A Companys Articles of Association - Dissertation Example

A Company’s Articles of Association Introduction A company’s articles of association regulate its affairs and contain regulations that prescribe procedures which a company must follow when calling board and shareholder meetings, conducting meetings and appointing or removing company officers. A company’s articles operate effectively as its rule book. Under the Companies Act 2006 (CA 2006) the articles may also contain provisions regulating the company’s external affairs, e.g. an objects clause. The articles of the company constitute a form of statutory contract between the company and its members, and between the members themselves. This therefore makes the arrangement an unusual one given the unusual nature of the contract. This paper seeks to assess how this arrangement operates in practice by analysing case law and statute, in order to ascertain how such a prima facie awkward contractual relationship is governed. First, one must look at the relevant law with regard to the articles of association in the most recent legislation. Choice of articles A company effectively has three choices as to the form of its articles. Under s. 19 CA 2006, the Secretary of State may prescribe model articles for public companies, private companies limited by shares and companies limited by guarantee. The model articles will be the default articles for companies incorporated from 1 October 2009. However, it is also open to such companies to choose to adopt Table A under the Companies Act of 1985. Legal effect of articles The nature of the contract established by the articles of a company is set out in s. 33(1) CA 2006, which provides that the provisions in the company’s articles bind the company and its members to the same extent as if they were covenants on behalf of the company and each member was to observe those provisions. Whatever form the company’s articles take, they are binding on both company and members. S33(1) states that “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.” The effect of this provision is that members can sue if their membership rights are infringed. These rights are limited and rights of members which are not membership rights are not enforceable under s.33. In order to protect members, it is important, therefore, that any of their rights which are not membership rights, are set out in a separate contract (such as a shareholders’ agreement) and not in the articles of association. It should also be noted that a company’s articles are deemed to be a complete contract and the Court will not imply any terms into them whether to create business efficacy or otherwise.1 The practical effect of the predecessor to s. 33(1) CA 2006 (namely s. 14 CA 1985) has been the subject of considerable case law. The established rule is that the articles evidence a contract between the company and its members in their capacity as members and with respect to their rights and obligations as members. This was confirmed in Hickman v Kent or Romney Marsh Sheep-Breeders’ Association2, which held that though articles of association do not give any individual member special contractual rights beyond those of the members generally,3 they do constitute a contract between a company and its members concerning their ordinary rights as members.4 Courts have been willing to prevent a company infringing its members’ rights in breach of the articles by granting injunction orders. Each member, acting in his capacity as a member, is similarly obliged to the company to comply with the articles. However, a member may not enforce any rights contained in the articles against the company that are not relevant to his capacity as a member. Such enforceable rights contained under s. 33 CA 2006 would be the right to vote or the right to receive an interim dividend if such a dividend has been declared. The unusual nature of the contractual situation created by the article is most evident when one looks at the relationship with which employees and directors are in. Unlike shareholders, there is no equivalent provision concerning the company and its officers, highlighted in Re Famatina Development Corporation Limited.5 Here it was held that an employee who claimed under an indemnity clause in the articles could not rely on them as he was not a member of the company. (He did however succeed in the Court of Appeal on the basis that he was acting as the agent of the company.) 6 However, in Re New British Iron Company7 the directors claimed sums owed by the company under an article provision had the effect that each director would be paid a fixed yearly sum. Wright J observed that whilst the article is not itself a contract between the company and its directors, where the directors are employed by the company and accept office “on the footing of that article”, its terms form part of their contractual relationship.8 Further, in Re City Equitable Fire Insurance Company Limited9 the Court of Appeal held that where no separate terms of engagement existed between the company and its auditors and the articles contained provisions concerning performance of their duties and obligations, then those articles must be assumed to express the terms upon which they accepted their appointment. However, if the terms had been expressed in a separate document, then “that document must be taken to define the conditions of their engagement, and it would not be proper to assume any implied terms either from the provisions of the articles or elsewhere,” (per Warrington L.J.).10 Both of these cases were referred to in John v PriceWaterhouse-Coopers (formerly Price Waterhouse)11. Here, the judge did not feel it was appropriate to enforce the indemnity clause in the articles, but did allow PWC to seek to enforce its right to indemnity by bringing separate proceedings for breach of contract. A point which has firmly been reiterated by the courts over the years is the fact that a shareholder only receives a contractual obligation from the