• Enviroco - A Country-By-Country Investigation of the Consequences of This Decision on Share Security
  • August 1, 2011
  • Law Firm: Norton Rose Canada LLP - Montreal Office
  • Introduction

    The Supreme Court has recently decided that the transfer of shares in a company to a lender as security could separate a subsidiary from its group for the purposes of the Companies Act statutory definition of “Subsidiary”1.

    The statutory definition is used in many English law contracts to which overseas companies may be a party. This means the decision, whilst limited in its facts, has the potential to disconnect subsidiaries from their group, not only in England but also overseas. We have been canvassing opinion across our offices and contacts to consider the potential effects on cross-border transactions to be considered when structuring financings, and whether it is necessary to revisit existing share security arrangements to consider the effects on groups of companies. We have also taken the opportunity to give a reminder in this briefing of the pros and cons of taking security over shares in the context of a group finance transaction.

    In this briefing we cover:

    • A comparison of taking share security in different jurisdictions
    • A short summary of how the Companies Act definition of Subsidiary was interpreted by the Supreme Court in the Enviroco case
    • A summary of common uses of the Companies Act definition of “Subsidiary” where the risk of a company falling outside the corporate group should be considered
    • Common reasons for considering taking share security
    • A summary of how share security is taken under English law



    Footnote
    1. Enviroco Ltd v Farstad Supply A/S [2011] UKSC 16




    A comparison of taking share security in different jurisdictions

    The risk of a subsidiary no longer forming part of the group as identified in Enviroco will only occur where shares in a company have been transferred to a lender.  However, in most jurisdictions, it is unnecessary for the lender to become the outright owner of shares to benefit from a security interest.  In some jurisdictions though, it is common to convey voting rights to secured shares which may also de-group a subsidiary for the purposes of the English law Companies Act definition. 

    Below is a comparative table showing how security is taken in various countries canvassed during our cross border share security survey and identifying where particular methods for taking security may take a company outside the parent-subsidiary relationship.

    As a matter of English law, the Enviroco decision has not made the further leap from separating the subsidiary from its original parent granting security, to finding it instead a subsidiary of the secured lender - the statutory parent-subsidiary test requires not just membership of the subsidiary but also majority voting rights and voting rights are not usually conveyed to the lender until the security is enforced.


    Country of incorporation of company whose shares are secured

    Methods of taking security over shares

    Risk of taking a subsidiary outside the group (Low/Medium/High)

    England, Hong Kong, Singapore, Australia, Malaysia, Vietnam

    In each of these jurisdictions, there is the possibility of taking security by way of legal mortgage as an alternative to a charge. In the case of a legal mortgage, transfer of title to the shares is necessary but it is more common to follow the charge route.

    Low/Medium

    Germany, The Netherlands, Greece, South Africa, Russia, Sweden, People’s Republic of China, Indonesia, Thailand, Liberia, Panama, Marshall Islands, Cyprus, Malta

    In each of these jurisdictions, it is common to take pledges which do not require transfer of title to shares.

    Low

    Scotland

    A Scottish law pledge of shares requires transfer of title to the shares to the secured lender.

    High

    France

    In the majority of cases security is taken over shares by way of pledge which does not require transfer of ownership of the shares to the pledgee. However, under legislation enacted in 2007 and amended in 2009, it is now also possible under French law to create a “security assignment” of secured assets to a fiduciary (fiduciaire) designated for such purpose, who holds title to such assets and administers them in favour of a designated group of beneficiaries. For various reasons, the use of the fiducie structure has been extremely rare in France but nevertheless if used, would involve a transfer of title.

    Low

    Poland

    Security is taken over shares by way of registered pledge involving no transfer of title and so no de-grouping risk under the English law Companies Act. However, the pledgee may be considered as a parent entity under Polish antitrust law, companies law and capital market regulations when it is entitled to exercise a majority of votes at the shareholders' meeting regardless of whether it exercises such voting rights as a shareholder or as a pledgee.

    Medium

    Czech Republic

    A security interest is created over shares by way of a pledge which does not require the transfer of ownership to the lender.

    However, a recent Czech case has held a secured lender holding a pledge over the shares in the borrower effectively controlled the borrower, and as a result the borrower formed part of the lender’s corporate group. The lender holding voting rights to the pledged shares contributed to the court forming this conclusion. This has several adverse consequences in Czech law:

    1.       Under Czech law, banks are limited in owning or controlling qualified (more than 10%) stakes in companies other than financial institutions. This may result in a penalty being imposed by the Czech National Bank.

    2.       Group creditors do not have the same rights as other creditors on insolvency and are restricted from being members of a creditors' committee.

    3.       If a lender, by virtue of its share security, is found to indirectly control a majority stake in a company, it may be liable for damages to the company and its shareholders caused as a result of it exercising its influence.

    Medium

    Canada (Toronto and Québec)

    A security interest in certificated and uncertificated shares is created through a security agreement and perfected by control by either possession of endorsed share certificates, or alternatively by delivery of a certificate to the lender showing it as the registered holder. In the latter case, this would make the lender the shareholder of record.

    In most cases a lender will use the first option which gives it flexibility to exercise the right to become a registered holder at a later time, while giving the pledgor continued rights as shareholder (whether voting or otherwise). Lenders usually avoid becoming owner of record.

    For uncertificated shares, control is obtained through a control agreement (where the issuer agrees to act on instructions of the lender without the need for any further consent from the registered holder) or through being registered on the share register of the issuer as the shareholder. Again, in virtually all cases, lenders prefer to use control agreements and not become the registered holder.

    Medium

    Japan

    Security over certificated shares is usually created in the form of a pledge or security transfer. In the case of a security transfer, the creditor is shown in the share registry as sole holder of the shares and is entitled to shareholder rights and benefits subject to any restrictions in the security agreement.

