPANY LAW PAGE 36

Summary

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

7.2.2 Book debts

Book debts are ‘debts arising in a business in which it is the proper and usual course to keep books,
and which ought to be entered in such books’ (Official Receiver v Tailby (1886) 17 QBD 88). It is
common for a company to have debts continuously owed to it by customers for goods and services
that the company has rendered. Rather than wait for payment a company can borrow money from
creditors against the debts that remain unpaid. A question that has frequently come before the
courts is whether a fixed charge can be created over book debts. Although the issue has now been
settled by the Privy Council in Agnew v Commissioner of Inland Revenue [2001] 2 AC 710, PC and,
more significantly, by the House of Lords in National Westminster Bank plc v Spectrum Plus Ltd
(discussed below), it is worthwhile considering the cases that gave rise to the problem in order to
understand the reasoning of the House of Lords in Spectrum.

In Siebe Gorman & Co Ltd v Barclays Bank Ltd [1979] 2 Lloyd’s Rep 142, the company granted a
debenture in favour of Barclay’s Bank. The security was expressed to be a ‘first fixed charge’ over all
of its present and future book debts. The debenture required the company to pay the proceeds of all
book debts into its Barclays account and it prohibited the company from charging or assigning its
book debts without first obtaining the bank’s consent. It was held that the company’s charge over its
receivables was fixed. The judge reasoned that taking the restrictions placed on the company’s
power to deal with the proceeds of the debts, together with the bank’s right to prevent the
company making withdrawals from the account even when it was in credit, gave the bank a degree
of control that was inconsistent with a floating charge. On the other hand, in Chalk v Kahn [2000] 2
BCLC 361 under the terms of the charge, described as a fixed charge, the chargor was required to
pay the proceeds into a specified account not held with the chargee bank but with another bank.
Since the chargee had no control over the account it was held that the charge was a floating charge.
A particularly contentious decision is that reached by the Court of Appeal in Re New Bullas Trading
Ltd [1994] 1 BCLC 485, in which it was held that it was possible to create a combined fixed and
floating charge over book debts. Here a fixed charge was created over uncollected book debts but as
soon as the proceeds of the debts were credited to a specified bank account a floating charge took
effect over them.

The decision in Re New Bullas attracted much criticism and in Agnew, Lord Millett declared New
Bullas ‘to be fundamentally mistaken’. In Agnew the debenture was so drafted as to mirror that in
New Bullas but the Privy Council held that where the chargor company is free to deal with the
charged asset(s) in the ordinary course of business it must be construed as a floating charge.
However, where the chargee retains control over the debts and their proceeds so as to severely
restrict the company’s freedom to deal with them, as in Siebe Gorman, it will be a fixed charge. The
notion of a combined charge was rejected by the Privy Council.

In National Westminster Bank plc v Spectrum Plus Ltd [2005] UKHL 41, the chargor, Spectrum,
granted a fixed (specific) charge to the bank over its book debts to secure an overdraft of £250,000.
The debenture stated that the security was a specific charge over all present and future book debts
and other debts. It also prohibited Spectrum from charging or assigning debts and the company was
required to pay the proceeds of collection into an account held with the bank. The debenture did not
specify any restrictions on the company’s operation of the account.
COMPANY LAW PAGE 37

Spectrum’s account was always overdrawn and the proceeds from its book debts were paid into the
account which Spectrum drew on as and when necessary. When Spectrum went into liquidation the
bank sought a declaration that the debenture created a fixed charge over the company’s book debts
and their proceeds. The Crown, however, argued that the debenture merely created a floating
charge so that its claims in respect of tax owed by the company took priority over the bank. The trial
judge, applying Brumark and declining to follow Bullas, held that, given the charge permitted
Spectrum to use the proceeds of the debts in the normal course of business, it must be construed as
a floating charge. In so holding the Vice-Chancellor also declined to follow Siebe Gorman.

The bank successfully appealed to the Court of Appeal. Lord Phillips MR, delivering the leading
judgment (Jonathan Parker and Jacob LJJ concurring), took the view that where a chargor is
prohibited from disposing of its receivables before they are collected and is required to pay the
proceeds into an account with the chargee bank, the charge is to be construed as fixed. He explained
that it was not, as a matter of precedent, open to the Court of Appeal to hold that Bullas was
wrongly decided even though the Privy Council had, in Brumark, expressed the view that the
decision was mistaken. Further, Siebe Gorman was correctly decided given that the debenture in
that case clearly restricted the company’s ability to draw on the bank account into which the
proceeds of its book debts were paid. The Court of Appeal noted that the form of debenture used in
Siebe Gorman had been followed for some 25 years and thus it was inclined to hold that it had, by
customary usage, acquired meaning. Lord Phillips observed that in Siebe Gorman:

Slade J could properly have held the charge on book debts created by the debenture to be a fixed
charge simply because of the requirements (i) that the book debts should not be disposed of prior to
collection and (ii) that, on collection, the proceeds should be paid to the Bank itself. It follows that
he was certainly entitled to hold that the debenture, imposing as he found restrictions on the use of
the proceeds of book debts, created a fixed charge over book debts.

A seven-member House of Lords, as expected, overturned the decision of the Court of Appeal and
overruled Siebe Gorman and Bullas. Following the line of reasoning adopted by the Privy Council in
Brumark, it held that although it is possible to create a fixed charge over book debts and their
proceeds (Tailby v Official Receiver (1888)), the charge in the present case was a floating charge.
Lord Scott delivered the leading judgment. He stressed that the ability of the chargor to continue to
deal with the charged assets characterised it as floating. For a fixed charge to be created over book
debts, the proceeds must, therefore, be paid into a ‘blocked’ account (see Re Keenan [1986] BCLC
242). Lord Scott reasoned that:

The bank’s debenture placed no restrictions on the use that Spectrum could make of the balance on
the account available to be drawn by Spectrum. Slade J in [Siebe Gorman] thought that it might
make a difference whether the account were in credit or in debit. I must respectfully disagree. The
critical question, in my opinion, is whether the charger can draw on the account. If the chargor’s
bank account were in debit and the charger had no right to draw on it, the account would have
become, and would remain until the drawing rights were restored, a blocked account. The situation
would be as it was in Re Keeton Bros Ltd [above]. But so long as the charger can draw on the
account, and whether the account is in credit or debit, the money paid in is not being appropriated
to the repayment of the debt owing to the debenture holder but is being made available for
drawings on the account by the charger.

Although the House of Lords has jurisdiction in an exceptional case to hold that its decision should
not operate retrospectively or should otherwise be limited, it nevertheless held that in this case
there was no good reason for postponing the effect of overruling Siebe Gorman.
COMPANY LAW PAGE 38

For a case in which a lender did, unusually, have sufficient control over the book debts that had been
charged by a borrower for that charge to be a fixed one, see Re Harmony Care Homes Ltd [2009]
EWHC 1961.

7.3 Priority

The general rule is that security interests are prioritised according to the order of their creation.
However, as we saw above, a feature of the floating charge is that the company can continue to deal
with the charged assets in the ordinary course of business. Therefore a fixed charge can be created
which will take priority over an earlier floating charge. In order to protect their priority, floating
chargees can insert a so-called ‘negative pledge’ clause in the charge that prohibits the chargor from
creating a charge that ranks equally with (pari passu) or in priority to the earlier floating charge.

Such a restriction is not inconsistent with the nature of a floating charge (Re Brightlife Ltd [1987] Ch
200). However it should be noted that the subsequent chargee will not lose priority unless he has
actual notice of the negative pledge clause. Mere notice of the earlier floating charge is not sufficient
(Wilson v Kelland [1910] 2 Ch 306). Where there are competing floating charges the governing
principle is that the earliest created takes priority. However, the parties may agree that the company
may create a subsequent floating charge which will take priority or rank pari passu with the earlier
floating charge (Re Benjamin Cope & Sons Ltd [1914] 1 Ch 800).

7.3.1 Registration

Understandably, a creditor who is considering lending money to a company may wish to find out the
extent of its indebtedness. Companies are therefore required to register certain details of mortgages
over their their assets, under s.859A CA 2006. (‘Mortgages’ is a broad term, likely to cover most
types of charges a company would create. Section 859A replaced s.860 CA 2006, which contained a
much longer list of different types of charge subject to registration.)

The 21-day registration requirement

Part 25 of the CA 2006 lays down the registration requirements. The principal obligations are
contained in s.859A-Q, which provide that prescribed particulars of certain categories of charges
created by a company, together with the instrument creating it, must be delivered to, or received
by, the Companies Registrar within 21 days of the creation of the charge. Failure to deliver the
particulars to the Registrar within the 21-day period renders the charge void against (see s.874):

• a liquidator
• any creditor of the company (see Smith v Bridgend County Borough Council [2002] 1 BCLC
77).

Note that the loan is not void for want of registration of the charge, but rather the failure to register
results in the lender ranking as an unsecured creditor.

Previously, if a charge was not registered, the company and every defaulting officer is liable to a fine
(s.860(4)). This criminal sanction has now been repealed.

Once registered, the charge is valid from the date of its creation. This results in what has been
termed the 21-day invisibility problem (see the CLRSG’s consultation document Registration of
Company Charges (October 2000), para 3.79). This is because whenever a person checks the register
it cannot be assumed that it is comprehensive because there may be a charge for which the 21-day
period is still running.
COMPANY LAW PAGE 39

Section 859A also requires companies to maintain at its registered office a register containing certain
prescribed particulars of all registrable mortgages. The failure to keep such a register does not affect
the validity of the charge.

When a charge is registered the Registrar must issue a certificate stating the amount secured by the
charge. The certificate is conclusive evidence that the statutory registration requirements have been
complied with. The charge cannot then be set aside if the particulars are incorrect.

See, for example:

• Re Eric Holmes (Property) Ltd [1965] Ch 1052

• Re CL Nye Ltd [1971] Ch 442.

Registration is a perfection requirement. It does not determine priority which, as we saw above,
depends upon the date the charge was created. Creditors who ought reasonably to have searched
the register will be deemed to have constructive notice of the charge (Siebe Gorman, above).

Rectification of the register may be possible where the court is satisfied that the failure to register
within the required period or that an omission or misstatement of any particular was accidental or
inadvertent, or is not of a nature to prejudice creditors or shareholders of the company, or that on
other grounds it is just and equitable to grant relief (s.873). Generally, leave to register out of time is
granted by the courts subject to the rights of intervening secured creditors and provided the
company is solvent (see, for example, Re IC Johnson & Co Ltd [1902] 2 Ch 101).

7.4 Avoidance of floating charges

Section 245 of the Insolvency Act 1986 invalidates a floating charge created within 12 months
(termed ‘the relevant time’) prior to the onset of insolvency unless it was created in consideration
for money paid, or goods or services supplied, at the same time as or subsequent to the creation of
the charge. The ‘relevant time’ is extended to two years where the charge is created in favour of a
connected person. However, s.245(4) provides that a floating charge created in favour of a non-
connected person within the ‘relevant time’ (i.e. 12 months) will not be invalidated if the company
was able to pay its debts at the time the charge was created and did not become unable to do so as
a result of creating the charge.

It should be noted that this provision does not extend to charges created in favour of connected
persons. The term ‘connected person’ is defined by s.249 as a director or shadow director of the
company; an associate of a director or shadow director of the company; and an associate of the
company. The object of s.245 is to prevent an unsecured creditor obtaining a floating charge to
secure his or her existing loan at the expense of other unsecured creditors.

8 Capital

Introduction

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

Learning outcomes

By the end of this chapter and the relevant readings, you should be able to:
COMPANY LAW PAGE 40

• explain the objectives of the doctrine of maintenance of capital

• state the rule proscribing shares being issued at a discount
• describe the rules relating to dividend payments
• describe the procedure for reducing capital
• explain the regime governing financial assistance for the purchase of shares.

8.1 Overview – the maintenance of capital doctrine

The legal rules governing maintenance of share capital are a mixture of legal and accounting
principles that are aimed at ensuring that the company’s capital is not dissipated on activities
beyond its objects (Guinness v Land Corporation of Ireland (1883) 22 ChD 349). While a company’s
capital may be spent in carrying out its legitimate business activities no part of it can be returned to
a member so as to subtract from the fund from which creditors are to be paid. Shareholders also
benefit from the doctrine because the objective of the capital maintenance regime is to ensure that
their investment is used only for the objects stated in the company’s constitution (assuming the
constitution restricts its objects; see Chapter 13, below).

It should be noted that a company’s share capital is not kept in a ring-fenced bank account to be
drawn upon only in the event of winding up, in order to meet the claims of creditors. Rather, it is a
book-keeping entry which serves as the basis for measures of profitability such as return on capital
employed (ROCE). Before any returns (e.g. dividends) are paid to shareholders the accounts must
show that the value of the company’s assets exceeds the value of its share capital. As indicated
above, the law is directed towards preventing illegal returns of capital to shareholders and there are
numerous ways in which shareholders may receive legitimate returns on their investment: for
example, by way of a dividend payment (see below).

We now turn to consider the maintenance regime. It should be noted that the law distinguishes
between private and public companies. It should also be borne in mind that, when reading the case
law decided under the CA 1985 and its predecessors, the law was notoriously complex. In this
respect, it should be noted that in accordance with the policy objectives of the company law review,
the 2006 reforms are directed towards removing requirements that are ‘unnecessary and
burdensome for private companies’.

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

The rule in Ooregum Gold Mining Company v Roper [1892] AC 125, which is now codified in s.552 of
the CA 2006, is that shares may not be issued at a discount to their nominal value. Accordingly, a
shareholder must pay the full nominal value of the shares he or she holds. But the rule does not
require that the share is paid for in full when it is issued because payment may be deferred. Thus,
there can be paid-up and unpaid-up capital where the shareholder remains liable to contribute the
balance outstanding (i.e. the difference between the amount actually paid and the nominal value).
From the outsider’s perspective, the consequence of the rule is that he or she can be sure that the
company has received (or has enforceable claims for) at least the sum total of its issued share
capital. The consideration paid for a share does not have to be in money and so goods or services
may be the price paid. In Re Wragg Ltd [1897] 1 Ch 796 the court held that the judgment of the
directors – which was made in good faith – that the benefit received in return for the shares was
equal in value to their nominal value was not open to challenge.

Because of the scope this gives for abuse, public companies must satisfy strict statutory
requirements where the consideration for shares is other than money (the decision in Re Wragg only
applies to private companies). For example, for public companies s.593 CA 2006 requires an
COMPANY LAW PAGE 41

independent valuation of any non-cash consideration. Failure to comply with this provision renders
the allottee/holder and any subsequent holder liable to pay again in cash together with interest (see
ss.588 and 593(3) CA 2006). Thus, the allottee/holder could end up paying twice for the shares. The
policy here is directed towards preventing public companies from issuing shares at a discount.

The 2005 consultative document states that the requirement of ‘authorised share capital’ is to be
removed on the basis that it is invariably set at a level higher than the company will need and so it
serves no useful practice. This is achieved by Part 17 of the CA 2006 which abolishes the concept of
authorised share capital but retains the concept of nominal value. Thus, s.542(1) requires companies
to issue shares with a fixed nominal value. The requirement for public companies to have a
minimum share capital (£50,000 or euro equivalent, currently fixed at €65,000) is retained by the
2006 Act (see ss.761 and 763).

8.3 Returning funds to shareholders

8.3.1 Dividends

Part 23 of the CA 2006 codifies the common law by requiring that dividends may only be paid out of
distributable profits (see, in particular, s.830). Thus, dividends may only be paid out of accumulated
profits and not if the effect would be to reduce the company’s net assets below the value of its share
capital.

A dividend paid in breach of this rule is unlawful and ultra vires. A director who knew (or ought to
have known) that the payment amounted to a breach is liable to repay the dividends (see Bairstow v
Queens Moat Houses plc [2001] 2 BCLC 531; and Re Exchange Banking Co, Flitcroft’s Case (1882) 21
ChD 519).

In Bairstow v Queens Moat Houses plc, the directors, who acted on the company’s 1991 accounts
that incorrectly showed inflated profits, paid dividends that exceeded the available distributable
reserves. The Court of Appeal held that their liability was not limited to the difference between the
unlawful dividends and the dividends that could have been lawfully paid. Directors owe fiduciary
duties to the company and therefore have trustee-like responsibilities arising out of their duty to
manage the company in the interests of all its members. They were therefore ordered to pay the
company over £78 million. A shareholder who, with knowledge of the facts, receives an improper
dividend payment will be held liable to repay it as a constructive trustee (Precision Dippings Ltd v
Precision Dippings Marketing Ltd [1986] Ch 447; see also, IRC v Richmond [2003] EWHC 999).

In It’s a Wrap (UK) Ltd v Gula [2005] EWHC 2015, the liquidator sought repayment of dividends paid
to the defendants who were the sole shareholders and directors of the company. During a two-year
period in which there were no profits available for distribution, the company’s accounts showed that
dividends had nevertheless been paid to the defendants. When the company went into insolvent
liquidation, the liquidator claimed that the dividends had been paid in contravention of s.263(1) CA
1985 (now s.830(1) CA 2006) and were therefore recoverable under s.277 CA 1985 (now s.847 CA
2006). The defendants argued that the sums in question were paid to them as remuneration and
only appeared in the accounts as ‘dividends’ because they had been advised that this was tax
efficient. The court dismissed the liquidator’s claim. On the evidence it was clear that the defendants
had sought to gain a proper tax advantage and had not deliberately set out to contravene the Act.
The words ‘is so made’ contained in s.277(1) (now s.847(2)) required that the defendants knew or
had reasonable grounds to believe not just the facts giving rise to the contravention but also the
legal result of the contravention. Not surprisingly, the Court of Appeal reversed the judge’s decision
and held that the defendants’ ignorance of the law was no defence. Arden LJ stated that s.277 (now
COMPANY LAW PAGE 42

s.847) had to be interpreted in a manner consistent with Article 16 of the Second Company Law
Harmonisation Directive which it is designed to implement. On this particular issue she concluded
that:

Section 277 [now s.847] must be intrepreted as meaning that the shareholder cannot claim that he
is not liable to return a distribution because he did not know of the restrictions in the Act on the
making of distributions. He will be liable if he knew or ought reasonably to have known of the facts
which mean that the distribution contravened the requirements of the Act.

8.3.2 Other examples of illegal returns of capital

Disguised gifts out of capital

In Re Halt Garage (1964) Ltd [1982] 3 All ER 1016, the court held that where the directors of a
company are also shareholders their remuneration might be viewed as a ‘disguised gift out of
capital’. In this case the director who had received remuneration (the wife of the majority
shareholder) had not actually provided any services for several years due to ill health and the
company had gone into insolvent liquidation. Oliver J held that only £10 out of the £30 per week
that had been paid to her while she was ill was genuine remuneration. She was therefore liable to
repay the balance.

In Aveling Barford Ltd v Perion Ltd [1989] BCLC 626, Aveling Barford Ltd (AB Ltd) and Perion Ltd (P
Ltd) were owned and controlled by Mr Lee. Aveling Barford Ltd, while not technically insolvent, did
not have any distributable reserves. It did, however, own a sports ground for which planning
permission for residential redevelopment had been granted. In October 1986 its directors decided to
sell the sports ground, valued at £650,000, to Perion Ltd for £350,000. The sale was completed in
February 1987. In August 1987 Perion Ltd resold it for £1.52 million. When Aveling Barford Ltd went
into liquidation, the liquidator successfully sued to have Perion Ltd declared a constructive trustee of
the proceeds of sale on the ground that the transaction was an unauthorised return of capital by
Aveling Barford Ltd to Lee, its sole shareholder, via Perion Ltd.

The decision in Aveling Barford has proved controversial because of its impact on companies in a
group who want to transfer assets to each other. In Completing The Structure (November 2000) the
CLRSG concluded that Part VIII of the Companies Act 1985 should be changed to enable intra-group
transfer of assets to proceed in a more straightforward way. This has been implemented by ss.845-
846 CA 2006.

8.3.3 Reduction of share capital

The CA 2006 contains a range of deregulatory measures that target the requirements contained in
the CA 1985 that were considered unnecessary and burdensome for private companies. However,
with respect to public companies, the provisions generally restate the pre-existing regime (see
ss.642–644 CA 2006).

Under CA 2006 companies no longer need authority in the articles of association which permit a
reduction of capital, although they are able to restrict or prohibit the power if they wish (s.641(6)).
Section 641(1) states the general rule that a private limited company may reduce its capital by
special resolution supported by a solvency statement; but that any limited company may reduce its
capital by special resolution if confirmed by the court. In other words, a private company is not
compelled to follow the new simplified procedure but can opt instead to go through the rather
convoluted and expensive step of obtaining the court’s confirmation, as was required under the
1985 Act and which is preserved for public companies.
COMPANY LAW PAGE 43

Private companies: reduction of capital supported by a solvency statement

The simplified procedure for private companies to reduce their capital is detailed in ss.642–644 CA
2006. The solvency statement, as required for private companies under s.641, must be made by all
of the directors not more than 15 days before the date on which the special resolution is passed
(s.642(1)). If one or more of the directors is not able or is not willing to make the statement, the
company will not be able to use the solvency statement procedure to effect a reduction of capital
unless the dissenting director or directors resign (in which case the solvency statement must be
made by all of the remaining directors). Where the special resolution is passed as a written
resolution, a copy of the directors’ solvency statement must be sent or submitted to every eligible
member at or before the time at which the proposed resolution is sent or submitted to them
(s.642(2)). If the resolution is passed at a general meeting, a copy of the solvency statement must be
made available for inspection by members throughout the meeting (s.642(3)). However, the validity
of the resolution is not affected by a failure to comply with these requirements (s.642(4)).

Section 643 provides that the solvency statement must state that each of the directors has formed
the opinion, taking into account all of the company’s liabilities (including any contingent or
prospective liabilities), that:

a. as regards the company’s situation at the date of the statement, there is no ground on which the
company could then be found to be unable to pay its debts; and

b. if it intended to commence the winding up of the company within 12 months of that date, the
company will be able to pay its debts in full within 12 months of the winding up or, in any other case,
the company will be able to pay its debts as they fall due during the year immediately following that
date.

Section 644 lays down the filing requirements in respect of a reduction of capital. Within 15 days
after the special resolution is passed, the company must file with the Registrar

a copy of the solvency statement together with a statement of capital and a statement of
compliance. The special resolution itself must also be filed in accordance with s.30 CA

2006. The resolution does not take effect until these documents are registered (s.644(4)).

If the directors make a solvency statement without having reasonable grounds for the opinions
expressed in it, and that statement is subsequently delivered to the Registrar, every director who is
in default commits an offence (see s.643(4); the penalties, which may include imprisonment, are set
out in s.643(5)).

Public companies: reduction of capital confirmed by the court

As we have seen, public companies are required to have the special resolution for the reduction of
capital confirmed by the court. The policy here is that the interests of creditors are safeguarded.
Sections 645 and 646 CA 2006 (which restate s.136 of the 1985 Act) specify the procedure for
making such an application for an order confirming the reduction, including the creditors’ right to
object. The court will settle a list of creditors with a view to ensuring that each one of them has
consented to the reduction. If a creditor does not consent the court may, in its discretion, dispense
with that creditor’s consent where the company secures the debt or claim (s.646(4)). If, on such an
application, an officer of the company intentionally or recklessly conceals a creditor or
misrepresents the nature or amount of a debt owed by the company, or is knowingly concerned in
any such concealment or misrepresentation, he or she commits an offence (s.647).
COMPANY LAW PAGE 44

The court may make an order confirming the reduction of capital on such terms and conditions as it
thinks fit (s.648(1)). However, it will not confirm the reduction unless it is satisfied, with respect to
every creditor of the company entitled to object, that either his consent to the reduction has been
obtained, or his debt or claim has been discharged or secured (s.648(2)). The reduction will take
effect on registration of the court order confirming the reduction (and statement of capital) by the
Registrar (s.649(5)).

Where there is a reduction of capital, certain shares will be cancelled or reduced in nominal value.
Here the main issue the court has to consider, when deciding whether or not to exercise its
discretion to approve the reduction, is whether the proposal strikes a fair balance between the
interests of the different classes of shareholders. It has long been established that the rule most
likely to achieve fairness is that money should be repaid in the order in which the classes of shares
would rank, as regards repayment of capital, on a winding up. However if the proposed reduction
varies or abrogates class rights it may be possible to disapply this prima facie approach. In Re
Chatterley-Whitfield Collieries Ltd [1948] 2 All ER 593 the company’s coal-mining business had been
nationalised and it proposed to carry on operations on a reduced scale for which it would need less
capital. It therefore decided to reduce its capital by paying off preference capital but keeping its
ordinary shareholders. The court confirmed the reduction as fair because it was carried out in
accordance with the rights of the two classes of shareholders in a winding up (see also Re Saltdean
Estate Co Ltd [1968] 1 WLR 1844).

If the reduction of a public company’s capital has the effect of bringing the nominal value of its
allotted share capital below the authorised minimum, the Registrar must not register the court order
confirming the reduction unless either the court so directs, or the company is first re-registered as a
private company (s.650). Section 651 provides for an expedited procedure for re-registration as a
private company.

8.3.4 Redemption or purchase by a company of its shares

Court approval for a reduction of capital can be avoided where the reduction is achieved through a
redemption or purchase by a company of its own shares. The common law prohibited a company
acquiring its own shares because of the risk to creditors (Trevor v Whitworth (1887) 12 App Case
409). This is given statutory effect by s.658(1) CA 2006. However, s.684 expressly allows a limited
company to issue shares that are to be redeemed at the option of the company or the shareholder.
A public company, however, must be authorised by its articles to issue redeemable shares (s.684(3)).
For private companies no such authorisation is required, although their articles may exclude or
restrict the issuing of redeemable shares (s.684(2)). Section 690(1) confers on limited companies the
power to purchase their own shares, although this is subject to any restriction or prohibition in the
articles of association. The difference between a redemption and a purchase of shares in this context
is that for a redemption, the shares will have been issued on the basis that they are redeemable and
so the holders will have been aware of the terms of the redemption from the outset. For a purchase
of shares, the parties will need to agree the terms of the repurchase at the time the company seeks
to exercise the power.

The scope of the general prohibition contained in s.658(1) was considered in Acatos and Hutcheson
plc v Watson [1994] BCC 446. It was held that it was not unlawful for a company to purchase another
company whose only asset was a significant shareholding (nearly 30 per cent) in the purchasing
company. This was so even though it would have been unlawful for the purchasing company to buy
its own shares directly. Lightman J observed that to hold otherwise would permit target companies
COMPANY LAW PAGE 45

to protect themselves against a takeover bid by the simple device of buying shares in the purchasing
company. He described this result as being ‘absurd’.

As a result of the need for companies, particularly private companies, to have greater flexibility over
their capital structure, the rule in Trevor v Whitworth has, as mentioned above, been relaxed.

Effecting a redemption of shares

For both public and private companies, the directors may determine the terms, conditions and
manner of the redemption if so authorised by the articles of association or by a resolution of the
company (s.685(1)).

An ordinary resolution is required even though its effect is to amend the articles (s.685(2)).

Shares may not be redeemed unless they are fully paid and the terms of the redemption may
provide that the amount payable on redemption may, by agreement between the company and the
shareholder concerned, be paid on a date later than the redemption date (s.686(1) and (2)).

Where the directors are authorised to determine the terms, conditions and manner of redemption,
they must do so before the shares are allotted and such details must be specified in any statement
of capital which the company is required to file (s.685(3)). When a company redeems any
redeemable shares it must give notice to the Registrar within one month, specifying the shares
redeemed together with a statement of capital which details the company’s shares immediately
following the redemption (s.689). If default is made in complying with the notice requirements, an
offence is committed by the company and every officer of the company who is in default (s.689(4)).

Effecting a purchase by a company of its own shares

As noted above, s.690(1) authorises a limited company to purchase its own shares, including any
redeemable shares, subject to any restriction or prohibition in the company’s articles. Further, a
company may not purchase its own shares if as a resultthere would no longer be any issued shares
other than redeemable shares (s.690(2)). Only fully paid shares can be purchased and they must be
paid for on purchase ((s.691); payment by instalments is not, therefore, permissible (see Pena v Dale
[2004] EWHC 1065 (Ch)). A company cannot subscribe for its own shares but is restricted to
purchasing them from existing members (see Re VGM Holdings Ltd [1942] Ch 235).

With respect to financing the purchase, a public company must use distributable profits or the
proceeds of a fresh share issue made for the purpose of financing the purchase (s.692(2)). However,
a private company may, as under the CA 1985, purchase its own shares out of capital (s.692(1) and
s.709).

As mentioned above, the main difference introduced by the 2006 Act for a private company is that
the power to purchase its own shares need no longer be contained in the articles. The articles may,
however, restrict or prohibit the exercise of this statutory power. Where a private company
purchases its own shares out of capital, then ordinarily the use of capital must be a ‘permissible
capital payment’ under s.709, and the company and its directors must comply with a number of
safeguards designed to protect the company’s creditors in such a case. However, for ‘small’ buy-
backs, a private company can pay for the shares it is repurchasing out of capital, without complying
with such safeguards (see s.692 CA 2006). A small buy-back is one where the amount paid does not
exceed (the lower of) £15,000 or 5 per cent of the company’s share capital.

For larger repurchases, where the company is using a permissible capital payment under s.709, the
directors are required to make a statement specifying the amount of the permissible capital
COMPANY LAW PAGE 46

payment for the shares in question. Section 714 provides that this statement must also confirm that
the directors have made a full enquiry into the affairs and prospects of the company and that they
have formed the opinion:

a. as regards the company’s situation immediately after the date on which the payment out of
capital is made, there will be no grounds on which the company could then be found unable to pay
its debts; and

b. as regards the company’s prospects for the year immediately following that date, the company
will be able to continue to carry on business as a going concern and be able to pay its debts as they
fall due in the year immediately following the date on which the payment out of capital is made.

In forming their opinion on the company’s solvency and prospects, the directors must take into
account all of the company’s liabilities (including contingent and prospective liabilities).

Directors who make this statement without reasonable grounds for their opinion commit an offence
(s.715).

As an additional safeguard, s.714(6) provides that the directors’ statement must have annexed to it a
report by the company’s auditor confirming its accuracy. Further, the payment out of capital must
be approved by a special resolution of the company which must be passed on the date of the
directors’ statement or within the week immediately following (s.716). The holders of the shares in
question are barred from voting on the resolution (s.717). Within the week immediately following
the date of the s.716 resolution, the company must give public notice in the London Gazette (the
official newspaper of record for the UK) and in an appropriate national newspaper of the proposed
payment. This must also state that any creditor may apply to court under s.721 within five weeks of
the resolution for an order preventing the payment (s.719). Following the purchase, the company
must give notice to the Registrar. Such notice must include a statement of capital (s.708).

In certain circumstances a company which purchases its own shares need not cancel them but can,
instead, hold them ‘in treasury’ from where they can be either sold or transferred, for example to an
employee share scheme. This relaxation, which took effect on 1 December 2003, was introduced by
the Companies (Acquisition of Own Shares) (Treasury Shares) Regulations 2003 (SI 2003/1116). The
regulations inserted ss.162A – 162G into the 1985 Act which are re-enacted in ss.724-732 CA 2006.