company in his capacity as a shareholder. The leading authority for this proposition remains Eley v Positive Government Security Life Assurance Company,12 where a member of the company who had inserted a right into the company’s articles for him to be employed as the company’s solicitor for life could not enforce this provision as this was not a right which he held in his capacity as a member, but rather as the company’s solicitor. The Articles contained a clause stating that the plaintiff should be the company solicitor, and should transact all its legal business for the usual fees and he should not be removed from office except for misconduct. The articles were signed by seven company members, and were registered and incorporated under the Companies Act 1862. Ultimately the company ceased to employ the plaintiff and employed other solicitors. The plaintiff brought an action for breach of contract on the terms of the articles. It was held that the articles were a matter between the shareholders inter se, or the shareholders and the directors, and did not create any contract between the plaintiff and the company. Articles as a contract between the members inter se Although the courts have acknowledged that the articles constitute a contract between the members themselves, as well as with the company, there is conflicting authority regarding whether one member may enforce the articles against another member directly. The right of a shareholder to initiate proceedings as a member of the company against a director or shareholder in his capacity as a member for breach of “contract” 13 under the articles has been established since Rayfield v Hands.14 Where such an action takes place within this context, it has been argued that the action bears a close resemblance to the action taken between partners for breach of fiduciary duty.15 In Rayfield v Hands16 , the plaintiff was a shareholder. Article 11 required him to inform the directors of his intention to transfer shares, and provided that the directors "will take the said shares equally between them at a fair value."17 Accordingly, the plaintiff informed the directors, who contended that they need not take and pay for his shares, on the grounds that the articles imposed no such liability. It was held first that upon their true construction the articles required the directors to purchase the plaintiff's shares at a fair price.18 Secondly, Article 11 concerned the relationship between the plaintiff as a member and the defendants, not as directors of the company, but as members.19 Thirdly, it was not necessary, for the plaintiff to succeed, that he should join the company as a party in addition to the directors.20 The particular facts of Rayfield v Hands suggests that if a member accepts a personal obligation to another member via the articles, that member can enforce their right against the other member directly. Otherwise, the courts appear to opine that members are only able to enforce provisions contained in articles through the company itself. If a member wishes to enforce their rights against other members, they should be advised to enter into a shareholders’ agreement. This principle was reinforced in Welton v Saffery21, where it has held that where it was ultra vires for a company to issue discounted shares or by way of bonus, despite being authorised under the articles, the relevant members were not relieved from liability, in a winding up, to calls for the amounts unpaid on their shares for the adjustment of the rights of contributories inter se, as well as for the payment of the company's debts and the costs of winding up.22 The rule in Foss v Harbottle The potential unfairness that can arise due to the interpretation of the articles in such a way has forced the courts to find an alternative remedy for shareholders so that they are not discriminated against or unjustly treated. The rule in Foss v Harbottle23 has long provided that, in situations where a wrong has been done to a company, the company is the proper claimant. In other words, a member would not be the proper claimant. Accordingly, the Court will not interfere in the internal management of a company acting within its powers. The effect of this rule is that, in general, under the common law a minority shareholder is not allowed to sue for a wrong committed against a company of which he is a member, even if the company is refusing to take action. However, over the years the courts recognised that, in order for justice to be done, there needed to be some circumstances in which a shareholder could bring a claim on a company’s behalf if the company would not do so. It was as a result of this recognition by the courts that various exceptions to the rule in Foss v Harbottle were established. One of these exceptions focused solely on the breach of the articles of association. An action brought under one of the exceptions to the rule in Foss v Harbottle would be a derivative action because the shareholder’s right to sue is not a right personal to that shareholder but derived from the company’s right to sue which it has not exercised. Indeed in O’Neill and another v Philips and others24 Lord Hoffman stated that: “A member of a company will not ordinarily be entitled to complain of unfairness unless there has been some breach of the terms on which he agreed that the affairs of the company should be conducted… [However,] there will be cases in which equitable considerations make it unfair for those conducting the affairs to rely upon their strict legal powers.” The relationship between a Shareholders’ Agreement and the company’s Articles of Association It is important to understand why it is necessary or indeed preferable for shareholders to enter into a Shareholders’ Agreement rather than to rely solely on the Articles to regulate the company’s affairs. A Shareholders’ Agreement is a contract between some or all of the shareholders. This regulates the relationship between the shareholders themselves and contains provisions