Company Law - The Formation of a Company (Part 2)

The Articles of Association

The articles of association form the ‘rule book’ of the company. The lay down, in detail, how its internal affairs operate. The articles will therefore provide the answer as to whether the members or directors are permitted to do certain acts and the procedure they need to follow.

The law prior to the Companies Act 2006

Prior to the Companies Act 2006, the enforcement of the articles of association caused a number of problems. The case of Salomon v Salomon, often considered to be the cornerstone case of company law, established three principles.
1)The company has a separate legal personality to its members;
2)Its members enjoy limited liability;
3)Provided the correct procedures were followed, incorporation was open to all, irrespective of how large or small the business was.

The upshot of this was that a number of small businesses incorporated to enjoy these benefits (as occurred in Salomon itself). However, even after incorporation these were still operated as if they were partnerships.

Some of the characteristics of a ‘quasi-partnership’ include:
- Small number of shareholders;
- Equal shareholdings;
- Most shareholders are individuals;
- Restrictions in share transfer;
- Provisions in articles or other agreement providing, for example, a role in management;

In particular, the original founding member(s) of the business would often want to ensure that they remained in control of the business once it was transferred to the company. One way that they attempted to do this was to incorporate, for example, the right to be director for life into the articles. However, this raised a question as to whether it was appropriate to use the articles, which were for the running of the company, to preserve personal rights of members.

Generally, difficulties were encountered when the member tried to enforce these personal rights under what became known as the ‘statutory contract’:

s.14 CA 1985: “Subject to the provisions of this Act, the memorandum and articles, when registered, bind the company and its members to the same extent as if they respectively had been signed and sealed by each member, and contained covenants on the part of each member to observe all the provisions…”

This contract was deemed to exist both between the members inter se and between the members and the company.

However, despite section 14 clearly stating “all the provisions”, the courts took an inconsistent approach as to whether certain provisions could be enforced: This can be seen from the following two cases:

Quin & Axtens v Salmon
Facts: The company’s articles allowed either managing director to ‘veto’ the decision of the board of directors. Salmon attempted to veto a decision, but the other directors continued regardless and obtained approval by ordinary resolution at a general meeting of the shareholders. Salmon sought an injunction to prevent the act from continuing.

Held: “in truth this was an attempt to alter the terms of the contract between the parties by a simple resolution instead of by a special resolution”

Essentially, the effect of allowing the board to continue would have been to remove the power of veto, which could only be done using s.9/special resolution.

However, the effect of this decision was to indirectly enforce the director’s personal right of veto.

This can be contrasted with:

Eley v Positive Life Association
Facts: Eley, a solicitor, had drafted the company’s articles, including a term that he would the company’s solicitor. He later became a member of the company, but the company began using a different solicitor. He sought to enforce the term.

Held: The court refused his claim. The power to appoint a solicitor remained with the board of directors, and therefore to allow Eley’s claim would be contrary to each member’s right to have the company’s affairs conducted by the organ identified in the articles.

Because of this lack of consistency, the courts had to find a way to give effect to validly incorporated terms while at the same time ensure that the articles remained focussed on the corporate constitution rather than the rights of individual (and possibly transient) shareholders.

Thus, in Hickman a ‘filter’ was introduced:

Hickman v Kent or Romney Marsh Sheep-Breeders Association
Held: “First, no article can constitute a contract between the Company and a 3rd person;

secondly, no right merely purporting to be given by an article to a person, whether a member or not, in a capacity other than that of a member… can be enforced against the Company;

thirdly articles regulating the rights and obligations of the members generally as such do create rights and obligations between them and the company respectively.”

Therefore, Hickman introduced a two-stage filter when trying to enforce a right found in the articles:
1) Who is trying to enforce the right? Only a member may do so;
2) What kind of right are they trying to enforce? Only an ‘insider’ right may be enforced.

‘Insider’ rights have been said to be those given to a member in their capacity as member, and include:
- The right to attend a general meeting;
- The right to vote;
- The right to have that vote recorded;
- The right to receive a dividend (if declared).

What this does NOT include is rights other than those held as member. For example:
- The right to be director;
- The right to be solicitor. 
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