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Law for Business

Knowhow - guidance - precedents

08 JUL 2014

Did you know … that some provisions in articles of association are unenforceable?

Did you know … that some provisions in articles of association are unenforceable?
A great deal of time and effort goes into drafting articles of association, both upon the company’s formation and during the course of its life. This is as it should be, for the articles govern many of the most important aspects of a company’s activities, and it is vital to ensure that they meet the parties’ needs. However, the task of drafting suitable wording can be so demanding that those charged with undertaking it can overlook a crucial question: are these provisions, upon which I am expending so much energy, actually enforceable?

The answer to this question will depend upon the provisions in question, but the fact of the matter is that some provisions are, by their nature, unenforceable.
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The articles as a’statutory contract’
The statutory underpinning of the articles is to be found in section 33(1) of the Companies Act 2006, which reads as follows:

‘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.’
This is rather opaque language, but its effect is clear: the articles operate as a contract between the company and its shareholders.

This statutory contract is not treated in law as a normal contract. For example, it can be amended even if some of the parties to it (in this case the shareholders) do not agree, since section 21 of the Act provides for the articles to be amended by means of a special resolution. It is also the case that the usual rules on implied terms and rectification do not apply, the logic being that since it is a public document the courts should not readily amend it in order to reflect the parties’ intentions. Of more importance than either of these points for the purposes of this article, however, is the fact that the courts have shown themselves to be unwilling to enforce certain types of provisions in articles.

Enforcement
There are two core rules as far as enforcement is concerned.

  • An ‘outsider’ cannot enforce a right purportedly conferred on him by the articles (Eley v The Positive Government Security Life Assurance Company, Ltd (1876) 1 Ex D 88). In light of section 33, anyone other than the company and the shareholders is an outsider for these purposes. Take the case of a provision which confers upon a director a right of indemnity. Since the director is an outsider, he will not be able to enforce that provision in the event that the company declines to comply with it. (He will not be rescued by the Contracts (Rights of Third Parties) Act 1999, because the right of enforcement which the Act confers on third parties to contracts is expressly stated not to apply in relation to articles of association (section 6(2)).)

  • Even shareholders, despite the fact that they are parties to the statutory contract, can only enforce rights which are (a) conferred on them in their capacity as a shareholder; and (b) personal in nature. These conditions have given rise to a body of deeply confusing case-law, which means that it can sometimes be difficult to know whether a particular provision is enforceable.
The effect of the first condition is that where a right is conferred on someone in his capacity as an outsider, he will not be able to enforce it even if he happens also to be a shareholder. By way of illustration, consider a provision setting out details of a director’s entitlement to remuneration. If the director is also a shareholder, he might assume that he will be able to enforce the provision, since he is a party to the statutory contract, but this assumption would probably be wrong, for a court would be likely to conclude that the right was given to him in his capacity as a director. (The courts have, admittedly, shown a willingness to give this condition a wide interpretation, at least in the quasi-partnership context (see, for example, Rayfield v Hands [1960] 1 Ch 1), but it is by no means clear in precisely what circumstances a judge might adopt a liberal approach.)

The second condition draws a distinction between rights which are personal in nature and rights which are concerned with procedural matters. In some cases, it will be fairly obvious that a provision confers a personal right; a provision conferring multiple voting rights, for example, would presumably fall within this category. In other cases, though, the nature of the right may be less clear.

Is there a solution to the problem?
The solution in many cases is to deal with certain aspects of the parties’ arrangements in a separate agreement, which will be subject to enforcement in accordance with normal principles of contract law. For example, a director who is to be indemnified by the company will want to ensure that the indemnity is set out in a standalone agreement between himself and the company. Similarly, shareholders may wish to set out some of their rights in a shareholders’ agreement.

And if the worst comes to the worst?
As to whether anything can be done to enforce a provision which, in light of the rules discussed above, will not be enforced by the courts, the key is to think creatively, and to consider whether there might be an indirect means of enforcing it. For example, might the failure to comply with the provision form the basis of an unfair prejudice claim under section 994? Might it give rise to a claim against a director for breach of his duty under section 171(a) to act in accordance with the constitution? Might the provision be held to form part of an extrinsic contract (see Re New British Iron Company, ex parte Beckwith [1898] 1 Ch 324)?

There may not always be a satisfactory alternative to direct enforcement, but an action under section 33 should by no means be regarded as the only possible option available to an aggrieved party.

In conclusion
Articles of association can give rise to difficult company law questions, and those who work with them on a regular basis certainly need to be familiar with the underlying substantive law. It is equally important, however, that they have a sound understanding of the rules concerning enforcement. After all, the most beautifully crafted provision will be of little use if the party for whose benefit it was drafted cannot, when push comes to shove, enforce it.
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