Articles Form Contract between Company and Members

“The articles are said to form a contract between a company and its members and the members inter se. In terms of enforcement, however, this contract is an unusual one.’

Discuss.

Under the new the Companies Act 2006 [1] , s 33(1) has been redrafted to make it very clear that not only is the articles a contract between each member and each other member, but it is also a contract between the company and each member. [2] It 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.’ [3]

The company therefore being bound by the articles to the member force members to comply with the articles and members as shareholders can only enforce such member rights which are common to all other members. While issues regarding enforcement of the articles usually revolve around “outsider rights”, it needs to be duly noted what makes this articles contract so unique and distinct from other contracts. By doing so, this will set the foundation as to why enforcement is unique.

Characteristics of the articles contract

According to Dillon LJ [4] , the articles contract is a statutory contract of a very special nature, with distinct features. These distinct features make this contract unique from an ordinary contract.

One of the first distinct features is to note that in an ordinary contract, all parties to the contract usually have some role in the drafting of the contract or at least they agree with the terms as to how they will be bound. In the articles contract however, upon becoming a new member, the articles are immediately binding even though the new member had no role in drafting the articles.

The articles can then be amended as with any contract, but unusually agreement is not required from all members. Amendment of the articles can take place subject to entrenchment by a special resolution for which agreement is only required from 75% of the members [5] .

In the event that the articles end up not representing the intentions of the members, the court has no jurisdiction to rectify the articles. [6] Furthermore, if the articles contract does not fall under the auspices of the statute Rights of Third Parties Act 1999 [7] or Unfair Contract Terms Act 1977 [8] , therefore an aggrieved party whether a member or a director has limited if any legal recourse.

With all of these distinct characteristics of the articles contract, it is easy to see that enforcement would not be simple and straight forward. Based on established common law, there are only certain rights that the courts are willing to enforce as the articles contract is considered to relate only to the dealings of members and not to any other position or capacity. Due to the facts in some of the cases, various decision made have been difficult to comprehend. What I have found however is that most decisions are easier to digest if the company’s interest is consider as paramount, shareholders rights secondly and then proprietary interest last.

Enforcement of the Contract by the company

In the case of Hickman v Kent [9] , Hickman was a member who sued the company in court to enforce his rights as a member. The association had a clause in their articles that stated that disputes should be resolved by arbitration, however Hickman decided to sue to enforce his rights as a member. Hickman wanted to have his sheep registered by the company in its published flock book. In this case, the rights being sought for enforcement were rights common to all members, therefore this case involved ‘membership rights’ [10] . The courts stayed the proceedings on the basis that as member, Hickman was bound by the articles contract and as such the company was entitled to have the matter go to arbitration.

The company was allowed to enforce the articles contract as this case involved rights that were common to all members, but it should be noted that the company cannot enforce rights against a member in a different capacity, such as a director [11] .

Enforcement of the contract by members

In enforcing the articles as a contract, members can enforce clauses of the articles contract against the company or other members. Enforcement of the by a member against the company was demonstrated in the case of Wood v Odessa Waterworks Co [12] .

In this case, the articles of Odessa Waterworks allowed the directors to declare a dividend with the approval of the general meeting. The directors instead recommended that members should be given debenture-bonds and this was approved in the general meeting. Wood as a member, brought an injunction against the company on his and the other members behalf, as the company’s action was not in line with the company articles.

Stirling J held that: ‘What I have to determine is, whether that which is proposed to be done is in accordance with the articles of association as they stand, and, in my judgment, it is not, and therefore the Plaintiff is entitled to an injunction so far as relates to the payment of dividends’. [13]

The enforcement of the article contract member against other members can be seen in Rayfield v Hands [14] . In this case, the articles stated that any shareholder wishing to sell their shares must offer them to the members who were directors and those members were required to purchase them at a fair price. The members refused to buy the shares when offered for sale, therefore Rayfield who was a member sued to enforce the articles.

While the court enforced the articles in this case, Vaisey J cautioned that this might not apply in all cases of articles enforcement of one member against the other: ‘The conclusion to which I have come may not be of so general application as to extend to articles of association of every company, for it is, I think, material to remember that this private company is one of that class of companies which bears a close analogy to a partnership [15] .’

From the above case it is obvious that the there may be some provisions that might not be enforceable by members. What is rather strange is that in the aforementioned case, a member is suing a member who is also a director and is succesful, for what can be argued to have been a director duty to purchase the shares; however in the case of Eley [16] where he is a member and a also has an ‘outsider right’ of solicitor the case is only interpreted from the point of the outsider right capacity which is looked at in more detail below. Suffice it to say that courts stances is that there should be restrictions on enforcement for cases concerning enforcement of outsider rights and cases concerning internal irregularities so as not to interfere with the “the company’s internal dispute-resolution machinery [17] .”

Enforcebility of Outsiders Rights

There is still much confusion whether a member can sue to enforce ‘outsider rights’ in the articles. Outsider rights would be those rights outside of the company member relationship, such as those assigned to a director or company solicitor [18] .

The more widely-held view appears to be that a member cannot sue to enforce outsider rights [19] and this adds to the confusion as to enforcement of the contract articles when there is already much confusion as to the definition of rights which are allowed.

In the case of Eley v Positive Government Security Life Assurance Co [20] , Positive stated in their articles that Eley should be employed as a solicitor for life unless he was found guilty of misconduct. Upon Positive Government hiring a different solicitor, Eley sued for breach of contract.