    High

    United Arab Emirates

    Shares are pledged under UAE law and this does not required title transfer. However, Article 164 of the UAE Commercial Companies Law gives the mortgagee the right to receive dividends in respect of the shares and utilise the entitlements attached to the shares (including voting rights), however, the law is silent in respect of how voting rights should be exercised. The relevant pledge agreement or commercial mortgage may contain details of how voting rights should be dealt with, and if prior to enforcement, the secured lender is entitled to exercise voting rights in its own interest rather than just for the purposes of its security or otherwise on the instruction of, or in the interest of, the pledgor, then this may also have the effect of de-grouping the subsidiary for the purposes of the English law Companies Act statutory definition of Subsidiary.

    Medium

    Philippines

    Security over shares can be taken by way of chattel mortgage (requiring transfer of title) or by way of pledge (by transfer of possession). It is however more common to take a pledge.

    Medium

    South Korea

    For granting a security interest over shares, the following four methods are mainly used; i) unregistered pledge, ii) registered pledge, iii) unregistered security by transfer of ownership (with an obligation to retransfer following satisfaction of the secured obligations) and iv) registered security by transfer. The most common form of security effected over shares is by registered pledge.

    High

     


     

    Enviroco - how the Companies Act definition of Subsidiary was interpreted by the Supreme Court

    The particular facts of the Enviroco case were fairly unusual in that the parent company exercised majority voting rights by way of a shareholder agreement but only held a 50 per cent shareholding, pledged under Scottish law to a bank. The parent and its subsidiaries held a group insurance policy which used the English Companies Act definition of Subsidiary to determine the group companies able to benefit from the policy.

    There are three alternative definitions of a subsidiary within section 1159 of the Companies Act 2006 (the statutory test being the same under the equivalent section 736 of the Companies Act 1985). The most commonly relied on limb in subsection (a) applies where the parent holds a majority of the voting shares. In this case, the 50 per cent holding did not satisfy this limb so instead the parent relied on the alternative test in section 1159(c) where the parent is a member and exercises a majority of the voting rights in the subsidiary by way of agreement with other shareholders. However, to perfect the share pledge, it had been necessary under Scottish law for the parent’s lender to become the registered shareholder in the books of the company. As a consequence of this, the Supreme Court found that the parent did not satisfy the “member” part of the test in section 1159(c) and the relevant subsidiary was unable to rely on the insurance policy.



    Common uses of the Companies Act definition of ‘Subsidiary’ where issues may arise if a company whose shares are secured to a lender may fall outside the corporate group

    Where share security is taken in jurisdictions where title transfer is necessary, consideration needs to be given to the effect on any English law governed commercial agreement or other group related arrangements to ensure the subsidiary-parent relationship is maintained for all necessary purposes. Examples of where problems may arise if a subsidiary falls outside the group, are set out below.

    • Loan agreements often refer to the borrower’s group for a variety of purposes, including in group financial covenant tests, default provisions triggered by insolvency within the group or a change of control of a company within the group, or in restrictions aimed at ring-fencing the assets of a group
    • Company law provisions relating to groups, for example, financial reporting, transactions between a company and its directors and restrictions on the purchase of a company’s own shares
    • If a member ceases to be a subsidiary it may no longer be eligible to be treated as a member of the group for VAT
    • Change of control provisions relating to a subsidiary
    • When considering the extent of the business occupation of a tenant for the purposes of statutory security of tenure under the Landlord and Tenant Act 1954 and occupation under a lease by a “group company”
    • Restrictions on intra-group transactions
    • Insurance for the benefit of a group of companies
    • Indemnity provisions for the benefit of a group of companies
    • Employee benefits which may depend on employees being employed by a member of a group of companies
    • Limitations of liability provisions protecting a group of companies.


    Common reasons for considering taking share security

    • If listed, shares will be fairly easily realised to set against an outstanding debt. Shares in a private company may also be realised by private sale and will probably carry rights to dividends and further share issues, all with intrinsic value. A solvent winding up of a company would also result in a distribution to shareholders.
    • Security over shares can provide a lender with the possibly easier option of selling the company as a whole on a going concern basis, rather than selling particular secured assets.
    • Sometimes a lender may wish to enforce by transferring the shares to its own name, or that of a nominee, in order to hold the business until the market for its sale improves or to otherwise achieve a sale of assets on terms better controlled by the lender.


    A summary of how share security is taken under English law

    Under English law, it is possible to transfer title to shares to a lender by way of legal mortgage, but it is more common for a lender to take a charge over shares which does not involve a transfer of title. Instead, a charge holder has an equitable right to the proceeds of sale of those shares to discharge its secured debt. A charge document would usually provide for share certificates and stock transfers executed but leaving the transferor blank, to be given to the chargee. The lender could then enforce the charge by completing those transfer forms in favour of either a purchaser of the shares, or perhaps the lender or its nominee, rather than needing to apply to the court for an order for sale.

    The advantages of a legal mortgage include receiving directly dividends and all documents relating to rights issues, bonus issues, takeover bids and shareholders’ meetings, and having the right to vote the shares (perhaps only in its own interests post-enforcement). However, these rights are generally considered to be quite administratively onerous to a lender. In addition, as shareholder, a lender might be held liable for uncalled capital on the shares, although shares are rarely partly paid. Generally speaking, banks are reluctant to own and control shareholdings in companies unrelated to the bank’s group due to both concerns of incurring liabilities for which connected parties can sometimes be held accountable, for example pension deficit or tax liabilities, and as to the administrative burden of being the shareholder of record. For these reasons, although a mortgage is a stronger form of security in English law (it would take priority over any prior charge taken over the shares), it is far more common for lenders to take security over English company shares by way of charge.