Companys Constitution and Company Statutory Contract

The Memorandum of Association and the Articles of Association describe a company’s constitution and create a statutory contract between the members of the company themselves and between each member and the company. S33 (1) CA 2006 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 preserve its provisions”.

It has always been said that by subscribing, the shareholders enter into a contract between themselves and the company and between each and every shareholder. However as Dignam and Lowry note it is an “odd sort of contract” [1] . This research will examine the type of contract which is formed between the members and between the members and the company, with an overview of what the contract looks like. The focus will then move to the aspects of the application of “the contract” which may have lead Dignam and Lowry to describe it as “odd”.

In order to examine the application of the contract, we must first take an overview of the kind of details contained within the company’s constitution, which establishes the terms of the contract if one wishes to put it this way.

The Memorandum of Association sets out the details of a company’s existence. It must be signed by the subscribers and contains such information as the company’s name, the address of the Registered Office, the objects for which the company is formed, a statement that the liability of the company members is limited, the amount of the “issued share capital” and the names of the subscribers (or those contracting).

The Articles of Association govern the running of the company defining for example the voting rights of shareholders, the conduct of shareholder and directors’ meetings, and the other powers of management. The articles constitute a contract between a company and its members, but this applies only to rights of the shareholders in their capacity as members of the company.

On purchasing shares, shareholders must subscribe to the above documents thus creating a contract between them and the company but one of the questions which arose in the past was whether it was binding between the members themselves. The significance of this is that if the member can enforce his or her rights against each member, then enforcement becomes more practical. As we will see from later discussion, if the company is the only one who can enforce the contract then the minority shareholders are placed at risk of the majority shareholders getting the company to ratify whatever they want at general meeting. [2] However, there have certainly been some inconsistencies in the court’s application of this contract inter se. In Wood v Odessa, [3] the court held that,

“The articles of association constitute a contract not merely between the shareholders and the company, but between each individual shareholder and every other” [4] .

Yet in Salmon v Quin [5] Farwell LJ decided that although there was probably some truth in the above quotation, the courts were unlikely to enforce “in most cases” [6] whatever contract was between the shareholders unless the company brought the action. Rayfield v Hand [7] s further considered this but Vaisey J considered that it could not be considered a general rule because of the extraordinary circumstances within that case; namely the fact that he was dealing with a quasi-partnership. [8]

The complexities of the issues here are still being debated and this lack of clarity is further emphasised by the wording of the guidance to the CA 2006. It states that the contract is between the company and member and member to member, appearing to settle the dispute about whether the shareholders can enforce the contract between them inter se. Yet, the wording of s33 which replaced s 14 of the CA 1985 is unchanged indicating that the same issues can still be brought up to say that the contracts are not enforceable except by the company in most cases. [9]

The above discussion then brings us on to a more full discussion as to who may sue where a breach or a wrong has been committed. In a usual contractual arrangement, any party to a contract can sue another party to that contract who has wronged him. However, for members of a company it is not so straightforward. They can sue each other but enforcing the s31 contract against the company is slightly more complex. The question becomes whether the wrong has been done to the member or to the company. If the wrong has been done to the company then the company has to bring the action unless the rules in Foss v Harbottle are followed.

Let us look first at the rules which were established in this case. “The proper plaintiff rule”, which was established by Sir James Wigram in Foss v Harbottle, [10] holds that when a wrong is done to the company, the cause of action vests in the company and it is the company who must bring any action necessary or relevant. [11] Another principle stemming from the decision in Foss v Harbottle, [12] says that a member cannot take an action with regard to a wrongdoing in the management of the company, if the irregularity which has shown up can be condoned or rectified by the general meeting of the company using ordinary resolutions. [13] A derivative action in general law can only be taken once the company has met in general meeting and failed to ratify the wrongdoing or when the company is incapable of doing so. This will occur notably when the wrong is a fraud on the company, or a fraud on the minority. [14] In this way the courts are stopping every little issue from being litigated by minority shareholders. This illustrates a main feature of company law that the company should be self-sufficient as far as possible and manage itself using its articles and memorandum and leave the courts out of it as much as possible.

