Corporate Law - ICSA · corporate law principles and the ability to apply those principles to the facts given in the questions. To prepare themselves to be able to do this, candidates

© ICSA, 2013 Page 1 of 18

Corporate Law November 2012

Suggested answers and examiner’s comments Important notice When reading these answers, please note that they are not intended to be viewed as a definitive ‘model’ answer, as in many instances there are several possible answers/approaches to a question. These answers indicate a range of appropriate content that could have been provided in answer to the questions. They may be a different length or format to the answers expected from students in the examination. Examiner’s general comments The quality of scripts written in the November 2012 examination was comparable to the quality demonstrated in past Corporate Law examinations. Unfortunately, once again, a majority of scripts indicated that candidates had not prepared sufficiently for the examination. On the whole, candidates managed their time well and answered four questions. In too many cases, however, timing was not an issue because candidate answers were too short. Candidates appeared not to have sufficiently detailed knowledge of basic principles of company law. Indeed, the most obvious and persistent shortcoming in scripts was that answers contained very vague statements. Too many candidates simply did not actually answer the precise questions asked, or did not reach conclusions. Other candidates boldly stated conclusions of law without setting out the stages of reasoning they had gone through to arrive at their conclusions. All conclusions must be supported with clearly expressed legal reasoning. To succeed in this examination, candidates need to demonstrate knowledge of current, basic corporate law principles and the ability to apply those principles to the facts given in the questions. To prepare themselves to be able to do this, candidates are urged to work through the ICSA Corporate Law study text. It contains the knowledge needed to answer all of the questions on the examination well.


1. A year ago, Frank started up a business visiting workplaces to sell sandwiches and other luncheon foods he made at home. Demand was good, and Frank began to pay another person, Gillian, to visit the workplaces he could not get to before lunch time. Sales have steadily increased, and Frank now wants to put the business on a more formal footing. He and Gillian work well together and have talked about how to expand the business.

Frank lives in a rented apartment and travels everywhere by bicycle. He has £5,000 in savings, enough to buy a second-hand van, but is reluctant to leave himself with no personal funds. Gillian, who has recently inherited a house and £50,000, has suggested they buy two new vans and livery them with the name of the business, ‘Desk Deli’. New vans would cost approximately £30,000. Required (a) Describe to Frank and Gillian the various legal structures, apart from a registered

company, that could be adopted to run the business and describe the main legal advantages and disadvantages of each.

(11 marks) Suggested answer Candidates were expected to identify and describe the following legal structures and their advantages and disadvantages: Sole trader (study text pages 20-21) Candidates were credited for mentioning the sole trader model as the current arrangement and explaining that it could have continued to be the legal structure utilised, with Frank as the sole owner entitled to all the profits and exposed to all the losses of the business and Gillian as an employee. Its attraction is its simplicity. No registration or public disclosure regime exists. Its major shortcoming is that only one person is entitled to the profits and exposed to the losses of the business. As the facts imply that Frank and Gillian wish to expand the business as a joint venture, i.e. sharing the profits and risks of the business, candidates should have concluded that a sole trader arrangement was inappropriate. General partnership (study text pages 20-21) Partnerships are defined in and governed by the Partnership Act 1890, as amended. By section 1(1), partnership is, “… the relation which subsists between persons carrying on a business in common with a view to profit.” Unless agreed otherwise, relations between the partners are governed by the 1890 Act. By section 24, partners share equally in the capital, profits, losses and management of the partnership. This assumption of equality may or may not suit the intentions of Frank and Gillian, and candidates should have emphasised that the statutory default rules can be varied by the terms of the partnership agreement with greater or lesser powers and interests being given to one partner vis a vis the other. No partnership registration or public disclosure regime exists, which candidates should have identified as an attractive feature, but partnerships are unincorporated. Therefore the personal assets of Frank and Gillian would be exposed should the business fail, regardless of their proportionate interests in the partnership, as, vis a vis third parties, each partner is jointly and severally liable for the entire debts of the partnership, and the partnership assets would be available to the personal creditors of Frank and Gillian. Limited partnership (study text pages 21-22) This special type of partnership provided for by the Limited Partnership Act 1907 has the characteristics of a general partnership but allows one or more partners to be a “sleeping partner” or limited partner, participating in profits, losses and capital but taking no part in management. Registration is required and the Registrar of Companies issues a certificate of


registration. Candidates should have identified that the facts did not suggest the limited partnership to be an appropriate structure as it appeared that both Frank and Gillian wished to be involved in management. Limited liability partnership (study text pages 31-32) Limited liability partnerships (LLPs), governed by the Limited Liability Partnerships Act 2000, are structures with the legal characteristics of private registered companies that are taxed as general partnerships. Although it is not a registered company, an LLP is a corporation so is an artificial entity that owns property, contracts, sues and can be sued. Its members are not liable for its debts. Members are required to contribute to the LLP any sum provided for in the LLP agreement and have no further statutory liability to contribute to the LLP assets. Nor are LLP assets available to the personal creditors of members. Candidates should have highlighted that this structure would provide limited personal liability to Frank and Gillian. The lack of familiarity of businesses with LLPs and the uncertainties attaching to the rules and regulations may suggest that a registered company would be a more familiar and therefore less expensive choice. (b) If Frank and Gillian were to form a registered company, advise them on:

The types of company available and which type of company they should register.