The court held that Eley could not rely on or enforce the articles which were ‘a matter between the directors and shareholders, and not between them and the plaintiff’ [21] . Eley’s argument was considered to be one regarding outsiders rights.

The case of Eley clearly supports the argument that the articles contract only confers rights on members and not third parties. According to privity of contract law, a contract cannot (as a general rule), confer rights or impose obligations arising under it on any person except the parties to it, therefore as an “outsider” Eley was not party to the contract. What is rather interesting is that Eley was a member at the time of the court case, however he did not choose to sue as a ‘qua member’ [22] to enforce the articles. What is also further interesting is that the court did not address the point of Eley’s membership in the ruling, so it is unclear if this was intentionally ignored by the court since the suit was from an outsider rights perspective, or if it the membership matter was not brought to the courts attention at all. The question remains, what would have happened if Eley had indeed sued to enforce his membership rights?

Astbury J addresses this exact point in Browne v La Trinidad [23] : “The actual decision amounts to this. An outsider right to whom rights purport to be given by the articles in his capacity as such and outsider, whether he is or subsequently becomes a member, cannot sue on those articles treating them as contracts between himself and the company to enforce those rights. Those rights are not part of the general regulations of the company applicable alike to all shareholders and can only exist by virtue of some contract between such person and the company, and the subsequent allotment of shares to an outsider in whose favour such an article is inserted does not enable him to sue the company on such an article to enforce rights which are res inter alios acta and are not part of the general rights of the corporators as such ….” [24] :

Another case noted in support of the unenforceability of outsider rights by a member is Hickman [25] . It is a bit surprising that this case would be used for outsider rights when it was in fact based on membership rights. The case was referred to arbritration by the courts rather than allowing the suit to proceed therefore any discussion regarding outsider rights would have been limited and most importantly, obiter.

The final case cited as supporting the unenforceability of outsider rights is Beattie v E & F Beattie Ltd [26] . In this case, a member brought an injunction against a director (who was also a member) on behalf of the company for breach of duty, as the director refused to provide the company accounts for review. The director

requested the court to stay the action, as there was a clause in the articles stating that all disputes between members and the company should be arbitrated. In this case it should be noted that here the right that the director is trying to enforce is an outsider right rather than member right as in Odessa [27] . It is therefore very much like the case of Eley [28] .

In the judgement, Greene MR stated that ‘he is not, in my judgment, seeking to enforce a right which is common to himself and all other members’ [29] .

With the above cases supporting the unenforceability of outsider rights, there is leading case that suggests that outsider rights in the articles are enforceable [30] . In this case a shareholder who was also a managing director was allowed to enforce a veto based on the clause in the articles. The reasoning for the ruling was that there was an attempt to circumvent decision-making rules contained within the articles and to do so a special resolution was required. Accordingly, the court had a duty to prevent the company from acting unconstitutionally. In effect, the managing director, who also happened to be a member was successful in enforcing ‘outsider rights’ as the position of managing director was not common to all shareholders.

Lord Wedderburn has argued that this case establishes that members can indirectly enforce outsider rights in the articles by suing as members to require the company not to depart from the contract in the articles [31] , therefore the precedent as to enforcement of outsider rights is still open.

Enforceability of internal irregularity

Due to the principle of majority rule, an individual member cannot assume the power of the majority of the shareholders. As such the courts, have shown that they will not interfere in any internal workings of the company where the articles allows for the majority to decide. Internal irregularities are breaches of obligations on the part of the company and if supported by the majority members, such breaches will be ratified and will leave the lone shareholder powerless. [32]

As in Grant v Uk Switchback Railways [33] , it was similarly documented in an early Court of Appeals [34] case that it was very important that the court not engage in the internal matter of the company to suit an individual shareholder. Mellish LJ, ‘there can be no use in having a litigation … the ultimate end of which is only that a meeting has to be called, and then ultimately the majority gets its wishes … [I]f what is complained of is simply that something which the majority are entitled to do has been done or undone irregularly, then I think it is quite right that nobody should have a right to set that aside, or to institute a suit in Chancery about it, except the company itself.’ [35]

The court takes the opposite view in the case of Pender v Lushington [36] and does allow an injunction. The assumption is that the court intervened in this case because this case focused on the rights of shareholders. Ruling was in favour of enforcing the grant to circumvent the majority. Per Jessel MR, ‘This is an action by Mr. Pender for himself. He is a member of the company, and … he is entitled to have his vote recorded – an individual right in respect of which he has a right to sue [37] ….”.

Conclusion

The articles contract is a very unique and distinct contract from that of a normal contract and was reformed by the Law Commission under the Companies Act 2006 [38] in order to encourage shareholders to be proactive in preparing for disputes. This Law Commission approach was to protect the articles therefore maintaining the sanctity of the contract.

While it is very difficult to reconcile the different approaches taken by the courts, it is recognised that there is much confusion as to what rights can be enforced. The courts will obviously continue to keep out of the internal workings of the company therefore directors need to take up their leadership positions and encourage shareholders to utilise the entrenchment by a special resolution to enact the will of the majority regarding rights. These rights can be proactively documented and thereby making enforcement of future anticipated rights issues straightforward. Failure to do this will result in continued legal disputes, confusion of what rights are enforceable and questions regarding the sanctity of the articles as a contract.

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