When is a subsidiary not a subsidiary

Alex Innes continues his series around how banks can manage the risk of lending.

Banks and the risk of lending is a question that the Supreme Court recently had to consider. The decision is especially relevant to anyone who is involved in taking security over shares. One of the consequences of the decision was to confirm that a company that was subject to a share pledge was no longer deemed to be a subsidiary of another company. This is an important decision as it is unlikely that this was anticipated when the share pledge was granted.

Under Scottish law, in order to create a fixed security over shares, the shares require to be transferred to the security holder who is then recorded in the register of members. This is an important point which makes this decision especially relevant in Scotland, as under English law a charge over shares can be created without altering the register of members.

In this case, the Parent was in a joint venture with a third party, in terms of which, although it held less than 50 per cent of the shares in the joint venture company, it did control more than 50 per cent of the voting rights in that company, and therefore it was a subsidiary of the Parent (JVCo).

The Parent entered into a contract with A which included a cross indemnity whereby the Parent and its subsidiaries, and A and its subsidiaries, agreed to indemnify each other.

The Parent charged its shares in JVCo to a Bank, and the Bank was noted as the registered shareholder in the register of members of JVCo. The share pledge provided that all voting rights and other rights and powers in respect of the shares (including the right to receive a dividend) should remain exercisable by the Parent until the security became enforceable (and the security was never enforced).

During the contract with A, a dispute arose, and A was seeking damages from JVCo. The Parent argued that as JVCo was a subsidiary, then under the original contract, it was included in the cross indemnity, and no action could be taken. However, A argued that JVCo was not a subsidiary as it had charged its interest in the shares to the Bank.

The definition of “subsidiary” in the contract with A referred to the usual definition in the Companies Acts, which was closely examined. In brief, a company is a subsidiary of another company if that other company:

(1) holds a majority of the voting rights; or (2) is a member and has the right to appoint or remove a majority of the directors; or (3) is a member and controls alone, pursuant to an agreement with other members, a majority of the voting rights.

The court disregarded the second and third tests as the Parent was not a registered member of JVCo (as the Bank was the registered member); and as the Parent did not hold a majority of the voting rights (noting that it did control a majority of the voting rights), it did not comply with the first test. Therefore, JVCo was not a subsidiary of the Parent under a strict interpretation of the Companies Acts; and as a consequence, JVCo was liable to A under the contract as the cross indemnity did not apply.

It is important to note that these circumstances were unusual and this will not affect the most common type of subsidiary, where a holding company holds the majority of voting rights in its subsidiaries; but it may affect joint venture companies.

If a share pledge is required, the rights to be taken, and the consequences on other contracts and change of control provisions should be carefully considered. Banks should consider the definition of “subsidiary” in all its documents, particularly if it is lending to a Borrower with joint ventures interests. If required, a solution may be to add a further qualification to the usual definition of subsidiary in documents, to include any entity that has charged its shares in security, so that the true intention of the parties is properly reflected.

Semple Fraser LLP is one of Scotland’s leading commercial law specialists, offering advice of the highest quality across a range of areas. With lawyers qualified in both Scots and English law, we are able to deliver a full banking service throughout the UK. The Banking & Finance Group of Semple Fraser LLP has expertise in all areas of banking and property finance, and works closely with the other specialists areas of the firm to provide the complete service to clients.

For more information on these topics, please go to www.semplefraser.co.uk, or contact Alex Innes on 0131 273 3771 or alex.innes@ semplefraser.co.uk www.semplefraser.co.uk

Alex Innes is Head of the Banking & Finance Group of Semple Fraser LLP.

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