For ‘qualifying shares’, as defined in s.724(2), to become treasury shares they must be purchased by
the company out of distributable profits. There are a number of restrictions on the rights attaching
to treasury shares. For example, s.726(2) states that the company may not exercise any right in
respect of treasury shares. Any purported exercise of such a right is void. Further, no dividend or
other distribution may be paid to the company (s.726(3)).

8.4 Prohibition on public companies assisting in the acquisition of their own shares

8.4.1 Financial assistance

A company might wish to provide financial assistance for the purchase of its own shares by, for
example, giving a gift to a third party on the understanding that the money would be used to buy the
donor company’s shares or, for instance, through guaranteeing a potential purchaser’s borrowing.
This is prohibited by the Companies Act 2006.

The policy underlying the prohibition is explained by Arden LJ in Chaston v SWP Group plc [2003] 1
BCLC 675:
COMPANY LAW PAGE 47

[It] is derived from section 45 of the Companies Act 1929 which was enacted as a result of the
previously common practice of purchasing the shares of a company having a substantial cash
balance or easily realisable assets and so arranging matters that the purchase money was lent by the
company to the purchaser… The general mischief… remains the same, namely that the resources of
the target company and its subsidiaries should not be used directly or indirectly to assist the
purchaser financially to make the acquisition. This may prejudice the interests of the creditors of the
target or its group, and the interests of any shareholders who do not accept the offer to acquire
their shares or to whom the offer is not made.

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

8.4.2 The statutory provisions prohibiting financial assistance

The prohibition against public companies providing financial assistance is laid down by s.678(1) of
the 2006 Act which provides:

Where a person is acquiring or proposing to acquire shares in a public company, it is not lawful for
that company, or a company that is a subsidiary of that company, to give financial assistance directly
or indirectly for the purpose of the acquisition before or at the same time as the acquisition takes
place [emphasis supplied].

(Prior to the CA 2006 the prohibition also extended to private companies: see s.151 CA 1985.)

It is noteworthy that s.678(1) makes no reference to proof of improper intention. Breach is therefore
determined objectively from the surrounding circumstances. Section 678(3) broadens the
prohibition so as to cover situations where assistance is provided by a private company in order to
discharge a liability incurred by a purchaser for the purpose of acquiring shares, but which, at the
time the post-acquisition assistance is given, has re-registered as a public company.

Section 678(1) is supplemented by s.679(1), which extends the prohibition to cover financial
assistance (directly or indirectly) provided by a public company which is a subsidiary of a private
company for the purpose of acquiring shares in that private company before or at the same time as
the acquisition takes place. Section 679(3) extends the prohibition to cover after the event financial
assistance given by a public company to its private holding company.

Section 677 (together with s.683(1) and (2)) seeks to limit the scope of the meaning of ‘financial
assistance’ by listing certain forms or ways in which it can arise. Examples include:

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

The giving of a security is illustrated by Heald v O’Connor [1971] 1 WLR 497. Mr and Mrs Heald sold
all of the shares in D.E. Heald (Stoke on Trent) Ltd to O’Connor. The price was £35,000 but they lent
him £25,000 in order to enable him to complete the purchase. The company thereby granted the
COMPANY LAW PAGE 48

vendors a floating charge over all of its assets by way of security for the loan. Thus, if O’Connor
defaulted, the security would be enforceable against the company. This was held to be illegal.

A residual category falls within s.677(1)(d) which proscribes ‘any other financial assistance given by a
company where the net assets of the company are reduced to a material extent by the giving of the
assistance, or the company has no net assets’. Therefore, even if a public company were in a
position to return funds to shareholders because it had distributable profits, it would not be able to
provide any sort of financial assistance for the acquisition of its own shares which materially
depleted its net assets. In this regard, s.677(2) and (3) state that in determining the company’s ‘net
assets’ it is the actual value of the assets and liabilities, as opposed to their book value, that is to be
applied (see Parlett v Guppy’s (Bridport) Ltd (1996); Grant v Lapid Developments Ltd [1996] 2 BCLC
24).

The exceptions

Section 681 contains a wide list of ‘unconditional’ exceptions. Those in s.681(2) are unexceptional.
They mainly relate to procedures which are specifically authorised elsewhere in the Act: for
example, to effect a redemption of shares or a reduction of capital. So-called ‘conditional
exceptions’ are listed in s.682. They therefore only apply if the company has net assets and either:

a. those assets are not reduced by the giving of the financial assistance, or

b. to the extent that those assets are so reduced, the assistance is provided out of distributable
profits.

An example of a ‘conditional exception’ is where the provision of financial assistance by the

company is for the purposes of an employee share scheme, provided it is made in good faith in the
interests of the company or its holding company (s.682(2)(b)), or which assists in the promotion of a
policy objective such as facilitating the acquisition of the shares by an employees’ share scheme or
by spouses or civil partners, widows, widowers or surviving civil partners or children of employees
(see s 682(2)(c)).

Section 678(2) and (3), however, also contain the ‘principal purpose’ and ‘incidental part of a larger
purpose’ defences which are carried over from the 1985 Act. In essence, financial assistance is not
prohibited:

• if the principal purpose of the assistance is not to give it for the purpose of an acquisition of
shares, or where this assistance is incidental to some other larger purpose of the company
and,
• in either case, where the financial assistance is given in good faith in the interests of the
company.

The exceptions are designed to ensure that the prohibition in s.678(1) does not also catch genuine
commercial transactions which are in the interests of the company. However, attempting to assess a
person’s ‘purpose’ is necessarily difficult (for instance, the need to distinguish purpose from effect)
because the court will need to determine whether the giving of assistance for the purpose of an
acquisition of shares is an incidental part of some larger purpose. Something is a ‘purpose’ of a
transaction between A and B if it is understood by both of them that it will enable B to bring about
the desired result. The difficulties of assessing ‘purpose’ came to the fore in Brady v Brady [1989] AC
755.
COMPANY LAW PAGE 49

In Brady v Brady [1989] AC 755 the scheme involved a company’s business being divided between
two brothers, Jack and Bob Brady, who were the controlling shareholders. They were not on
speaking terms and the deadlock between them threatened the survival of the company and its
subsidiaries. It was decided that Jack should take the haulage business and Bob the soft drinks
business. However, the haulage business was worth more than the soft drinks business and so to
make the division fair and equal, extra assets had to be transferred from the haulage business to the
drinks business. This involved the principal company, Brady, transferring assets to a new company
controlled by Bob. It was conceded that s.151 (now s.678) had been breached because the transfer
involved Brady providing financial assistance towards discharging the liability of its holding company,
M, for the price of shares which M had purchased in Brady. When Jack sought specific performance
of the agreement, Bob, who by now had decided against the arrangement, contended that it was an
illegal transaction. Jack argued, however, that the financial assistance was an incidental part of a
larger purpose of the company (i.e. the removal of deadlock between the two brothers which had
threatened to result in the liquidation of the business).

The House of Lords held that the purpose of the transaction was to assist in financing the acquisition
of the shares: the essence of the reorganisation was for Jack to acquire Brady Ltd’s shares and
therefore the acquisition of those shares was not incidental to the reorganisation. Lord Oliver
concluded that the acquisition ‘was not a mere incident of the scheme devised to break the
deadlock. It was the essence of the scheme itself and the object which the scheme set out to
achieve.’

This approach means that in looking for some larger overall corporate purpose, it is necessary to
distinguish ‘purpose’ from the reason why a purpose is formed.

The commercial advantages flowing from providing the financial assistance for the acquisition of the
shares may be the reason for providing it but the commercial advantages are a by-product of
providing the assistance – they are not an independent purpose to which the financial assistance can
be considered incidental.

The approach of the House of Lords in Brady towards the interpretation of the ‘purpose exceptions’
has been criticised on the basis that it unduly restricts the width of the defences (see s.678, above),
and, indeed, it makes it very hard to ascertain exactly what sort of situations would fall within these
exceptions.

Ascertaining whether or not the prohibition has been breached is a fact-intensive exercise and the
case law provides little guidance in predicting an outcome. In MT Realisations Ltd v Digital
Equipment Co Ltd [2003] EWCA Civ 494, Mummery LJ stressed that:

each case is a matter of applying the commercial concepts expressed in non-technical language to
the particular facts. The authorities provide useful illustrations of the variety of fact situations in
which the issue can arise; but it is rare to find an authority… which requires a particular result to be
reached on different facts.

The facts of Dyment v Boyden [2005] 1 WLR 792 (CA) provide an interesting illustration of how an
allegation of financial assistance can arise. The Court of Appeal had to consider whether rent which
was significantly greater than the market value of the premises in question constituted a breach of
s.678 (s.151 of the 1985 Act). Because of local authority rules the transfer of shares had to be
undertaken in order that the respondents no longer retained an interest in the company. The Court
of Appeal held that the trial judge was right in finding that the company’s entry into the lease was ‘in
connection with’ the acquisition by the appellant of the shares but was not ‘for the purpose of that
COMPANY LAW PAGE 50

acquisition’. His finding that the entry into the lease was for the purpose of acquiring the premises
rather than the shares was a finding of fact with which the Court of Appeal should not interfere.

The sanctions for breach

Section 680 CA 2006 makes breach of the prohibition a criminal offence with the company being
liable to a fine ‘and every officer of it who is in default liable to imprisonment or a fine or both’. The
effect of this is to make the transaction unlawful which can affect the enforceability of the
underlying agreement.

In Carney v Herbert [1985] AC 301, the Privy Council had to decide if the vendors of shares in A Ltd
could sue the purchaser (or the guarantor thereof) for the purchase price when a subsidiary of A Ltd
had provided illegal financial assistance in relation to the purchaser’s acquisition (by charging land
owned by it as security for the purchaser’s promise to pay for the shares). If the agreement could
not have been severed, the purchaser would have been able to keep the shares without any
payment being made for them. Lord Brightman, delivering the decision of the Privy Council, stated:

as a general rule, where parties enter into a lawful contract of, for example, sale and purchase, and
there is an ancillary provision which is illegal but exists for the exclusive benefit of the plaintiff, the
court may and probably will, if the justice of the case so requires, and there is no public policy
objection, permit the plaintiff, if he so wishes, to enforce the contract without the illegal provision.

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

Summary

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

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

Introduction

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

Learning outcomes

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

• explain the function of the articles of association

• describe the problems that arise with enforcing the contract of membership
• explain why shareholder agreements have become increasingly common
• describe the mechanisms for altering the articles and any restrictions on alteration.

9.1 The operation of the articles of association

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

• shareholders
• company
COMPANY LAW PAGE 51

• board.

On incorporation the founders of a company can provide their own set of articles. If they do not,
model articles provided by the law apply by default. Until 2009, there was a single set of model
articles, applicable to both public and private companies, called Table A. For companies formed after
1 October 2009, there now exist separate models, known as the Model Articles for Public Companies
Limited by Shares, and the Model Articles for Private Companies Limited by Shares. These are
containedin the Companies (Model Articles) Regulations 2008. The model articles, with some
amendments, are usually adopted. Because of this, the model articles effectively provide the key
legislative model for the running of the company. While companies often have very complex
organisational structures, the allocation of power in the model articles between the general meeting
and the board of directors is at the core of every corporate structure.

It is this allocation of power that is the central function of the articles of association.

As a result, even though the model articles are only a default set of rules, their almost universal
adoption has meant that they form the core organisational structure of the UK registered company:

• the board of directors (the management organ)

• the general meeting (the members organ).

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

9.2 The articles of association

9.2.1 The model articles

With regard to the general meeting, the model articles regulate the organisation of meetings (article
38-42 private, article 28-33 public) and voting at the meeting (article 43-48 private, article 34-40
public). Similarly, the model articles provide, with regard to the board of directors, for the allocation
of management power to the board (article 3-6 private and public), directors’ appointment (article
17-20 private, article 20-24 public) and decision making by directors (article 7-16 private, article 7-19
public). It is important to note here that the articles do not provide for the general removal of
directors except in the case of incapacity or resignation (articles 18 private and 22 public). Direct
removal is covered by s.168 CA 2006, which gives members the right by simple majority (a vote for
the resolution of more than 50 per cent of those who vote) to remove a director for any reason
whatsoever.

Key management powers

Historically the most important allocation of power in the articles was contained in Article 70 of the
old Table A. Article 70 provided that:

‘[s]ubject to the provisions of the [CA 1985], the memorandum and the articles and to any directions
given by special resolution, the business of the company shall be managed by the directors who may
exercise all the powers of the company.’

This is now contained in articles 3 and 4 of the Model Articles (public and private) and states:

Directors’ general authority

3. Subject to the articles, the directors are responsible for the management of the company’s
business, for which purpose they may exercise all the powers of the company.
COMPANY LAW PAGE 52

Shareholders’ reserve power

4. (1) The shareholders may, by special resolution, direct the directors to take, or refrain from taking,
specified action.

(2) No such special resolution invalidates anything which the directors have done before the passing
of the resolution.

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

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

Although the power to run the company is subject to qualifications, it is important to note that the
board is the primary power-wielding organ of the company. In Howard Smith Ltd v Ampol Petroleum
Ltd (1974) Lord Wilberforce summed up the position:

[t]he constitution of a limited company normally provides for directors, with powers of
management, and shareholders, with defined voting powers having power to appoint the directors,
and to take, in general meeting, by majority vote, decisions on matters not reserved for
management ... it is established that directors, within their management

powers, may take decisions against the wishes of the majority of shareholders, and indeed that the
majority of shareholders cannot control them in the exercise of these powers while they remain in
office.

The power delegated to the board derives from the total power the company actually has, thus the
power they wield is always limited by the objects clause. It is also worth noting that the discretion is,
of course, tempered by the very practical fact that s.168 CA 2006 allows the majority of the
members to remove the board. Thus the board cannot stray too far from the shareholders’ wishes if
they are to keep their jobs.

The board is also given, by virtue of articles 30 (private) and 70 (public), the power to decide
whether to distribute any surplus profits to the shareholders in the form of dividends. Although
technically the general meeting declares the dividend it cannot do so unless the board recommends
a dividend. This may not seem like a significant power but it is a very important independent
management power exercised by the board. The shareholders cannot therefore get any income
from their shareholding unless the directors allow it.

Key shareholder powers

While s.336 CA 2006 does mean that private companies are no longer required to hold an annual
general meeting, it is important to note that the meeting is, in theory, designed to fulfill an
important supervisory function for public companies. The general meeting is in effect the residual
power organ which meets once a year (s.336 CA 2006) to exercise its continued supervision over the
board (article 3).

Significantly, the general meeting has certain other powers. For example its most important power is
the power to elect and remove directors (article 20 (public) gives both the shareholders and the
board the power to elect directors but the CA 2006, s 168 provides that only shareholders may
remove directors). It may also issue shares (article 43 (public), although this is commonly altered to
give the board that power). Section 437 CA 2006 requires that the annual accounts and reports be
COMPANY LAW PAGE 53

put before the annual general meeting of a public company (there is however no requirement for a
vote on these reports but it is common practice for larger companies to require a vote). Section 420
CA 2006 requires the directors of a quoted company to prepare a remuneration report each year
(identifying the remuneration being paid to directors) and s.439 CA 2006 requires this report to be
approved by shareholders in a general meeting. The general meeting is also empowered by s.21 CA
2006 to alter the articles if three-quarters of the members (by a special resolution,) vote in favour of
the resolution. Thus in effect the members can alter the internal rules by which the company’s
power is allocated.

9.2.2 General reform

The CLRSG addressed two key issues with regard to the operation of the articles of association. First
they found that the general meeting was a burden on small

companies and recommended doing away with the need for a general meeting for private
companies unless the company wished to have one (Final Report, July 2001, Chapter 2). The CLRSG
also recommended that public companies could dispense with annual general meetings if all the
shareholders agree (Final Report, para 7.6). This has been implemented for private companies but
public companies, as we noted above, are still required to hold an annual general meeting (s.336 CA
2006.).

For most public companies the general meeting, in theory, fulfils an important accountability
function. In reality, however, large shareholders don’t tend to vote, leading to accountability
problems. The CLRSG recommended that institutional investors who hold the vast majority of shares
(insurance companies, pension funds and investment trusts) should disclose their voting record at
general meetings to increase accountability and transparency (Final Report, Chapter 6 paras 6.22–
6.40). The White Paper (2002, Vol I, paras 2.6–2.48) adopted all the procedural recommendations of
the CLRSG regarding the general meeting except the recommendation to force institutional investors
to disclose their votes (para 2.47) and the CA 2006 does not contain a provision requiring
compulsory disclosure.

Summary

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

9.3 The contract of membership

The shareholders and the company are said to have a contract with each other. This consists of the
constitution of the company (the memorandum and articles). At the heart of this contract is s.33(1)
CA 2006, which states:

The provisions of a 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.

This rather odd statutory contract was introduced in the 19th century to automatically bind the
shareholders and the company together to observe the constitution of the company (see Hickman v
Kent or Romney Marsh Sheep-Breeders’ Association (1915) 1 Ch881). It is an odd contract, as it can
be varied without the consent of all the parties to it by special resolution. It also binds future
members. It does, however, have a key advantage far beyond just the observation of the
COMPANY LAW PAGE 54

constitution. When new members join the company by buying shares, the constitution will
automatically bind them to observe the pre-existing constitution.

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

9.3.1 A contract inter se?

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

9.3.2 Who can sue?

Continuing the complexity of the issue of enforcement of the s.33 contract is the question of who
can sue to enforce the contract. Can a member of the company enforce the contract against the
company? The answer to the question seems to depend on whether the breach complained of is a
wrong to the company or a wrong to the individual. As we will see in Chapter 11 this concerns a
central aspect of company law – majority rule. As a general rule individual shareholders are not
empowered to initiate proceedings for a wrong to the company. This is known as the rule in Foss v
Harbottle (1843) 2 Hare 461. Only the company through its organs – the board or the general
meeting – can sue on such a wrong (see Chapter 11 for a detailed analysis of majority rule). So if the
article that has been breached is classified as a corporate right then only the company can enforce it.
However, a shareholder may be able to enforce the contract against the company directly if the
article in question constitutes a personal right.

Lord Wedderburn (1957) suggests that the following have been considered personal rights in the
past.

• Voting rights.
• Share transfer rights.
• A right to protect class rights.
• Pre-emption rights.
• The right to be registered as a shareholder.
• The right to obtain a share certificate.
• The right to enforce a dividend that has been declared.
• The right to enforce the procedure for declaring the dividend.
• The right to have directors appointed in accordance with the articles.
COMPANY LAW PAGE 55

• Other procedural rights such as notices of meetings.

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

9.3.3 Outsider rights

To add to the confusion surrounding the enforcement of the s.33 contract is the question of whether
everything contained in the articles falls within the s.33 contract. Companies have sometimes added
what are called outsider rights to the articles.These are rights that have nothing to do with the
membership of the company but may cover a wide range of other issues. For example, in Eley v
Positive Government Security Life Assurance Co (1876) 1 Ex D 20 the articles contained a clause
which ensured that a particular member of the company was appointed as the company’s solicitor.
The member was not appointed as the company’s solicitor and sued for breach of contract.

The court found that he could not rely on breach of that clause in the articles as the cause of his
action as there was no contractual relationship between the member as ‘solicitor’ and the company.
However, again here the courts have been somewhat contradictory. In Salmon v Quin & Axtens Ltd
[1909] 1 Ch 311 the articles of association provided that the consent of both managing directors was
needed for certain decisions. Mr Salmon was a managing director and member of the company and
he dissented from a decision to buy and let some property. The general meeting then passed a
resolution authorising the purchase and letting of the property. Mr Salmon sued as a member to
enforce the article requiring his consent as managing director to the transactions. In coming to their
decision the House of Lords accepted a general personal right of members to sue to enforce the
articles by allowing a member to obtain an injunction to stop the completion of the transactions
entered into in breach of the articles. Here the matter was viewed by the judges in terms of
enforcing a member right which tangentially affected his right as a director, rather than a director
right which has a tangential effect on the membership. (For a more recent example see Globalink
Telecommunications Ltd v Wilmbury Ltd [2003] 1 BCLC 145).

9.3.4 Reform

The CLRSG’s Final Report (July 2001 paras 7.34–7.40) recommended clarifying the s.14 issues by
allowing all the articles to be enforceable by the members against the company and each other
unless the contrary was provided. The courts would also be able to strike out trivial actions. These
same recommendations are present in the Government’s Consultative Document March 2005 (para
5.1). However, strangely, the CA 2006 simply reworded the old problematic s.14 of the CA 1985.

Thus after nearly a decade of examining the failings in the area the Government was content to
ignore the CLRSG and its own White Papers to leave the issues in this area unresolved.

Summary

The s.33 contract fulfils a useful function. It ensures that all the members (even future ones) and the
company are bound to observe the constitution. It is an unusual contract in that:

• it binds future parties who cannot renegotiate it

• it can be continually altered by special resolution.

As a result, not all the parties to the contract have to agree to the alteration yet will be bound by the
new terms. However it is the enforcement of the statutory contract that has exercised much judicial
and academic thought. Can it be enforced by a member against another member? Can a member
COMPANY LAW PAGE 56

enforce it against the company? Are all the articles, even outsider articles, enforceable?
Unfortunately the CA 2006 leaves these questions unresolved.

9.4 Shareholders’ agreements

Given the confusion surrounding the enforcement of the s.33 contract it is unsurprising that
shareholders began to take things into their own hands by forming shareholders’ agreements.
Shareholders’ agreements are agreements between shareholders themselves (that is all the
shareholders or just between some of them) or between the company and the shareholders (all of
them or just some of them). The agreement usually concerns the exercise of the shareholder’s rights
in certain given situations. For example, to only allow an increase in the authorised share capital of
the company if all the parties to the shareholders’ agreement agree, or to exercise votes at the
general meeting in a particular way. The key advantage of a shareholders’ agreement is that it is
easily enforceable against another party to the agreement (see Puddephatt v Leith [1916] 1 Ch 200).

In small- to medium-sized companies it is also common to add the company to the agreement for
security. Companies may, however, be limited in what they can agree to do. For example in Punt v
Symons & Co Ltd [1903] 2 Ch 506 the court held that a company could not contract out of the right
to alter its articles. This means in effect that a provision of a shareholders’ agreement which binds
the company not to alter its articles will not be enforceable. However, here we find somewhat
contradictory case law once again.

In Russell v Northern Bank Development Corporation [1992] BCLC 431 the House of Lords considered
a shareholders’ agreement where the company agreed not to increase the share capital of the
company without the agreement of all the parties to the shareholders’ agreement. The company did
attempt to increase the share capital of the company and one of the shareholders who was a party
to the shareholders’ agreement objected and attempted to enforce the agreement. The statutory
conflict here was between the agreement and s.121 CA 1985, which allowed companies to increase
their share capital if their articles contain an authority (note s.617 CA 2006 has amended this
provision so authority is now unnecessary). The article of the company did provide such an
authorisation. The House of Lords found that the company’s agreement not to increase its share
capital was contrary to s.121 and, therefore, unenforceable. However, the court did not declare the
whole shareholders’ agreement invalid – just the company’s agreement not to increase the share
capital. This meant that the shareholder who objected could not enforce it against the company but
could enforce it against the other members. As all the members of the company were party to the
shareholders’ agreement this has the same effect as if the company was bound. The shareholders
could not vote to increase the share capital.

9.5 Altering the articles

One of the odd features of statutory contract in s.33 is that the contract can be varied by the
members by special resolution (s.21 CA 2006). Sometimes the courts have allowed more informal
methods of change to occur. In Re Duomatic [1969] 2 Ch 365 the court allowed a decision not made
at the general meeting, but which clearly had the backing of all the shareholders, to stand. However,
there are restrictions on the shareholders’ ability to alter the articles. As we have observed above,
the alterations to the articles must not conflict with any statutory provisions. Further, the members
must exercise their power to alter the articles in good faith. This power to alter the articles has been
famously expressed by Lindley MR in Allen v Gold Reefs Co of West Africa [1900] 1 Ch 656 as being:

exercised subject to those general principles of law and equity which are applicable to all powers
conferred on majorities enabling them to bind minorities. It must be exercised, not only in the
COMPANY LAW PAGE 57

manner required by law, but also bona fide for the benefit of the company as a whole, and it must
not be exceeded. These conditions are always implied, and are seldom, if ever, expressed.

However, minority shareholders wishing to challenge an alteration of the articles on the ground that
it fails the Allen test, because it was not passed ‘bona fide for the benefit of the company as a whole’
have rarely succeeded. They have met two problems. First, the courts have applied this test in what
we might call a ‘qualified subjective’ way. They have said that what matters is not whether the judge
herself thinks the alteration was, objectively speaking, for the benefit of the company. Instead, the
judge should ask whether some reasonable shareholder could think it would benefit the company.
The idea is that there might be a range of different, reasonable, opinions. Some reasonable
shareholders might think the alteration harmful. But provided that some shareholder could,
reasonably, conclude the alteration was of benefit to the company, the court should not strike it
down. This makes it much more difficult to challenge an alteration: it has to be much more clearly
harmful before the courts will intervene.

The second problem concerns what is meant by ‘for the benefit of the company as a whole’. The
court noted, in Greenhalgh v Arderne Cinemas Ltd [1951] Ch 286, that many alterations do not really
affect the company itself, as a separate commercial entity. Instead, they merely adjust the
respective rights of the shareholders, with little impact on the company. The court therefore said
that the test should be whether the alteration was ‘discriminatory’ between the shareholders.
However, it seems that proving discrimination is difficult. In Greenhalgh itself for example, the court
refused to find such discrimination, notwithstanding that the alteration clearly benefitted the
majority shareholder and left the minority worse off.

One area where the courts have been somewhat readier to strike down alterations is where they are
being made to enable the shares of a member to compulsorily bought off them: see Brown v British
Abrasive Wheel Co Ltd [1919] 1 Ch 290 and Dafen Tinplate Co Ltd v Llannelli Steel [1920] 2 Ch 124.
Perhaps changing the articles to allow for this is seen as simply too great an attack on the
fundamental property rights of a member. However, even in this context the minority is not sure to
win; see for example Re Charterhouse Capital Ltd [2014] EWHC 1410 (Ch).

We have been considering a minority’s right to challenge shareholder votes, but specifically where
the vote is to alter the articles. Can other shareholder resolutions be challenged on the grounds that
they were not passed bona fide for the benefit of the company as a whole? In general, the answer is
‘no’. Shareholders are usually free to vote ‘selfishly’. For example, shareholders voting to remove a
director under s.168 do not need to show that they passd the vote bona fide for the benefit of the
company. However, one case in which the bona fides of a shareholder resolution was reviewed,
even though the resolution did not involve the alteration of the articles, was Clements v Clements
Bros Ltd [1976] 2 All ER 268. Foster J declined to recognise the ability of a majority shareholder to
authorise an allotment of shares, the motive behind the share allotment being to dilute the voting
power of the minority shareholder plaintiff. Foster J considered that the majority shareholder was
‘not entitled to exercise her vote in any way she pleases’. He based his decision on what he termed
‘equitable considerations’ and thus the mala fides (bad faith) element of the allotment precluded it
from ratification (see also Menier v Hooper’s Telegraph Works (1874) LR 9 Ch D 350.

Summary

As a result of the uncertainty surrounding the s.33 contract, shareholders have formed contractually
binding agreements which the courts have been willing to enforce. The only real complication with
these agreements is where the company is a party to the agreement and some or all of the
COMPANY LAW PAGE 58

agreement is contrary to a statutory provision. In such a case the company cannot contract out of its
statutory obligation. Alteration of the company’s constitution normally occurs by special resolution.
However, sometimes the courts have allowed more informal processes to stand. There may also be
restrictions on the ability of shareholders to vote if a statutory obligation is affected or a minority
shareholder is disadvantaged.

10 Class rights

Introduction

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

Finally, we consider how the company may vary the rights attaching to a class of shares.

Learning outcomes

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

• explain the legal nature of a share

• describe the various classes of shares
• describe how class rights attaching to shares are determined
• outline the procedure for varying class rights.

10.1 Shares and class rights

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

10.1.1 The nature of a share

A share is both a contract between the shareholder and the company (see Chapter 9) and a right of
property, somewhat unhelpfully termed a ‘chose in action’, which can be bought, sold and charged.
The classic definition of a share was delivered by Farwell J in Borland’s Trustee v Steel Bros & Co Ltd
[1901] 1 Ch 279:

A share is the interest of a shareholder in the company measured by a sum of money, for the
purpose of liability in the first place, and of interest in the second, but also consisting of a series of
mutual covenants entered into by all the shareholders inter se in accordance with [section 16CA
1862, now s.33 CA 2006]. The contract contained in the articles of association is one of the original
incidents of the share. A share is not a sum of money… but an interest measured by a sum of money
and made up of various rights contained in the contract, including the right to a sum of money of a
more or less amount.
COMPANY LAW PAGE 59

We saw in Chapter 3 that shareholders do not have an interest in the property belonging to the
company (see Macaura v Northern Assurance Co Ltd [1925] AC 619); rather their relationship is with
the company as a separate and distinct entity in its own right. A shareholder thus has rights in the
company not against it as in the case of debenture holders (see Chapter 7).

In Short v Treasury Commissioners [1948] 1 KB 116 (affirmed by the House of Lords [1948] AC 534)
the legal nature of a share was subjected to considerable examination by the court in relation to its
valuation. The Government purchased all of the shares in the company, valuing them on the basis of
the quoted share price. The shareholders argued that because the whole of the issued shares were
being acquired then the entire undertaking should be valued and the price apportioned between
them. It was held, however, that where a purchaser is buying control but none of the sellers holds a
controlling interest, the higher price that ‘control’ demands can be ignored. The Treasury was
therefore able to purchase the company for a price considerably less than its asset value.

Summary

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

10.2 Classes of shares

As seen above, broadly speaking it can be said that a shareholder has rights and liabilities that arise
from the general nature of a share. There is a presumption of equality between shareholders so that
they are deemed to enjoy equal voting and dividend rights, when the company is a going concern,
and equal rights to participate in any surplus assets should the company be wound up. This
presumption of equality will be rebutted where a company issues shares that carry different class
rights. For example, the holders of preference shares generally enjoy preferential dividend rights
and priority in the return of capital in a winding up.

Generally, the articles of association give the company the power to issue shares with such rights or
restrictions as the company may by ordinary resolution determine. The different classes of shares
commonly issued are ordinary, preference, redeemable and employees’ shares.

10.2.1 Ordinary shares

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

10.2.2 Preference shares

Holders of preference shares have certain preferential rights attached to their shares. A fixed
preferential cumulative dividend will be paid to them in any year in which the company has
distributable profits. The cumulative element means that arrears become payable in respect of those
years in which a dividend was not declared. It is presumed that preference shares are cumulative
(Webb v Earle (1875) LR 20 Eq 556). Where preference shares are participating as to dividend, they
have the right to a further dividend payment after the ordinary shareholders have received a
COMPANY LAW PAGE 60

distribution equivalent to their initial fixed rate. Preference shareholders are also generally entitled
to a return of capital on a winding up in priority to the ordinary shareholders, but unless they have
an express right of participation, they do not have a claim to any surplus assets (Scottish Insurance
Corpn Ltd v Wilson and Clyde Coal Co Ltd [1949] 1 All ER 1068). Preference shares generally have
restricted voting rights so that their owners cannot vote in general meetings unless, for example,
their dividends are in arrears.