The registration documents they would need to complete, the information required and decisions they would need to make to complete those documents, and how to complete the incorporation process.

The legal arrangements by which Gillian could provide funds to the company to purchase the vans and the effect of each of the arrangements on both control of the company and the allocation of risk and reward arising from the business.

(14 marks) Suggested answer Candidates were required to answer all aspects of this part of the question, as follows: Types of company available and the most appropriate (study text pages 23-31) Candidates should have identified, described and commented on the suitability of the following: Frank and Gillian have the choices of an unlimited or limited company (s. 3). If they choose limited, they have the choice between a company with a guarantee or share capital. Companies limited by guarantee are less flexible and a less common choice for businesses run for profit, which, in the absence of evidence to the contrary, can be presumed to be their intention. If they chose a company with a share capital it may be private or public. They should choose a limited company, to protect the personal belongings of the shareholders from creditors of the company, and a private company for the lighter administrative burden (including less onerous annual filings such as small company accounts (s. 381), the potential to benefit from the small company audit exemption (s. 477), only one director required (s. 154), no requirement to appoint a company secretary (s. 270), no minimum share capital requirement (ss. 761 & 763)), and greater flexibility (such as use of the written resolution procedure (s. 288)) (see the table at page 26 of the study text). The documents, information and decisions to be taken to register a company (study text pages 47-51) Candidates were required to identify the memorandum of association in prescribed from, Form IN01: Application to Register a Company and (possibly) articles of association as the required documents.


The information needed/decisions to be made is/are (ss. 9-13):

Company name.

Registered office address (which determined the relevant registry office and governing law).

Shareholders’ details including the shares to be held by each and the extent paid-up.

Share capital.

Directors.

Secretary (or not).

Whether to rely wholly on the model articles or to amend them or draft a bespoke set of articles (s. 20).

Candidates then needed to proceed to advise on “how to complete the incorporation process”, indicating that the documents needed to be sent to the relevant registrar, depending upon the location of the registered office, could be filed in hard copy or online and needed to be accompanied by the registration fee. The registrar enters the name of the company on the register, gives it a number and issues a certificate of incorporation (ss. 14 and15). Provision of funds to buy the vans Candidates should have focussed on how Gillian could provide the funds, identifying that this could have been by loan, by equity investment (in return for allotment of paid up ordinary shares), by investment in non-equity shares, (i.e. preference shares: a new class of shares with different rights from the ordinary shares), or by a mixture of the foregoing. Loan A loan would mean that Gillian would be entitled to interest on the loan before the calculation of profits to determine whether or not dividends could be paid (study text page 182 – distributions to be out of profits available for the purpose) and, on a winding-up, to receive the sum lent back, ahead of any sum being paid to Frank (study text page 187 – shareholder last principle). A loan is a less risky way for Gillian to invest the funds than to invest in return for shares in the company. She would not be entitled to participate in any of the profits of the company nor would she have any legal rights in the residual capital of the company. A loan could be made on an unsecured basis, or the company could grant a charge to secure the loaned amount, making Gillian a secured creditor. Paid up share capital The issue of ordinary shares to Gillian would give Gillian voting rights and the right to participate in declared dividends and the residual capital of the company. The starting point is that the degree of control of the company and her share of the company’s profits and losses would directly reflect her proportion of the total ordinary shares issued. The existing business would need to be valued to determine Frank’s proportion of the ordinary shares issued. If the relative values of the sum contributed by Gillian on the one hand, and the value of the business on the other, did not reflect the respective proportionate share of control, profits and residual capital sought by Gillian and Frank, the allocation of control, risk and reward could be varied by creating a special class of shares with specified (limited) voting and dividend rights as well as specified rights to return of capital and participation in any residual value on a winding up. These are often called preference shares (study text pages 145-147 – different types of shares). Examiner’s comments Question 1 was the most popular question on the paper by far. Part (a) and the first two parts of (b) were answered equally well with candidates demonstrating accurate knowledge of the main characteristics of the key legal structures through which businesses can be operated. A substantial number of answers were at a very good standard. The provision of funds part of the question was not answered that well. Many candidates wrote about accessing funds generally, not confining their discussion to Gillian providing the funding. Also, many candidates did not mention creating a new class of shares, or ‘preference shares’.


2. Harry, Ian, Kevin and May are executive directors of Largo Group plc (‘Largo’) the ordinary shares of which have a Premium Listing on the London Stock Exchange Main Market. Largo is a FTSE 350 company. The company’s articles are the Model Articles for public companies. The other two members of Largo’s board are non-executive directors, Smith and Jones. Smith is the company’s ex-Head of Marketing, who retired three years ago, and Jones has been a member of the board for 10 years. At a board meeting to which all directors were invited, but which was attended by Harry, Ian, Kevin and May only, the board resolved to enter into three-year service contracts with each executive director. Each director abstained from voting on the resolution to approve entry into his own service contract.