There are further criteria for an individual to bring an action for perceived breach of contract. If the wrongdoing complained of is a fraud against the minority, a derivative action will only be considered where those doing the defrauding are in control of the company at general meeting.28 This principle is based on the fact that if they do not hold the majority they cannot sway a general meeting and the company will still be able to take the decision..29 Therefore, whether a contemplated derivative action goes ahead relies upon the outcome of a general meeting and the company’s decision over whether or not to impeach those who have done wrong or alternatively, on whether under the circumstances the general meeting can actually make such a decision.31

Pender v Lushington [15] confirmed that a company member’s right to vote may not be interfered with, because it is a personal right of a member to sue in his own name to enforce his right. As Lord Jessel MR put it, a member,

“has a right to say, “Whether I vote in the majority or minority, you shall record my vote, as that is a right of property belonging to my interest in this company, and if you refuse to record my vote I will institute legal proceedings against you to compel you” [16]

However, the courts have always been quick to say that “the derivative action is not a favoured tool for enforcing corporate rights and the extent to which it can replace the general meeting in initiating proceedings against wrongdoers is limited”. [17] The fact is also that taking derivative actions is expensive. If the action bears fruits it is the company which benefits and if it fails then the shareholder who brought the action must pay the costs. [18] The incentive for shareholders to take such action is consequently very small. [19] An added disincentive is the fact that the courts have shown themselves unwilling to get their hands dirty in company business. As Zen Qu puts it, “the court’s attitudes towards derivative actions have never been supportive”. [20] The concern has always been that such actions are motivated by personal gain or vendetta by disgruntled shareholders and have tried to restrict litigation by taking a harsh party line in respect of litigation of this sort.38 Resultantly, it would seem that shareholders are bound by a strange sort of contract which is only enforceable in breach on some occasions under very tight criteria and on some occasions will not be available at all. To many this may seem to conflict with the very root of the principle of contract law. The point of a contract is surely to allow its parties to enforce its provisions once they have complied with the terms and duties allocated to them under it. In the case of the s33 contract, the members do not seem to have all of the same rights as the main party, which appears to be the company. We will see from later discussion that this is a theme which runs through the court’s decisions in relation to the statutory contract.

We have discussed whether individual shareholders can bring actions against other shareholders and actions in the name of the company where the company has been unable to ratify its actions, but there is also need for an examination of the position for third parties in contract with the company.

Outsiders can only make contracts with the company in accordance with extrinsic provisions for contracting with a company. It is separate from the contracts between company and member and between members. In Hickman v Romney, [21] it was found that shareholders could not enforce “outsider” agreements either because they were nothing to do with the shareholding, which forms the root of the contract between them and the company and each other. [22] This was obiter however and has met with academic challenge since the decision. This is on the basis that the contract between shareholder and company allows them surely to expect that the company will be run properly. Breach of an outsider agreement with no subsequent action from the company itself surely breaches this term? [23]

Indeed, the Company Law Review recommended that individual shareholders should have the right to enforce all provisions in a company’s constitution both against the company itself and against other members unless the constitution expressly permits otherwise. [24] Unfortunately there was a view that the implementation of this principle would lead to an increase in shareholder agreements which added to the complexities of the general contract between shareholder and company and shareholder to shareholder and as such, it was rejected by the legislature.

The above discussion leads us neatly onto shareholder agreements and their position as an extension of the main contract. Such agreements are becoming much more popular within the running of modern companies adding to the constitutional documents of the company, in the way that those documents cannot. Its main benefit is that it does not need to be registered at Companies House as the articles of association do. According to Ryan, “It fulfils many roles that would otherwise be fulfilled by provisions in the articles of association”. Why then are the types of matters included in shareholder agreements not included within the articles? Does this not weaken the strength of the s33 contract? The discussion, which follows, will attempt to address these questions.

The shareholder agreement is used for such things as providing a way for the company to ensure buy-back of their own shares if a member decides to sell his shareholding. It may also allow for shareholders to contract to vote in certain ways in relation to resolutions of the company or govern how and how much the company can borrow and from whom. Ryan advises that it is usually compulsory for all shareholders to sign shareholder agreements as well as the memorandum of association. [25] Thus, a shareholder agreement seems to bulk up the provisions of the company’s constitution indicating that the s33 contract does not provide full terms required. It may be then that it does indicate a weakness in the statutory contract.

The fact is that the articles of association may not have the final word on how the rights and duties of the company members are allocated. If the company is made a party to the agreement because the shareholders wished the added security of being able to enforce it against the company, the agreement will only be enforceable if it does not conflict with the provisions of the Companies Act 2006. In Punt v Symons [26] , the shareholders put together an agreement purporting to prevent the company from being able to alter its articles but the court held that the company could not contract out of this statutory right. Therefore, if a shareholder agreement contains a provision like this it will be unenforceable. Therefore, although the articles may not have the last word, this would suggest that when a shareholder agreement is in conflict with the statutory contract established by the company’s articles, the latter will take precedence. However, as Dignam and Lowry point out the courts have not always been consistent in applying this as a general principle. [27]