10.2.3 Redeemable shares

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

10.2.4 Employees’ shares

To give employees a ‘stake’ in the business, companies may issue shares to them. Such shares enjoy
certain tax advantages. Employee shares are generally issued through an ‘employee share scheme’
which is defined as being a scheme for facilitating the holding of shares or debentures in a company
by or for the benefit of:

a. bona fide employees or former employees of the company, including its subsidiary or holding
company, or

Company Law 10 Class rights

b. their spouses, civil partners, surviving spouses, surviving civil partners or minor children or step-
children under the age of 18 (s.1166).

Such shares are normally issued as ordinary shares or preference shares and are typically subject to
restrictions relating to their disposal.

10.3 Variation of class rights

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

1. What are class rights?

2. What course of conduct will amount to a variation or abrogation of class rights?

10.3.1 What are class rights?

In Cumbrian Newspapers Group Ltd v Cumberland and Westmoreland Herald Newspapers and
Printing Co Ltd [1987] Ch 1, Scott J stated that rights or benefits conferred by a company’s articles of
association can be classified into three distinct categories:
COMPANY LAW PAGE 61

• Rights or benefits which are annexed to particular shares, such as dividend rights, and rights
to participate in surplus assets on a winding up. Where the articles provide that particular
shares carry particular rights, these are class rights for the purposes of s.125 CA 1985 (see
now s.630 CA 2006).
• Rights or benefits that, although contained in the articles, are conferred on individuals who
are not qua members or shareholders but, for ulterior reasons, are connected with the
administration of the company’s affairs (see Chapter 9).
• Rights or benefits that, although not attached to any particular shares, are conferred on the
beneficiary in his or her capacity as member or shareholder in the company.

On the facts of the case it was held that provisions in the articles which gave the claimant a pre-
emptive right over the transfer of shares in the defendant company, together with the right to
nominate a director to its board so long as it held 10 per cent of the ordinary shares, were class
rights. Scott J said:

A company which, by its articles, confers special rights on one or more of its members in the capacity
of member or shareholder thereby constitutes the shares for the time being held by that member or
members a class of shares for the purposes of section 125. The rights are class rights.

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

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

While s.630 stipulates the procedure to be followed in order to effect a variation of class rights, the
CA 2006 offers little insight into the meaning of variation or abrogation. Guidance must therefore be
drawn from the case law. The courts have adopted a restrictive approach and have drawn a
distinction between conduct which impacts upon the substance of a shareholder’s class right (which
would amount to a variation) and conduct which merely affects its exercise or enjoyment. In White v
Bristol Aeroplane Co Ltd [1953] Ch 65, article 68 of the company’s articles of association provided
that the rights attached to any class of shares may be ‘affected, modified, varied, dealt with, or
abrogated in any manner’ with the approval of an extraordinary resolution passed at a separate
meeting of the members of that class. The preference shareholders argued that an issue of
additional shares, both preference and ordinary, ‘affected’ their voting rights and therefore fell
within article 68. However, the company contended that the proposal did not amount to a variation
of class rights but rather it was the effectiveness of the exercise of those rights that had been
affected and therefore a separate meeting of the preference shareholders was not required.

The Court of Appeal rejected the preference shareholders’ contention. Romer LJ explained that the
proposal would not affect the rights of the shareholders: ‘the only result would be that the class of
persons entitled to exercise those rights would be enlarged…’ (see also Greenhalgh v Arderne
Cinemas Ltd [1946] 1 All ER 512).

A successful claim was brought in Re Old Silkstone Collieries Ltd [1954] Ch 169. The company’s
colliery was nationalised by the government of the day. While waiting for the final settlement of
compensation, the company had twice reduced its capital by returning part of the preference
shareholders’ capital investment. On both occasions the company had promised the shareholders
that they would not be bought out entirely but that they would retain their membership so that they
COMPANY LAW PAGE 62

could participate in the compensation scheme to be introduced under the nationalisation legislation.
Subsequently, it was proposed to reduce the company’s capital for a third time by returning all
outstanding capital to the preference shareholders. The effect of this would be to cancel the class
completely and they would no longer qualify for compensation. The Court of Appeal refused to
sanction the reduction, holding that the proposal amounted to an unfair variation of class rights in
so far as the preference shareholders had been promised that they would participate in the
compensation scheme.

But note that a cancellation of a class of shares on a reduction of capital will not generally be held to
constitute a variation of class rights. Such a course of action is viewed as consistent with the terms of
issue of the particular shares in question (see House of Fraser plc v ACGE Investments Ltd [1987]
BCLC 293; Re Saltdean Estate Co Ltd [1968] 3 All ER 829).

10.3.3 The statutory procedure for effecting a variation of class rights

As commented above, the procedure for varying class rights is set out in s.630 CA 2006. The
provision is far more straightforward than its predecessor (see s.125 CA 1985).

Section 630 provides that class rights may only be varied:

(a) in accordance with the relevant provisions in the company’s articles; or

(b) if no such provision is made in the articles, if the holders of three-quarters in value of the shares
of that class consent either in writing or by special resolution (passed at a separate meeting of the
holders of such shares.

The company must then notify the registrar of any variation of class rights within one month from
the date on which the variation is made (ss.637 and 640).

Although the CLRSG had recommended that the consent of 75 per cent of the holders of the class
affected should be a statutory minimum, notwithstanding any less onerous procedure contained in
the company’s articles, this was removed from the Companies Bill at a fairly late stage. As a
consequence, the company’s articles may specify either less or more demanding requirements for
variation of class rights than the default provisions laid down in the Act (see s.630(3)). This has two
important effects.

• First, if, and to the extent that, the company has adopted a more onerous regime in its
articles for the variation of class rights, for example requiring a higher percentage than the
statutory minimum, the company must comply with the more onerous regime.
• Second, if and to the extent that the company has protected class rights by making provision
for the entrenchment of those rights in its articles (see s.22 CA 2006), that protection cannot
be circumvented by changing the class rights under s.630.

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

10.3.4 The right of a minority to object to a variation

Section 633 of the CA 2006 provides that, whether a variation has been effected through the
statutory procedure or under a provision contained in the company’s constitution, the holders of not
less than 15 per cent of the issued shares of the class affected may, if they did not consent to or vote
COMPANY LAW PAGE 63

in favour of the variation, apply to the court within 21 days of the resolution to have it cancelled.
The effect of such an application is to suspend the variation until it is confirmed by the court. If, on
hearing the application and having regard to all the circumstances of the case, the court is satisfied
that the variation would unfairly prejudice members of the class of shareholders represented by the
applicant, it shall disallow the variation (s.633(5)). If it is not so satisfied, the court must confirm it.

11 Majority rule and wrongs against the company

Introduction

We are concerned here primarily with one particular aspect of majority rule: how it affects action
taken for wrongs done to the company. The most important example of such a wrong would be
where the directors have breached their duties to the company (see Chapter 15). As we saw in
Chapter 3, a consequence of the Salomon doctrine is that a company can sue in its own right to
vindicate a wrong done to it. Thus, whenever a wrong has been committed against the company, the
proper claimant is the company itself. However, a company is a metaphysical person and as such it
must act through its organ of management (the directors) and the decision to bring legal
proceedings is generally vested in the board (see the model articles of association for private and
public companies, article 3 (directors’ general authority). But what if the wrongdoers are the
directors themselves who, controlling the company, prevent it from seeking legal redress against
them? In this chapter we consider how the law seeks to solve this problem by permitting minority
shareholders, in certain exceptional circumstances, to bring a derivative action on the company’s
behalf.

It is worth bearing in mind here when examining this issue that there is a tension between the
theory of corporate personality and majority rule. As a result this is a conceptually difficult and
technical topic that requires concentrated study. Given its complexity, you will need to read and
reflect on these conceptual tensions. Don’t be put off if you do not understand the topic
immediately – take a break and then re-read the material. You will find that patiently working
through the chapter (perhaps several times) will pay dividends.

Learning outcomes

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

• describe the rule in Foss v Harbottle (the proper claimant rule) and the policies that underlie
it
• describe and critically assess the exceptions to the rule in Foss v Harbottle
• describe the various types of shareholder actions
• outline the difficulties which confront a shareholder who seeks to initiate litigation when a
wrong has been done to the company by those in control
• assess the statutory procedure for bringing a derivative claim.

11.1 The rule in Foss v Harbottle – the proper claimant rule

The rule in Foss v Harbottle (1843) 2 Hare 461 is that when a wrong has been committed against the
company, the proper claimant in respect of that wrong is the company itself. The rationale for the
rule is twofold:

• it prevents a multiplicity of legal proceedings being brought in respect of the same issue – if
minority shareholders were permitted to initiate such proceedings there could be hundreds
of actions
COMPANY LAW PAGE 64

• it upholds the principle of majority rule: if the majority of shareholders do not wish to
pursue an action then the minority is bound by that decision.

Saying that the company is ‘the proper claimant’ begs the question of who is to decide if the
company will sue. It should be noted that the model articles of association for private and public
companies (see article 3) place the management of companies into the hands of their directors and
the decision whether to sue a third party who has committed a wrong against the company or, on
the other hand, to defend an action brought against the company falls within the remit of the board.
Consequently, even where the directors do not hold a majority of shares (as is common in large
private companies and public companies) the shareholders cannot generally direct them to sue or
defend an action (Breckland Group Holdings Ltd v London and Suffolk Ltd (1988) 4 BCC 542). (For a
very good discussion of whether the board is the best body to take the decision that the company
will, or will not, sue a director, see Kershaw (2012), pp.589–95.)

In essence, the rule in Foss v Harbottle is a procedural device. As explained by Jenkins LJ in Edwards
v Halliwell [1950] 2 All ER 1064, it has two limbs.

The proper plaintiff in an action in respect of a wrong done to a company is prima facie the company
itself.

Where the alleged wrong is a transaction which might be made binding on the company and all its
members by a simple majority of the members, no individual member of the company is allowed to
maintain an action in respect of that matter ‘for the simple reason that, if a mere majority of the
members of the company… is in favour of what has been done, then cadit quaestio (in other words,
the majority rule).

In Foss v Harbottle (1843) 2 Hare 461 the claimants were two shareholders in the Victoria Park
Company. They brought an action against the company’s five directors and promoters, alleging that
the defendants had misappropriated assets belonging to the company and had improperly
mortgaged its property. The claimants sought an order to compel the defendants to make good the
losses suffered by the company. They also applied for the appointment of a receiver. It was held that
the action must fail. The harm in question was suffered by the whole company, not just by the two
shareholders. It was open to the majority in general meeting to approve the defendants’ conduct. To
allow the minority to bring an action in these circumstances would risk frustrating the wishes of the
majority.

A clear application of the rule that illustrates how it fits with the principle of majority rule is
MacDougall v Gardiner (1875) 1 ChD 13. The chairman of the Emma Silver Mining Co had adjourned
a general meeting of the company without allowing a vote to be taken on the issue of adjournment
as requested by a shareholder, MacDougall. He therefore brought an action claiming first, a
declaration that the chairman had acted improperly and second, an injunction to restrain the
directors from taking any further action. The Court of Appeal held that the basis of the complaint
was something that in substance the majority of the shareholders were entitled to do and there was
no point in suing where ultimately a meeting has to be called at which the majority will, in any case,
get its way. Against this background Lord Davey in Burland v Earle [1902] AC 83 formulated what has
become a classic statement of the rule:

It is an elementary principle of the law relating to joint stock companies that the Court will not
interfere with the internal management of companies acting within their powers, and in fact has no
jurisdiction to do so. Again, it is clear law that, in order to redress a wrong done to the company or
COMPANY LAW PAGE 65

to recover money or damages alleged to be due to the company, the action should prima facie be
brought by the company itself.

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

11.2 Forms of action

It will be useful here to describe a number of different types of action that might be brought.

Corporate actions

This is an action brought by the company itself, so that the company will be named as the claimant.
As we have seen, according to the rule in Foss, this is the type of action that should be brought
where a wrong has been done to the company. It must be authorised by whoever within the
company has the authority to decide the company will sue, and this ordinarily will be the board of
directors.

The derivative action/claims

This is the name for proceedings brought by one or more shareholders, but to enforce a cause of
action that the company itself has. So, unlike a personal action, considered next below, the
shareholder is not suing to enforce their own rights, but is instead suing to enforce the company’s
rights – say in respect of a breach of duty owed to the company by a director. And if successful, the
benefits will go to the company, not the shareholder. As hopefully will be clear, such proceedings are
an exception to Foss, for they allow a shareholder to sue for a wrong done to the company. We will
consider below the restrictive conditions that must be satisfied before such proceedings can be
brought.

As we shall see, those conditions used to be set out in the common law, when the proceedings were
called derivative actions. The rules have now been incorporated into legislation, and the name of
such proceedings changed to derivative claims.

Personal actions

This is an action brought by, and in the names of, an individual shareholder or group of shareholders.
They sue to enforce their own rights, and for their own benefit. As we have seen, according to the
rule in Foss, shareholders cannot bring a personal action in respect of a wrong done to the company.
However, there may be situations where the misconduct that has occurred does not constitute a
wrong to the company but is instead an infringement of the personal rights of the shareholder. In
that case, the shareholder can sue personally, and the rule in Foss does not prevent her doing so. As
Mellish LJ observed in MacDougall v Gardiner (above), where the right of a shareholder has been
infringed by the majority, he can sue. Here, the injury or wrong in question is not suffered by the
company as such, but by the shareholder personally. Therefore, the anxiety underlying Foss v
Harbottle does not arise.

A shareholder’s rights can arise by virtue of a contract, for example, under the company’s
constitution or a shareholders’ agreement. Thus, where a dividend is declared but not paid, a
shareholder can sue personally for payment by way of a legal debt. See, for example, Wood v Odessa
Waterworks Co (1889) 43 Ch D 636 (Ch D)).

The representative action

COMPANY LAW PAGE 66

A representative action is brought by a shareholder on behalf of himself and all other members who
have an interest in the litigation (r.19.6 Civil Procedure Rules). For example, where a class of
shareholders allege that a class right has been infringed (see Chapter 10).

The action avoids the costs of multiple suits. The court’s judgment will be binding on those
represented (see, for example, Quin & Axtens Ltd v Salmon [1909] 1 Ch 311). Thus, a representative
action is brought where a wrong has been committed by the company to a class of shareholders (see
Pender v Lushington).

Personal actions for reflective loss

We have seen that, according to Foss, a wrong done to the company should give rise to a corporate
action. Shareholders can only bring a personal claim if their personal rights have been infringed. But
imagine this situation. Suppose directors have breached their duties – say they have defrauded the
company of several millions of pounds. The company has clearly been harmed, and according to
Foss, it is the one that should sue to recover those losses. But could not a shareholder argue that
they too have been individually, personally, harmed because their shares in the company are now
worth much less as a result, allowing them to bring a personal action for their own personal loss?

The shareholder will find two difficulties in using that argument. The first reflects what we have
discussed so far in this chapter. The shareholder may be out of pocket, but cannot easily point to the
breach of any duty owed to them personally. The directors’ fraud will be a breach of their duties, but
these duties are owed only to the company itself (see Chapter 15). Directors do not owe duties
directly to individual shareholders. So, legally speaking, the wrong can be said to be done only to the
company (even though it leaves the shareholders out of pocket).

This first difficulty might not be insurmountable, however. In some (exceptional) cases, the
shareholder might be able to show that, alongside the duties which the director owes to their
company, they do also owe duties directly to individual shareholders. There are a number of grounds
on which directors might come to owe duties directly to shareholders (although it is important to
emphasise that all of the grounds apply only exceptionally). First, directors may owe a duty of care
to shareholders in tort. That duty would include not misleading the shareholders, for example by
giving careless advice to shareholders about how they might vote at a shareholders’ meeting: see
Sharp v Blank [2015] EWHC 3220 (Ch).

Another way is if the directors were to enter into a sufficiently close relationship with shareholders
to give rise to duties owed directly to them. This has sometimes happened where directors are
closely advising shareholders on the sale of their shares: see the discussion in Section 15.1.2. A final
ground might arise where there is some separate contract between the directors and the
shareholders, and that contract imposes obligations on the directors in favour of the shareholders.
See the case of Giles v Rhind, below, for an example of this. See also Platt v Platt [1999] 2 BCLC 745.
However, even if the shareholder were able to establish that, exceptionally, the directors did owe
the shareholders some duties (over and above the duties the directors owed to the company), the
shareholders would still face a second difficulty.

The second difficulty is this: where a wrong results first in a loss to the company and this leads in
turn to a diminution in the value of a member’s shareholding, the shareholder’s loss has been
termed ‘reflective loss’ by Lord Bingham and Lord Millett in Johnson v Gore Wood & Co [2001] 1 All
ER 481. The shareholder’s loss merely reflects the loss caused first to the company. And in Prudential
Assurance Co Ltd v Newman Industries Ltd (No.2) [1982] 1 All ER 354, the Court of Appeal held that a
shareholder cannot sue for such reflective loss. Quite simply, the rule in Foss v Harbottle means that
COMPANY LAW PAGE 67

the company is the proper claimant and the shareholder’s reflective loss will be remedied if the
company sues the wrongdoer.

However, if the court is satisfied that a member suffered a personal loss which is separate and
distinct from that sustained by the company (and provided of course that the member can show this
arose from the breach of a duty owed personally to them, so they can overcome the first difficulty
noted above), then the member will be able to sue (Johnson v Gore Wood & Co). The authorities
were summarised by Lord Bingham in the Johnson decision as supporting three propositions.

(i) Where a company suffers loss caused by a breach of duty owed to it, only the company may sue
in respect of that loss. No action lies at the suit of a shareholder suing in that capacity and no other
(i.e. a shareholder is not entitled to sue merely as a shareholder) to make good a diminution in the
value of the shareholder’s shareholding where that merely reflects the loss suffered by the
company. A claim will not lie by a shareholder to make good a loss which would be made good if the
company’s assets were replenished through action against the party responsible for the loss, even if
the company, acting through its constitutional organs, has declined or failed to make good that
loss…

(ii) Where a company suffers loss but has no cause of action to sue to recover that loss, the
shareholder in the company may sue in respect of it (if the shareholder has a cause of action to do
so), even though the loss is a diminution in the value of the shareholding…

(iii) Where a company suffers loss caused by a breach of duty to it, and a shareholder suffers a loss
separate and distinct from that suffered by the company caused by breach of a duty independently
owed to the shareholder, each may sue to recover the loss caused to it by breach of the duty owed
to it but neither may recover loss caused to the other by breach of the duty owed to that other.

Recently, the no reflective loss principle has been subjected to considerable judicial scrutiny. These
cases suggest that the principle is of wide application and will readily be invoked by the courts. The
essential point is that the courts prefer the company itself to sue for the loss it has suffered, rather
than permitting (potentially many) individual personal actions to be brought by those who have
suffered some harm as a result of the loss caused to the company. In Ellis v Property Leeds (UK) Ltd
[2002] 2 BCLC 175, the Court of Appeal held that the principle applies equally where the claimant is
suing qua director as to when he sues qua shareholder. Moreover, it was held in Sevilleja Garcia v
Marex Financial Ltd [2018] EWCA Civ 1468, that the principle also prevents a creditor from suing
personally for reflective loss and it does so whether or not the creditor is a shareholder in the
company. The principle also applies even if the company happens to be in administrative
receivership, for being in administrative receivership does not prevent the company itself from
pursuing any claim it may have for harm done to it (see Gardner v Parker [2004] EWCA Civ 781, in
which the Court of Appeal also stressed that the bar is an obvious consequence of the rule against
double recovery). However, the prohibition can be circumvented where the shareholder is able to
bring a claim qua beneficiary of a trust of shares of which the wrongdoer is trustee (see Walker v
Stones [2001] 2 WLR 623, CA; Shaker v Al-Bedrawi [2002] EWCA Civ 1452).

In Breeze v Chief Constable of Norfolk [2018] EWHC 485 (QB), the court confirmed that the reflective
loss principle is not restricted to cases where there is a breach of directors’ duties. Rather, the
principle applies to ‘any situation where a company (whether or not it actually sues) has a cause of
action in respect of an actionable wrong, which, if pursued to its fullest extent, would enable it to
seek to recoup the loss’. (In this particular case, the claim the company itself could have sued for
was ‘misfeasance in a public office’.)
COMPANY LAW PAGE 68

One exception to the reflective loss principle was established in the case of Giles v Rhind [2001] 2
BCLC 582. The company was insolvent due to a former director’s breach of certain duties (not to
compete or misuse confidential information). Both duties were also express terms in a shareholders’
agreement to which the defendant and claimant were parties. Although the company had initiated
an action against its former director, the administrative receivers discontinued it when the
defendant director applied for a security of costs order. In effect, the defendant had, by his breach
of duty, rendered the company incapable of seeking legal redress against him. The claimant brought
a personal action against the former director to recover losses to the value of his shareholding, loss
of remuneration and loss of the value of loan stock. The Court of Appeal, in placing considerable
emphasis on the fact that the defendant’s own wrongdoing had, in effect, disabled the company
from suing him for damages, found that this situation had not confronted the House of Lords in
Johnson v Gore Wood & Co. Given that the duties in question were expressly provided for in the
shareholders’ agreement, it was held that the claimant could pursue his claim for breach of the
agreement, including his losses in respect of the value of his shareholding. However, in Sevilleja (see
above) the court also held that this exception must be construed narrowly. In particular, the court
said that the company’s inability to sue must be ‘legal’ rather than merely ‘factual’. In other words,
the effect of the wrongdoing against the company must be such as to create a legal barrier to the
company suing, and not merely to cause ‘factual’ difficulties (such as a lack of the necessary funds to
pursue the action).

Summary

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

11.3 Derivative claims: introduction

Having dealt with personal claims, we can now return to the main theme of this chapter, namely
derivative proceedings. We have noted above their essential characteristics, and these are reflected
in s.260(1) CA 2006, which defines them as proceedings brought by a member of a company in
respect of a cause of action vested in the company and seeking relief on behalf of the company.

UK company law has long permitted them. Prior to the CA 2006, however, the rules governing
derivative actions (as they were then known) were found not in the Companies Acts, but were
instead established only by case law. These rules were much criticised (consider for example the
views of the Law Commission (see the LCCP No.142 (1996) and the ensuing Report, No.246 (Cm
3769, 1997)). It was felt that the rules, being buried in case law, were inaccessible and often unclear.
It was also felt that the rules were too restrictive, and made it too difficult for shareholders to
succeed in bringing such actions.

The Law Commission did not recommend abandoning the rule in Foss v Harbottle itself, and its
requirement that a company should be the claimant where the company had been wronged. It felt
the rule itself was sound. Derivative proceedings should remain an exception to that rule – a
procedural device that would enable individual shareholders to take action for the company, to
ensure the company’s rights were vindicated. But there should be ‘a new derivative procedure with
more modern, flexible and accessible criteria’. This was achieved by introducing a new statutory
COMPANY LAW PAGE 69

‘derivative claim’, in Part 11 CA 2006. The common law derivative action has, therefore, almost been
completely replaced by the new statutory claim. Almost, but not entirely: what are termed ‘multiple
derivative actions’ are not covered by the statutory provisions of Part 11. A multiple derivative
action is one brought by a shareholder of a parent company in respect of a wrong done to the
company’s subsidiary, or its sub-subsidiary, and so on. Such claims must still be brought under the
old common law procedure: see Re Fort Gilkicker Ltd [2013] EWHC 348 (Ch) and Abouraya v
Sigmund [2014] EWHC 277 (Ch).

When a derivative claim is brought, the company itself is joined as a defendant. It cannot be joined
as a claimant. That would only be possible if the board had authorised this, and if a derivative claim
is being brought, we must assume the board is refusing to do that. By being joined as a defendant to
the action, however, the company can still be bound by the judgment and can enforce any remedy
awarded. The wrongdoers will also be joined as defendants.

11.4 A short excursion into the former common law

We noted above that the common law rules were criticised for being unclear and restrictive, making
it difficult for shareholders successfully to bring such actions. It would be tempting to hope that the
old rules are now just a matter of history. Unfortunately, that is not yet so. First, as we have seen,
the old rules remain applicable to multiple derivative claims. Secondly, the old rules may still
influence judges when they apply the new statutory provisions. So, we need to spend a few
moments examining the old rules. Doing that will also let us see whether Part 11 turns out to be an
improvement on what went before.

At common law, the derivative action was available only where there was ‘fraud on the minority’. It
became known, then, as the fraud on the minority exception to Foss. It appears in a longer list of
‘exceptions to Foss’ which Jenkins LJ set out in Edwards v Halliwell [1950] 2 All ER 1064. These were:

• where the act complained of is illegal or is wholly ultra vires the company (this is discussed
further in Chapter 13)
• where the matter in issue requires the sanction of a special majority, or there has been non-
compliance with a special procedure
• where a member’s personal rights have been infringed
• where a fraud has been perpetrated on the minority and the wrongdoers are in control.

(Attempts to add a fifth exception – where it would be in the interests of justice to relax the rule –
were roundly rejected by the Court of Appeal in Prudential Assurance v Newman (No.2) [1982] 1 All
ER 354.)

This list of ‘exceptions’ is useful, but it is important to see, as Wedderburn noted in his frequently
cited article, ‘Shareholders’ rights and the rule in Foss v Harbottle’ [1957] CLJ 194 and [1958] CLJ 93,
that only fraud on the minority is a ‘true’ exception. There, the wrong is indeed done to the
company, the company itself should ordinarily sue, and to permit a shareholder to sue instead must
be an exception to Foss. In the first three cases, the wrong is not being done to the company; in
truth, it is the shareholder personally who is being wronged.

11.4.1 Fraud on the minority

At common law, then, a shareholder was allowed to bring a derivative action where the company
had been wronged, but only if that wrong amounted to a ‘fraud’ and if those who had wronged the
company were in control of it and preventing it from suing. These twin elements – a wrong that
COMPANY LAW PAGE 70

constituted fraud, and wrongdoer control – defined the preconditions for a successful derivative
action. Unfortunately, the meaning of each was unclear and restrictive.

The meaning of ‘fraud’

Not all breaches of duty by directors amounted to fraud, however, but which ones did, and which
did not, was never clear. It was sometimes said that only breaches which cannot be ratified by the
majority (see Cook v Deeks, in Chapter 15) amounted to fraud. But this merely begs the question:
which duties cannot be ratified by the majority (and therefore amount to fraud)? Megarry V-C in
Estmanco (Kilner House) Ltd v GLC [1982] 1 WLR 2 explained that:

‘Fraud’ in the phrase ‘fraud on a minority’ seems to be being used as comprising not only fraud at
common law but also fraud in the wider equitable sense of that term…

So, we know that ‘fraud’ here does not necessarily mean that the breach of duty was dishonest or
deceitful, but that still gives little positive guidance. The judges perhaps deliberately left the
definition of fraud in this context open, although some guidelines were laid down. In Burland v Earle
(above), fraud was defined as: ‘when the majority are endeavouring directly or indirectly to
appropriate to themselves money, property or advantages which belong to the company or in which
the other shareholders are entitled to participate’.

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

The meaning of ‘wrongdoer control’

Like fraud, wrongdoer control was also unclear in its meaning.

There was judicial debate over whether actual (de jure) control was required (for example whether
the wrongdoers needed to control 51 per cent or more of the votes), or whether de facto control
sufficed. In Prudential Assurance Co Ltd v Newman Industries Co Ltd (No.2) (above), the Court of
Appeal adopted a restrictive approach to the issue and this lead was followed by Knox J in Smith v
Croft (No.2) [1988] Ch 114, who stated that if the majority of the shareholders who were
independent of the wrongdoers did not wish the action to proceed ‘for disinterested reasons’, as
occurred on the facts of the case, the single member who sought to initiate the proceedings would
be denied standing to sue (locus standi). The logic of this was that if a majority of disinterested
shareholders were against action by the company, then the company was being stopped from suing
(or ‘controlled’) not by the wrongdoers, but by non-wrongdoing shareholders. This attempted to
reassert the importance of majority rule, but rule by a majority of disinterested and impartial
shareholders. The judge went on to observe that in determining the independence of the
shareholders who did not support an action being brought against the wrongdoers: ‘[their] votes
should be disregarded if, but only if, the court is satisfied either that the vote or its equivalent is
actually cast with a view to supporting the defendants rather than securing benefit to the company’.

Summary
COMPANY LAW PAGE 71

At common law, a shareholder would be permitted to sue on behalf of the company, as an exception
to Foss, in a derivative claim, but only if she could establish that the wrong to the company
amounted to ‘fraud’, and the company could not itself sue because it was controlled by the
wrongdoer(s). But these conditions were unclear in their meaning, and restrictively applied. The
hope was that the new statutory derivative claim procedure, in Part 11 CA 2006, would be both
clearer, and give the individual shareholder a greater chance of success. We must now see if this has
proved to be the case.

11.5 The statutory procedure: Part 11 of the CA 2006

As noted above, s.260(1) CA 2006 defines derivative claims as proceedings brought by a member of
a company in respect of a cause of action vested in the company and seeking relief on behalf of the
company.

The grounds for bringing a derivative claim are laid down by s.260(3), which provides that such a
claim may be brought only in respect of a cause of action arising from an actual or proposed act or
omission involving negligence, default, breach of duty or breach of trust by a director of the
company.

It is clear that claims against directors for any breach of their duties owed to the company fall within
its scope. In this respect s.260(3) is wider than the common law action it replaces. The breach no
longer needs to be one that is considered ‘fraud’ (with all the uncertainty about what fraud actually
meant). On a practical level, this means that a derivative claim now can be brought for a breach of
the duty to exercise reasonable care, skill and diligence (see s.174 CA 2006) whether or not that
breach is ‘self-serving’ (compare the case of Pavlides v Jensen, above). Section 260(3) also makes it
clear that a derivative claim may be brought, for example, against a third party who dishonestly
assists a director’s breach of fiduciary duty or one who knowingly receives property in breach of a
fiduciary duty.

It is also immaterial whether the cause of action arose before or after the person seeking to bring or
continue the derivative claim became a member of the company (s.260(4)).

Finally, note that CA 2006 does not say that the shareholder bringing the derivative claim must show
that the wrongdoers are in control of the company (recall that establishing ‘wrongdoer control’ was
one of the conditions under the common law rules). However, it is less clear whether this means this
condition no longer applies to the new statutory claim: see Kershaw, D. ‘The rule in Foss v Harbottle
is dead; long live the rule in Foss v Harbottle’ (2015) Journal of Business Law 274.

The application for permission to continue a derivative claim

Section 261 states that once a derivative claim has been brought, the member must apply to the
court for permission to continue it.

This entails a two stage process. The first stage involves a paper hearing, where the court considers
the member’s evidence. The onus is on the member to establish that they have a prima facie case
for permission to continue the derivative claim. If this is not demonstrated the court will dismiss the
application. If the application is dismissed at this stage, the applicant may request the court to
reconsider its decision at an oral hearing, although no new evidence will be permitted at this hearing
from either the member or the company. The Practice Direction 19C, Derivative Claims, which
amends Part 19 of the Civil Procedure Rules (CPR), provides that this stage of the application will
normally be decided without submissions from the company. If the court does not dismiss the
COMPANY LAW PAGE 72

application at this stage, the application will then proceed to the second stage, which is a full
permission hearing, and here the court may order the company to provide evidence at this stage.