The Company Secretary of Largo, Oran, retired on 31 May 2012 and the current Company Secretary, Nina, joined Largo on 1 June 2012. Nina had met with Oran on 25 May 2012 and suggested that individual training on the duties and responsibilities of directors by a specialist training firm should be arranged for each of the directors. Oran had thought it a good idea and asked Nina to “arrange all that please”. Straight after their meeting, Nina had contacted a training firm, CoCoach, on behalf of Largo, and received confirmation from CoCoach of its agreement to develop individualised programs and provide to Largo 10 hours of personal coaching for each of its directors. When Nina called CoCoach to schedule the training she was told that since they had won the prize for Best Corporate Trainers 2012, CoCoach was focussing on FTSE 100 companies and, in the circumstances, the Largo personalised training contract would not be performed. Required (a) Advise Largo whether or not it has complied with the law and the UK Corporate

Governance Code in relation to the composition of its board and the remuneration arrangements for its directors. State the consequences of any failure to comply for the company and each of its directors.

(17 marks) Suggested answer Candidates needed to advise Largo on both compliance with the Companies Act 2006 and compliance with the UK Corporate Governance Code, including the following: Compliance with the Companies Act 2006 (study text pages 224-226, 385, 386 and 388) In the absence of evidence to the contrary, Largo should have been presumed to have articles in the form of the Model Articles for Public Companies (study text Appendix 3). Article 23 permits the directors of a public company to set remuneration payable for services provided by directors. Article 16 precludes a director from voting to approve his own remuneration or service contract (it being a contract in which he has an interest) and he does not count towards quorum for any such decision. A quorum for directors’ meetings is two unless determined otherwise (Article 10). Candidates should have concluded that the articles seemed to have been adhered to. However, candidates should have identified s. 188 as governing director service agreements, which must be approved in advance by the shareholders if they could run for two years or longer. Failure to secure shareholder approval renders the provisions in the agreements as to their length void and the service agreements can be terminated by the company giving reasonable notice to the directors in question (s. 189). As there was no evidence of shareholder approval, candidates should have concluded that Largo was non-compliant with s. 188. Responding to the requirement to state the consequences of failure to comply, candidates should have concluded that the company could terminate the service contracts by giving reasonable notice and could sue the directors who approved the service agreements without


complying with s. 188, for breach of director’s duties, as they had acted negligently in failing to comply with the Act. Each of the four executive directors may have found themselves with rights to reasonable notice only, and liable to compensate the company for any losses that flowed from their breach of s. 174. Arguments could also be articulated to establish breaches of ss. 171, 172 and 175. In relation to s. 175, for example, it could be argued that when each director voted to approve the contract of the other directors he had a conflict of interest, knowing that if he did, the director in question would vote to approve his contract. Candidates were credited for logical and compelling lines of argument (study text pages 243-249 and 251-254). Compliance with the UK Corporate Governance Code (‘the UK Code’) (the code is set out in Appendix 4 of the study text (pages 407-423) and relevant references and discussion are found at pages 222-227) Candidates should have commented on the composition of the board (Principle B1). At least 50% of the board should be non-executive directors determined by the board to be independent. It has only 33% (two out of six) and the directors are not independent (see B.1.1 (study text pages 412 and 219-220)). Candidates should also have commented on the UK Code provisions for a remuneration committee and the procedure for fixing remuneration packages of directors (Code provisions D2.1, D.2.2 and D2.3) (study text page 227). The UK Code has not been complied with in this regard. Code provision D.1.5 states that notice or contract periods “should be set at one year or less…” and again, this has not been complied with. Listing rules require a company with a Premium Listing that does not comply with the UK Code to include in its annual report and accounts a statement of how it has not complied, for how long, and its reasons for non-compliance (study text pages 28 and 422). Failure to explain is a failure to comply with the listing rules which could, ultimately, result in Largo’s shares being removed from the official list. (b) Advise Largo whether the contract for personalised training is legally binding and

whether or not Largo could successfully sue CoCoach for breach of contract, setting out in your advice the precise legal basis for your conclusions.

(8 marks)

Suggested answer This part of the question tested the ability of candidates to identify the key legal concept that operates to allow a human to change the legal position of a company, specifically in relation to making the company a party to a contract. The key legal question is: did Nina have legal authority, as an agent, to bind the company, as principal, to the contract with CoCoach? Candidates should have identified and considered the existence on the facts of actual and ostensible authority (study text pages 228-231 and 119-125). Candidates should have pointed out that Nina was not an employee nor was she the company secretary, (who is an officer of the company), when she purported to enter into the contract on behalf of Largo. Oran was the company secretary at the relevant time and, as company secretary, he could have bound the company to the contract as the contract was relevant to the administration of the company: Panorama Developments v Fidelis (1971) (study text page 230). Candidates should have considered whether Oran’s words had been sufficient to authorise Nina to enter into the contract. Even if Oran had authority to appoint Nina as an agent of the company, i.e. authorise her to bind the company, his words were not specific and would be unlikely to be read as conferring any actual authority on Nina.