In fact, a very strange decision was arrived at in the case of Russell v Northern Bank Development Corporation. [28] The shareholders had entered into an agreement with the company whereby it would not increase its share capital without the consent of all of the shareholders party to this particular agreement. On an attempt by the company to increase the share capital under its statutory powers under s121 CA 1985 and consequently by virtue of a provision contained within its articles, one of the shareholders objected stating that he could rely upon the shareholders agreement. The House of Lords found it to be unenforceable – the company could not contract out of this right. However, what is interesting is that the court did not find the entire agreement unenforceable only that part which purported to prevent the company from exercising its statutory rights. The consequence of this was that the shareholder could enforce the agreement against the other shareholders party to the agreement. As all of the shareholders were party to the agreement this had the same effect as if the company were bound by the agreement in that the shareholders would have been in breach of the agreement had they voted to increase the share capital. It is clear that the decision in this case casts severe doubt over the principle that a company cannot contract out of its statutory rights as set down in the documents which make up the statutory contract. [29]

An important anomaly when looking at the s33 contract is that the company can change the terms of the contract by way of a special resolution. In a normal contractual situation, this would require the consent of all parties to vary however this is not the case here. This is very much in conflict with the law of contract since once a company’s articles are registered5, the court has no power to rectify them even if they do not accord with what is proved to be the concurrent intention of the members6. The company can therefore change and register that change and the shareholders will from then on be bound by that change.

The intention of the parties at the time the parties entered into the contract has always been a vital consideration for the judiciary when determining what effect to give challenged areas of contract. However, this statutory contract provides for priority to be given to the Articles and Memorandum of Association of a company. On first sight, this is acceptable since the shareholders entered into the contract knowing the set-up – they would have to subscribe to the Memorandum after all. However, one issue which has risen time and time again which needs exploring in the context of this discussion in particular is the fact that the Articles – which govern the running of the company and therefore could be considered to provide the root of the contract – can be altered. [30] This part of the research will look at how the company can alter its articles and in what cases shareholders can object.

The alteration of a company’s articles is seen to be protected by the checks and balances required to follow Companies Act procedure when undertaking to do so. A special resolution of the company is required and any alterations to a company’s articles must be made in good faith for the benefit of the company as a whole. [31] This part of the research will examine whether the checks and balances are enough to ensure much needed certainty for the shareholder entering into the contract as one would expect from any other commercial contract.

One of the major problems, which was widely discussed in relation to the Companies Act 1985, is the wideness of the drafting of s9, which allowed a company to change its articles. The new Companies Act 2006 s21, although implemented to high hopes over the last four years, is similarly as wide. It merely states that a company can change its articles by special resolution. This is barely different from s9 of its predecessor, the Companies Act 1985. If we simply looked at the Acts for protection for minority shareholders, there would seem to be a severe lack of assistance here. However, Allen v Gold Reefs [32] introduced the rule that a company may only exercise the power to amend its articles of association “bone fide in the best interests of the company as a whole” [33] . This is “neither clear [n]or easy to apply” [34] . As we have seen in Foss v Harbottle, the courts are very reluctant to interfere with business decisions merely because some of the shareholders object to what has been decided [35] . According to Christopher Nugee QC in Constable v Executive Communications Ltd regarding the relevant case law, there are “no recent English cases and the older ones are quite difficult [36] “.

It is up to the shareholders to decide whether the act spoken of would be in the company’s best interests, which is open to abuse if the majority shareholders wish the change to occur. The court will normally regard an alteration as being in the interests of the company if the majority of the shareholders are in favour of the proposed alteration, especially as a special resolution is needed to pass the alteration. In Allen v Gold Reefs [37] the articles contained a provision imposing a lien on partly paid shares. One shareholder owed money to the company and the articles were altered to impose a lien on partly paid shares. The court regarded the fact that one (and only one) shareholder was indebted to the company at the time of alteration was in the interests of the company as a whole. Clearly it is in the interests of a company that it should have security for money due to it and no discrimination and no discrimination against particular members were expressed in the altered articles.

Shuttleworth [38] is perhaps an even stronger example. Most of the Board of the company suspected one of the other directors of misconduct but they had insufficient grounds to dismiss him, due to a distinct lack of evidence. Their solution was to alter the articles to say that any director would cease to hold office if voted out by the majority of the Board Members. The test applied by the court was whether any reasonable man could come to the conclusion that the alteration was in the interests of the company. If it was open to a reasonable man to come to that conclusion, the alteration would only be invalid on proof of actual bad faith. The court was satisfied that a reasonable man could come to the conclusion that the alteration was in the interests of the company and so, since the claimant could not prove actual bad faith, the alteration was held to be valid [39] . This shows that the courts are fairly reticent when it comes to interfering with the workings of the s33 contract, sometimes to the detriment of the minority shareholders. They seem equally unsure as to the principles which should be applied when deciding whether an alteration is valid. However, Williams believes that greater clarity has been reached with the decision in Citco Banking Corporation v Pusser’s Ltd [40] . In this case, it was held that the correct test was established in Shuttleworth v Cox Brothers and Co (Maidenhead) Ltd [41] and stated that it was not for the court to decide the commercial benefits to the company of altering the articles [42] but it was for the reasonable shareholder to consider what would be beneficial.