Sections 263(2) and (3) sets out the criteria which the court must take into account when
determining whether to grant permission to a member to continue a derivative claim.

Section 263(2) contains three criteria that operate as what might be called ‘mandatory bars’, in the
sense that if any one of these criteria applies, the court must then refuse its permission to continue
the claim. So, permission must be refused if the court is satisfied that:

• a person acting in accordance with s.172 (duty to promote the success of the company)
would not seek to continue the claim; or
• where the claim arises from an act or omission that is yet to occur, that the act or omission
has been authorised by the company; or
• where the complaint arises from an act or omission that has already occurred, that act or
omission was authorised before it occurred, or has been ratified since it occurred.

For an example of a case where the court found that the breach of duty had been authorised or
ratified by the shareholders, see Re Singh Brothers Contractors (North West Limited) [2013] EWHC
2138 (Ch). In Cullen Investments Ltd v Brown [2015] EWHC 473 (Ch) the court made clear that for an
authorisation to be effective, the director would have to show that he had made a ‘full and frank
disclosure’ to the shareholders about his conduct. The same point would presumably apply to a
ratification.

For the first of these mandatory bars (whether a person is acting in accordance with s.172, etc.), the
issue here is really whether continuing the claim would be in the best interests of the company. In
Iesini v Westrip Holdings Ltd [2009] EWHC 2526 (Ch), Lewison J listed the considerations to take into
account in deciding whether it would be in the company’s interests to continue, or to stop, the
proceedings. These included:

• the size of the claim

• the strength of the claim
• the cost of the proceedings
• the company’s ability to fund the proceedings
• the ability of the potential defendants to satisfy a judgment
• the impact on the company if it lost the claim and had to pay not only its own costs but the
defendant’s as well
• any disruption to the company’s activities while the claim is pursued
• whether the prosecution of the claim would damage the company in other ways (e.g. by
losing the services of a valuable employee or alienating a key supplier or customer).

However, Lewison J also noted that a judge should only refuse permission under this mandatory bar
if ‘no reasonable director’ would think it worth proceeding with the claim. In other words, if there
were a reasonable doubt about whether it was in the company’s best interests to continue the
claim, then the judge ought not to stop proceedings on this ground.

Where none of the mandatory bars apply, the judge is not compelled to refuse permission. But nor
are they compelled to give permission to let it continue. Instead, the judge now has a discretion
what to do, and to exercise that discretion, they must move on and apply a list of ‘discretionary
factors’, set out in s.263(3). These factors are:
COMPANY LAW PAGE 73

• whether the member is acting in good faith

• the importance that a person acting in accordance with s.172 (duty to promote the success
of the company) would attach to pursuing the action
• whether prior authorisation or subsequent ratification of the act or omission would be likely
to occur
• whether the company has decided not to pursue the claim
• whether the shareholder could pursue the action in their own right.

In a number of cases, the courts have decided that the shareholder would be better off pursuing an
action in their own right. The action that the court has in mind here is a claim under s.994 CA 2006
for ‘unfair prejudice’ (see Chapter 12). See, for example, Mission Capital plc v Sinclair [2008] EWHC
1339 (Ch) and Franbar Holdings v Patel [2008] EWHC 1534 (Ch).

The reference above to whether ‘the company’ has decided not to pursue the claim means the
board of directors. In Kleanthous v Paphitis [2011] EWHC 2287 (Ch) the court placed some weight on
this factor, with the judge noting that the company’s directors were better placed than the judge to
determine the likely impact upon the company of either continuing, or stopping, the claim.

Section 263(4) goes on to add the requirement, as laid down in Smith v Croft (No.2) (above), that the
court ‘shall have particular regard’ to any evidence before it as to the views of members who have
no personal interest in the derivative claim. There will need to be a factual enquiry into whether or
not the breach is likely to be ratified. In practice the courts will probably adjourn the permission
hearing in order for the question of ratification to be put to the company.

Provision is also made for a member of the company to apply to the court to continue a derivative
claim originally brought by another member but which is being poorly conducted by him or her.
Section 264 provides that the court may grant permission to continue the claim where the manner in
which the proceedings have been commenced or continued by the original claimant amounts to an
abuse of the process of the court, the claimant has failed to prosecute the claim diligently and it is
appropriate for the applicant to continue the claim as a derivative claim. Similarly, by virtue of s.262,
where a company has initiated proceedings and the cause of action could be pursued as a derivative
claim, a member may apply to the court to continue the action as a derivative claim on the same
grounds listed in s.264. This addresses the situation where directors, fearing a derivative claim by a
member, seek to block it by causing the company to sue but with no genuine intention of pursuing
the action diligently.

In assessing the statutory reforms it is noteworthy that there is little or no change of emphasis in
terms of formulation. The focus of the rule laid down in Foss v Harbottle and its jurisprudence was
on prohibiting claims unless one of the exceptions to the rule was satisfied. The statutory language
similarly proceeds from the rather negative standpoint that the court must dismiss the application or
claim in the circumstances specified in ss.261(2), 262(3), 263(2)–(3) and 264(3).

The modern case law, though decided prior to the 2006 Act, suggests that the mandatory
requirement for permission cannot be dismissed as a mere technicality. It reflects the real and
important principles that the Court of Appeal reaffirmed in Barrett v Duckett and underlines the
need for the court to retain control over all the stages of a derivative action (see Portfolios of
Distinction Ltd v Laird). Against the background of the statutory criteria for granting permission to
continue the claim, the decision in Jafari-Fini v Skillglass [2005] EWCA 356, is of interest. The Court of
Appeal upheld the judge’s refusal to allow the derivative claim to continue. Chadwick LJ explained
COMPANY LAW PAGE 74

that the company itself would not benefit from the action and the claimant shareholder had
alternative avenues open to him, specifically a personal claim.

A major deterrent against speculative claims is, of course, costs. Although CPR, r.19.9E enables the
court to order the company to indemnify the member, in practice such an order will rarely be
granted where permission is denied. Finally, it is also noteworthy that the law on ratification has
been tightened and the votes of the ‘wrongdoers’ will no longer be counted on such ordinary
resolutions (although such members may be counted towards the quorum and may participate in
the proceedings; see further, ss.175 and 239 CA 2006).

11.6 The proceedings, costs and remedies

If permission is granted to continue the claim the member will bring the action on the company’s
behalf. The Civil Procedure (Amendment) Rules 2007 (SI 2007/2204), r.7 and Schedule 1 substitute
CPR 19.9 and inserts new CPR rr.19.9A – 19.9F. As noted above, the company for whose benefit a
remedy is sought must be made a defendant in the proceedings in order formally to be a party to
the action and be bound by any judgment.

If permission is granted to continue the claim the member will bring the action on the company’s
behalf. Unless otherwise permitted or required by r.19.9A or r.19.9C, the claimant may take no
further action in the proceedings without the permission of the court. A practical hurdle which
confronts a shareholder litigant is the cost of a proposed action. This is covered by r.19.9E. The court
may order the company to indemnify the claimant against any liability in respect of costs incurred in
the claim or in the permission application, or both. An application for costs made at the time of
applying for permission to continue the claim is commonly called a pre-emptive costs order. It
derives from the decision Wallersteiner v Moir (No.2) [1975] 2 QB 273, where Buckley LJ observed
that the shareholder who initiates the derivative claim may be entitled to be indemnified by the
company at the end of the trial for his costs provided he acted reasonably in bringing the action. The
position in the event of the action failing was also considered by the court. Lord Denning MR said:

But what if the action fails? Assuming that the minority shareholder had reasonable grounds for
bringing the action – that it was a reasonable and prudent course to take in the interests of the
company – he should not himself be liable to pay the costs of the other side, but the company itself
should be liable, because he was acting for it and not for himself. In addition, he should himself be
indemnified by the company in respect of his own costs even if the action fails. It is a well-known
maxim of the law that he who would take the benefit of a venture if it succeeds ought also to bear
the burden if it fails… In order to be entitled to this indemnity, the minority shareholder soon after
issuing his writ should apply for the sanction of the court in somewhat the same way as a trustee
does.

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

Finally, in Bhullar v Bhullar [2015] EWHC 1943 (Ch), the court refused to award an indemnity where
it felt that the claimant was using the derivative claim as a tactic to pressurise the majority, and that
the dispute between the parties was likely to be settled under s.994 CA 2006 (unfair prejudice
proceedings).
COMPANY LAW PAGE 75

Summary

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

12 Statutory minority protection

12.1 Winding up on the ‘just and equitable’ ground

12.1.1 Defining just and equitable grounds

Section 122(1)(g) of the Insolvency Act 1986 (IA 1986) provides that ‘a company may be wound up
by the court if the court is of the opinion that it is just and equitable that the company should be
wound up’. The provision derives from partnership law where the court had equitable jurisdiction to
dissolve a partnership where relations had broken down between the partners and the only
alternative was to dissolve the business. For companies the remedy has come to the fore in relation
to small private companies termed quasi-partnerships. Such companies are akin to partnerships
because the personal relationships between the directors (who generally have a number of roles, for
example as both shareholders and employees) are so crucial to the effective operation of the
company’s business that if confidence breaks down between them the company is effectively
disabled. A company that begins as a quasi- partnership might cease to be so as the relationship
between its members changes (becoming, perhaps, based less on personal trust and confidence, and
more on formal agreements between the parties): Re AMT Coffee Ltd [2019] EWHC 46 (Ch). A
company might be a quasi-partnership as between some of the members (who have a close personal
relationship) but not as between others (who may lack that close personal relationship): Waldron v
Waldron [2019] EWHC 115 (Ch).

It should be noted, however, that given the range of remedies available under the unfair prejudice
provision (see 12.2 below) that provision has now become the dominant means available to minority
shareholders seeking redress. However, it does not provide for winding up and so s.122(1)(g) IA 1986
is still of relevance.

Winding up on the just and equitable ground was subjected to extensive analysis by the House of
Lords in Ebrahimi v Westbourne Galleries Ltd [1973] AC 360. The company was incorporated to take
over the Oriental rug business which N and the petitioner, E, had been running as a partnership for
some 10 years. Initially N and E were equal shareholders and the only directors. When N’s son joined
the company as director and shareholder, E became a minority both within the board and at the
general meeting, where he could be outvoted by the combined shareholding of N and his son.
Relations between E on the one hand, and N and his son on the other, broke down and E was voted
off the board using the power conferred by s.303 CA 1985 (now s.168 CA 2006).

It was held that even though E had been removed from the board in accordance with the Companies
Act and the articles of association, the just and equitable ground conferred on the court the
COMPANY LAW PAGE 76

jurisdiction to subject the exercise of legal rights to equitable considerations. Since E had agreed to
the formation of the company on the basis that the essence of their business relationship would
remain the same as with their prior partnership, his exclusion from the company’s management was
clearly in breach of that understanding. It was therefore just and equitable to wind up the company.
Lord Wilberforce listed the typical elements in petitions brought under the just and equitable
ground.

• The basis of the business association was a personal relationship and mutual confidence
(generally found where a pre-existing partnership has converted into a limited company).
• An understanding that all or certain shareholders (excluding ‘sleeping’ partners) will
participate in management.
• There was a restriction on the transfer of members’ interests preventing the petitioner
leaving.

Lord Wilberforce stressed that the court was entitled to superimpose equitable constraints upon the
exercise of rights set out in the articles of association or the Companies Act. He went on to say that
the words ‘just and equitable’ are:

…a recognition of the fact that a limited company is more than a mere legal entity, with a personality
in law of its own: that there is room in company law for recognition of the fact that behind it, or
amongst it, there are individuals, with rights, expectations and obligations inter se which are not
necessarily submerged in the company structure…

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

The following are illustrations of the grounds which will support a petition under s.122(1)(g).

i. The company’s substratum has failed

The petitioner will need to establish that the commercial object for which the company was formed
has failed or has been fulfilled (see Re German Date Coffee Co (1882) 20 Ch D 169; Virdi v Abbey
Leisure Ltd [1990] BCLC 342; Re Perfectair Holdings Ltd [1990] BCLC 423).

ii. Fraud

The remedy will enable shareholders to recover their investment where the company was formed by
its promoters in order to perpetrate a fraud against them (see Re Thomas Edward Brinsmead & Sons
[1887] 1 Ch 45).

iii. Deadlock

If the relationship between the parties has broken down with no hope of reconciliation, the court
may order a dissolution (see Re Yenidje Tobacco Co Ltd [1916] 2 Ch 426). However, in Re Paramount
Powders (UK) Ltd [2019] EWCA Civ 1644, the court held that a petitioner had no automatic right to
have a company wound up merely because there had been a breakdown in mutual trust and
confidence between the members. The court might refuse a winding up in such a case if, for
example, the petitioner were responsible for that breakdown.

iv. Justifiable loss of confidence in the company’s management

COMPANY LAW PAGE 77

Winding up may be ordered where there is a lack of confidence in the competence or probity of its
management, provided the company is, in essence, a quasi-partnership (see Loch v John Blackwood
Ltd [1924] AC 783).

v. Exclusion from participation in a small private company where there was a relationship based on
mutual confidence

A classic example is the case of Ebrahimi v Westbourne Galleries (above).

12.1.2 Relationship with other remedies

Winding up is a measure of last resort. Thus where the petitioner is acting unreasonably in seeking
to have the company wound up instead of seeking an alternative remedy, such as a purchase of their
shares, or an order under s.994 CA 2006 (see below) the petition may be struck out (s.125(2) IA
1986). However, for a situation where the court decided that the company should be wound up,
because of the depth of the shareholders’ disagreement and their inability to agree a method for
valuing the minority’s shares, see Harding v Edwards [2014] EWHC 247 (Ch).

12.2 Unfair prejudice – s.994 CA 2006

Section 994(1) CA 2006, replacing s.459 CA 1985, provides that:

A member of a company may apply to the court by petition for an order… on the ground

that the company’s affairs are being or have been conducted in a manner which is unfairly
prejudicial to the interests of its members generally or of some part of its members (including at
least himself), or

that any actual or proposed act or omission of the company (including an act or omission on its
behalf) is or would be so prejudicial.

Although, as will be seen, s.996 provides for a range of remedies, petitioners generally seek an order
requiring the respondents, who are usually the majority shareholders, to purchase their shares.

The courts have adopted a flexible approach towards what constitutes ‘the company’s affairs’. Thus,
in Nicholas v Soundcraft Electronics Ltd [1993] BCLC 360, the Court of Appeal held that the failure of
a parent company (Soundcraft Electronics) to pay debts due to its subsidiary (in which the petitioner
was a minority shareholder) constituted acts done in the conduct of the affairs of the company. In Re
City Branch Group Ltd [2004] EWCA Civ 815, the Court of Appeal held that an order under s.994
could be made against a holding company where the affairs of a wholly-owned subsidiary have been
conducted in an unfairly prejudicial manner and the directors of the holding company are also the
directors of the subsidiary.

However, in Graham v Every [2014] EWCA Civ 191, the court held that an alleged breach of a pre-
emption provision in the company’s articles did not constitute the conduct of the company’s affairs,
as it concerned only the rights of the shareholders themselves. See also, Re Phoneer Ltd [2002] 2
BCLC 241; Gross v Rackind [2004] 4 All ER 735, CA; Re Legal Costs Negotiators Ltd [1999] 2 BCLC 171,
CA.

12.2.1 The elements of the remedy

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

‘Interests’
COMPANY LAW PAGE 78

Although the petitioner must be a shareholder in order to bring the action, the conduct which forms
the basis of his complaint need not affect him in his capacity as a member. For example, exclusion
from the management of the company, which is conduct affecting the petitioner qua director, will
suffice (O’Neill v Phillips [1999] 1 WLR 1092). The use of the term ‘interests’ is expansive in effect,
thereby effectively avoiding the straitjacket which terminology based on the notion of ‘rights’ would
impose on the scope of the provision (Re Sam Weller & Sons Ltd [1989] 5 BCC 810; see also Re a
Company (No.00477 of 1986) [1986] BCLC 376).

In Ebrahimi v Westbourne Galleries, Lord Wilberforce recognised that in most companies,

irrespective of size, a member’s rights under the articles of association and the Companies Act could
be viewed as an exhaustive statement of his or her interests as a shareholder. However, as we saw
above, he went on to list three situations in which equitable considerations could be ‘superimposed’.

1. Where there is a personal relationship between shareholders which involves mutual confidence.

2. Where there is an agreement that some or all should participate in the management.

3. Where there are restrictions on the transfer of shares which would prevent a member from
realising his or her investment.

This element of Lord Wilberforce’s speech received extensive consideration by the House of Lords in
O’Neill v Phillips [1999] 1 WLR 1092, in which it was concluded that for the purposes of s.994 the
court can apply equitable restraints to contractual rights.

Re Ghyll Beck Driving Range Ltd [1993] BCLC 1126 is an excellent example of a s.994 case. A father
and son, along with two other people, incorporated a company to operate a golf range. They were
each equal shareholders and directors. Within six months of the company’s existence the
relationship between the parties had become acrimonious due mainly to disagreements over
business strategy which left the petitioner feeling ‘isolated’. Following a fight between the father
and the petitioner the business was managed without consulting him. It was held that the petitioner
had been unfairly excluded from the management of the company when from the start it had been
anticipated that all four would participate in managing the business. The court therefore ordered the
majority to purchase the petitioner’s shares on the basis that the affairs of the company had been
conducted in a manner unfairly prejudicial to his interests.

However, it should be noted that s.994 does not mean that the judges administer arbitrary justice
without reference to the commercial relationship that exists between the parties. Indeed, Lord
Wilberforce had recognised in Ebrahimi that the starting point for the court was always to look to
the agreement between the parties, for example, as contained in the articles.

In Re a Company (No.004377 of 1986) [1987] BCLC 94, the majority, including the petitioner, voted
for a special resolution to amend the company’s articles so as to provide that a member, on ceasing
to be an employee or director of the company, would be required to transfer his or her shares to the
company. To remedy a situation of management deadlock, the petitioner was dismissed as director
and was offered £900 per share. When he declined this offer the company’s auditors valued his
shares in accordance with the pre-emption clauses. He petitioned the court under s.459 (now s.994)
to restrain the compulsory acquisition of his shares, arguing that he had a legitimate expectation
that he would continue to participate in the management of the company. Hoffmann J held that
there could be no expectation on the part of the petitioner that should relations break down the
article would not be followed. The judge stressed that s.994 could not be used by the petitioner to
relieve him from the bargain he made. Further, in Re Saul D Harrison & Sons plc [1995] 1 BCLC 14,
COMPANY LAW PAGE 79

Hoffmann LJ laid down guidelines for determining unfairness. He stressed that fairness for the
purposes of s.994 must be viewed in the context of a commercial relationship and that the articles of
association are the contractual terms which govern the relationships of the shareholders with the
company and each other. The first question to ask, therefore, is whether the conduct of which the
shareholder complains was in accordance with the articles of association.

Summary

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

Unfair prejudice

The petitioner must establish that the conduct in question is ‘both prejudicial (in the sense of
causing prejudice or harm) to the relevant interests and also unfairly so’ (Re a Company, ex p
Schwarcz (No.2) [1989] BCLC 427, per Peter Gibson J). In Re Ringtower Holdings plc (1988) 5 BCC 82,
Peter Gibson J stated that ‘the test is unfair prejudice, not of unlawfulness, and conduct may be
lawful but unfairly prejudicial…’ The notion of unfairness was considered by the Jenkins Committee
(Cmnd. 1749, 1962) to be ‘a visible departure from the standards of fair dealing and a violation of
the conditions of fair play on which every shareholder who entrusts his money to a company is
entitled to rely’ (para 204, adopting the view expressed by Lord Cooper in Elder v Elder & Watson Ltd
[1952] SC 49). Although there is no requirement that the petitioner should come to court with ‘clean
hands’, his or her conduct will be relevant in assessing whether the conduct of the company, though
prejudicial, is unfair.

In O’Neill v Phillips [1999] WLR 1092 (the only House of Lords decision on the unfair prejudice
remedy so far) Lord Hoffmann held that fairness was to be determined by reference to ‘traditional’
or ‘general’ equitable principles. He stressed that company law developed from the law of
partnership – which was treated by equity as a contract of good faith. The facts of O’Neill v Phillips
were that the company, Pectel Ltd, provided asbestos stripping services to the construction industry.
In 1983 the issued share capital of the company, 100 £1 shares, was owned entirely by Mr Phillips
(P). Mr O’Neill (O) was employed by the company in 1983 as a manual worker. P was favourably
impressed by O and he received rapid promotion.

In early 1985 O received 25 per cent of the company’s shares and he was made a director. In May
1985 O was informed by P that he, O, would eventually take over the running of the company’s
business and at that time would receive 50 per cent of the profits. In December 1985 P retired from
the board and O became sole director and effectively the company’s managing director.

The business enjoyed good profitability for a while, but its fortunes declined during the economic
recession of the late 1980s. In August 1991, disillusioned with O’s management of the business, P
used his majority voting rights to appoint himself managing director and took over the management
of the company. O was informed that he would no longer receive 50 per cent of the profits but his
entitlement would be limited to his salary and dividends on his 25 per cent shareholding. Early
COMPANY LAW PAGE 80

discussions about further share incentives when certain targets were met were aborted. O
thereupon issued a petition alleging unfairly prejudicial conduct on the part of P.

The House of Lords found that P’s conduct would have been unfair had he used his majority voting
power to exclude O from the business. He had not done this, but had simply revised the terms of O’s
remuneration. P’s refusal to allot additional shares as part of the proposed incentive scheme was
not unfair as the negotiations were not completed and no contractual undertaking had been entered
into by the parties. Nor was P’s decision to revise O’s profit-sharing arrangement considered to be
unfair conduct. O’s entitlement to 50 per cent of the company’s profits was never formalised and it
was, in any case, conditional upon O running the business. That condition was no longer fulfilled as P
had to assume control over the running of the business. Although O argued that he had lost trust in
P, that alone could not form the basis for a petition under the unfairly prejudicial conduct provision.
To hold otherwise would be to confer on a minority shareholder a unilateral right to withdraw his
capital. O’s petition therefore failed. He did not prove that P’s conduct was both unfair and
prejudicial.

Thus, a petitioner will need to demonstrate either that they relied on some pre- association
understanding, or a post-association agreement that was either legally binding or that they
specifically relied on. (For recent examples, see the approach of Jonathan Parker J in Re Guidezone
Ltd [2000] 2 BCLC 321 and the comments of Auld and Jonathan Parker LJJ in Phoenix Office Supplies
Ltd v Larvin [2002] EWCA Civ 1740 to the effect that a petitioner cannot enlist s.994 to force a right
of exit from the company that does not exist under the company’s constitution.) On the other hand,
the failure on the part of the majority shareholders to hold meetings and to otherwise conduct the
affairs of the company as a going concern will be held to be unfairly prejudicial to the interests of the
minority (Fisher v Cadman [2005] EWHC 377 (Ch)).

A mere breakdown in relationship between the shareholders, which is not caused by conduct in the
company’s affairs that is unfairly prejudicial, is insufficient (although such a breakdown might, if
sufficiently serious, justify a winding up order under s.122(1)(g) Insolvency Act 1986); see Hawkes v
Cuddy (No.2) [2009] EWCA Civ 291.

Examples of unfair prejudice include the following.

• Exclusion from management, which is a typical s.994 complaint (see Re XYZ Ltd (No.004377
of 1986) [1987] 1 WLR 102; Re Ghyll Beck Driving Range Ltd (above); Brownlow v GH
Marshall Ltd [2001] BCC 152; Phoenix Office Supplies Ltd v Larvin [2002] EWCA Civ 1740).
• Mismanagement (breach of the directors’ duties of care and skill) (see Re Elgindata Ltd
[1991] BCLC 959; and Re Macro (Ipswich) Ltd [1994] 2 BCLC 354).
• Excessive remuneration taken by the directors and the failure to pay dividends (see Re Sam
Weller & Sons Ltd [1990] Ch 682; Re a Company (No.004415 of 1996) [1997] 1 BCLC 479; Re
Cumana Ltd [1986] BCLC 430; Anderson v Hogg [2002] BCC 923; Grace v Biagioli [2006] 2
BCLC 70; Re Tobian Properties Ltd [2012] EWCA Civ 998; Re CF Booth Ltd [2017] EWHC 457
(Ch)).
• Breach of fiduciary duties – the case law shows that s.994 may be used to obtain a personal
remedy despite the rule in Foss v Harbottle (see Re London School of Electronics Ltd [1986]
Ch 211; Re Little Olympian Each-Ways Ltd (No.3) [1995] 1 BCLC 636).
• See also, Re Baumler (UK) Ltd [2005] 1 BCLC 92; Re Cumana Ltd [1986] BCLC 430, CA. It
should be noted that in Re Baumler (UK) Ltd, George Bompas QC (sitting as a Deputy Judge
of the High Court) observed that in the case of a quasi-partnership company, a breach of
duty by one participant may lead to such a loss of confidence on the part of the innocent
COMPANY LAW PAGE 81

participant and breakdown in relations that the innocent participant is entitled to relief
under s.996 of the CA 2006 (see below). The judge noted that, in effect, the unfairness lies in
compelling the innocent participant to remain a member of the company.

Summary

In Re Saul D Harrison and O’Neill v Phillips Lord Hoffmann took the opportunity to inject content into
the concept of fairness. He reaffirmed the sanctity of the s.33 contract (see Chapter 9 of this guide).
The House of Lords stressed that the remedy did not confer on the petitioner a unilateral right to
withdraw his capital. In order to succeed under s.994 a petitioner will need to prove either a breach
of contract (including the s.33 contract) or breach of a fundamental understanding which, although
lacking contractual force, makes it inequitable for the majority to go back on the ‘promise’.

This emphasis on respecting the parties’ own agreements seems also to be evident in the case of
Fulham Football Club (1987) Ltd v Richards [2011] EWCA Civ 855, where the court upheld a provision
in the company’s articles which obliged a member to refer disputes to arbitration rather than
seeking relief under s.994.

12.2.2 Remedies

Section 996(1) CA 2006 provides that the court:

may make such order as it thinks fit for giving relief in respect of the matters complained of.

Section 996(2) goes on to add that:

Without prejudice to the generality of subsection (1), the court’s order may: regulate the conduct of
the company’s affairs in the future;

require the company–

to refrain from doing or continuing an act complained of, or

to do an act which the petitioner has complained it has omitted to do,

authorise civil proceedings to be brought in the name and on behalf of the company by such person
or persons and on such terms as the court may direct;

require the company not to make any, or specified, alterations in its articles without the leave of the
court;

provide for the purchase of the shares of any members of the company by other members or by the
company itself and, in the case of a purchase by the company itself, the reduction of the company’s
capital accordingly.

Note the width of the court’s powers under s.996(1) (compare the winding up remedy, above). In Re
Phoneer Ltd, the petitioner sought a winding up order on the just and equitable ground and the
respondent cross-petitioned for winding up under s.994. Roger Kaye QC, granting a winding up order
since both parties obviously desired it, noted that ‘section 996 enables, but does not compel, the
court to make an order under that section’. Although the respondent held 70 per cent of the shares,
the judge felt that on the facts of the case ‘justice is served by ordering the winding up of the
company… on the basis of a 50/50 split’. The court can fashion a remedy to the wrong done: see Re
A Company ex parte Estate Acquisition & Development Ltd [1991] BCLC 154.
COMPANY LAW PAGE 82

Section 996(2) specifies certain remedies available (see above). The most common remedy sought is
that under s.996(2)(e) (purchase of shares). Indeed, in Grace v Biagioli [2005] EWCA Civ 1222 , the
Court of Appeal affirmed the view that there is a presumption in favour of a buyout order for
successful unfair prejudice petitions.

Valuation of shares

Valuing shares in quoted companies is a fairly straightforward exercise because reference can be
made to their market price. For unquoted companies – and the vast majority of s.994 petitions fall
within this category – the valuation exercise is a far more difficult undertaking. The court has a wide
discretion to do what is fair and equitable in all the circumstances of the case and under the Civil
Procedure Rules the court is expected to adopt a vigorous approach towards share valuation (North
Holdings Ltd v Southern Tropics Ltd [1999] BCC 746).

In Re Bird Precision Bellows Ltd [1984] Ch 419, affirmed by the Court of Appeal [1985] 3 All ER 523,
the court reviewed the approach to be adopted towards valuing shares. It was stressed that the
overriding objective was to achieve a fair price and that normally no discount would be applied.
Thus, a 49 per cent shareholding in the company will be valued pro rata, being worth 49 per cent of
whatever the company as a whole is worth. This (generous) approach was justified on the grounds
that the petitioner is an unwilling vendor of what is, in effect, a partnership share. One issue that has
generated a considerable amount of case law is whether this presumption in favour of a pro rata
valuation should apply to all companies or only to those companies that are quasi- partnerships. In
Irvine v Irvine [2006] EWHC 1875 (Ch), the High Court had suggested that this pro rata principle
would apply only in a quasi-partnership. In Re Blue Index Ltd [2014] EWHC 2680 (Ch), on the other
hand, the court felt that restricting the pro rata approach to quasi-partnerships was inappropriate
and declared that the pro rata principle would apply in all companies. However, in Estera Trust
(Jersey) Ltd v Singh [2018] EWHC 1715 (Ch), the court suggested, again, that the pro rata
presumption applied only to quasi- partnerships. The law on this point, then, remains rather
uncertain. Even where the pro rata presumption does apply, it is rebuttable if there are good
reasons for applying a discount. If, for example, the minority shareholder acquired her shares by way
of an investment then a discount may, in the circumstances, be fair so as to reflect the fact that the
petitioner has little control over the company’s management (see the speech of Lord Hoffmann in
O’Neill v Phillips; see also, Profinance Trust SA v Gladstone [2002] 1 BCLC 141, CA).

13 Dealing with outsiders: ultra vires and other attribution issues

Introduction

As we discussed briefly in Chapter 9, companies were at one time conferred with the power in their
constitutional documents to carry out certain specific functions (the objects) by a specific statute or
grant from the Crown.

The objects clause was a necessary part of the constitutional documents of early charter and statute
companies as they were formed to carry out certain functions by a specific charter or statute.
However, as the registered company opened up corporate status to ordinary businesses, a particular
problem arose. These registered companies were also required to have specific purposes (objects) in
their memorandum but were much more likely to change the nature of their business over time.
This was both a problem for companies who legitimately wished to change the nature of their
business and for outsiders who were dealing with the company and were in danger of having
unenforceable contracts because the company was acting outside its powers. Over time the courts
became somewhat flexible about the issue but eventually statutory intervention was needed to
COMPANY LAW PAGE 83

solve the remaining problems. The chapter also considers how responsibility is attributed to the
company for tortious and criminal actions.