Candidates should then have considered whether the company could have relied on the ostensible authority of Nina to bind the company to enforce the contract. Any attempt to establish and rely on ostensible authority would have faced two fundamental problems. First, it was Nina alone who represented to CoCoach that she had the authority to contract on behalf of Largo and an agent cannot self-authorise (Armagas v Mundogas SA (1986)). She held no position with Largo, at the time the contract was entered into, that carried with it usual authority to bind the company. Secondly, the company, as principal, could not rely on ostensible authority of Nina because ostensible authority operates as an estoppel in favour of the third party, CoCoach, only. Examiner’s comments Question 2 was not a popular question. Answers to part (a) were essentially split between those demonstrating excellent knowledge of relevant parts of the UK Corporate Governance Code, and inaccurate answers with no detailed knowledge, with few answers lying between these extremes. Very few candidates correctly explained the relevant provisions of the Companies Act 2006. Many candidates omitted any reference to ss. 188 and 189. Of those candidates who did refer to s. 188, many were under the misconception that failure to secure a shareholder resolution rendered the entire service contract void. Part (b), which assessed understanding of agency law, was answered far too generally. Few candidates analysed the basis for and requirements of actual and apparent authority. Fewer still set out clearly their legal reasoning to determine whether or not Nina had authority to bind the company to the training contract. Of the candidates who referred to apparent authority, many did not appreciate that it can be relied on by the third party only, not by the company.


3. Arden Ltd (‘Arden’) was incorporated by Bill, Chris and Dan on 1 July 2007, with a share capital of 300,000 x £1 ordinary shares which are 75p paid up. It commenced business immediately, retailing designer clothes for men. Bill, Chris and Dan are the directors and each of them owns 100,000 x £1 ordinary shares. In each of the first two years of trading, Arden lost £125,000 and £75,000 respectively. In August 2009, the company’s accountants wrote to the directors stating that a significant improvement in trading was needed in coming months if the company was to avoid insolvency. The directors all believed trade would improve in the months before Christmas and that, at the very least, Arden would break even in its third year of operation. Arden’s annual accounts for 1 July 2009 to 30 June 2010 showed that a £50,000 profit had been made in its third year of operation. In August 2010, Arden paid a final dividend of £10,000 to each of Bill, Chris and Dan. Trading did not continue to improve but deteriorated very quickly. In January 2011, Arden was struggling to pay the staff working in its shop and unpaid invoices were mounting up. A trade creditor, tired of repeated requests for overdue payments being ignored, commenced winding up proceedings in March 2011, and Ellen was appointed liquidator. Required (a) Advise Ellen on the lawfulness of the dividends paid by Arden and any and all legal

grounds on which she may be able to recover the sums paid as dividends. (15 marks) Suggested answer The relevant material to answer this part of the question is covered in the study text at pages 180-187. Candidates were credited for briefly stating the procedure for declaring dividends but should not have gone into detail, for two reasons. First, in a private company such as Arden in which the directors and the shareholders are the same individuals, the procedure can be informal and there is no indication in the question of any procedural shortcoming. (The model articles permit unanimous informal decisions by directors outside board meetings (Article 8) and courts recognise as binding on the company unanimous informal decisions by shareholders (Re Duomatic Ltd (1969))). Secondly, with or without procedural shortcomings, the entire dividend was substantively unlawful. Candidates should have explained that dividends are a form of distribution, defined in s.829 of the Companies Act 2006 (‘CA 2006’), which private companies may make only out of profits available for the purpose, defined for this purpose as accumulated, realised profits, not previously utilised by distribution or capitalisation, less accumulated realised losses not written off (s.830 CA 2006). It was stated that Arden lost £125,000 and a further £75,000 before making £50,000 profits, making a cumulative loss of £150,000 at the end of June 2010. Consequently, when the dividends were paid, no profits were available for distribution, as that term is defined in s. 830, and the dividends were unlawful. (Candidates were credited for referring to chapter 2 of Part 23 of the CA 2006 “Justification of distribution by reference to accounts”.) As Bill, Chris and Dan were both directors and shareholders, claims to recover based on both roles needed to be considered. Recovery based on liability of Bill, Chris and Dan as directors (study text page 186) The directors at the time of payment of an unlawful dividend are jointly and severally liable to compensate the company for the whole amount paid (Flitcroft’s Case (1882)). Bairstow v Queen’s Moat Houses (2001) made it clear that the liability of the directors does not depend upon whether or not the company is insolvent. Alternative potential breaches of duty were of the duty to exercise reasonable care, skill and diligence (s. 174), to act within their powers (s. 171), and to act in the way they consider in good faith would be most likely to promote the success of the company (s. 172).


Recovery based on liability of Bill, Chris and Dan as shareholders (page 186) Remedies against a shareholder arise both under the CA 2006 and pursuant to the common law principle that payment of an unlawful distribution is a misapplication of corporate funds. Section 847(1) makes a shareholder liable to repay any sum received in contravention of the statutory distribution rules if at the time the distribution was made he knew or had reasonable grounds for believing the distribution was made in contravention of the statutory distribution rules. This test was likely to have been satisfied here. A shareholder who receives a distribution that contravenes the common law prohibition on distributions out of capital or the statutory rules may be required to repay the sum received to the company based on the imposition of a constructive trust (Precision Dippings Ltd v Precision Dippings Marketing Ltd (1986).This remedy would have been more effective than recovery pursuant to s. 847 because it is a proprietary remedy which means that if any of Bill, Chris or Dan had become bankrupt or insolvent after the imposition of the constructive trust, the constructive trust funds would not be available to their other creditors. (b) Identify any other steps Ellen should consider taking to increase the assets of

Arden for the benefit of its creditors and explain in detail what she would need to establish to succeed.