As has been inferred by the judiciary’s inherently passive treatment of s33 disputes, the articles are a business document and the outcome of any interpretation of them ought to be to give them reasonable business efficacy, in place of a meaning which would be impractical and unworkable. Indeed, it has been shown that “a purely constructional implication is not precluded but the court will not imply a term from extrinsic circumstances” [43] . However, this principle has been challenged [44] in the recent decision of the Privy Council in Attorney General of Belize v Belize Telecom Ltd [45] . The Privy Council heard an appeal against a decision of the Court of Appeal of Belize upon a question on the construction of the articles of association of a privatised company, including whether the court could imply terms into the articles. Lord Hoffman allowed the appeal stating that the issue was whether the court could imply into the articles a term which would expressly state what the instrument, taken in its relevant context, would be reasonably understood to mean. The question should be whether the term to be implied would “go without saying” [46] , and be “necessary to give business efficacy to the contract” [47] but these would not be separate criterion, this issue would be looked at as a whole. In this case, the more pressing consideration appeared to be the fact that if a term implying that the government-appointed directors should vacate office after the special share ceased to exist had not been implied, this would have led to absurd consequences. [48] Therefore, it would seem the policy reasons allowed the court to hold that terms can be implied into the statutory contract. It is arguable that the courts will imply terms into ordinary commercial contracts however it is usual for terms to be implied where absurd consequences clearly not within the intentions of the parties at the time of contracting would have followed where they were not.

This piece looked at the form of the contract between the company and its shareholders and whether it is enforceable between members. It was found that it is not generally in most cases but of course, it is open to challenge. Outsiders can enforce contracts against the company and even appear to be in a better position to do so than individual members of the company. The use of shareholder agreements has also been examined and it has been shown that their effect is yet to be consistently determined. Whether they bind the company seems to be a question to be asked of the court on a particular set of facts. Additionally, it would appear that articles may be rather freely altered since the test that the shareholders must comply with in this regard is in no way conclusive. The court has shown itself unwilling to intervene in such matters, which leaves wide scope for abuse. It is even possible for the alteration to retrospectively affect the contract between shareholder and member which seems absurd in the language of contracts. Unfortunately, the only relevant conclusion to be made is that s33 (1) is a complex contract, far from settled by precedent, and even with the advent of the new and improved Companies Act 2006, the debate shows no signs of abating.

Bibliography

Articles

Case Comment (2009) “Attorney General of Belize v Belize Telecom Ltd: Privy Council implies terms into articles of association” Co. L.N. 8

Ryan, Chris (2008) “The statutory contract under s 33 of the Companies Act 2006: the legal consequences for banks Pt II” 7 JIBFL 360

Wedderburn, K (1957) “Shareholders Rights and the Rule in Foss v Harbottle” CLJ 193

Williams, Richard “Bona fide in the interest of certainty” Case Comment Cambridge Law Journal 2007

Zhen Qu, Charles (2007) “Some Reflections on the General Meeting’s Power to Control Corporate Proceedings” CLWR 36 3 (231)

Books

P.L. Davies (ed.), Gower and Davies: Principles of Modern Company Law, 7th edn (Sweet & Maxwell: London, 2003)

Dignam & Lowry, Company Law (OUP Fifth Edition, 2009)

Ford, HAJ et al., Ford’s Principles of Corporations Law, 12th edn (Butterworths: Sydney, 2005)

Griffiths, Andrew (2007) Contracting with Companies

Slorach J Scott & Ellis J Business Law 2006-07 Oxford

Cases

Allen v Gold Reefs of West Africa Ltd [1900] 1 Ch CH 656

Attorney General of Belize v Belize Telecom Ltd [2009] UKPC 10; [2009] 1 W.L.R. 1988 (PC (Bze))

Citco Banking Corporation NV v Pusser’s Ltd [2007] UKPC 13

Constable v Executive Communications Ltd [2005] 2 BCLC 638

Dafen Tinplate Company Ltd v Llanelly Steel Company (1907) Ltd [1920] 2 Ch 124

Foss v Harbottle (1843) 3 Hare 461

Greenhaigh v Arderne Cinemas Ltd Ch 286 [1951]

Hickman v Kent or Romney Marsh Sheep-Breeders Assoc (1915) 1 Ch 881

Pender v Lushington (1877) 6 Ch D 70

Prudential Assurance Co Ltd v Newman Industries (No. 2) [1982] Ch 204

Punt v Symons & Co Ltd (1903) 2 Ch 506

Rayfield v Hand (1960) Ch. 1

Russell v Northern Bank Development Corporation (1992) BC LC 431

Salmon v Quin & Axtens Ltd (1909) AC 442

Wood v Odessa Waterworks Co (1889) 42 Ch D 636

Other Publications

Halsburys Laws online