Learning outcomes

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

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

13.1 The objects clause problem

Two key issues combined in this area to cause problems. First, in the 19th century it was impossible
to change a company’s objects clause. This was modified somewhat in the 20th century, but until
1989 the objects clause could only be changed in very limited circumstances. Second, the doctrine of
constructive notice could combine with the ultra vires rule to leave outsiders with unenforceable
contracts. The doctrine of constructive notice applies to public documents. A company’s
memorandum and articles of association are public documents which are provided as part of the
registration process and constructive notice deems anyone dealing with registered companies to
have notice of the contents of its public documents. As a result an outsider dealing with a company
is deemed to have knowledge of its objects clause and has therefore entered into the unenforceable
contract with that knowledge.

In the late 19th century the courts adopted a fairly strict interpretation of the ultra vires rule. In
Ashbury Carriage Company v Riche (1875) LR 7 HL 653 the House of Lords considered that the ultra
vires doctrine did apply to registered companies. If a company incorporated by, or under, statute
acted beyond the scope of the objects stated in the statute or in its memorandum of association
such acts were void as beyond the company’s capacity even if ratified by all the members. Over the
course of the 20th century the courts retreated from this strict position, allowing companies to carry
out transactions reasonably incidental to the objects of the company and eventually accepting very
wide objects clauses as being valid – either a list of all possible commercial activities or a statement
that the company could carry out any commercial venture it wished. However, problems still
remained.

Some examples

In Re Jon Beauforte (London) Ltd [1953] Ch 131 the company’s objects stated that it was to carry on
a business as gown makers but the business had evolved into making veneered panels. No change
had been made to the objects clause to reflect this change. A coal merchant had supplied coal to the
company which was ordered on company notepaper headed with a reference to the company being
a veneered panel maker. The coal merchant was deemed because of constructive notice to know of
the original objects clause and because of the headed notepaper to have actual notice of the change
in the business. As a result the transaction was ultra vires and void.

In Re Introductions Ltd v National Provincial Bank (1970) Ch 199 the case concerned a company
incorporated in 1951, around the time of the Festival of Britain, with the specific object of providing
foreign visitors with accommodation and entertainment. After the Festival was over the company
diversified and eventually devoted itself solely to pig breeding, which the original framers of the
objects had not considered (naturally enough). The company had granted National Provincial Bank a
COMPANY LAW PAGE 84

debenture (see Chapter 7) to secure a substantial overdraft which had accumulated prior to its
eventual insolvent liquidation. The company was held to have acted ultra vires and therefore the
transaction was void and the bank could not enforce the debenture or even claim as a normal
creditor in the liquidation (see Chapter 17 on the statutory liquidation procedure).

As a result of cases like this it was generally agreed that only legislative intervention could solve the
problem in the long term.

Summary

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

13.2 Reforming ultra vires

13.2.1 Changes following EC membership

In 1972 the UK joined the European Community and as part of its obligations on entry it introduced
legislation reforming ultra vires in s.9(1) of the European Communities Act 1972. This removed the
doctrine of constructive notice where it concerned the memorandum and articles of association. It
also contained a saving provision for ultra vires transactions where the transaction was dealt with by
the directors and the third party was acting in good faith. While this reform narrowed the extent of
the ultra vires rule it still left the potential for problems to arise. In 1989 further reforms were
introduced which allowed the memorandum to be easily changed and for the company to have a
general wide objects clause (ss.4 and 3A CA 1985). Three new sections (ss.35, 35A and 35B) were
also introduced. Section 35 thus became the main saving provision for outsiders in classic ultra vires
situations. It stated:

(1) The validity of an act done by a company shall not be called into question on the ground of lack
of capacity by reason of anything in the company’s memorandum.

Under the CA 1985 the memorandum formed part of the company’s constitution. Now, however, s.8
of the CA 2006 has reduced the memorandum of association to a more limited function. The
memorandum is now a simple document providing certain basic information and key declarations to
the public which state that subscribers wish to form the company and agree to become members
taking at least one share each. The subscribers to the memorandum are those who agree to take
some shares or share in the company, thus becoming its first members. If the application to the
Registrar is successful the subscribers become the first members of the company and the proposed
directors become its first directors.

To eliminate any remaining problems with the objects clause the CLRSG, in the Final Report (July
2001 para 9.10) and the Consultative Document (March 2005, Chapter 5), proposed that companies
be formed with unlimited capacity. The CA 2006 partly implements the recommended approach.
Companies registered under the 2006 Act have unrestricted objects unless a company chooses to
have an objects clause stating what it is empowered to do (s.31 CA 2006). If a company does choose
to have an objects clause, and for companies formed under the previous Principal Acts in 1948 and
1985 with an objects clause (unless these companies now remove their objects clause (s.31(2) CA
2006)), the objects clause forms part of the articles of association (s.28 CA 2006).
COMPANY LAW PAGE 85

As most companies currently in existence were formed under principal Companies Acts that
required an objects clause, this change will only really affect companies newly incorporated under
the CA 2006. For companies already in existence with an objects clause, that clause still operates to
restrict them and will now become part of their articles of association (s.28 CA 2006). In recognition
of the fact that a large number of companies will still have an objects clause, s.35 CA 1985 has been
replaced by an almost exact replica in s.39 CA 2006 which states:

(1) The validity of an act done by a company shall not be called into question on the ground of lack
of capacity by reason of anything in the company’s constitution.

As a result of the reform process, what were traditional ultra vires actions became a question of
whether the required internal authority to transact was given to those who transacted with the
outsider.

13.2.2 Internal authority

When examining issues of internal corporate authority, agency principles and specific statutory
provisions will usually determine the outcome. Normal principles of agency provide that a principal
will be bound by a contract entered into on his behalf by his agent if that agent acted within either
the actual scope of the authority given by the principal before the contract or the apparent or
ostensible scope of his authority. The principal may also ratify a contract entered into without
authority. Companies, because of their complexity, pose certain problems for agency principles.
While specific authority is conferred on the board to run the company, once the authority goes
below board level actual authority in the context of a corporation or any other complex organisation
can be difficult to locate conclusively. This is because authority to carry out some functions may not
be specifically conferred but rather is implicit in the nature of the job. A ‘stationery manager’ may
not have any actual authority to purchase stationery, yet it is implicit in his appointment that he is
empowered to do so. Further authorisation can be given through apparent or ostensible authority.
This arises when no actual authority is conferred, yet the company allows someone to hold
themselves out as having that authority – for example, allowing someone to act as managing
director even though they have never been appointed (see, for example, Freeman & Lockyer v
Buckhurst Park Properties Ltd [1964] 2 QB 480; MCI WorldCom International Inc v Primus
Telecommunications Inc [2004] 1 BCLC 42).

Here again the company’s constitution can cause problems for outsiders dealing with the company.
Sometimes the constitution will specify a procedure that has to be carried out before authority is
conferred. For example, it is common for directors to have to seek approval of the general meeting
for large loans. Again the doctrine of constructive notice could potentially be problematic here. In
Royal British Bank v Turquand (1856) 6 E & B 327 an action was brought for the return of money
borrowedby the company. The company argued that it was not required to pay back the money
because the manager who negotiated the loan should have been authorised by a resolution of the
general meeting to borrow but he had no such authorisation. As a result of constructive notice the
bank was deemed to know this. In attempting to mitigate this effect the court held that the public
documents only revealed that a resolution was required, not whether the resolution had been
passed. The bank had no knowledge that the resolution had not been passed and thus it did not
appear on the face of the public documents that the borrowing was invalid. Outsiders are therefore
entitled to assume that the internal procedures have been complied with. This is known as the
indoor management rule.
COMPANY LAW PAGE 86

The Companies Act 1989 introduced ss.35A and 35B into the CA 1985. Both these sections concern
the issue of internal authority.

Section 35A states:

(1) In favour of a person dealing with a company in good faith, the power of the board of directors to
bind the company, or authorise others to do so, shall be deemed to be free of any limitation under
the company’s constitution.

(2) For this purpose

(a) a person ‘deals with’ a company if he is a party to any transaction or other act to which the
company is a party;

(b) a person shall not be regarded as acting in bad faith by reason only of his knowing that an act is
beyond the powers of the directors under the company’s constitution; and

(c) a person shall be presumed to have acted in good faith unless the contrary is proved.

The section had the effect of protecting outsiders who deal either directly with the board or those
authorised to bind the company. It is worth noting that the section set the standard of bad faith
fairly high as sub-s.2(b) specifically allowed third parties to have knowledge that the transaction was
irregular. As a result it implied that active dishonesty might be required in order to qualify as bad
faith (see EIC Services Ltd v Phipps [2004] 2 BCLC 589). To further emphasise the lower good faith
requirement sub- s.2(c) set a presumption of good faith.

The section also contained a similar provision to s.35 allowing shareholders to prevent an imminent
irregular transaction and protected insiders who deal with the company, which the indoor
management rule did not. However, s.322A CA 1985 was also introduced as an amendment to the
CA 1985 by the CA 1989 and s.35A was subject to it. That section provided that a transaction
between the company and a director or a person connected to him (family, etc.) which exceeded the
powers of the board was voidable at the instance of the company.

Section 35B CA 1985 also attempted to deal with the issue of constructive notice. It states:

[a] party to a transaction with the company is not bound to enquire as to whether it is permitted by
the company’s memorandum or as to any limitation on the powers of the board of directors to bind
the company or authorise others to do so.

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

13.2.3 Further internal authority reform in the CA 2006

With regard to internal authority the CA 2006 makes little change to previous law simply replicating
the provisions of ss.35A and 35B CA 1985 in one new section (s.40 CA 2006).

40 Power of directors to bind the company

In favour of a person dealing with a company in good faith, the power of the directors to bind the
company, or authorise others to do so, is deemed to be free of any limitation under the company’s
constitution.

For this purpose—

COMPANY LAW PAGE 87

a person “deals with” a company if he is a party to any transaction or other act to which the
company is a party,

a person dealing with a company—

is not bound to enquire as to any limitation on the powers of the directors to bind the company or
authorise others to do so,

is presumed to have acted in good faith unless the contrary is proved, and

is not to be regarded as acting in bad faith by reason only of his knowing that an act is beyond the
powers of the directors under the company’s constitution.

The references above to limitations on the directors’ powers under the company’s constitution
include limitations deriving—

from a resolution of the company or of any class of shareholders, or

from any agreement between the members of the company or of any class of shareholders.

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

(4) This section does not affect any liability incurred by the directors, or any other person, by reason
of the directors’ exceeding their powers.

(5) This section has effect subject to— section 41 (transactions with directors or their associates),
and section 42 (companies that are charities).

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

Summary

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

13.3 Other attribution issues

13.3.1 Vicarious liability in tort

Agency and statutory provisions, however, have not solved all the problems inherent in attributing
responsibility to a company for its actions. Corporate liability for tort was one such problem that the
courts originally had great difficulty with in the corporate context. At first the courts considered that
a tort was an ultra vires act in that a company could never be authorised by its objects clause to
commit a tort. However, in Campbell v Paddington [1911] 1 KB 869 it was accepted that companies
could commit torts and the courts have subsequently applied the principle of vicarious liability to the
company as employer. As a result a company can be vicariously liable in tort for the acts of its
employees, even though they may not be specifically authorised to carry out the act that leads to
the tort but are nevertheless acting within the scope of their employment. It is important to note
here that attribution through vicarious liability in the context of a tort involves no fault on the part of
COMPANY LAW PAGE 88

the company: it is simply legally responsible for the acts of another. Where a fault qualification or
intention is required by law, attribution of liability becomes more complex. As a result, vicarious
liability will not attribute criminal liability for the act of an employee. Where fault or intention is
needed the courts began to develop a complex attribution concept known as the alter ego or
‘organic’ theory of the company.

13.3.2 The ‘organic’ theory

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

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

As a result, if one individual can be identified who can be said to be essentially the company’s alter
ego and that individual has the required fault, then the fault of that individual will be attributed to
the company. The attribution of responsibility here is very different than through vicarious liability in
tort, where the company is responsible for the actions of another. The individual’s fault here is
attributed to the company because the law treats the individual and the company as the same
person. There is, however, a central problem with the alter ego theory in that it required the
identification of a single individual in what was often a complex corporate organisational structure.
This was often not possible unless a very small company was at issue. The theory has been
particularly problematic in attributing criminal responsibility to companies, especially when
attempting to determine the company’s mens rea or guilty mind.

In Tesco Supermarkets Ltd v Nattrass [1971] 2 All ER 127 Tesco was charged with an offence under
the Trade Descriptions Act 1968. They had advertised goods at a reduced price but sold them at a
higher price. In order to avoid conviction Tesco had to show that they had put in place a proper
control system. Tesco argued that they had and that the manager of the store had been at fault. The
court considered whether the manager was acting as an organ of the company. Lord Reid found
that:

[a] living person has a mind which can have knowledge or intention or be negligent and he has hands
to carry out his intentions. A corporation has none of these; it must act through living persons,
though not always one or the same person. Then the person who acts is

not speaking or acting for the company. He is acting as the company and his mind which directs his
acts is the mind of the company. There is no question of the company being vicariously liable. He is
not acting as a servant, representative, agent or delegate. He is an embodiment of the company or,
one could say, he hears and speaks through the persona of the company, within his appropriate
sphere, and his mind is the mind of the company.

In this case the manager who was at fault was not the guiding mind and therefore Tesco could not
be liable for his action. Subsequently the application of the organic theory has effectively acted as an
COMPANY LAW PAGE 89

immunity from criminal prosecution for large complex corporate organisations where it is impossible
to identify a single individual responsible for the company’s action.

13.3.3 The issue of control

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

13.3.4 Corporate responsibility for injury and death

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

Summary

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

14 The management of the company

Introduction

The first part of this chapter considers the relationship between the board of directors and the
general meeting. It then goes on to outline the various categories of director, their appointment and
COMPANY LAW PAGE 90

removal. It also discusses the Company Directors Disqualification Act 1986 (CDDA 1986) relating to
the disqualification of ‘unfit’ directors.

Learning outcomes

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

• define the term ‘director’

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

14.1 Directors

14.1.1 Defining the term ‘director’

As we saw in Chapter 3, companies are artificial legal entities and as such they must operate through
their human organs. The management of the company is vested in the board of directors, who are
expected to act on a collective basis, although the articles may – and in large companies generally do
– provide for delegation of powers to smaller committees of the board or to individual directors. It
should be borne in mind that in small private companies the same individuals may wear a number of
hats: as directors, workers and shareholders. In large companies, however, there is generally a clear
division between the board and the shareholders (although it should be borne in mind that even
here directors will often receive shares as part of their remuneration package).

The Companies Act 2006 (CA 2006) does not define the term ‘director’ beyond stating in s.250 that
the term ‘includes any person occupying the position of director, by whatever name called’. Thus,
whatever title the articles adopt to describe themembers of the company’s board (for example,
‘governors’), the law will nevertheless view them as directors. Section 154 lays down the minimum
number of directors that companies must have: two for public companies and one for private
companies. The Small Business, Enterprise and Employment Act 2015 inserted a new s.156A into the
CA 2006. This requires all those appointed as directors to be natural persons. Therefore, it is no
longer possible, for example, for a company to be appointed as a director – what was known as a
‘corporate director’. Any existing corporate directors will cease to be directors 12 months after
s.156A is brought into force.

14.1.2 The position of the board of directors

The CA 2006 does not attribute specific roles to company directors. The Act is also silent with
respect to the structure and form of corporate management, leaving such matters to the company’s
constitution.

Although it is now accepted that in the modern company the board enjoys a position of
management autonomy this has not always been the case. Until the end of the 19th century the
general meeting of the company had constitutional supremacy: the board of directors was viewed as
its agent and had to act in accordance with decisions of the general meeting. However, by the early
20th century, with shareholding becoming more dispersed and directors beginning to be appointed
on the basis of professional merit rather than social standing, articles of association were drafted so
as to give boardrooms greater independence. Consequently, the judicial response was that the
board should no longer be viewed as the agent or servant of the general meeting. In Automatic Self-
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cleansing Filter Syndicate Co Ltd v Cunninghame [1906] 2 Ch 34 the question for the Court of Appeal
was whether the directors were bound to give effect to an ordinary resolution of the general
meeting requiring them to sell the company’s undertaking to a new company incorporated for the
purpose. The company’s articles of association, in terms similar to article 3 of the model articles of
association for private and public companies (see below), provided that ‘the management of the
business and the control of the company’ was in the hands of its directors. Collins MR, having
reviewed the relevant article, explained that:

it is not competent for the majority of the shareholders at an ordinary meeting to affect or alter the
mandate originally given to the directors by the articles of association… the mandate which must be
obeyed is not that of the majority – it is that of the whole entity made up of all the shareholders.

See also Gramophone and Typewriter Ltd v Stanley [1908] 2 KB 89; and John Shaw & Sons (Salford)
Ltd v Shaw [1935] 2 KB 113.

This ‘balance of power’ between the shareholders and the directors is now confirmed by article 3
(directors’ general authority) of the model articles of association for both private and public
companies the equivalent provision of the 1985 Table A, namely article 70, was also drafted in very
similar terms). Article 3 confers on the board virtual managerial autonomy. Article 3 provides:

Directors’ general authority

Subject to the articles, the directors are responsible for the management of the company’s business,
for which purpose they may exercise all the powers of the company.

However, even though directors are, by virtue of article 3, given the power to manage the company,
this does not mean that shareholders are denied any say within the company. First, article 4 of the
model articles for both private and public companies allows shareholders to ‘give directions’ to the
board. Article 4 provides that:

Shareholders’ reserve power: ‘The shareholders may, by special resolution, direct the directors to
take, or refrain from taking, specified action.

Thus, shareholders can instruct the board how to act, but crucially, for such an instruction to be
binding on the directors, it must be passed as a special resolution (which requires a 75 per cent
majority). The CA 2006 also empowers the shareholders to take a number of decisions within the
company, for example dealing with alterations to the articles (s.21); share capital (ss.617 and 641);
and the allotment of shares (ss.549 and 551). If shareholders disapprove of a director they can
remove him from office by ordinary resolution (s.168 CA 2006, see Section 14.1.5). Moreover,
executive power will revert to the general meeting where the board of directors is deadlocked so
that it is incapable of managing the company (Barron v Potter [1914] 1 Ch 895).

Summary

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

14.1.3 Appointment of directors

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Subject to certain statutory provisions, the appointment of directors is left to the articles of
association. Section 16(6) CA 2006 provides that the persons named in the statement of proposed
officers are, on the company’s incorporation, deemed to be its first directors and secretary. We have
seen above that s.154 stipulates the minimum number of directors for companies. Section 160 goes
on to provide that for public companies the appointment of directors shall be voted on individually.
Section 157 lays down the minimum age of 16 for appointment as a director. Beyond these
particular statutory provisions the CA 2006 is silent on boardroom appointments, leaving the issue
to the articles of association.

Although first directors are appointed in accordance with s.12 CA 2006 their successors are elected
by the shareholders in a general meeting. Article 20 of the model articles of association for public
companies (the 1985 Table A, article 73) provides that at the first annual general meeting (AGM) all
the directors shall retire from office and at every subsequent AGM any directors who have been
appointed by the directors since the last AGM or who were not appointed at one of the preceding
two AGMs, must retire from office. It should be noted that this requirement does not appear in the
model articles for private companies.

Summary

Sections 154–167 CA 2006 govern the appointment and registration of directors. The principal
requirements for appointment are:

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

14.1.4 Directors’ remuneration

As with trustees, directors are not entitled as of right to be paid for their services unless the articles
of association or a service contract between them and the company provide otherwise (Re George
Newman & Co [1895] 1 Ch 674). Article 18 (model articles of association for private companies) and
article 22 (model articles of association for public companies) provide that the directors shall be
entitled to such remuneration as they determine.

Given the power of directors to set their own remuneration, issues of transparency and
accountability obviously arise. The temptation for directors to vote themselves ‘fat cat’ awards has
generated much debate over the past 20 years or so and this is considered in the corporate
governance section of this chapter. For the present it should be noted that the BIS (formerly the DTI)
published a number of proposals for reinforcing the accountability of directors to shareholders over
boardroom pay awards (see the DTI consultative documents, Directors’ Remuneration (URN 99/923)
(London, DTI, 1999) and (URN 01/1400) (London DTI, 2001)). A significant proposal was that there
should be a mandatory requirement for the company’s annual report to contain a statement of
remuneration policy and details of the remuneration of each director. This was first implemented for
all quoted companies for financial years ending on or after 31 December 2002 by statutory
COMPANY LAW PAGE 93

instrument (the Directors’ Remuneration Report Regulations 2002 (SI 2002/1986)), which came into
force on 1 August 2002, and is now incorporated into the ss.420–422 CA 2006.

The remuneration report must be approved by the board of directors and signed on behalf of the
board by a director or secretary of the company (s.422(1)). Besides requiring companies to supply
shareholders with more information through the remuneration report, the 2002 Regulations also
required the report to be put before the shareholders, and voted on by them. Initially, this vote was
only ‘advisory’, so that boards might lawfully choose to ignore a negative vote by shareholders.
However, s.439 CA 2006 (which was introduced by s.79 Enterprise and Regulatory Reform Act 2013)
makes the shareholders’ vote binding as to the company’s remuneration ‘policy’. To explain: each
quoted company must have its policy on executive remuneration approved by shareholders every
three years, and the company can only then pay its executive directors in accordance with the
approved remuneration policy.

Section 412 of the CA 2006 requires disclosure in the annual accounts of directors’ emoluments,
including present and past directors’ pensions and compensation for loss of office. Sections 228–330
provide that the terms of a director’s service contract must be made available for inspection either
at its registered office or the place where its register of members is kept if other than its registered
office. Breach of this requirement may result in a fine on conviction.

14.1.5 Removal of directors

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

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

14.2 Categories of director

14.2.1 Executive and non-executive directors

Executive directors are full-time officers who generally have a service contract with the company.
The articles will normally provide for the appointment of a managing director, sometimes called a
COMPANY LAW PAGE 94

chief executive, who has overall responsibility for the running of the company. Non-executive
directors are normally appointed to the boards of larger companies to act as monitors of the
executive management. They are typically part-time appointments. For the role of non-executive
directors see Section 14.4 of this chapter.

14.2.2 De facto directors

A de facto director is one who has not been formally appointed but has nevertheless acted as a
director (Re Kaytech International plc [1999] BCC 390, CA). The issue of whether or not an individual
is a de facto director generally arises in relation to disqualification orders under the Company
Directors Disqualification Act (CDDA) 1986 (see below). The courts have formulated guidelines for
determining the issue. In Re Richborough Furniture Ltd [1996] BCC 155, Lloyd J stated that emphasis
should be given to the functions performed by the individual concerned (see also Secretary for State
for Trade and Industry v Jones [1999] BCC 336). In Secretary of State for Trade and Industry v Tjolle
[1998] BCC 282 Jacob J stated that the essential test is whether the person in question was ‘part of
the corporate governing structure’. This was approved by the Court of Appeal in Re Kaytech
International plc.

In Secretary of State for Trade and Industry v Hollier [2006] EWHC 1804 (Ch), Etherton J, having
made the point that no one can simultaneously be a de facto and a shadow director, went on to
state that although various tests have been laid down for determining who may be a de facto
director there is no single touchstone. The key test is whether someone is part of the governing
structure of a company and participates, or is entitled to participate in, collective decisions on
corporate policy and strategy and its implementation. In Re Gemma Ltd (in liquidation) [2008] BCC
812 it was emphasised that what mattered was what the director did (and in particular whether they
were part of the governing structure of the company), not the label that was attached to them. See
also HM Revenue & Customs v Holland [2010] UKSC 51. Since a de facto director falls within the
definition of a ‘director’ in s.250 CA 2006 (see above), then all provisions in CA 2006 which apply to
‘directors’ (such as the general duties found in ss.171–77 CA 2006) apply equally to de facto
directors.

14.2.3 Shadow directors

In order to evade the duties to which directors are subject a shareholder might avoid formal
appointment as such yet nevertheless direct the board’s decision making. In this case the
shareholder may be classified as a ‘shadow director’.

Section 251(1) of the CA 2006 defines a ‘shadow director’ as a person in accordance with whose
directions or instructions the directors are accustomed to act (see also s.22(5) CDDA 1986). Those
who provide professional advice are expressly excluded. But a professional person may be held to be
a shadow director if his or her conduct amounts to effectively controlling the company’s affairs (Re
Tasbian Ltd (No.3) [1993]

BCLC 297). In Re Hydrodam (Corby) Ltd [1994] BCC 161, Millett J, considering the definition
contained in s.741(2) CA 1985, took the view that in determining whether or not an individual is a
shadow director four factors are relevant, namely that:

• the de jure and de facto directors of the company must be identifiable

• the person in question directed those directors on how to act in relation to the company’s
affairs or that he was one of the persons who did
• the directors did act in accordance with his instructions
COMPANY LAW PAGE 95

• they were accustomed so to act.

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

We noted above that all the statutory provisions (such as directors’ duties) that apply to ‘directors’
apply equally to de facto directors. Is the same true of shadow directors? The position here is a little
more complex. Some provisions of CA 2006, and of the Insolvency Act 1986, expressly apply to
shadow directors too. So, for example, under s.214(7) Insolvency Act 1986, a shadow director may
be held liable for wrongful trading (see Chapter 4). However, the position with regard to the general
duties on directors (found in ss.171–77) is less certain. Section 170(5) CA 2006 (which was inserted
by the Small Business, Enterprise and Employment Act 2015) now provides that ‘The general duties
apply to a shadow director of a company where and to the extent that they are capable of so
applying’. In Standish v Royal Bank of Scotland plc [2019] EWHC 3116 the court held that the duties
owed by the shadow would depend on the instructions they gave. A shadow director could not be
held liable for conduct that was unconnected with the instructions being given to the directors. Note
that in Popely v Popely [2019] EWHC 1507 (Ch) the court held that a person might be simultaneously
both a de facto and a shadow director.

14.3 Disqualification of directors

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

14.3.1 Discretionary orders

Conviction of an offence

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

Persistent breaches of the companies legislation

The court may disqualify a director where it appears that he or she has been ‘persistently in default’
in complying with statutory requirements relating to any return, account or other document to be
filed with, delivered or sent, or notice of any matter to be given, to the Registrar (s.3(1)). Persistent
COMPANY LAW PAGE 96

default will be presumed by showing that in the five years ending with the date of the application
the person in question has been convicted (whether or not on the same occasion) of three or more
defaults (s.3(2)). Section 5 goes on to provide that a disqualification order for persistent default can
be made by a magistrates’ court (in England and Wales) at the same time as a person is convicted of
an offence relating to the filing of returns, etc.

Fraud

The court may make a disqualification order against a person if, in the course of the winding up of a
company, it appears that he:

a. has been guilty of an offence for which he is liable (whether he has been convicted or not) under
s.993 CA 2006 (fraudulent trading), or

b. has otherwise been guilty, while an officer or liquidator of the company or receiver or manager of
its property, of any fraud in relation to the company or of any breach of his duty as such officer,
liquidator, receiver or manager (s.4).

The maximum period for disqualification is 15 years (s.4(3)). Where a person has been found liable
under s.213 or s.214 of the Insolvency Act 1986 (respectively the fraudulent trading and wrongful
trading provisions, see Chapter 17 of this guide), the CDDA 1986 gives the court a discretion to
disqualify such person for a period of up to 10 years.

Disqualification after investigation of the company

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

14.3.2 Mandatory disqualification orders for unfitness

Section 6(1) CDDA 1986 provides that the court shall make a disqualification order against a person
in any case where it is satisfied:

a. that he is or has been a director of a company which has at any time become insolvent (whether
while he was a director or subsequently), and

b. that his conduct as a director of that company (either taken alone or taken together with his
conduct as a director of any other company or companies) makes him unfit to be concerned in the
management of a company.

The minimum period of disqualification is two years and the maximum period is 15 years (s.6(4)). In
contrast with the other grounds for disqualification noted above, s.6 is restricted to directors or
shadow directors, including de facto directors.

The policy underlying s.6 was explained by Dillon LJ in Re Sevenoaks Stationers (Retail) Ltd [1991] Ch
164 as being ‘to protect the public, and in particular potential creditors of companies, from losing
money through companies becoming insolvent when the directors of those companies are people
unfit to be concerned in the management of a company’.
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An insolvent company is defined as including a company which goes into liquidation at a time when
its assets are insufficient to meet the payment of its debts, liabilities and liquidation expenses
(s.6(2)). An application under s.6 must be brought by the Secretary of State or, if the company is in
compulsory liquidation, by the Official Receiver, if it appears to him that it is expedient in the public
interest that a disqualification order should be made against any person (s.7(1)).

The meaning of ‘unfitness’

Section 6 CDDA 1986 provides that the court must be satisfied that the director’s conduct ‘makes
him unfit to be concerned in the management of a company’. This has been construed as meaning
‘unfit to manage companies generally’ rather than unfit to manage a particular company or type of
company (Re Polly Peck International plc (No.2) [1994] 1 BCLC 574; see also Re Grayan Building
Services Ltd [1995] Ch 241).

In determining whether a person’s conduct renders him unfit to be a director, s.9 CDDA 1986 directs
the court to take into account the matters listed in Schedule 1, although those matters are not
exhaustive. The list is divided into those matters which are generally applicable and those that are
applicable only where the company has become insolvent. The first category comprises:

• misfeasance or breach of any fiduciary or other duty by the director (para 1)

• the degree of the director’s culpability in concluding a transaction which is liable to be set
aside as a fraud on the creditors (paras 2 and 3)
• the extent of the director’s responsibility for any failure by the company to comply with the
numerous accounting and publicity requirements of the CA 2006 (paras 4 and 5).

Those matters to which regard is to be had when the company is insolvent are listed in Part II of
Schedule 1 and include:

• the extent of the director’s responsibility for the causes of the company becoming insolvent
(para 6)
• the extent of the director’s responsibility for any failure by the company to supply any goods
or services which have been paid for, in whole or in part (para 7).

In Re Lo-Line Electric Motors Ltd [1988] Ch 477 Sir Nicholas Browne-Wilkinson V-C said that while
ordinary commercial misjudgment is not in itself sufficient to establish unfitness, conduct which
displays ‘a lack of commercial probity’ or conduct which is grossly negligent or displays ‘total
incompetence’ would be sufficient to justify disqualification (see also Re Dawson Print Group Ltd
[1987] BCLC 601; Secretary of State for Trade and Industry v Ettinger, Re Swift 736 Ltd [1993] BCLC
896; Re AG (Manchester) Ltd (in liquidation); Official Receiver v Watson [2008] 1 BCLC 32).

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

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

14.3.3 Disqualification undertakings

The Insolvency Act 2000 amends the CDDA 1986 by introducing a procedure whereby in the
circumstances specified in ss.7 and 8 of the 1986 Act, the Secretary of State may accept a
disqualification undertaking by any person that, for a period specified in the undertaking, the person
will not be a director of a company, or act as a receiver, ‘or in any way, whether directly or indirectly,
be concerned or take part in the promotion, formation or management of a company unless (in each
case) he has the leave of the court’ (s.6(2) of the 2000 Act, inserting s.1A into the CDDA 1986). In
determining whether to accept a disqualification undertaking by any person, the Secretary of State
may take account of matters other than criminal convictions, notwithstanding that the person may
be criminally liable in respect of those matters.