(10 marks)

Suggested answer The relevant material to answer this part of the question is covered in the study text at pages 72, 155 and 356-358. Candidates needed to cover the following: The unpaid share capital Arden was a limited company so the liability of the shareholders was limited to payment for their shares. Ellen could have called upon Bill, Chris and Dan, as shareholders, to pay the sum unpaid on their shares, which was 25 pence per share, £25,000 each, or £75,000 in total (Insolvency Act 1986, section 74(1) and 74(2)(d)). Wrongful trading Ellen could have made an application to court for an order that Bill, Chris and/or Dan, as directors, make a contribution to the assets of the company, being such contribution as the court thinks fit (Insolvency Act, s. 214). Ellen would have to establish that the company was in liquidation, was insolvent, and that Bill, Chris and/or Dan “knew or ought to have concluded that there was no reasonable prospect” that Arden would avoid going into insolvent liquidation. Candidates should have discussed the objective/subjective nature of the knowledge test. Even if Ellen had established the above, it would be a defence for the directors to show that they had taken every step with a view to minimising the potential loss to Arden’s creditors (s. 214(3)). The question contained insufficient information for a conclusion to be reached concerning the liability of the directors. Fraudulent trading Ellen could have made an application to court for an order that Bill, Chris and/or Dan make a contribution to the assets of the company, being such contribution as the court thinks fit. Ellen would have had to establish that the company was in liquidation, was insolvent and that the business was being carried on with intent to defraud creditors. She would also have had to establish that Bill, Chris and/or Dan were persons who were knowingly parties to the carrying on of the business with that intent (Insolvency Act, s. 213). Ellen would have had to establish actual dishonesty involving real moral blame (Re Patrick & Lyon Ltd (1933)), of which the question provides no evidence.

© ICSA, 2013 Page 10 of 18

Section 212 Candidates could have characterised the unlawful payment as a breach of duty and dealt with that breach under part (b), founding a section 212 application by Ellen. This was part of the answer to part (a) but was credited under (a) or (b) (not both). Examiner’s comments Question 3 was not well answered. Candidates answered part (a) too generally. Most candidates demonstrated knowledge of the basic requirement that dividends may be paid only out of profits available for the purpose and that such profits were calculated on a cumulative basis. However, very few candidates examined both (i) remedies available against a director and (ii) remedies available against a shareholder. Such remedies as were covered were examined at a very basic level. Candidates tended to answer part (b) in general terms with little reference to the facts in the question. Typically, candidates recited the powers of liquidators, one by one, and often described the order of distribution in an insolvent liquidation (which was not relevant to the question).

© ICSA, 2013 Page 11 of 18

4. Pippa and Ruth are directors of Sequel plc (‘Sequel’), a manufacturer of high specification lighting. Each owns 20,000 shares of its share capital of 60,000 x £1 ordinary shares and the remaining shares are owned by Ursula. Sequel has no other class of shares. Sequel needs £2 million to fund its expansion. Vince, a venture capitalist, has agreed to invest £1 million in return for owning 25% of the equity in the company, the right to appoint (and have exclusive rights to remove) two directors and the right to veto the issue of any further shares. Required Set out the legal steps, requirements and considerations to enable Sequel to allot the requisite shares to Vince, give him the right to appoint (and have exclusive rights to remove) two directors, and give him the right to veto the issue of any further share issues. (25 marks) Suggested answer This question required familiarity with the law governing the issue of shares and pre-emption rights (study text at pages 155-163), limits on the content of the articles and amending the articles (study text pages 92-93 and 100), shareholders’ agreements (study text pages 106-7), and appointment and removal of directors (study text pages 221-222). Candidates were required to cover the following issues: Allotment of shares with special rights As the contemplated shares were to have special rights, the articles of the company would have to be checked to ensure that they permitted the issue of a different class of shares. The relevant model articles are those for public companies, which have such an article (article 43). The directors must have had authority to issue the shares, which required either a provision to that effect in the articles (none appear in the model articles) or an ordinary resolution to be passed authorising the directors to issue shares with different rights (s. 551). Allotment of equity shares Candidates should have identified the shares as equity shares within s. 560 because neither Vince’s participation in dividends nor his rights in a capital distribution were to be limited. Consequently, statutory pre-emption rights would apply and every equity shareholder was entitled to be offered a pro-rata share of the new equity shares (s. 561). Pippa, Ruth and Ursula were all equity shareholders for this purpose. They could have declined to take up any offer of the shares or the pre-emption rights could have been disapplied by special resolution (ss. 570 and 571). Number and price of the shares The directors would have needed to consider the number of shares to issue, their nominal value and the price at which to issue the shares. The simplest solution was to issue 20,000 x £1 shares. This would have given Vince a 25% share of dividends and capital distributions. The price of issue would have been more than the nominal value to reflect the value of the company when they are issued. This would have entailed the directors fixing a premium, which they should have determined based on what they considered in good faith would be most likely to promote the success of the company (s. 171).