concerning their personal rights and obligations particularly concerning voting rights. Further, the Articles are treated as a contract between the company and its shareholders in their capacity as shareholders pursuant to s.33 CA 2006 and do not therefore deal with shareholders’ personal rights and obligations. The provisions of the Articles are subject to the CA 2006 whereas a Shareholders’ Agreement is an arrangement arrived at between the shareholders in their personal capacities. The CA 2006 gives companies certain statutory powers. One should not, therefore, include any provision in the Articles which would require the company to fetter (i.e. restrict) its statutory powers, since any such provision would be void and the CA 2006 would override the conflicting provision in the Articles. However, a Shareholders’ Agreement could stipulate that no amendments will be made to the Articles without the unanimous consent of all the shareholders because shareholders can make a private agreement amongst themselves how they will vote on certain matters It may also be more difficult for shareholders to enforce certain provisions contained in the Articles against the company or against fellow shareholders. Shareholders can only enforce rights against the company that are relevant to their capacity as shareholders (such as the right to vote or the right to a declared dividend) and while it is true that the Articles are a contract between each of the shareholders of a company, it has been established by case law that members can only enforce their rights against another member through the company or through a liquidator representing the company. Therefore, if a member wishes to enforce rights or obligations directly against another member, a Shareholders’ Agreement is the most effective way of achieving this. Another key reason why Shareholders’ Agreements exist is because they can be kept private (unless they are explicitly referred to in the Articles) unlike the Articles which must be filed at Companies House and are therefore documents of public record. As such, the shareholders may want to include any commercially sensitive terms in the Shareholders’ Agreement instead of the Articles. It is also important for shareholders to bear in mind the procedural steps required for amendments to the Articles and Shareholders’ Agreement respectively. S.21(1) CA2006 requires a special resolution to amend the Articles. This means that one party who has a minority interest (i.e. less than 25% of the voting rights) will not be able to prevent changes being made to the Articles as a general rule (although note the point made above about requiring unanimous consent to change the Articles in the Shareholders’ Agreement). Like any contract, it is usual for any changes made to the Shareholder’s Agreement to require the unanimous approval of all parties to the agreement. This effectively gives a minority shareholder a veto over any amendment. The leading case in this area is Russell v Northern Bank Development Corpn Ltd25 where the plaintiff was a party to a Shareholders’ Agreement to which the company was also a party. The agreement included a clause preventing any increase in the share capital of the company without the written consent of all the parties to the agreement. An action was brought against the other parties for an injunction restraining them from increasing the share capital of the company. The defendants argued that the agreement was void in its entirety both as regards the company and as between the shareholders inter se because it amounted to an unlawful and invalid fetter on the company’s statutory powers (namely, the power of a company to alter its articles of association by special resolution). It was held that an agreement outside the Articles between shareholders inter se as to how they would vote on a resolution to alter the articles was enforceable in so far as it amounted merely to a private agreement as to the exercise by the shareholders of their respective voting rights and an injunction could be granted to prevent a shareholder from breaching that agreement. A Shareholders’ Agreement did not constitute an unlawful and invalid fetter on the company’s statutory power to increase its share capital. The House of Lords held that the agreement between the company and the shareholders, which was void as being contrary to statute, could be severed from the agreement between the shareholders which was valid and enforceable. The significance of this case is that it puts beyond question the shareholders’ freedom to contract in respect of voting rights. Conclusion In sum, and in light of the foregoing analysis, the articles create an unusual contractual situation with regard to the obligations of the shareholders to the company and vice versa. Further, they also create obligations inter se between members, but only in their capacity as shareholders. As illustrated before this can lead to potential injustices for minority shareholders or those who are shareholders but deemed not to be acting in their capacity as shareholders. Therefore it is important that the law develops so that such potential anomalies do not lead to future injustice. The CA 2006 was only just come into force and it is still in its infancy. It shall be interesting to see if the Supreme Court carries on the previous line of case law established under the 1985 Act, or whether they will take a new direction to reflect the new legislation provisions in force. It is possible that some of the old exceptions, particularly to Foss v Harbottle, will become less significant in future years as Companies are increasingly regulated. However, such developments are still only theoretical. In time, shareholders agreements may become an increasingly prominent means of achieving one’s aims as a shareholder, as opposed to relying on the articles of association. So long as such agreements do not fetter or interfere with the provisions of the CA 2006, then this can only be a good thing. Read More