It is further provided that if it appears to the Secretary of State that the conditions mentioned in
s.6(1) are satisfied with respect to any person who has offered to give him a disqualification
undertaking, he may accept the undertaking if it appears to him that it is expedient in the public
interest that he should do so (instead of applying or proceeding with an application for a
disqualification order) (s.6(3) of the 2000 Act, inserting s.7(2A) into the CDDA 1986).

Section 8 of the CDDA 1986 is amended by IA 2000 so that where it appears to the Secretary of State
from the report of a DTI investigation that, in the case of a person who has offered to give him a
disqualification undertaking, (a) the conduct of the person in relation to a company of which the
person is or has been a director or shadow director makes him unfit to be concerned in the
management of a company, and (b) it is expedient in the public interest that he should accept the
undertaking (instead of applying or proceeding with an application for a disqualification order), he
may accept the undertaking (s.6(4) of the 2000 Act, inserting s.8(2A) into the CDDA 1986). Section
8A of the CDDA 1986 provides that, on the application of a person who is subject to a
disqualification undertaking, the court may:

a. reduce the period for which the undertaking is to be in force, or

b. provide for it to cease to be in force (s.6(5) IA 2000).

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

Competition disqualification orders

Directors who have breached competition law may also be disqualified by virtue of s.204 of the
Enterprise Act 2002 which inserts ss.9A–9E into the CDDA 1986 with effect from June 2003. Section
9A places the court under a duty to make a disqualification order against a director of a company
which commits a breach of competition law provided that the court considers that his conduct as a
director makes him unfit to be concerned in the management of a company. The maximum period
for disqualification is 15 years. Application for a disqualification order on this ground may be made
by the Office of Fair Trading (OFT) and certain other specified regulators (including, among others,
COMPANY LAW PAGE 99

the Director General of Telecommunications, the Gas and Electricity Markets Authority, and the Rail
Regulator). The 2002 Act also introduces a parallel scheme for competition disqualification
undertakings under s.9B to the one for disqualification undertakings introduced by the Insolvency
Act 2000. The OFT or a specified regulator may accept a disqualification undertaking for up to 15
years from a director instead of applying for a court order. Section 9C provides that if the OFT (or
specified regulator) has reasonable grounds for suspecting that a breach of competition law has
occurred, it may carry out an investigation for the purpose of deciding whether to make an
application under s.9A for a disqualification order.

Compensation orders

Although disqualification might prevent a person from acting, and therefore misbehaving, as a
director in the future, it does not redress any harm their past misbehaviour has already caused to
others. Section 15A CDDA 1986, which was introduced by the Small Business, Enterprise and
Employment Act 2015, seeks to address this. It now allows the court to make a ‘compensation order’
against a person who has been disqualified as a director.

According to s.15A(3)(b) CDDA 1986, a compensation order can only be made if ‘the conduct for
which the person is subject to the [disqualification] order or undertaking has caused loss to one or
more creditors of an insolvent company of which the person has at any time been a director.’ The
money will either be paid to the Secretary of State, for the benefit of all or some creditors, or else
will be paid as a contribution to the assets of the company.

Re Noble Vintners Ltd [2019] EWHC 2806 (Ch) is the first case in which the court has used its new
powers, found in ss.15A and 15B of the Company Directors Disqualification Act 1986, to order a
disqualified director to compensate creditors of the company who have been harmed by the
director’s misbehaviour. The court found that the amount of compensation payable should depend
upon the loss suffered by the creditor, the nature of the director’s misbehaviour and whether the
director had already made any other payments in respect of her misbehaviour (for example, to the
company under the wrongful trading regime found in s.214 Insolvency Act 1986).

15 Directors’ duties

Introduction

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

Learning outcomes

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

• discuss the fiduciary position of directors

• discuss the content and scope of the duties of directors restated in Part 10 of the CA 2006
• explain the authorisation process
• describe the principal transactions with directors that require the approval of members
• explain the court’s discretion to relieve directors from liability
COMPANY LAW PAGE 100

• describe the specific statutory duties of directors.

15.1 Directors’ duties

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

15.1.1 The origins of Part 10 CA 2006

In July 1999 the Law Commission and the Scottish Law Commission issued a joint report, Company
Directors: Regulating Conflicts of Interests and Formulating a Statement of Duties (Nos 261 and 173,
respectively). The Law Commissions’ examination of directors’ duties and Part X of the Companies
Act 1985 was already underway at the time of the DTI’s (now BIS) announcement in March 1998 of
the company law review. As part of this wider project the Law Commissions undertook to place their
final report before the CLRSG. The DTI had charged the Commissions with the objective of
determining whether or not the relevant statutory provisions could be ‘reformed, made more simple
or dispensed with altogether’ (the Law Commissions Consultation Paper No.153 (LCCP), para 1.7).
The aim was to examine the presentation of the law governing directors’ duties rather than its
reform. The report was lodged with the CLRSG in July 1999. The Law Commissions’
recommendations, and the DTI’s response (see below), are wide ranging.

The Law Commissions examined the case for restating directors’ duties in statute. Arguments against
this were founded on loss of flexibility, while those in favour saw advantages in terms of certainty
and accessibility. The Commissions’ conclusion was that the case for legislative restatement was
made out and that the issue of inflexibility could be addressed by:

• ensuring the restatement was at a high level of generality by way of a statement of

principles; and by
• providing that it was not exhaustive (i.e. while it would be a comprehensive and binding
statement of the law in the field covered, it would not prevent the courts inventing new
general principles outside the field).

The hallmark of the Law Commissions’ approach was their regard for the wider economic context in
which company law, particularly that regulating directors, operates. It is asserted that in regulating
the enterprise, the law should operate efficiently, promoting prosperity (LCCP para 2.8). More
particularly, it is recommended that the law ‘should move towards a general principle of meaningful
disclosure, and that approval rules should be seen as the exception’ (Law Com No.261 and 173, para
3.72).

The CLRSG proposed that the duties of directors should be restated and to this end the general
duties owed by a director of a company to the company are set out in Part 10 CA 2006. We will
examine each restated duty in turn.

The Final Report of the CLRSG accepted the case for codification for two principal reasons.
COMPANY LAW PAGE 101

• First, directors should know what is expected of them and therefore such a statement will
further the CLR’s objectives of reforming the law so as to achieve clarity and accessibility.
• Second, the process of formulating such a statement would enable defects in the present
law to be corrected ‘in important areas where it no longer corresponds to accepted norms of
modern business practice’.

The CLR thought that this was particularly so with respect to the duties of conflicted directors.

Before we begin our examination of directors’ duties, we first consider the important question of to
whom are the duties owed?

15.1.2 To whom are the duties owed?

The orthodox answer to this question is now contained in s.170 CA 2006. It states that directors’
duties are owed to the company and not to shareholders individually (although note the corporate
governance debate considered in Chapter 16 of this guide). Consequently, a breach of duty is a
wrong done to the company and the proper claimant in proceedings in respect of the breach is the
company itself (see Chapter 11 of this guide).

The classic case which is now given the force of statute by s.170 is Percival v Wright [1902] 2 Ch 421.
The directors offered to buy the shares held by the company’s members without disclosing that at
the time of the purchase they were negotiating with an outsider for the sale of the company at a
higher price. The shareholders claimed that the directors were in breach of their fiduciary duty to
them and that the sale ought to be set aside for non-disclosure. The court rejected their claim. The
duty was owed to the company and, in any case, there was no unfair dealing by the directors. The
shareholders had initially approached the directors asking them to purchase their shares.

The decision in Percival v Wright leaves the critical question unanswered; namely, what is the
company? Some assistance in solving this issue can be gleaned from the Report of the Second Savoy
Hotel Investigation (The Savoy Hotel Ltd, and the Berkeley Hotel Co Ltd, Report of an Investigation
under s.165 (6) of the Companies Act 1948, (HM Stationery Office, 1954)). The Report concluded
that it was not enough for directors to act in the short-term interests of the company alone (see
Greenhalgh v Arderne Cinemas Ltd [1951] Ch 286, on the meaning of ‘the company as a whole’), but
that regard must be taken of the long-term interests of the company. In other words, the duty is not
confined to the existing body of shareholders, but extends to future shareholders. Some assistance
in addressing this issue is also given in s.172 CA 2006 (see Section 15.2.2).

It is noteworthy that subsections (3) and (4) of s.170, taken together, direct the courts to have
regard to the pre-existing case law when interpreting the statutory statement. The relevance of the
existing jurisprudence is, therefore, put beyond doubt.

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

15.1.3 Other points to note about s.170

COMPANY LAW PAGE 102

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

Summary

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

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

Part 10 of the 2006 Act restates seven duties for directors. These are:

• the duty to act within powers (s.171)

• the duty to promote the success of the company (s.172)
• the duty to exercise independent judgment (s.173)
• the duty to exercise reasonable care, skill and diligence (s.174)
• the duty to avoid conflicts of interest (s.175)
• the duty not to accept benefits from third parties (s.176)
• the duty to declare interest in proposed transactions or arrangement (s.177).

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

15.2.1 Duty to act within powers, s.171

Section 171 provides that:

A director of a company must—

act in accordance with the company’s constitution, and

only exercise powers for the purposes for which they are conferred.

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

For the purpose of paragraph (a), the company’s constitution is defined in s.17 CA 2006 as including
the company’s articles of association, decisions taken in accordance with the articles and other
decisions taken by the members, or a class of them, if they can be regarded as decisions of the
company. The importance of directors appreciating the purposes of the company as detailed in the
constitution is critical if they are to fulfil the duty laid down by s.172 to promote the success of the
company (see Section 15.2.2).

The articles of association may increase the burden of the duties by, for example, requiring directors
to obtain shareholder authorisation for their remuneration packages. However, the articles may not
dilute the duties except to the extent expressly provided for in the relevant provisions. In this regard,
s.173 (duty to exercise independent judgment (see 15.2.3 below)) provides that a director will not be
in breach if he has acted in accordance with the constitution. As we will see, s.175 (duty to avoid
conflicts of interest (see 15.2.5 below)) provides that a director will not be in breach where, subject
to the constitution, the matter has been authorised by independent directors.
COMPANY LAW PAGE 103

Paragraph (b) of s.171 codifies the proper purposes doctrine formulated by Lord Greene MR in Re
Smith & Fawcett Ltd [1942] Ch 304, where he stated that directors must not exercise their powers
for any ‘collateral purpose’.

The facts of Extrasure Travel Insurances Ltd v Scattergood [2002] All ER (D) 307 (Jul) (ChD) afford a
clear illustration of a power (the power to deal with corporate assets) being exercised for an
improper purpose. More generally, however, the issue of whether directors have used a power for a
proper purpose arises in relation to their authority to issue shares. If shares are allotted in exchange
for cash where the company is in need of additional capital the duty will not be broken. But where
directors issue shares in order to dilute the voting rights of an existing majority shareholder because
he or she is blocking a resolution supporting, for example, a takeover bid, then the duty will be
breached (see Hogg v Cramphorn [1967] Ch 254). In Piercy v S Mills & Co Ltd [1920] 1 Ch 77 the
court set aside a share issue on the basis that this was done ‘simply and solely for the purpose of
retaining control in the hands of the existing directors’.

The Privy Council in Howard Smith Ltd v Ampol Petroleum Ltd [1974] AC 821 subjected the content
of the duty to thorough scrutiny. The directors allotted shares to a company which had made a
takeover bid. The effect of the share issue was to reduce the majority holding of two other
shareholders, who had made a rival bid, from 55 to 36 per cent. The two shareholders sought a
declaration that the share allotment was invalid as being an improper exercise of power. The
directors argued, however, that the allotment was made primarily in order to obtain much needed
capital for the company. It was held that the directors had improperly exercised their powers:

it must be unconstitutional for directors to use their fiduciary powers over the shares in the
company purely for the purpose of destroying an existing majority, or creating a new majority which
did not previously exist. To do so is to interfere with that element of the company’s constitution
which is separate from and set against their powers.

Lord Wilberforce stressed that the court must examine the substantial purpose for which a power is
exercised and must reach a conclusion as to whether that purpose was proper or not (see also
Extrasure Travel Insurances Ltd v Scattergood; Criterion Properties plc v Stratford UK Properties LLC
[2003] BCC 50).

The power to issue shares may be exercised for reasons other than the raising of capital provided
‘those reasons relate to a purpose benefiting the company as a whole; as distinguished from a
purpose, for example, of maintaining control of the company in the hands of the directors
themselves or their friends’ (Harlowe’s Nominees Pty Ltd v Woodside (Lake Entrance) Oil Co (1968)
CLR 483). Further, it has been held that it may be in the company’s interest for directors to forestall
a resolution accepting a takeover offer by issuing shares. In Teck Corporation Ltd v Millar [1972] 33
DLR (3d) 288 the British Columbia Supreme Court held that an allotment of shares designed to
defeat a takeover was proper even though it was made against the wishes of the existing
shareholder and deprived him of control. Berger J stressed that, provided the directors act in good
faith, they are entitled to consider the reputation, experience and policies of anyone seeking to take
over the company and to use their power to protect the company if they decide, on reasonable
grounds, that a takeover will cause substantial damage to the company.

See further, Criterion Properties plc v Stratford UK Properties LLC [2004] UKHL 28; West Coast
Capital (Lios) Limited [2008] CSOH 72; Eclairs Group Ltd v JKX Oil and Gas plc [2013] EWCA Civ 640.

Summary
COMPANY LAW PAGE 104

The proper purposes doctrine restated in s.171 is an incident of the central fiduciary duty of
directors to promote the success of the company (s.172, see Section 15.2.2).

The power of directors to issue shares (ss.549-551 CA 2006), may be exercised for reasons other
than the raising of capital provided those reasons relate to a purpose benefiting the company as a
whole.

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

Section 172 reasserts the notion of the primacy of shareholders while recognising that well-managed
companies operate on the basis of ‘enlightened shareholder value’ (see Developing the Framework
(URN 00/656, Department of Trade and Industry (DTI), 2000), paras 2.19–2.22; and Completing the
Structure (URN 00/1335, DTI, 2000), para 3.5). According to this approach, directors, while
ultimately required to promote shareholder interests, must take account of the factors affecting the
company’s relationships and performance.

This duty has two elements. First, a director must act in the way he or she considers, in good faith,
would be most likely to promote the success of the company for the benefit of its members as a
whole. Secondly, in doing so, the director should have regard (among other matters) to the factors
listed in s.172(1). This list is not exhaustive, but highlights areas of particular importance which
reflect wider expectations of responsible business behaviour.

The question of what will promote the success of the company is one for the director’s good faith
judgment. This aligns the duty with the position long taken by the courts that, as a general rule, their
role is not to interfere in the internal management of companies. The orthodoxy here is that the
management of companies is best left to the judgment of their directors, subject to the good faith
requirement. In discharging this duty and, more particularly, in taking account of the factors listed in
subsection (1), directors are bound to exercise reasonable care, skill, and diligence (s.174, see 15.2.4
below).

A director will, therefore, need to demonstrate that the stakeholder interests listed informed his or
her deliberations. In this regard, it is noteworthy that the requirement for a ‘strategic report’ set out
in s.414A CA 2006 (though not applying to small companies) specifies, in s.414C, that its purpose ‘is
to inform members of the company and help them assess how the directors have performed their
duty under section 172…’.

Section 172(1) restates Lord Greene MR’s formulation of the duty in Re Smith & Fawcett Ltd:

directors must exercise their discretion bona fide in what they consider – not what a court may
consider – is in the interests of the company …

In Item Software (UK) Ltd v Fassihi [2005] 2 BCLC 91, Arden LJ, having noted that ‘the fundamental
duty [of a director]… is the duty to act in what he in good faith considers to be the best interests of
his company’, concluded that this duty of loyalty is the ‘time-honoured’ rule (citing Goulding J in
Mutual Life Insurance Co of New York v Rank Organisation Ltd [1985] BCLC 11).

The determination of good faith is partly subjective in that the court will not substitute its own view
about a director’s conduct in place of the board’s own judgment. In Regentcrest plc v Cohen [2001] 2
BCLC 80, Jonathan Parker J observed ‘the question is whether the director honestly believed that his
act or omission was in the interests of the company. The issue, therefore, relates to the director’s
state of mind’ (see also, Extrasure Travel Insurances Ltd v Scattergood (above)). However, in
determining whether the duty has been discharged an objective assessment is also made. In
COMPANY LAW PAGE 105

Charterbridge Corporation Ltd v Lloyd’s Bank Ltd [1970] Ch 62, Pennycuick J stated that the test for
determining whether this duty has been discharged ‘must be whether an intelligent and honest man
in the position of a director of the company concerned, could, in the whole of the existing
circumstances, have reasonably believed that the transactions were for the benefit of the company.’
Thus, in Neptune (Vehicle Washing Equipment) Ltd v Fitzgerald (No.2) [1995] BCC 1000, the
company’s sole director resolved at a board meeting in which he and the company secretary were
the only attendees, that his service contract should be terminated and that £100,892 be paid to him
as compensation. It was held that he was not acting in what he honestly and genuinely considered to
be in the best interests of the company but rather was acting exclusively to further his own personal
interests.

(See also Knight v Frost [1999] 1 BCLC 364; Ball v Eden Project Ltd [2002] 1 BCLC 313, Laddie J; Item
Software (UK) Ltd v Fassihi [2004] EWCA Civ 1244; Re Southern Counties Fresh Foods Ltd [2009]
EWHC 1362 (Ch) and R (on the application of People & Planet) v HM Treasury [2009] EWHC 3020
(Admin).)

Sections 172 and 414A–D CA 2006: the strategic report

Directors are now required, for each financial year of the company, to prepare a ‘strategic report’ of
the company’s business and operations: see s.414A–D CA 2006. It replaces the ‘business review’,
which was previously required under s.417. The strategic report is a narrative report of the
company’s business activities designed to flesh out the figures contained in the accounts. It must
contain ‘a fair review of the company’s business’ and ‘a description of the principal risks and
uncertainties facing the company’. It must also include information about ‘environmental matters,
the company’s employees, social, community and human rights issues and information about the
policies of the company in relation to these matters and the effectiveness of those policies’.

The statutory objective of the strategic report is laid down in s.414C. It provides that:

The purpose of the strategic report is to inform members of the company and help them assess how
the directors have performed their duty under section 172.

It is therefore made clear that the review is an integral part of the duty of loyalty. In informing the
members about the directors’ performance of this duty, s.414C states that the review must give a
balanced and comprehensive analysis using key performance indicators (KPIs) relating to financial,
environmental and employee matters. Although the particular KPIs used are left to the discretion of
the directors, they must be effective in measuring the development, performance or position of the
business. Moreover, s.414CZA now requires the strategic report to include a statement that
‘describes how the directors have had regard to the matters set out in section 172(1)(a) to (f) when
performing their duty under section 172’.

Insolvency and creditors – s.172(3)

Note that s.172(3) states that the duty to promote the success of the company has effect subject to
any rule of law requiring directors to act in the interests of creditors. In this respect English and
Australian courts have reasoned that where a company is insolvent directors must have regard to
the interests of the creditors. In West Mercia Safetywear Ltd v Dodd [1988] BCLC 250 the Court of
Appeal, citing with approval the decision of the New South Wales Court of Appeal in Kinsela v Russell
Kinsela Pty Ltd (1986) 10 ACLR 395, held that shareholders cannot absolve directors from a breach of
duty to creditors so as to bar the liquidator’s claim. In Dillon LJ’s view the following passage from
Street CJ’s judgment in Kinsela was of particular note.
COMPANY LAW PAGE 106

In a solvent company the proprietary interests of the shareholders entitle them as a general body to
be regarded as the company when questions of the duty of directors arise ... But where a company is
insolvent the interests of the creditors intrude. They become prospectively entitled, through the
mechanism of liquidation, to displace the power of the shareholders and directors to deal with the
company’s assets. It is in a practical sense their assets and not the shareholders’ assets that, through
the medium of the company, are under the management of the directors pending either liquidation,
return to solvency, or the imposition of some alternative administration ...

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

The duty is to consider the interests of creditors as a general class; it is not to consider the interests
of any specific creditor above others: see GHLM Trading Ltd v Maroo [2012] EWHC 61 (Ch). See also
Re HLC Environmental Projects Ltd [2013] EWHC 2876 (Ch).

One remaining uncertainty is when exactly directors are obliged, under s.172, to consider, or even
prioritise, the interests of creditors. In Dickinson v NAL Realisations (Staffordshire) Ltd [2017] EWHC
28 (Ch), the High Court refused to say precisely when this obligation starts, but noted that it did not
arise merely because ‘there is a recognised risk of adverse events that would lead to insolvency’.

In Wessely v White [2018] EWHC 1499 (Ch), the court accepted that the duty to prioritise the
interests of creditors was still a ‘subjective one’. If a director does what she concludes is best for
creditors then she will not be in breach of s.172, even if she is negligent in reaching that conclusion
(although that negligence may mean she is liable for breach of her duty of care and skill under
s.174).

Standing to sue

The question of standing to sue to enforce this duty (locus standi) arose in Yukong Line Ltd of Korea
v Rendsburg Investment Corpn of Liberia (No.2) [1998] 2 BCLC 485 in which it was pointed out that
creditors have no standing, individually or collectively, to bring an action in respect of any such duty.
Toulson J held that a director of an insolvent company who, in breach of duty to the company,
transferred assets beyond the reach of its creditors owed no corresponding fiduciary duty to an
individual creditor of the company. The appropriate means of redress was for the liquidator to bring
an action for misfeasance (s.212 Insolvency Act 1986).

Notwithstanding the logistical issue of locus standi raised by Toulson J, the question of directors’
duties to creditors again emerged in two recent decisions of the Companies Court. In Re Pantone
485 Ltd [2002] 1 BCLC 266, Richard Reid QC, sitting as a deputy judge in the High Court, observed
that:

In my view, where the company is insolvent, the human equivalent of the company for the purposes
of the directors’ fiduciary duties is the company’s creditors as a whole, i.e. its general creditors. It
follows that if the directors act consistently with the interests of the general creditors but
inconsistently with the interest of a creditor or section of creditors with special rights in a winding
up, they do not act in breach of duty to the company.
COMPANY LAW PAGE 107

Again, in Colin Gwyer and Associates Ltd v London Wharf (Limehouse) Ltd [2003] 2 BCLC 153, it was
held that a resolution of the board of directors passed without proper consideration being given by
certain directors to the interests of creditors would be open to challenge if the company had been
insolvent at the date of the resolution. Leslie Kosmin QC, sitting as a deputy judge in the High Court,
stated that in relation to an insolvent company, the directors, when considering the company’s
interests, must have regard to the interests of the creditors. The court was required to test the
directors’ conduct by reference to the Charterbridge Corp Ltd v Lloyd’s Bank Ltd [1970] Ch 62 test
(i.e. ‘could an honest and intelligent man, in the position of the directors, in all the circumstances,
reasonably have believed that the decision was for the benefit of the company’). In the case of
insolvent companies the test is to be applied with the benefit of the creditors substituted for the
benefit of the company.

Section 172(3) also makes express reference to ‘any enactment’. In this respect, it should be noted
that Section 214 of the Insolvency Act 1986 provides that a liquidator of a company in insolvent
liquidation can apply to the court to have a person who is or has been a director of the company
declared personally liable to make such contribution to the company’s assets as the court thinks
proper for the benefit of the unsecured creditors. The liquidator must prove that the director in
question allowed the company to continue to trade, at some time before the commencement of its
winding up, when he knew or ought to have concluded that there was no reasonable prospect that
the company would avoid going into insolvent liquidation.

15.2.3 Duty to exercise independent judgment, s.173

Section 173 provides the following.

(1) A director of a company must exercise independent judgment.

(2) This duty is not infringed by his acting—

This provision restates the principle developed in the case law that directors must exercise their
powers independently and not subordinate their powers to the control of others by, for example,
contracting with a third party as to how a particular discretion conferred by the articles will be
exercised. This is a facet of the duty to promote the success of the company laid down in Section
172. Directors are not permitted to delegate their powers unless the company’s constitution
provides otherwise.

The duty operates so as to prohibit directors fettering their discretion by contracting with an
outsider as to how a particular discretion conferred by the articles will be exercised except, possibly,
where this is to the company’s commercial benefit.

In Fulham Football Club Ltd v Cabra Estates plc [1994] BCLC 363, four directors of Fulham football
club agreed with Cabra, the club’s landlords, that they would support Cabra’s planning application
for the future development of the club’s ground rather than the plan put forward by the local
authority. In return for this undertaking, Cabra paid the football club a substantial fee. The directors
subsequently decided to renege on this promise and wanted to give evidence to a planning enquiry
opposing the development. They argued that their agreement with Cabra was an unlawful fetter on
their powers to act in the best interests of the company. The Court of Appeal rejected this argument.

It was held that:

• the agreement with the landlords was part of a contract that conferred significant benefits
on the company
COMPANY LAW PAGE 108

• the directors, in giving their undertaking to Cabra, had not improperly fettered the future
exercise of their discretion.

In fact, it was not a case of directors fettering their discretion because they had exercised it at the
time they gave their undertaking. The Court drew a distinction between:

• directors fettering their discretion, which is a clear breach of duty

• directors exercising their discretion in a manner which restricts their future conduct; this is
not a breach of duty.

Neil LJ endorsed the view of Kitto J in the Australian case Thornby v Goldberg (1964) 112 CLR 597
stating:

There are many kinds of transaction in which the proper time for the exercise of the directors’
discretion is the time of the negotiation of a contract and not the time at which the contract is to be
performed ... If at the former time they are bona fide of opinion that it is in the interests of the
company that the transaction should be entered into and carried into effect I see no reason in law
why they should not bind themselves.

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

Section 174 gives statutory effect to the modern judicial stance taken towards the determination of
the standard of care expected of directors. It provides the following.

A director of a company must exercise reasonable care, skill and diligence.

This means the care, skill and diligence that would be exercised by a reasonably diligent person
with—

the general knowledge, skill and experience that may reasonably be expected of a person carrying
out the functions carried out by the director in relation to the company, and

the general knowledge, skill and experience that the director has.

In Re D’Jan of London Ltd [1993] BCC 646, Hoffmann LJ, applying s.214(4) of the Insolvency Act 1986,
held the director negligent and prima facie liable to the company for losses caused as a result of its
insurers repudiating a fire policy for non-disclosure. The director had signed the inaccurate proposal
form without first reading it.

The effect of s.174 is that a director’s actions will be measured against the conduct expected of a
reasonably diligent person. This is therefore an objective test. However, subjective considerations
will also apply according to the level of any special skills the particular director may possess.

The focus on objective assessment can also be seen in cases brought under the Company Directors
Disqualification Act 1986 (see Chapter 14, above), particularly in relation to where directors delegate
their powers. Inactivity on the part of directors is no longer acceptable. Therefore little weight is
given to any contention to the effect that the director was unaware of a state of affairs because he
had trusted others to manage the company (see Re Landhurst Leasing plc [1999] 1 BCLC 286).

Thus, a director cannot take a passive role in the management of the company. This is also the case
in small private owner-managed companies (termed quasi- partnerships) where a spouse or son or
daughter may assume the role of director without ever expecting to play a proactive part in the
affairs of the company. In Re Brian D Pierson (Contractors) Ltd [2001] 1 BCLC 275 the court refused
to countenance such symbolic roles:
COMPANY LAW PAGE 109

The office of director has certain minimum responsibilities and functions, which are not simply
discharged by leaving all management functions, and consideration of the company’s affairs to
another director without question, even in the case of a family company… One cannot be a
‘sleeping’ director; the function of ‘directing’ on its own requires some consideration of the
company’s affairs to be exercised.

Further, in Re Westmid Packing Services Ltd, Secretary of State for Trade and Industry v Griffiths
[1998] 2 BCLC 646, Lord Woolf stated that:

The collegiate or collective responsibility of the board of directors of a company is of fundamental

importance to corporate governance under English company law. That collegiate or collective
responsibility must however be based on individual responsibility. Each individual director owes
duties to the company to inform himself about its affairs and to join with his co-directors in
supervising or controlling them.

Similar observations about this ‘core’ responsibility of directors to play a role in overseeing the
management of the company were also expressed in Dorchester Finance Co Ltd v Stebbing [1989]
BCLC 498, Lexi Holdings plc (in administration) v Luqman [2009] EWCA Civ 117 and again in Raithatha
v Baig [2017] EWHC 2059 (Ch).

15.2.5 Duty to avoid conflicts of interest, s.175

Section 175 replaces the equitable obligation to avoid conflicts of interest whereby directors are
liable to account for any profit made personally in circumstances where their interests may conflict
with their duty owed to the company.

The substance of this duty is strict. This is reflected in the language of s.175(1), in that it is framed in
terms of the possibility of conflict rather than actual conflicts of interest.

A director of a company must avoid a situation in which he has or can have, a direct or indirect
interest that conflicts, or possibly may conflict, with the interests of the company.

This encompasses the significant body of case law spanning over a century or so which the provision
codifies. See Re Lands Allotment Co [1894] 1 Ch 616 and JJ Harrison (Properties) Ltd v Harrison
[2002] 1 BCLC 162, confirming that a director holds the proceeds made from a breach of fiduciary
duty as a constructive trustee.

The fundamental objective of the duty to avoid conflicts of interest is aimed at curbing any
temptation directors may succumb to when faced with the opportunity of preferring their own
interests over and above those of the company’s. As explained by Lord Herschell in Bray v Ford
[1896] AC 44:

It is an inflexible rule of a court of equity that a person in a fiduciary position… is not, unless
otherwise expressly provided, … allowed to put himself in a position where his interest and duty
conflict. It does not appear to me that this rule is… founded upon principles of morality. I regard it
rather as based on the consideration that, human nature being what it is, there is a danger, in such
circumstances, of the person holding a fiduciary position being swayed by interest rather than by
duty, and thus prejudicing those whom he was bound to protect.

A modern formulation of this duty was delivered by Millett LJ in Bristol and West Building Society v
Mothew [1998] Ch 1:
COMPANY LAW PAGE 110

The distinguishing obligation of a fiduciary is the obligation of loyalty. The principal is entitled to the
single-minded loyalty of his beneficiary. This core liability has several facets. A fiduciary must act in
good faith; he must not make a profit out of his trust; he must not place himself in a position where
his duty and his interest may conflict ...

The classic decision on this aspect of the fiduciary obligation is Regal (Hastings) Ltd v Gulliver [1942]
1 All ER 378, [1967] 2 AC 134n. Regal owned a cinema and its directors wished to acquire two
additional local cinemas and sell the whole undertaking as a going concern. They formed a subsidiary
company in order to take a lease of the other two cinemas but the landlord was not prepared to
grant the subsidiary a lease on these two cinemas unless the subsidiary’s paid-up capital was £5,000.
The company was unable to inject more than £2,000 in cash for 2,000 shares and so the original
arrangement was changed. It was decided that Regal would subscribe for 2,000 shares and the
outstanding 3,000 shares would be taken up by the directors and their associates. Later, the whole
business was sold by way of takeover and the directors made a profit. The purchasers of Regal
installed a new board of directors and the company successfully brought an action against its former
directors claiming that they should account for the profit they had made on the sale of their shares
in the subsidiary.