© ICSA, 2013 Page 12 of 18

Vince to have the right to appoint two directors Appointment of directors is governed by the articles and Vince may have been given this right by the company passing a special resolution amending the articles to that effect. Candidates should have noted that care needed to be taken to ensure that it was a membership right, otherwise Vince would struggle to enforce the article (Beattie v Beattie (1938)). This could have been done by making it clear that Vince had a different class of shares and that the members of that class had the right to appoint two directors. Vince to have the exclusive right to remove the directors he appoints The right to remove directors is governed by both the articles and the Act. There was no problem putting in the articles a provision that the holders of the new class of shares may remove any director they have appointed to the board. This would not, however, have precluded the removal of those directors pursuant to s. 168. Over-riding s. 168 would be problematic but for Bushell v Faith (1969), a case in which the House of Lords confirmed a way around s. 168. The right to remove could be expressed in terms of weighted voting rights attaching to the new shares to ensure that Vince could always outvote the other shareholders on a resolution to remove any director he has appointed. Candidates were credited for referring to a shareholder agreement as a place in which to capture the relevant provisions and avoid problems of enforcement of the articles. Examiner’s comments Question 4 was the least popular question on the paper and produced the least accurate answers of any of the questions. Many candidates simply did not demonstrate knowledge of the process for allotting shares and other candidates stated the process incorrectly. Many candidates did not mention statutory pre-emption rights at all, yet statutory pre-emption rights were an essential part of the answer.

© ICSA, 2013 Page 13 of 18

5. The following items were considered at a meeting of the directors of West plc (‘West’):

(i) A resolution to change the company’s property and business interruption insurer was proposed because it would reduce the annual premium significantly. The insurance proposal form for the new cover was circulated at the meeting. When the Finance Director, Zen, stated that it had been completed by Young, who had been West’s insurance broker for the past 12 years, and in whom he had complete faith, none of the directors read the proposal form. The resolution was passed unanimously. In fact, the proposal form contained errors amounting to material non-disclosures which would allow the insurer to avoid liability under the policy.

(ii) To save on operating costs, a resolution to close West’s sales office in Scotland

was proposed. Savings of £50,000 per annum were projected and the directors’ discussion focused on the likelihood of these savings actually being made. The Head of Strategy did not mention that 12 employees would be made redundant in an area of higher than average unemployment in the UK and no directors asked about the employment implications. As a result of an employee share participation plan, 10 of the employees facing redundancy own shares in West.

(iii) Under ‘any other business’, Zen raised the embarrassing fact that he was

experiencing personal financial difficulties which were causing him intense stress. On hearing that Bankit plc has agreed to lend Zen £50,000 if West was prepared to guarantee the loan, West’s directors resolved to provide this guarantee.

Required (a) Identify the directors’ duties and other laws relevant to the actions of West’s

directors described above. Explain whether or not these duties and laws have been complied with and the remedies potentially available.

(17 marks) Suggested answer The relevant material to answer this part of the question is covered in the study text at pages 238-262 (directors’ duties). Candidates needed to address the following: The insurance resolution The key duty relevant to the passing of the board resolution to change the insurer was the duty of a director to exercise reasonable care, skill and diligence (s. 174). The duty to exercise independent judgement (s. 173) could also have been discussed. The test for liability under each should have been stated and potential breaches by the Finance Director, Zen, should have been considered separately from breaches by the remaining directors. In relation to Zen, he did not appear to have read the proposal form which, relying on Re D’Jan (of London) Ltd (1994) is likely to have been a breach of s. 174, although good answers should have identified the need to understand precisely which information it was that was false and how reasonable it was for Zen to have relied on the broker to collate/know that information. A breach of s. 173 could have been argued but, as the issue was a director delegating the exercise of judgement but checking the accuracy of the statements in the proposal form, s. 174 appeared to be the more appropriate governing duty. In relation to the other directors, a breach of s. 174 would not have been as easy to establish. They could argue that they were entitled to assume that the proposal form has been checked by the finance director, or another responsible person, and that in the absence of being told that there was information in it that they should have reviewed in case they knew something that was relevant, the fact that they did not read it was not negligence on their part. In response to this it could be argued that a document circulated at a board meeting should be read. Another

© ICSA, 2013 Page 14 of 18

important point was that possibly, even had they read it, the directors may not have known and it might not have been reasonable to expect them to have known that the incorrect information it contained was incorrect. Again, although a breach of s. 173 could have been argued, s. 174 was the more appropriate governing duty. The cost-saving resolution The key duty relevant to the cost-saving resolution was the duty of a director to act in the way he considers, in good faith, would be most likely to promote the success of the company (s. 172). The statute requires directors, in performing this duty, to have regard to a non-exhaustive list of issues including the interests of the company’s employees and the impact of the company’s operations on the community. Candidates should have identified this duty as reflecting the concept of enlightened shareholder value. Candidates who noted the problem with who would initiate enforcement here, in part (a), were credited even though it belonged in part (b). The test for liability under s. 172 should have been discussed, including Re Smith & Fawcett (1942) and Charterbridge Corporation v Lloyds Bank (1970) (a case of failure to consider, which could be analogised to a failure, as here, to have regard to certain matters). The test is essentially subjective, with certain case law (Charterbridge included) suggesting an objective underpinning. Candidates should have pointed out that it would be very difficult to demonstrate a breach unless a clear procedural shortcoming could be pointed to. The directors had failed to consider expressly the effect of their decision on the employees of the company and/or the community and candidates should have discussed whether or not evidence of this procedural shortcoming would be enough to establish a breach of the s.172 duty. Breach of s. 175 should also have been discussed, as the failure to have regard to matters clearly listed in the statute could be characterised as lack of reasonable care. In relation to either duty, the difficulty of establishing loss to the company was also problematic, making it difficult to identify a pursuable remedy. The guarantee of the loan to Zen The key statutory provision that had not been complied with here was s. 197(1)(b) which requires company guarantees of loans to directors in excess of £10,000 (s. 207) to be approved in advance by an ordinary resolution (s. 197(1)). The remedies for non-compliance are set out in s. 213. It is not clear that West could avoid the guarantee, but if West is liable under it, the directors who approved it are jointly and severally liable to indemnify the company for any loss it suffers (ss. 213(3) and (4)). Candidates were also credited for a clear examination of the duties in ss. 171, 172, 174 and 175. None are likely to have been breached provided that the directors were acting in good faith, acted reasonably to preserve the attention and well-being of Zen, and because s. 175 does not apply (due to s. 175(3)). (b) Advise whether any of the employees facing redundancy are able to enforce any of