Lord Russell of Killowen stated that the opportunity and special knowledge to obtain the shares had
come to the directors qua fiduciaries ‘and having obtained these shares by reason of the fact that
they were directors of Regal, and in the course of the execution of that office, are accountable for
the profits which they have made out of them.’ Lord Russell went on to add that:

the rule of equity which insists on those, who by use of a fiduciary position make a profit, being
liable to account for that profit, in no way depends on fraud, or absence of bona fides; or upon such
questions or considerations as whether profit would or should otherwise have gone to the plaintiff…

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

Corporate opportunities

An incident of the duty to avoid a conflict of interests is the so-called corporate opportunity
doctrine. This ‘makes it a breach of fiduciary duty by a director to appropriate for his own benefit an
economic opportunity which is considered to belong rightly to the company which he serves’
(Prentice, [1974] MLR 464).

A corporate opportunity is viewed as an asset of the company which may not therefore be
misappropriated by the directors. In Cook v Deeks [1916] 1 AC 554, three of the four directors
diverted to their own personal benefit certain railway construction contracts which were offered to
the company. Notwithstanding that their conduct was ratified by the company, the directors were
held accountable. Lord Buckmaster said that the directors, ‘while entrusted with the conduct of the
affairs of the company [had] deliberately designed to exclude, and used their influence and position
to exclude, the company whose interest it was their first duty to protect.’

The distinction between Regal (Hastings) where ratification was a possibility and Cook v Deeks in
which the Privy Council ruled out the question of ratification as a means of avoiding liability is not
easy to discern. The answer probably lies in the fact that in the decision for Cook v Deeks the
directors were fraudulent. In Regal (Hastings) the House of Lords accepted that the directors acted in
good faith.

In Industrial Development Consultants Ltd v Cooley [1972] 1 WLR 443, the defendant, who was
managing director of Industrial Development Consultants Ltd (IDC), a designand construction
COMPANY LAW PAGE 111

company, failed to obtain for the company a lucrative contract to undertake work for the Eastern
Gas Board. The Gas Board subsequently approached Cooley indicating that they wished to deal with
him personally and would not, in any case, contract with IDC. Cooley did not disclose the offer to the
company. However, he promptly resigned his office so that he could take up the contract after
deceiving the company into thinking he was suffering from ill health.

Roskill J held that he was accountable to the company for all of the profits he received under the
contract. Information which came to Cooley while he was managing director and which was of
concern to the plaintiffs and relevant for the plaintiffsto know, was information which it was his duty
to pass on to the plaintiffs. It was irrelevant to the issue of liability that Cooley had been approached
in his personal capacity and that the Gas Board would not have contracted with IDC.

Roskill J concluded that:

if the defendant is not required to account he will have made a large profit as a result of having
deliberately put himself into a position in which his duty to the plaintiffs who were employing him
and his personal interests conflicted.

See also Bhullar v Bhullar, Re Bhullar Bros Ltd [2003] EWCA 424; Gwembe Valley Development Co
Ltd v Koshy [2003] EWCA Civ 1478.

One issue that arises is whether a director is only liable if the opportunity that they take for their
own benefit falls within the ‘existing scope’ of the company’s own business. The case of O’Donnell v
Shanahan [2009] EWCA Civ 751 suggests that it does not need to do so. A director was liable when
he made a personal profit from pursuing an opportunity that he learned about as a director, to
acquire certain property. The company had not engaged in property acquisition (its business being
restricted to providing advice and assistance to others). The director was nevertheless held liable.
On post-resignation breaches (s.175(4)) see Foster Bryant Surveying Ltd v Bryant [2007] EWCA Civ
200. In this regard in Peso Silver Mines v Cropper [1966] 58 DLR (2d) 1, the board of Peso was
offered the opportunity to buy a number of mining claims. Some of these were located on land
which adjoined the company’s own mining territories. The board bona fide declined the offer
because:

• of the then financial state of the company

• there was some doubt over the value of the claims.

Later, the company’s geologist formed a syndicate with the defendant and two other Peso directors
to purchase and work the claims. When the company was taken over, the new board (as in Regal
(Hastings)) brought an action claiming that the defendant held his shares on constructive trust for
the company. The claim was unsuccessful. It was held that the decision of the directors to reject the
opportunity had been made in good faith and for sound commercial reasons in the interests of the
company.

See also, Laskin J’s approach towards the issue of determining liability in Canadian Aero Service Ltd v
O’Malley [1973] 40 DLR (3d) 371.

Recent decisions have made it clear that the general fiduciary obligations of a director do not
prevent him from:

• making the decision, while still a director, to set up in a competing business after his
directorship has ceased
COMPANY LAW PAGE 112

• taking some preliminary steps to investigate or forward that intention provided he did not
engage in any competitive activity while his directorship continued.

In this regard, see:

• Island Export Finance Ltd v Umunna [1986] BCLC 460

• Balston Ltd v Headline Filters Ltd [1990] FSR 385
• Framlington Group plc v Anderson [1995] 1 BCLC 475
• Coleman Taymar Ltd v Oakes [2001] 2 BCLC 749
• British Midland Tool v Midland International Tooling [2003] EWHC 466.

A director may utilise confidential information or ‘know-how’ acquired while working for the
company after he departs but not ‘trade secrets’ (see Dranez Anstalt v Hayek [2002] 1 BCLC 693;
CMS Dolphin Ltd v Simonet [2001] 2 BCLC 704). They may also use the ‘general fund of skill and
knowledge’ they have developed in the role of director: see Thermascan Ltd v Norman [2011] BCC
535.

It is worth noting that s.175(4)(a) recognises that unexpected situations can arise where a conflict
exists, but that conflict alone does not necessarily constitute a breach by directors. As explained by
Lord Goldsmith (see Official Report, 6/2/2006; coll GC289):

Once you know that you are now in a situation of conflict, you will have to do something about it,
but you are not in breach simply because it happened when, as is set out in subsection (4)(a), it
could not, ‘reasonably be regarded as likely to give rise to’ the conflict.

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

Section 175(7) states that ‘any reference in this section to a conflict of interest includes a conflict of
interest and duty and a conflict of duties.’ This at last injects a long awaited measure of cohesion in
to the law and settles a long running dispute surrounding what was seen to be an anomalous
decision of Chitty J in London and Mashonaland Co Ltd v New Mashonaland Exploration Co Ltd
[1891] WN 165 in which it was held that no breach of duty arose where a director held office with
two or more competing companies.

The modern courts have adopted a stricter stance in viewing competing directors as giving rise to an
irreconcilable conflict of interest and duty. See SCWS v Meyer [1959] AC 324, where Lord Denning
said that such directors walk a very fine line, and Plus Group Ltd v Pyke [2002] EWCA Civ 370. See
also Bell v Lever Bros Ltd [1932] AC 161, HL; Hivac Ltd v Park Royal Scientific Instruments Ltd [1946]
Ch 169.

Thus, s.175(7) brings competing directorships into the general prohibition of conflicts of duty.

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

A major concern expressed by the Company Law Review was that the case law on conflicts of duty
holds the potential to ‘fetter entrepreneurial and business start-up activity by existing directors’ and
that ‘the statutory statement of duties should only prevent the exploitation of business
opportunities where there is a clear case for doing so’ (Completing the Structure). The 2005 White
Paper echoes this concern by stating that it is important that the duties do not impose impractical
and onerous requirements which stifle entrepreneurial activity (at para 3.26). Section 175(5)(a)
therefore implements the CLRSG’s recommendation that conflicts may be authorised by
independent directors unless, in the case of a private company, its constitution otherwise provides.
COMPANY LAW PAGE 113

For a public company the directors will only be able to authorise such conflicts if its constitution
expressly permits (s.175(5)(b)). Further, s.175(6) provides that board authorization is effective only if
the conflicted directors have not participated in the taking of the decision or if the decision would
have been valid even without the participation of the conflicted directors. The votes of the
conflicted directors in favour of the decision will be ignored and the conflicted directors are not
counted in the quorum.

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

The underlying rationale of the self-dealing rule, which prohibits a director from being interested in a
transaction to which the company was a party, was explained by the House of Lords in Aberdeen Rly
Co v Blaikie Bros (1854) 1 Macq 461. The company had contracted with John Blaikie for the supply of
iron chairs. At the time of the contract John Blaikie was both a director of Aberdeen Railway and a
partner of Blaikie Bros. Lord Cranworth LC, having stated that ‘no-one, having [fiduciary] duties to
discharge, shall be allowed to enter into engagements in which he has, or can have, a personal
interest conflicting, or which possibly may conflict, with the interests of those whom he is bound to
protect’, went on to stress that:

his duty to the company imposed on him the obligation of obtaining these iron chairs at the lowest
possible price. His personal interest would lead him in an entirely opposite direction, would induce
him to fix the price as high as possible. This is the very evil against which the rule in question is
directed.

It is noteworthy that the statutory statement of directors’ duties does not follow the common law
position. Self-dealing is removed from the realms of directors’ fiduciary duties and replaced with a
statutory obligation to disclose an interest. Section 175(3) makes it clear that the duty to avoid
conflicts of interest contained in s.175(1) ‘does not apply to a conflict of interest arising in relation to
a transaction or arrangement with the company.’ Rather, ‘self-dealing’ falls within s.177(1). This
provides that: ‘[i]f a director is in any way, directly or indirectly, interested in a proposed transaction
or arrangement with the company, he must declare the nature and extent of that interest to the
other directors.’ In similar terms s.182 applies to cases where a director has an interest in a
transaction after it ‘has been entered into by the company.’ The provisions do not apply to
substantial property transactions, loans, quasi-loans and credit transactions which require the
approval of the company’s members (ss.190–203, see Section 15.3).

Sections 177 and 182 reflect the common practice that companies’ articles of association generally
permitted directors to have interests in conflict transactions provided they were declared to the
board. The reason why the common law tolerated such relaxation of the rule was explained by
Upjohn LJ in Boulting v Association of Cinematograph Television and Allied Technicians [1963] 2 QB
606:

It is frequently very much better in the interests of the company that they should be advised by
someone on some transaction, although he may be interested on the other side of the fence.
Directors may sometimes be placed in such a position that though their interest and duty conflict,
they can properly and honestly give their services to both sides and serve two masters to the great
advantage of both. If the person entitled to the benefit of the rule is content with that position and
understands what are his rights in the matter, there is no reason why he should not relax the rule,
and it may commercially be very much to his advantage to do so.

The principal distinction between the two statutory provisions is that, whereas breach of s.177
carries civil consequences (s.178), breach of s.182 results in criminal sanctions (s.183). More
COMPANY LAW PAGE 114

particularly, s.178 states that the consequences of breach (or threatened breach) of ss.171–177 are
the same as would apply if the corresponding common law rule or equitable principle applied. This is
subject to the proviso introduced by s.180(1) that, subject to any provision to the contrary in the
company’s constitution, if s.177 is complied with, the transaction is not liable to be set aside by
virtue of any common law rule or equitable principle requiring the consent of members.

The question has arisen as to whether disclosure has to be made at a formal meeting of the board.
In Lee Panavision Ltd v Lee Lighting Ltd [1992] BCLC 22 and Runciman v Walter Runciman plc [1992]
BCLC 1084 it was held that informal disclosure to all members of the board would suffice. In
MacPherson v European Strategic Bureau Ltd [1999] 2 BCLC 203 each of the shareholders and the
directors knew the precise nature of other’s interest so that there was, in effect, unanimous
approval of the agreement. The court therefore held that:

[n]o amount of formal disclosure by each other to the other would have increased the other’s
relevant knowledge.

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

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

Section 176(1) provides that a director must not accept a benefit from a third party conferred by
reason of:

a. his being a director, or

b. his doing (or not doing) anything as director.

This duty is an element of the wider no-conflict duty laid down in s.175 and it too will not be
infringed if acceptance of the benefit cannot reasonably be regarded as likely to give rise to a conflict
of interest. It should be noted that it applies only to benefits conferred because the director is a
director of the company or because of something that the director does or does not do as director.

The word ‘benefit’, for the purpose of this section, is not defined in the Act although during the
Parliamentary debates on the Bill it was made clear that it includes benefits of any description,
including non-financial benefits (Official Report, 9/2/2006; coll GC330 (Lord Goldsmith)). While
s.175(5) provides for board authorisation in respect of conflicts of interest, this is not the case with
this particular duty. However, the company may authorise the acceptance of benefits by virtue of
s.180(4). Section 176(2) defines a ‘third party’ as a person other than the company or its holding
company or its subsidiaries and thus s.176(3) provides that benefits provided by the company fall
outside the prohibition.

15.2.7 Remedies for breach of duties

Section 178 CA 2006 preserves the existing civil consequences of breach (or threatened breach) of
any of the general duties. Although an attempt was made to codify the remedies available for
breach of directors’ duties, this proved to be a very difficult exercise and eventually it became ‘too
difficult to pursue’. It provides:

1. the consequences of breach (or threatened breach) of Sections 171 to 177 are the same as would
apply if the corresponding common law rule or equitable principle applied
COMPANY LAW PAGE 115

2. the duties in those sections (with the exception of Section 174 (duty to exercise reasonable care,
skill and diligence)) are, accordingly, enforceable in the same way as any other fiduciary duty owed
to a company by its directors.

In the case of fiduciary duties the consequences of breach may include:

• damages or compensation where the company has suffered loss (see Re Lands Allotment Co
[1894] 1 Ch 616, CA; Joint Stock Discount Co v Brown (1869) LR 8 Eq 381)
• restoration of the company’s property (see Re Forest of Dean Coal Co (1879) 10 Ch D 450; JJ
Harrison (Properties) Ltd v Harrison [2002] 1 BCLC 162, CA)
• an account of profits made by the director (see Regal (Hastings) Ltd v Gulliver)
• injunction or declaration (see Cranleigh Precision Engineering Ltd v Bryant [1965] 1 WLR
1293)
• rescission of a contract where the director failed to disclose an interest (see Transvaal Lands
Co v New Belgium (Transvaal) Land & Development Co [1914] 2 Ch 488, CA).

Presumably the rules developed for establishing the liability of accessories (for example, in the case
of receipt of property pursuant to a breach of fiduciary duty, or dishonest assistance of such a
breach) will be applied notwithstanding that the breach may be of a duty which is now statutorily
defined and imposed.

The liability to account arises even where the director acted honestly and where the company could
not otherwise have obtained the benefit (Regal (Hastings) Ltd v Gulliver; IDC v Cooley). In Murad v
Al-Saraj [2005] EWCA Civ 959, Arden LJ explained the policy underlying such liability:

It may be asked why equity imposes stringent liability of this nature ... equity imposes stringent
liability on a fiduciary as a deterrent – pour encourager les autres. Trust law recognises what in
company law is now sometimes called the ‘agency’ problem. There is a separation of beneficial
ownership and control and the shareholders (who may be numerous and only have small numbers
of shares) or beneficial owners cannot easily monitor the actions of those who manage their
business or property on a day to day basis. Therefore, in the interests of efficiency and to provide an
incentive to fiduciaries to resist the temptation to misconduct themselves, the law imposes exacting
standards on fiduciaries and an extensive liability to account.

In Coleman Taymar Ltd v Oakes [2001] 2 BCLC 749, Robert Reid QC, sitting as a Deputy Judge of the
High Court, stated that a company is entitled to elect whether to claim

• damages (equitable compensation)

• or an account of profits against a director who, in breach of duty, makes a secret profit.

However, even though the profit may arise out of the use of position as opposed to the use of trust
property, the judges more typically resort to the language of the ‘constructive trust’ as the means
for fashioning a remedy (see Boardman v Phipps [1967] 2 AC 46, although, Lord Guest excepted, all
of their Lordships spoke of the defendant’s liability to account).

In A-G for Hong Kong v Reid [1994] 1 AC 324, Lord Templeman explained that Boardman
‘demonstrates the strictness with which equity regards the conduct of a fiduciary and the extent to
which equity is willing to impose a constructive trust on property obtained by a fiduciary by virtue of
his office.’ In JJ Harrison (Properties) Ltd v Harrison [2002] 1 BCLC 162, CA, a director usurped a
corporate opportunity by acquiring for his own benefit development land owned by the company. At
the time of valuation he failed to disclose that planning permission was forthcoming which, once
COMPANY LAW PAGE 116

granted, would greatly inflate its value. The company, having unsuccessfully applied for planning
permission a couple of years earlier, was unaware that local authority policy in this respect had
changed. The director purchased the land from the company in 1985 for £8,400. Having obtained
planning permission through, to add insult to injury, use of the company’s resources, he then resold
part of it for £110,300 in 1988 and the rest in 1992 for £122,500. The director resigned and the
company sought to hold him liable as a constructive trustee. Chadwick LJ, citing Millett LJ in Paragon
Finance plc v DB Thakerar & Co (1999), said:

It follows… from the principle that directors who dispose of the company’s property in breach of
their fiduciary duties are treated as having committed a breach of trust that, a director who is,
himself, the recipient of the property holds it upon a trust for the company. He, also, is described as
a constructive trustee.

In the CMS Dolphin Ltd v Simonet, Lawrence Collins J subjected the issue of remedies for diverting a
corporate opportunity to detailed analysis. He held that S was a constructive trustee of the profits
referable to exploiting the corporate opportunity and, in general, it made no difference whether the
opportunity is first taken up by the wrongdoer or by a ‘corporate vehicle’ established by him for that
purpose.

I do not consider that the liability of the directors in Cook v Deeks would have been in any way
different if they had procured their new company to enter the contract directly, rather than (as they
did) enter into it themselves and then transfer the benefit of the contract to a new company.

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

15.2.8 Consent, approval or authorisation by members

Certain transactions require the approval of the members of the company. These are contained in
Part 10, Chapter 4 of the CA 2006 and include:

• long-term service contracts (s.188)

• substantial property transactions (s.190)
• loans, quasi-loans and credit transactions (ss.197–214)
• payments for loss of office (ss.215–222).

The policy underlying the requirement of shareholder approval of these specified transactions was
explained by Carnwath J in British Racing Drivers’ Club Ltd v Hextall Erskine & Co [1997] 1 BCLC 182.
He stressed that the possibility of conflicts of interests in these circumstances is such that there is a
danger that the judgment of directors may be distorted and so it ensures that ‘the matter will be ...
widely ventilated, and a more objective decision reached.’ Section 180 thus sets out, in part, the
relationship between the general duties of directors and these more specific provisions contained in
Part 10, Chapter 4 of the Act.

Section 180(1) provides that if the requirement of authorisation is complied with for the purposes of
s.175 (see s.175(4) and (5), above), or if the director has declared to the other directors his interest
in a proposed transaction with the company under s.177, these processes replace the equitable rule
that required the members to authorise such breaches of duty. This is made subject to any
enactment (for example, the above transactions contained in Chapter 4 of Part 10) or any provision
in the company’s articles which require the authorisation or approval of members.
COMPANY LAW PAGE 117

Thus, the company’s constitution can reverse the statutory change and can insist on certain steps
being taken requiring the consent of the members in certain circumstances. In that event, that
provision would have to be given effect to. That is the consequence of the change of approach – and
therefore a change of approach to the appropriate consequence of there not being members’
approval in particular cases because it would no longer be required (see Official Report, 9/2/2006;
coll GC337).

Section 180(3) states that compliance with the general duties does not remove the need for the
approval of members to the transactions falling within Chapter 4 CA 2006. Further, s.180(2) provides
that the general duties apply even though the transaction falls within Chapter 4, except that there is
no need to comply with ss.175 or 176 where the approval of members is obtained. Section 180(4)
preserves the common law position on prior authorisation of conduct that would otherwise be a
breach of the general duties. Thus, companies may, through their articles, go further than the
statutory duties by placing more onerous requirements on their directors (e.g. by requiring
shareholder authorisation of the remuneration of the directors). It also makes it clear that the
company’s articles may not dilute the general duties except to the extent that this is explicitly
permitted. The effect of this provision seems to be that interested members can vote on a resolution
to approve a prospective breach of the statutory duties, but cannot do so to ratify a breach after the
event (s.239).

15.2.9 Ratification by members of a director’s breach of duty

Under the common law a director could avoid liability for breach of duty by disclosing the breach to,
and obtaining the consent of, by ordinary resolution, the company in general meeting (see Regal Ltd
v Gulliver [1967] 2 AC 134; and Gwembe Valley Development Co Ltd v Koshy [2004] 1 BCLC 131). The
Companies Act 2006 maintains this rule, albeit subject to one major change. Section 239(1) states
that the provision applies to the ratification by a company of conduct by a director ‘amounting to
negligence, default, breach of duty or breach of trust in relation to the company.’

It thus extends the ratification process to all breaches of the duties set out in the statutory
restatement in Part 10 of the Act. The common law is modified by s.239(3) and (4) which provide
that the ratification is effective only if the votes of the director in breach (and any member
connected with him) are disregarded. The effect therefore is to disenfranchise the defaulting
director.

In North-West Transportation Co Ltd v Beatty (1887)) 12 App Cas 589 PC, it had been held that the
director could vote, qua shareholder, in favour of the resolution ratifying his breach of duty. The
reform follows the recommendation of the CLRSG which took the view that the question of the
validity of a decision by the members of the company to ratify a wrong on the company by the
directors (whether or not a fraud) should depend on whether the necessary majority had been
reached without the need to rely upon the votes of the wrongdoers, or of those who were
substantially under their influence, or who had a personal interest in the condoning of the wrong.
See DTI Consultation Document (November 2000) Completing the structure para.5.85.

Section 239(6)(a) goes on to provide that nothing in the section affects the validity of a decision
taken by the unanimous consent of the members of the company. This appears to mean that the
restrictions on who may vote on a resolution, contained in s.239(3)–(4), will not apply when every
member, including the director qua shareholder, agrees to condone the breach of duty. This places
on a statutory footing the common law principle that a breach of duty is ratifiable by obtaining the
informal approval of every member who has a right to vote on such a resolution.
COMPANY LAW PAGE 118

15.2.10 Cases within more than one of the general duties

The way in which the duties are framed results in an overlap between them. Section 179 serves to
emphasise that the effect of the duties is cumulative:

Except as otherwise provided, more than one of the general duties may apply in any given case.

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

15.3 Relief from liability

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

• negligence
• default
• breach of duty
• breach of trust.

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

• the officer has acted honestly and reasonably

• having regard to all the circumstances of the case, he ought fairly to be excused on such
terms as the court thinks fit.

A classic illustration of the way the provision might be used is Re Welfab Engineers Ltd [1990] BCLC
833. The directors of a company which had been trading at a loss sold its main asset for the lower of
two competing bids on the understanding that the company would continue to be run as a going
concern. Shortly afterwards the company went into liquidation. The liquidator brought misfeasance
proceedings against the directors. It was held that the directors had not acted in breach of duty in
accepting the lower offer but, even if they had, it was a case in which relief would be granted under
s.1157. Hoffmann J took the view that the directors were motivated by an honest and reasonable
desire to save the business and the jobs of the company’s employees.

Another example is Re D’Jan of London Ltd. You will recall that the director in question incorrectly
completed a proposal form for property insurance. The insurers subsequently repudiated liability on
the policy when the company claimed for fire damage. The director had signed the proposal without
reading it. Hoffmann LJ thought that it was the kind of mistake that could be made by any busy man.
In granting the director partial relief from liability, the court noted that he held 99 of the company’s
shares (his wife held the other). Therefore the economic reality was that the interests the director
had put at risk were those of himself and his wife. The judge observed that it ‘may seem odd that a
person found to have been guilty of negligence, which involves failing to take reasonable care, can
ever satisfy the court that he acted reasonably. Nevertheless, the section clearly contemplates that
he may do so. It follows that conduct may be reasonable for the purposes of s.1157, despite
amounting to lack of reasonable care at common law.’

A final example where relief was granted is given by Hedger v Adams [2015] EWHC 2540 (Ch).

More often, however, the courts have been reluctant to give relief under s.1157.
COMPANY LAW PAGE 119

In Re Duckwari plc (No.2) (above), the point was made obiter that a director who intends to profit by
way of a direct or indirect personal interest in a substantial property transaction could not be said to
have acted reasonably and therefore would be denied relief under s.1157.

For a further illustration of the courts’ reluctance to give relief under s.1157, see Towers v Premier
Waste Management Ltd [2012] BCC 72. And see also: Re Brian D Pierson (Contractors) Ltd [1999]
BCC 26; Re Simmon Box (Diamonds) Ltd [2000] BCC 275; Bairstow v Queens Moat Houses plc [2000]
1 BCLC 549.

Can a shadow director rely on s.1157? Instant Access Properties Ltd v Rosser [2018] EWHC 756 (Ch)
suggests that, in a roundabout way, such a director can. The court held that a shadow director ought
not to be found to be in breach of duty in the first place where, had she been a de jure or de facto
director, she would have been relieved of liability under s.1157.

15.4 Specific statutory duties

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

15.4.1 Substantial property transactions

Sections 190–196, which replace ss.320–322 CA 1985, require substantial property transactions
involving the acquisition or disposal of substantial ‘non-cash assets’ by directors or connected
persons (including shadow directors (s.223(1)(b)) to be approved in advance by the company’s
members. A ‘substantial property transaction’ is defined as arising where the market value of the
asset exceeds the lower of £100,000 or 10 per cent of the company’s net asset value, if more than
£5,000 (s.191). The principal features of the regime are the following.

• It permits a company to enter into a contract which is conditional on member approval. This
implements a recommendation of the Law Commissions (s.190). The company is not to be
liable under the contract if member approval is not forthcoming (s.190(3)).
• It provides for the aggregation of non-cash assets forming part of an arrangement or series
of arrangements for the purpose of determining whether the financial thresholds have been
exceeded so that member approval is required (s.190(5)).
• It excludes payments under directors’ service contracts and payments for loss of office from
the requirements of these clauses (s.190(6)). This implements a recommendation of the Law
Commissions.
• It provides an exception for companies in administration or those being wound up (s.193).

15.4.2 Loans and guarantees

The regulation of loans by companies to their directors dates back to the Companies Act 1948. It was
severely tightened in the CA 1980 in order to address the growing problem identified in a series of
DTI investigations of directors secretly directing money to themselves under the guise of loans from
their companies on highly favourable terms (see the White Paper, The Conduct of Company
Directors (Cmnd 7037, 1977)). In contrast to the CA 1985, ss.197–214 CA 2006 do not impose an
absolute prohibition on loans to directors (including shadow directors (s.223(1)(c)) and connected
persons, but make such transactions subject to the approval of the company’s members by
resolution and, in certain circumstances, also subject to the approval by the members of its holding
company. Further, there are no criminal sanctions for breach of the provisions but rather s.213
provides for civil consequences only and s.214 also provides for subsequent affirmation. The
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requirement for members’ approval of loans applies to all UK registered companies with the
exception of wholly-owned’ subsidiaries (s.195(7)). The provisions relating to quasi-loans and credit
transactions apply only to public companies and associated companies (ss.198–203).

There are a number of exceptions to the requirement for members’ approval which have been
consolidated (see ss.204–209). These cover: expenditure on company business (s.204); expenditure
on defending proceedings etc (s.205); expenditure in connection with regulatory action or
investigation (s.206); expenditure for minor and business transactions (s.207); expenditure for intra-
group transactions (s.208); expenditure for money-lending companies (s.209).

The effect of a breach of ss.197, 198, 200, 201 or 203 is that the transaction or arrangement is
voidable at the instance of the company (s.213(2)). Further, regardless of whether the company has
elected to avoid the transaction, an arrangement or transaction entered into in contravention of the
provision renders the director (together with any connected person to whom voidable payments
were made and any director who authorised the transaction or arrangement) liable to account to
the company for any gain he made as well as being liable to indemnify the company for any loss or
damage it sustains as a result of the transaction or arrangement (s.213(4)). A director who is liable as
a result of the company entering into a transaction with a person connected with him has a defence
if he can show that he took all reasonable steps to secure the company’s compliance with ss.200,
201 or 203.

The Act does not define ‘loan’, although s.199 does define the term ‘quasi-loan’ and related
expressions (see s.199)

16 Corporate governance

Introduction

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

Learning outcomes

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

• describe the main historical periods in the development of the modern company
• explain the various corporate theories that influence the corporate governance debate
• illustrate the current trends in corporate governance writing
• form your own view of what the main purpose of a company should be.

16.1 Introducing corporate governance

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

16.1.1 The concession or fiction theory

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

16.1.2 Corporate realism

This changed, however, with the advent of the registered company in the middle of the 19th
century. Anyone could register such a company for their own private purpose and the state’s role
was correspondingly diminished in the incorporation process. A second theory, called the corporate
realism theory (hereafter, corporate realism), was, at least partly, better suited to the registered
company. It argued that the company was no fiction but had a real existence. It did not, therefore,
depend on its membersor the state for its existence. In essence the members have come together to
form an association which, once formed, has an interest of its own, which is not related in any way
to its individual members’ interests. The strength of corporate realism is that it can best explain the
separate existence of the corporation and therefore justify departure from a shareholder-oriented
focus for the corporation. Its highpoint followed the advent of large managerial companies with
enormous dispersed shareholdings.

In 1932 Berle and Means, an economist and a lawyer, made two key observations about the
operation of American companies in the 1930s. First, that shareholders were so numerous
(described as dispersed ownership and subsequently as the Berle and Means corporation) that no
individual shareholder had an interest in attempting to exercise control over management. In their
view 65 per cent of the largest two hundred US companies were controlled entirely by their
managers. Second, they expressed concern that managers were not only unaccountable to
shareholders but exercised enormous economic power which had the potential to harm society.

At the same time Dodd (1932) sought to put flesh onto some of the key remaining questions posed
by corporate realism. Crucially he sought to answer the question ‘what are the interests of this real
person if they are not equated with the shareholders?’ He argued that, just as other real persons
have citizenship responsibilities that require personal self-sacrifice, a corporation has social
responsibilities which may sometimes be contrary to its economic objectives. In turn, managers of
this citizen corporation are expected to exercise their powers in a manner which recognises the
company’s social responsibility to employees, consumers and the general public.

16.1.3 The aggregate theory

Berle (1932) responded to Dodd’s article with an opposing argument based on the aggregate theory
(hereafter, aggregate). That theory describes the company as the central institution formed by the
aggregation of private contracting individuals. That is the members come together to pool their
investment on terms they all agree. The state therefore has little to do with the corporation as a
COMPANY LAW PAGE 122

nexus of private contracting individuals. As such Berle was opposed to Dodd’s solution. He believed
that the Dodd answer was too vague. It would be practically unenforceable and lead to the
furtherance of managerial dominance. Instead he sought to focus the company’s accountability
mechanism on just the shareholders. He argued that the managers are trustees for the shareholders,
not the corporation. Thus, the managers are accountable to the shareholders and shareholder
wealth maximisation is the sole corporate interest.

Until the late 1960s the tangible success of managerial companies and the ability of these companies
to behave as corporate citizens meant that corporate realism was the dominant theory. However, by
the 1980s a change was occurring in the way shareholders were behaving. Reform in state pension
and health care funding had pushed enormous amounts of money into the equity markets through
institutional investors (pension finds, investment funds and insurance companies). At the same time
barriers to capital inflows and outflows were removed in many countries which resulted in
international investment funds operating in both the London and New York markets. In all, the
institutional investor emerged as a dominant force in those markets, holding nearly 80 per cent of
the shares in the UK market and 60–70 per cent of the shares in the US market by the late 1980s.
While institutional investors preferred to remain largely passive investors for the most part, they did
favour market mechanisms in order to promote shareholder wealth maximisation. Thus share
options grew as a percentage of managements’ total salary as this focused management on share
price as a measure of performance and the non-executive director emerged as a monitoring
mechanism on management.

16.1.4 Nexus of contracts theory

Along with this change came a challenge to corporate realism from the work of economists who
provided evidence that managerial self-interest was a dominant feature of managerial corporations.
Aggregate theory, which evolved into the nexus of contracts theory, with its emphasis on the
shareholder as a monitoring mechanism, was revitalised by economic theory and remains the
dominant theory today. While largely a reformulation of aggregate theory, this provided the
additional tools based around economic efficiency to attack the managerial firm and the pluralism of
corporate realists such as Dodd. In a nexus of contracts analysis the firm is reduced to contracts and
markets and thus the firm is not in any sense a real person. Therefore, it has no interests of its own
into which one can place corporate social responsibility. Additionally, the allocation of resources by
management to social issues would be inefficient as the monitoring mechanism within the firm in a
nexus of contracts analysis ensures efficiency through a presumption that shareholders maximise
their own self-interest (see Jensen and Meckling (1976)).

The emergence of the Berle and Means corporation has not been universal. Indeed it only emerged
in the UK in the late 1960s. In most of the rest of the world a managerial class emerged but not
accompanied by dispersed ownership. Rather founding families, other companies and banks held
controlling stakes in these companies. Thus, outside the UK and the US the accountability issue has
not formed such a large part of the corporate governance debate. The differences in the corporate
governance systems around the world has also become a major area of study based around the
preconditions necessary for the emergence of a US/UK corporate governance system (see Coffee
(2001)).

16.2 The shareholder–stakeholder debate in the UK

UK company law has traditionally given primacy to the interests of shareholders. However
arguments supporting the status quo within the corporate governance debate in the UK have not,
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until recently, been influenced by economic theory (see Cheffins (1997)). Historically arguments
against the primacy UK company law gives to shareholders have been based on three general points.

• First, corporations are very powerful and therefore have an enormous effect on society.
Thus a narrow accountability to shareholders is insufficient to protect society’s interests.
• Second, some, like Parkinson (1995), argue that the assumption that shareholders have a
moral claim to primacy by virtue of their property rights is plainly incorrect. If shareholder
primacy is to be justified it must be on other grounds.
• Third, the moral claims of others (stakeholders) either outweigh the shareholders’ claims or
at are at least equal to them when it comes to allocating primacy.

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

16.3 UK corporate governance developments

16.3.1 The UK Corporate Governance Code

As we have seen, the UK has traditionally given primacy to shareholder interests, and the majority of
the corporate governance developments we shall address here reflect that position. Their aim is to
ensure that those running large, quoted, companies, are more accountable to their investors, rather
than to other ‘stakeholders’ within the company.

Perhaps the most significant instrument that seeks to achieve this accountability is the UK Corporate
Governance Code. This is now issued by the UK’s Financial Reporting Council (FRC), and the latest
version dates from 2018. It began its life, however, in 1992, following the report of the Cadbury
Committee (1992) on the Financial Aspects of Corporate Governance. That Committee was
established by the Financial Reporting Council, the London Stock Exchange and the combined
accounting bodies. The report was an industry attempt to address some of the accountability
concerns expressed about UK listed companies. While fairly narrowly focused the report succeeded
in identifying the lack of managerial accountability at the heart of most UK listed companies. The key
recommendation of the Cadbury Committee was to introduce non-executive directors to the main
board, the idea being that these non-executive directors would bring some objectivity to board
decisions. Cadbury also recommended that a committee structure should be put in place to improve
the accountability of the appointment of directors, the pay (remuneration) of directors and the audit
process. Therefore a listed company should have three sub-committees of the board to cover
appointments, remuneration and audit. The accountability process would be ensured by having non-
executives on each of the sub-committees. The remuneration committee in particular was to be
made up wholly or mainly of non-executives and the audit committee should have at least three
non-executives. The London Stock Exchange implemented the Cadbury recommendations on a
comply or explain basis (i.e. if you don’t comply you need to explain why) and subsequently the
Cadbury model has been adopted by stock exchanges around the world.

Accountability issues rumbled on after Cadbury, particularly regarding directors’ pay, and by 1995
the Greenbury Committee (Directors Remuneration, Report of the Study Group, 1995) was formed
to report on directors’ pay. Greenbury identified that there is an inherent conflict of interest in
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directors deciding on their own pay and recommended an enhanced disclosure regime for directors’
pay and a non- executive only remuneration committee. Unfortunately the open disclosure regime
recommended by the Greenbury committee only succeeded in providing a reference point for
managers to negotiate higher salaries as they could point to higher salaries in other similar
companies to justify higher pay claims.

We shall return to questions of pay below. But sticking with codes of practice, a third committee
called the Hampel Committee reported in 1998 and, while offering nothing new to the accountability
issues, provided an opportunity to combine the Cadbury and Greenbury recommendations into one
single code called the Combined Code.

The Hampel Committee’s importance lies in that fact that its failure to meaningfully engage in the
corporate governance debate antagonised the government into putting corporate governance firmly
on its reform agenda within the ambit of the CLRSG (see below).

The collapse of the US company Enron in 2002 spurred the government into announcing a review of
the role of non-executive directors in UK companies. The review was carried out by Derek Higgs,
who consulted widely and produced a final report in January 2003. Its key recommendation was to
provide a good definition of independence for non-executives, which was adopted by the LSE. A non-
executive director will now only be considered independent when the board determines that the
director is independent in character and judgment and there are no relationships or circumstances
which could affect, or appear to affect, the director’s judgment. Such relationships and
circumstances arise where the director:

• is or has been an employee of the company

• has or had a business relationship with the company
• is being paid by the company other than a director’s fee and certain other payments
• has family ties to the company or its employees
• holds cross-directorships or has significant links with other directors through involvement in
other companies or bodies
• represents a significant shareholder
• has served on the board for 10 years.

The Higgs independence criteria have subsequently been adopted by the London Stock Exchange.

In 2010, the Combined Code was renamed the UK Corporate Governance Code. Responsibility for
updating its provisions in future years, and for monitoring compliance with its terms, was taken on
by the Financial Reporting Council. It is now updated every two years.

Despite this change in responsibility, the basic philosophy of the code remains the same. It continues
to focus on the structure, composition and role of the board, with an emphasis on ensuring a
sufficient proportion of independent non-executive directors who are responsible for monitoring
their executive colleagues. Compliance remains optional, but the companies to which it applies
(those with a ‘premium listing’ on the LSE) must declare whether they do comply with its
recommendations and explain their reasons for any non-compliance. You can access the latest
version of the Code at: www.frc.org.uk/corporate/ukcgcode.cfm

One interesting change that was first introduced in the 2012 version of the Code is a
recommendation that the company’s annual report should ‘include a description of the board’s
policy on diversity, including gender, any measurable objectives that it has set for implementing the
policy, and progress on achieving the objectives’. This change to the Code followed on from the
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Review undertaken by Lord Davies into the proportion of women on company boards, which can be
accessed at: www.gov.uk/ government/news/women-on-boards

That review set a goal for the 100 largest quoted companies (known as the ‘FTSE 100’) to have at
least 25 per cent female board members by 2015. This target had been achieved by October 2015,
with a female board membership of 26 per cent.

As noted above, the latest version of the Code dates from 2018 and took effect from 1 January 2019.
This new version is rather shorter, and supposedly ‘punchier’, than its predecessors. There is now a
simpler division between the Code’s general ‘Principles’, and its more specific ‘Provisions’. There are
18 Principles, which are fairly broad, high-level statements of good practice, which companies are
expected to apply, and to explain how they do so. The 41 Provisions are more detailed and more
specific but companies have more scope for choosing not to follow some of them. Where they
choose not to do so, they must explain why.

16.3.2 The UK Stewardship Code

The UK Corporate Governance Code, as we have seen, focuses primarily on the contribution which a
reformed board of directors can make to good governance. But some might argue that shareholders,
rather than relying on non-executives, should take more responsibility themselves for improving
how their companies are managed. This sentiment lies behind the Stewardship Code, which was first
issued, again by the FRC, in 2010. Like the UK Corporate Governance Code, its life began rather
earlier, but we can pick up its story in 2009, with the report of the Walker Review.

The Walker Review

Sir David Walker had been appointed to examine corporate governance in, specifically, the financial
services industry, following the global financial crisis of 2008. In November 2009 he published his
report. Much of the report was critical of the behaviour of directors in financial institutions,
including their lack of understanding about the risks their organisations were running, their failure to
exercise proper control over the banks executives, and the structure of their remuneration awards.

However, criticism was also directed at the shareholders of financial institutions. They either
encouraged, or at least failed to stop, excessive risk taking, and generally failed to exercise their
responsibilities to engage with the banks executives and directors – their so-called ‘stewardship
responsibilities’. The full review can be found at: http://
webarchive.nationalarchives.gov.uk/20130129110402/http://www.hm-treasury.gov.uk/d/
walker_review_261109.pdf

Walker suggested a number of changes to the governance regimes of financial institutions. Again,
many of these focused on boards. But he also recommended that Institutional shareholders and
fund managers should be more engaged with the companies they invest in. To encourage this they
should comply, or explain non- compliance, with a ‘stewardship code’ overseen by the Financial
Reporting Council in the same manner as the UK Corporate Governance Code.

The Stewardship Code

In response to Walker’s recommendations, the Financial Reporting Council published the first
Stewardship Code in 2010. It was revised in 2012 and again, more extensively, with effect from 1
January 2020. It applies to ‘institutional investors’ generally. This group covers not only institutional
shareholders themselves (such as pension funds, or insurance companies) but also those firms of
‘asset managers’, which typically look after the shareholdings of such institutional shareholders. For
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these organisations, the Code sets out nine principles of stewardship, which such organisations are
expected to apply. They must also explain, through an annual reporting requirement, how the
principles have been applied. Furthermore, organisations that act as ‘service providers’ to
institutional shareholders (such as organisations that provide proxy voting services) are also made
subject to the 2020 version of the Code. Such service providers are subject to a shorter list of just
seven principles, which they must likewise ‘apply and explain’.

More information, including a copy of the 2020 Code itself, can be found here:
www.frc.org.uk/investors/uk-stewardship-code

16.3.3 Executive remuneration

We have noted already the controversy that executive pay has generated in the UK. You can read
more about the arguments around this topic (written from a critical perspective) at
http://highpaycentre.org/

Also, have a look back at this topic in Chapter 14, and note how, in quoted companies,
‘Remuneration Reports’ must be prepared, and these must be voted on by shareholders. As a result
of changes introduced in 2013, the shareholders’ vote is now binding (as to the company’s
remuneration policy).

In August 2016, the Government launched its project called Corporate Governance Reform, which
was a general review of corporate governance arrangements in the UK; see
www.gov.uk/government/consultations/corporate-governance-reform

One aspect of that review concerned executive remuneration, and especially the growing gap within
many companies between the pay of the company’s executives and the pay of the company’s other
workers. As a result, the Companies (Miscellaneous Reporting) Regulations 2018 have now been
introduced, requiring quoted companies to reveal the ratio between the pay of their CEO and the
average pay of the company’s UK workforce.

16.3.4 Long-termism

In October 2010 ‘BIS’ (a government department) launched a review of ‘corporate governance and
economic short-termism’; see: www.bis.gov.uk/Consultations/a-long- term-focus-for-corporate-
britain?cat=open. One major concern was whether UK equity markets in particular contributed
towards the alleged ‘short-termism’ of UK companies. To explore this issue further, Professor John
Kay was appointed to examine key issues related to investment in UK equity markets and its impact
on the long-term performance and governance of UK quoted companies. In February 2012, Kay and
his colleagues produced an interim review, which provided a wide range of evidence that British
companies were indeed subject to damaging short-term pressures, particularly from shareholders.

Kay’s final report appeared in July 2012. See: www.bis.gov.uk/kayreview

It listed 17 specific recommendations for addressing these short term pressures. The bulk of these
focused on investors (both shareholders and asset managers) and included:

• developing the Stewardship Code to ‘incorporate a more “expansive” form of stewardship,

focussing on strategic issues as well as questions of corporate governance’
• establishing an ‘investors forum’ to facilitate collective engagement by investors
• providing that those involved in the investment chain who had discretion over the
investments of others (e.g. asset managers) or who gave investment advice to others, should
be subject to fiduciary standards
COMPANY LAW PAGE 127

• increasing transparency over the costs charged by asset managers

• ensuring that the structure of asset managers’ pay encouraged long termism. Other
recommendations focused on companies themselves, and included:
• ensuring companies engaged more with long-term investors over major board appointments
• ensuring the structure of directors’ remuneration rewarded long-term performance
• discouraging companies from trying to manage shareholders’ ‘short-term earnings
expectations’.

To support some of the above recommendations, Kay also proposed a set of three ‘Good Practice
Statements’, aimed at directors of companies, asset managers and institutional shareholders. These
statements would highlight the responsibilities of these different actors for encouraging more
stewardship and more long-term decision making.

BIS largely accepted Kay’s analysis of the role which equity markets played in encouraging short-
termism, and also agreed with almost all of Kay’s specific recommendations. Of course, many of the
recommendations were aimed at investors, or companies, rather than government. But one
practical response BIS made immediately was to publish Kay’s three proposed ‘Practice Statements’
for directors, asset managers and shareholders. These statements can be found in Annexes A–C of
the BIS response. However, these practice statements are not legally binding on directors,
shareholders or asset managers, and no additional mechanisms have been developed to ensure that
those to whom they are addressed follow them. It remains to be seen, then, whether they will have
any impact on the behaviour of their addressees.

16.3.5 Stakeholder initiatives

So far, we have been concentrating on initiatives designed, primarily, to make companies more
accountable to their shareholders. We have noted already that UK company law and corporate
governance has, historically, tended to ally itself with shareholder primacy.

However, when a politically more left-leaning government was elected in the UK in 1997, there was
an expectation by some that this might result in greater attention being given to stakeholder
interests. The Government’s decision to embark on the ‘modernisation’ of company law, under the
leadership of the CLRSG, which would eventually lead to the CA 2006, increased this expectation. We
can note two areas of company law where the tension between a commitment to shareholder
primacy, and reforms aimed at increasing the weight given to stakeholder interests, were played
out.

Section 172 Companies Act 2006

The first area is in respect of directors’ duties, and in particular the duty that became s.172 CA 2006.
After a long exploratory process the CLRSG focused on including, in a simplified reform of directors’
duty, obligations to stakeholder groups. The CLRSG recommended that directors’ duties should be
expanded to include stakeholder constituencies and its recommendations were adopted by the CA
2006 in s.172. Remember that s.172 says that:

(1) A director of a company must act in the way he considers, in good faith, would be most likely to
promote the success of the company for the benefit of its members as a whole, and in doing so have
regard (amongst other matters) to—

(a) the likely consequences of any decision in the long term,

(b) the interests of the company’s employees,

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(c) the need to foster the company’s business relationships with suppliers, customers and
others,

(d) the impact of the company’s operations on the community and the environment,

(e) the desirability of the company maintaining a reputation for high standards of business
conduct, and

(f) the need to act fairly as between members of the company.

We have considered already the rather curious way this section is expressed. It does at least give an
express recognition of stakeholder interests, and tries to encourage or legitimise ‘enlightened’
directors considering the interests of ‘stakeholders’ in their decision-making process. However, most
commentators accept that it still retains the primacy of the shareholders’ interests, albeit while
perhaps gently nudging directors to think about stakeholders.

Social reporting

The other area where efforts have been made to address stakeholder interests is in respect of the
reporting obligations of companies. Even if companies, or their directors, are not compelled to give
more weight to stakeholder interests, requiring companies to disclose how well – or badly – they
treat their stakeholders may encourage companies to improve their behaviour. If companies must
disclose their employment and supply chain practices, their record on environmental impact, how
much tax they pay, and so on, fear of adverse publicity may provide a strong incentive against
misbehaviour.

Traditionally, of course, company law in the UK has focused on the release of financial information,
aimed at letting shareholders and creditors know how well the company is performing. However,
the White Paper published by the UK Government prior to the introduction of the Companies Bill
2005 (http://webarchive.nationalarchives.gov.uk/20090609003228/http://www.berr.gov.uk/
files/file25406.pdf at p.10) recommended the introduction of an Operating and Financial Review
(OFR) which would provide a narrative statement on the company’s activities as they affect
stakeholder constituencies. The justification for this was that directors would have to give more
credence to stakeholders if they had to write a report on the effect of the company’s activities on
those stakeholders.

Without waiting for the enactment of the CA 2006, the Government acted on this White Paper
proposal. It drafted the Companies Act 1985 (Operating and Financial Review and Directors’ Report
etc.) Regulations, and these were enacted in March 2005.

Almost immediately, however, the Regulations became mired in controversy. Directors were afraid
that they might face increased personal liability if there were errors in the more forward-looking
information they were now being required to provide. In response, somewhat remarkably, the then
Chancellor, Gordon Brown, announced on 28 November 2005 that the OFR would be repealed from
12 January 2006. (See the Companies Act 1985 (Operating and Financial Review) (Repeal)
Regulations 2005, SI 2005/3442.)

But this ill-thought out repeal was complicated further by the fact that European legislation, in the
form of the European Accounts Modernisation Directive (Directive 2003/51/EC), itself required a
‘fair business review’ (FBR) to take place. And the FBR sounded similar to what the OFR had
required, before it was so hastily repealed. As a result, the CA 2006, in s.417, then reinstated a
requirement for companies to include, as part of the directors’ annual report, a ‘business review’.
COMPANY LAW PAGE 129

Finally, in 2013, s.417 was itself repealed, and the need for a business review was replaced with a
requirement that companies prepare a ‘strategic report’ (see s.414A–D CA 2006). We have already
examined that requirement in Chapter 15.

This rather complicated and messy process of false starts and half measures does not reflect terribly
well on the reform of UK company law. The amount of stakeholder- relevant information that must
be given remains quite modest. But it is at least an acknowledgement that groups other than
shareholders also have an interest in how companies are performing. As noted already above, in
2016 the Government launched its review of UK corporate governance arrangements, entitled
Corporate Governance Reform. One recommendation from the Corporate Governance Reform
project was that companies should be required to give out more information about how their
directors implement the obligation, in s.172, to take account of the interests of a variety of
stakeholders. This has now been achieved through amendments to the strategic report requirement
in s.414, which was considered above.

Moreover, and going beyond mere ‘social reporting’, the Government also decided to direct the FRC
to amend the UK Corporate Governance Code to require companies that are subject to the Code to
improve their engagement with stakeholders. This has now been achieved in the new, shorter,
version of the Code that was issued in 2018. It now contains two new Principles focusing on
stakeholder engagement. Principle D states that ‘[in] order for the company to meet its
responsibilities to shareholders and stakeholders, the board should ensure effective engagement
with, and encourage participation from, these parties.’ Principle E declares that ‘[t]he board should
ensure that workforce policies and practices are consistent with the company’s values and support
its long-term sustainable success. The workforce should be able to raise any matters of concern.’
Finally, there is a new Provision 5, which states that ‘[f]or engagement with the workforce, one or a
combination of the following methods should be used:

• a director appointed from the workforce;

• a formal workforce advisory panel;
• a designated non-executive director.’

17 Liquidating the company

Introduction

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

Learning outcomes

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

• explain the ways in which a company may be wound up

• describe the powers and duties of the liquidator
• describe the order in which creditors are paid
• discuss the liabilities of directors of insolvent companies.
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17.1 Liquidating the company

The Insolvency Act 1986 (IA 1986) is the principal statute we are concerned with in relation to
liquidations.

There are three principal ways in which a company’s existence can be brought to an end (i.e.
dissolved).

• The members may decide to wind up the company – this is termed voluntary winding up.
• The creditors may force the dissolution of a company where it is insolvent (i.e. it cannot pay
its debts) – this is termed compulsory winding up.
• It is in the public interest to wind up a company.

17.1.1 Voluntary winding up

The members of the company may decide to wind it up. They may do this even though it is solvent –
because, for example, they wish to retire or its original purpose has come to an end. Or they may
choose to wind it up because it is in fact insolvent, and the members do not wish to wait until
creditors force the company into a compulsory winding up. Section 84(1) of the IA 1986 provides for
two situations in which the company may be voluntarily wound up.

1. When the period, if any, fixed for the duration of the company by the articles expires, or the
event, if any, occurs which the articles provide will result in the company being dissolved, and the
general meeting has passed a resolution requiring it to be wound up voluntarily (this category is rare
nowadays).

2. If the company resolves by special resolution that it be wound up voluntarily.

In practice, it is the second of these two situations (members passing a special resolution) which
most often leads to a voluntary winding up. A voluntary winding up can still proceed in two very
different ways. First, if the directors of the company are prepared to make a ‘statutory declaration of
solvency’ under s.89 of the IA 1986, then the winding up will proceed as a ‘members’ voluntary
winding up’. In that situation, the members will have a great deal more control over the winding up
process (such as the choice of liquidator). This degree of member-control is seen as appropriate
given that creditors are likely to be paid in full (because the company is solvent). Secondly, if the
directors are not prepared to make the declaration of solvency, then a ‘creditors’ voluntary winding
up’ will ensue.

In either case, a copy of the winding up resolution must be sent to the Registrar of Companies within
15 days (s.84(3) IA 1986 and s.30 CA 2006). It is the task of the liquidator to take control of the
company for the purpose of realising its assets, meeting its liabilities and distributing any surplus left
over to the shareholders (ss.91 and 107 IA 1986). Once the liquidator has completed this task and
has sent to the Registrar of Companies his final account and return under s.94 (members’ voluntary
winding up) or s.106 (creditors’ voluntary winding up), the Registrar shall then register them. Three
months after the registration of the return the company is deemed to be dissolved (s.201).

17.1.2 Compulsory winding up

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

It should be noted in relation to the third category that a company will be deemed to be insolvent
where the value of the company’s assets is less than the amount of its liabilities (s.123(2) IA 1986).
On the meaning of ‘unable to pay its debts’, see BNY Corporate Trustee Services Ltd v Eurosail-UK
2007-3BL plc [2013] UKSC 28.

However, if the debt is disputed on bona fide grounds the court will not allow the petition to
proceed. Thus, if a creditor presents a petition in order to pressurise the company into paying a
debt, the amount of which is genuinely disputed as being excessive, the court may dismiss the
petition with costs (Re London and Paris Banking Corp (1874) LR 19 Eq 444).

However, if the petition proceeds a creditor who is owed £750 or more will be entitled to a winding
up order although the court may refuse to make an order if the petition is not supported by the
majority of creditors (s.195). If the court does make an order to wind up the company it is made in
favour of all the creditors, not just the petitioner, and the Official Receiver is appointed as liquidator.
At this point, if the Official Receiver finds that the realisable assets of the company are insufficient to
cover the expenses of the winding up and that the affairs of the company do not require further
investigation, he or she may apply to the Registrar of Companies for the early dissolution of the
company. Such an application is then registered by the Registrar and three months after the date of
the registration of the notice the company is dissolved. But, if there are sufficient funds to cover the
expenses of the liquidation the Official Receiver has the power to summon separate meetings of the
company’s creditors and contributories for the purpose of choosing a person to be liquidator of the
company in his or her place (s.136(4)). Once the liquidator has completed his function (see below),
s.205 provides that when he has filed his final returns or the Official Receiver has filed a notice
stating that he considers the winding up to be complete, the Registrar of Companies shall register
those returns or the notice forthwith. At the end of the period of three months beginning with the
day of that registration the company is dissolved (s.205(2)).

17.1.3 Public interest winding up

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

17.2 The liquidator

17.2.1 The liquidator’s role and powers

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The winding up order terminates the management powers of the company’s directors (Measures
Bros Ltd v Measures (1910) 1 Ch 336). Their powers are transferred to the liquidator, together with
their fiduciary duties, and so a liquidator must act in good faith, avoid a conflict of interests and not
make a secret profit (Silkstone and Haigh Moore Coal Co v Edey (1900) 1 Ch 167). Section 230(3) of
the IA 1986 provides that a liquidator must be a qualified insolvency practitioner. He or she acts in
the name of the company and will not, therefore, be liable on contracts entered into on behalf of
the company (Stead, Hazel & Co v Cooper [1933] 1 KB 840).

The liquidator takes control of the company for the purposes of realising the company’s assets and
distributing them among the claimants according to their priority. For example, corporate property,
which is subject to a fixed charge, must be used first to redeem the secured loan to which the charge
relates. Similarly, where a supplier of goods has reserved title until payment, ownership will not
have passed to the company and so the liquidator cannot incorporate these goods into the common
pool of assets. If there are insufficient assets left over after taking account of any fixed charges
together with the preferential debts to satisfy the unsecured creditors, their debts abate equally.
The order in which debts are to be satisfied in a liquidation is as follows.

1. All expenses properly incurred in the winding up, including the remuneration of the liquidator.

2. Preferential debts as identified in ss.107, 115, 143 and 156 (e.g. unpaid employees’ wages).

3. Ordinary debts.

4. Deferred and subordinated debts.

(See ss.107 and 115 (voluntary liquidations) and ss.143 and 156 (compulsory liquidations); see also
s.175 which is of general application.)

Any balance remaining is distributed to members in accordance with their entitlements under the
company’s memorandum and articles.

Prior to the Enterprise Act 2002, preferential debts were defined by s.386 IA 1986 as debts listed in
Schedule 6. These included: debts owed to the Inland Revenue in respect of PAYE deductions during
the previous 12 months but not remitted to the Revenue; debts due to Customs and Excise in
respect of six months’ VAT; debts owed to the Department of Health and Social Security in respect of
employers’ National Insurance contributions; debts owed by way of unpaid wages to employees and
former employees for the four-month period before the commencement of the winding up
(maximum of £800) together with unpaid holiday pay and outstanding contributions to pension
schemes. Corporation tax liabilities which accrue after the commencement of a winding up are a
‘necessary disbursement’ of the liquidator and are therefore expenses of the winding up payable
before preferential debts (Re Toshoku Finance (UK) plc, Kahn v Inland Revenue (2002)). Section 251
of the Enterprise Act 2002 amends s.386 and Schedule 6 to the IA 1986 by abolishing Crown
preferential debts (i.e. debts due to the Inland Revenue, Customs and Excise and social security
contributions) and adds contributions to occupational pension schemes to the list in Schedule 6 (see
above). Section 252 of the Enterprise Act 2002 inserts a new s.176A into the IA 1986, which requires,
for the benefit of unsecured creditors, a ring-fenced fund to be created out of the realisations of
floating charges. The amount to be transferred to the prescribed fund for transmission to unsecured
creditors is calculated according to the following: 50 per cent of the first £10,000 plus 20 per cent of
available funds above £10,000 up to a maximum of £600,000. The prescribed fund only applies to
floating charges created after 15 September 2003.
COMPANY LAW PAGE 133

The liquidator is given extensive powers to deal with the company and its property, in order to wind
it up. These powers are contained in s.167 of the IA 1986, and Parts 1 to 3 of Schedule 4 of the IA
1986. Previously, the liquidator could only exercise some of these powers with the sanction of either
the court or the liquidation committee, but this is no longer the case. No such prior approval is now
required. If creditors, say, were dissatisfied with actions taken by the liquidator, they would have to
challenge the liquidator after she had already acted.

Although, as we have seen, the liquidator’s main role is to secure that the company’s assets are got
in and distributed to the creditors (s.143), he also, along with the court, polices the end of the
company to ensure insiders do not take advantage of the company’s genuine creditors. As such the
liquidator is empowered by s.238 IA 1986 to apply to court to set aside any transactions at an
undervalue which may have occurred in the two years preceding the winding up.

Sometimes in the lead-up to liquidation the company will attempt to put certain creditors in
preferred positions to ensure that they get paid (often the creditors in question are in fact directors
of the company who may have personally guaranteed a loan to the company). Section 239 allows
the liquidator to apply to court to have such a preferment set aside. Insiders may also enter into
extortionate credit arrangements which bind the company. If this occurs within three years of the
winding up, s.244 again provides for the liquidator to apply to the court to set the transaction aside.

The liquidator in a voluntary solvent liquidation, while he has the same duties of good faith as a
liquidator in a compulsory liquidation, has a very different role. In a voluntary solvent liquidation the
liquidator simply gathers together the assets, pays the liabilities and distributes any surplus to the
members. In a compulsory liquidation the liquidator will also carry out this function but usually
without any chance that the asset value will exceed the company’s liabilities. Thus the liquidator’s
main function will be to determine the priority in which creditors will receive payment. The
liquidator will also police the years immediately before the insolvency for any irregular transactions
that might be challengeable.

17.2.2 Post-winding up dispositions of company property

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

As a safeguard against possible abuses of power, directors of failed companies face certain
restrictions on their activities in the immediate aftermath of an insolvency. Sections 216 and 217 of
the IA 1986 prohibit a director of a company that has gone into insolvent liquidation from being
involved for five years in the management of a company using either the same name as the insolvent
company or a name that is so similar as to suggest an association with it. The objective of this
provision is to prevent a director simply registering a new company with a similar name and
continuing to trade. (See Re Produce Marketing Consortium Ltd (1989) BCLC 520 in which it was held
that the directors’ failure to keep proper accounts was no defence when determining whether they
knew, or ought to have known, that the company was insolvent.)

Additionally, directors face the real threat that they may become personally liable for the debts of
the company should the civil or criminal penalties for fraudulent and wrongful trading apply.

Fraudulent trading under s.213 IA 1986 occurs where any business of the company has been carried
on with intent to defraud creditors of the company or creditors of any other person, or for any
fraudulent purpose. The possibility of criminal liability for fraudulent trading also arises under s.993
of the CA 2006, the wording of which is virtually identical to s.213 IA. As a result of the linkage
between the two sections the courts have set the standard of proof for s.213 very high. This led to
the introduction of the easier-to-prove offence of wrongful trading in s.214. This provides that the
liquidator must prove that, at some time before the commencement of its winding up, a person was
a director of the company and he or she either knew, or ought to have concluded, that there was no
reasonable prospect that the company would avoid going into insolvent liquidation. The director is
then liable to contribute to the assets of the insolvent company, unless the director, from the
moment she knew (or ought to have concluded) that insolvency was inevitable, took all the steps
she ought to have taken to minimise the loss to creditors. The onus of proving that the director took
all the steps he or she ought to have taken is on the director: Brooks v Armstrong [2015] EWHC 2289
(Ch).

Liquidators have often proved unwilling to bring claims under ss.213 and 214 IA 1986. Now, s.246ZD
IA1986 (introduced by the Small Business, Enterprise and Employment Act 2015) permits liquidators
to assign (and therefore, effectively, to sell) such causes of action. Thus, a liquidator, who decides
that they do not want to bring an action against, say, a director of the company for wrongful trading,
might nevertheless choose to sell (and, thus, assign) the action to a third party, who would then be
able to bring the action instead. In this way, the liquidator gets at least some money for the benefit
of the creditors, and the risks associated with bringing the claim fall on the purchasing third party.
However, if the action is successful, the benefit will go to the third party (rather than to the insolvent
company for the benefit of all the creditors).

17.4 Reform

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