the duties that may have been breached in part (ii) above. If so, describe the stages they would need to go through and the factors a court would need to take into consideration before a legal claim could proceed.

(8 marks) Suggested answer This question tested understanding of the proper claimant principle and derivative actions (study text pages 265-271). As directors’ duties are owed to the company, the proper claimant for breach of duty is the company (Foss v Harbottle (1843)). Section 260 of the Companies Act 2006 sets out the right of a shareholder of a company to bring a derivative claim in the name of the company against one or more directors in respect of, amongst other things, a breach of directors’ duty. Those employees who are shareholders may, in their capacity as shareholders, commence a derivative

© ICSA, 2013 Page 15 of 18

claim on behalf of the company. Permission from the court to continue such a claim must be secured (s. 261(1)). Candidates should have outlined the stages of a derivative claim, as follows (and may have given more detail): The court must dismiss the claim or refuse permission to continue if the application and evidence filed does not disclose a prima facie case (s. 261(2)), if the behaviour complained of has been authorised or ratified by the company; or if a director acting in accordance with s. 172 would not seek to continue the action (s 263(2)). If not dismissed, or permission is not refused for a mandatory reason, the court must include in its consideration of whether or not to permit the claim to continue (s. 263(3)), the good faith of those bringing the claim, the importance attached to continuing the claim by a s. 172-compliant director, any authorisation or ratification, whether the company has decided not to pursue the claim and whether or not those bringing the claim have a personal cause of action they could pursue. Also, by s. 263(4), the court is to have particular regard to views of members who have no personal interest in the matter. Examiner’s comments Question 5 was the second most popular question on the paper. Although it was answered relatively well, many candidates did not identify part (b) as calling for analysis of statutory derivative claims (s. 260 of the Companies Act 2006). Part (a) was answered very generally. On the whole, candidates did not identify each relevant duty, or state the duties accurately and clearly. For example, far too many candidates omitted the word ‘reasonable’ from their statement of the duty set out in s. 174 of the Companies Act 2006. Typically, candidates referred to a duty vaguely and simply stated that it had been breached, without setting out any steps or legal reasoning to support the conclusion. Very few candidates attempted to explain the nature of the duty in s. 172. Candidates identified the guarantee of the loan as problematic, but few identified or applied s. 197 of the Companies Act 2006. A very small minority of candidates recognised part (b) as focussed on statutory derivative claims. Many candidates wrote about issues outside the scope of the question such as claims for breach of contract of employment. The question asked about enforcement of breaches of directors’ duties (not breaches by the company of its contractual obligations).

© ICSA, 2013 Page 16 of 18

6. White plc (‘White’) is the parent company of a corporate group. Two of its wholly owned subsidiaries are Blue Ltd (‘Blue’) and Dark Ltd (‘Dark’). Dark used to own the chemical production facility (‘the Facility’) it operates but now has negligible assets because it transferred ownership (but not operation) of the Facility to Blue four weeks ago. Blue ‘paid’ for the Facility by cancelling the sum Dark owed it under a pre-existing intra-group loan. Dark now leases the Facility back from Blue. Evan has worked for 15 years at the Facility, where ‘Ever-white’ – a powerful cleaning product – is produced. A toxic chemical called ‘whitox’ is used in the production process for Ever-white. Evan has unintentionally brought home traces of whitox on his clothes and his wife, Fiona, believes she has suffered ill health arising from exposure to the chemical. Fiona has consulted a solicitor to discuss bringing a negligence claim to recover damages for ill health. Ever-white is losing market share and Dark is paying its invoices later and later. Sharma, one of Dark’s suppliers, is owed £100,000, which is overdue. Sharma wishes to recover the sum but fears that Dark is unable to pay him. The directors of Dark are Dark’s Head of Operations, Omar, and three of the directors of White. Evan told Omar about his wife’s illness six weeks ago. Omar told Evan that he is ignored at board meetings and all important decisions are made by the White directors. He says the directors have known of the health dangers of whitox for years and deliberately ignored them. A proposal he made to the board to replace whitox with a safe chemical had not been passed, he said, because changes to the production facility, to enable use of the safe substitute, would cost £200,000. Required (a) Advise Fiona and Sharma whether they can sue either White, Blue or Dark. Identify

and explore in your advice the key arguments that have been made out in case law for piercing the veil of incorporation and assess the likelihood of success of each.

(20 marks) Note: You should not consider the liability of the directors of White or Dark. Suggested answer This question tested understanding of the consequences of incorporation and limitations on the implications (study text pages 68-82). Candidates gained marks for accurately stating the principles and referring to the cases referenced below. Sharma’s debts arose under contracts with Dark. He has claims for breach of contract. These claims should have been considered separately from Fiona’s claim in the tort of negligence which arose out of the negligence of Dark. As the supply contracts pursuant to which Sharma was owed the money were between Sharma and Dark, Sharma could sue Dark for breach of contract because Dark was an artificial legal person, a corporation aggregate, separate and distinct from its shareholders and managers or directors (see ss. 15 and 16 Companies Act 2006). Sharma could not have sued the parent company because shareholders are not, without more, liable for the debts of the company (Salomon v Salomon (1897)). This is so even though Dark is a wholly owned subsidiary of another company (Adams v Cape (1990)). The question then arose as to whether a court would, in the circumstances, regard the contract as between Sharma and White. The basis on which this might have been done would have been to find that Dark was the agent of White and had entered into the contracts on behalf of White, the parent company. This would only have been found if there was factual evidence establishing that at the time the contracts were entered into, Dark had had actual or ostensible authority to

© ICSA, 2013 Page 17 of 18

enter into the supply contracts on behalf of White. Candidates should have stated that no agency is assumed between a parent and subsidiary company just because of the parent subsidiary relationship (Yukong v Rendsberg (1998)). Alternatively, the courts may have been prepared to ignore the separate personality doctrine and treat the acts of Dark as the acts of White, sometimes called piercing the corporate veil. Candidates should have discussed Adams v Cape (1990), the leading case that examined the grounds on which, in the past, courts have been willing to ignore the separate corporate legal personality doctrine. The three grounds to be discussed (in addition to agency) and the key cases to be referenced were: single economic entity theory (emphatically rejected in Adams v Cape (1990) and demonstrated as not a valid ground in Ord v Belhaven (1998)); that justice requires it (also emphatically rejected in Adams v Cape (1990), although it seems to have been acting behind the scenes in Trustor v Smallbone (2001); and the sham or facade theory (identified as the only basis for piercing the corporate veil by Lord Keith of Kinkel in Woolfson v Strathclyde (1978)). Candidates should have mentioned that courts rarely pierce the veil in favour of a trade creditor as it interferes with the statutory order of distribution in insolvency law and that the theory is that a trade creditor, being a voluntary creditor, can decide whether or not to extend credit to a company. Sharma would not have been permitted to sue any company except Dark. Fiona would have been looked upon more kindly by the courts because she is an involuntary creditor of Dark. Nonetheless, the starting point is that Dark was liable to Fiona and the shareholder parent company was not liable, for the reasons stated above. Focussing on agency as a basis upon which to impose liability on White, the control of the Dark board by the White directors could have been used to argue that Dark was operating the Facility on behalf of White and that therefore White was liable for negligence claims arising out of that operation. The single economic entity theory would not have been accepted and the argument that justice requires liability to be imposed on the parent was rejected in Adams v Cape (1990) which itself involved tort claims. It would have been very difficult to argue that either White, Blue or Dark were facades or shams. An argument built upon Dark shifting assets to Blue at a time when it was aware of Fiona’s tort claim, the argument being that White was using Blue to avoid a contingent liability that was highly likely to arise and therefore the courts would be willing to pierce the corporate veil of Blue and regard the Facility as still owned by Dark, is morally compelling but difficult to support with legal authority. Consequently, Fiona was also likely to be able to sue Dark only. (b) What alternative legal course of action does Sharma have and which of the routes

available would you advise Sharma to take to be in a position to pursue that alternative course of action?

(5 marks) Suggested answer This question tested understanding of commencing a compulsory winding up (study text pages 341-342). Candidates should have advised that Sharma could have sought a compulsory winding up order under the Insolvency Act 1986 s. 122(1)(f) on the grounds that Dark was unable to pay its debts. To be in a position to petition for such an order on this ground, Sharma could have obtained a county court judgment, tried to enforce it, and secured evidence of failed execution (s. 123(1)(b)). Alternatively, as the sum due was over £750, he could have served a statutory demand (a written demand in the prescribed form) on Dark, waited for three weeks and, if it remained unpaid, immediately applied to the court to wind up the company (s 123(1)(a)).

© ICSA, 2013 Page 18 of 18

Examiner’s comments The most common problem with answers to part (a) of question 6 was that candidates’ descriptions of the key arguments for piercing the veil tended to be vague. Application of the law to the facts was often inaccurate and lacked clarity. Part (b) was often omitted by those who attempted question 6, possibly due to candidates running out of time. Many of those who did attempt to answer part (b) simply described the types of windings up available generally. Candidates need to be more selective and should avoid simply reciting their knowledge on a topic that appears to them to be relevant to the question.

The scenarios included here are entirely fictional. Any resemblance of the information in the scenarios to real persons or organisations, actual or perceived, is purely coincidental.

Documents

Corporate Law - ICSA · corporate law principles and the ability to apply those principles to the facts given in the questions. To prepare themselves to be able to do this, candidates