Law of Contract - Introduction (Part 2)

Competing Ideologies

It should be clear that there are competing ideologies within contract law. Adams and Brownsword explored this aspect of contract law in a 1987 article. Adams and Brownsword identified two basic philosophies, Market-individualism and Consumer-welfarism.

Market-individualism

This theory recognises the function of the market place as a venue for “competitive exchange.” The laws of contract facilitate competitive bargaining.

Although Adams and Brownsword recognise that it is not “the law of the jungle,” contract law does not require full disclosure of all pertinent facts to the other contracting party. This theory encapsulates the principles of freedom of contract and also caveat emptor.

One example of this is in purchasing a house. The seller is not legally obliged to tell the buyer about matters that may materially affect the value of the property (e.g. impending developments in the neighbourhood.)

The other aspect of market-individualism is that contracting parties should be free to make their own bargains without the interference of the court. This idea encapsulates the idea of the sanctity of a contract and also the laissez faire approach of the court.

Consumer-Welfarism

This theory is completely different. It makes the fundamentally different assumption that contracts should be regulated. This means in particular, consumer contracts, but it also includes commercial contracts. Important features of this theory are the potential for stronger parties to abuse their position-therefore the law should favour the weaker party.

An oral contract – is it worth the paper it isn’t written on?

The majority of contracts formed each day are made orally and are perfectly valid.

The law only requires certain contracts to be made in writing.

Under S.2 (1) Law of Property (Miscellaneous Provisions) Act 1989 a contract for the sale of any interest in land can only be made in writing.

Under S.4 The Statute of Frauds 1677 an agreement for guaranteeing an amount due under a debt or some other obligation must be in writing. Therefore an oral guarantee is not enforceable.

Contracts made by Deed

Under S.52 (1) Law of Property Act 1925, all conveyances of land must be made by deed.

Please note – the use of deeds is not restricted to conveyancing. It can useful for many important transactions. For contracts under deed there is no requirement that both parties provide consideration.

The role of the courts – the desire for certainty

If there were only one word to describe the rationale behind the courts’ attitude to contract law – that word would have to be certainty.

The courts have adopted a variety of different methods, doctrines and rules, all of which are intended to ensure that people can enter into agreements with the certainty that these agreements can and will be enforceable in the courts.

Although this approach has been significantly adapted (mostly by statute) to cater for the modern day consumer, the desire for certainty still lies at the heart of contract law.

See further, textbooks:

Law of Contract - Introduction (Part 1)

Contract is arguably the most pervasive and important subject that a lawyer will study.

An understanding of contract law is essential before areas such as commercial law, company law or international trade law can be studied properly.

The law of contract underpins all our everyday commercial transactions. Although the substantive law may vary from one jurisdiction to another, it is difficult to conceive of a system that does not have the law of contract at its heart.

To a large degree, the law of contract could be described as “Judge made”. The fundamental principles stem from a plethora of judgments- many of which date from the 19th Century and earlier.

Although these fundamental principles remain important; in the last 50 years, Parliament has enacted a variety of statutes which have affected this area significantly.

The most significant statutes are the Unfair Contract Terms Act 1977 and the Sale of Goods Act 1979.

What is a Contract?

There are various ways to define a contract. Chitty states that there are two main competing definitions. One defines a contract as follows:

“A promise or a set of promises that the law will enforce.”

The second definition is most clearly stated by Treitel:

“A contract is an agreement giving rise to obligations which are enforced or recognised by law.”

Where does contract law fit within the law?

Contract law is part of the law of obligations. Within this area are also the law of tort and the law of restitution.

Unlike tort, contract law is based on “voluntary obligations that are assumed in exchange for a benefit.”

Tort is based on non-voluntary obligations imposed by law to prevent wrongs.

Freedom of contract

Caveat emptor is a Latin term that means, “Let the buyer beware”.

Laissez-faire is a term of French origin that is used by contract lawyers to mean free enterprise or non-interventionism.

These terms are often stated in relation to the traditional attitude of the courts to contract law. They reflect the doctrine of freedom of contract. The rationale for this doctrine is that parties, dealing at “arms length” should be free to enter into any agreement without the interference of the courts. The courts role was to uphold valid contracts and prevent contracting parties from evading their contractual obligations merely because they had made a bad bargain.

This doctrine is most clearly explained by the chapter on exclusion clauses. Such clauses were (and are) placed into contracts to enable one party to avoid liability in the event of a breach of contract. (A breach is where one party fails to do something that he is contractually obliged to do.)

Under the justification of the freedom of contract doctrine, such clauses could easily be incorporated into contracts and were often upheld. The difficulty with this judicial approach was that many contracting parties were able to evade their contractual obligations by merely inserting these clauses in a contract. This created a potential for abuse by parties who were in a strong bargaining position.

The 20th Century saw the development of the consumer society – a consequence of the sale of mass-produced manufactured goods to an increasingly affluent population. A consumer contract is markedly different from the type of contract envisaged by the courts of the Victorian era (two parties dealing at arms length free to agree whichever terms they like.) In reality a consumer has little influence over the terms of the contract – it is very much a case of “take it or leave it.”

By developing various rules of interpretation (discussed later in the course), the courts went some way to curb the worst excesses, but it was only the actions of Parliament that gave modern day consumers the protection they needed. In relation to Exclusion clauses the most important development was the enactment of the Unfair Contract Terms Act 1977.

It has been said that today the “consumer is king” and we have moved from a position of Caveat Emptor to that of Caveat Venditor (Let the Seller Beware).

See further, textbook:

Company Law - Shares and Dividends (Part 3)

Potential to circumvent class protection

Again, it may be possible to utilise these provisions to circumvent the protection provided to class right-holders.

The court has held that a reduction which removes a class is not a ‘variation’ or ‘abrogation’ of those class rights, and so does not need the specific consent of that class – Re Saltdean [1968] 1 WLR 1844. Therefore, it is possible to treat different classes of shareholders differently – e.g. to reduce the whole of one class and none of another.

However, members within each class should be treated equally (Re Jupiter House Investments [1985] 1 WLR 975).

It is also necessary to obtain the consent of the court, which will only be provided if the reduction is ‘fair and equitable’ (Re Old Silkstone Collieries [1954] Ch 169).

Dividends

The Companies Act 2006, Part 23 uses the alternative term ‘distributions’.

A dividend is a payment of the profits of the company to the shareholders, and is assumed to be each member’s share of the profits to be divided (Henry v Great Northern Railway Co (1887) 1 De G & J 606).

There is no need for an express power to be contained in the memorandum of association in order to pay a dividend, but equally there is no rule that all profits must be distributed (Burland v Earle [1902] AC 83). If paid, it must be in cash unless the articles provide otherwise (Wood v Odessa Waterworks Co (1889) 42 ChD 636).

Which assets may be distributed?

When distributing the profits of the company, it is important for the directors to respect the ‘maintenance of capital’ doctrine. In addition, because the company’s assets will be in a constant state of flux, assets must be identified which may be safely distributed:

s.829 (1) CA 2006: “A company may only make a distribution out of profits available for the purpose”.

s.829(2) CA 2006: “A company’s profits available for distribution are its accumulated, realised profits, so far as not previously utilised by distribution or capitalisation, less its accumulated, realised losses, so far as not previously written off in a reduction or reorganisation of capital duly made”.

Public companies are subjected to further restrictions contained in s.831 Companies Act 2006.

The process of declaring a dividend:

For each financial year of the company, the directors must prepare a directors’ report (s.234(1) Companies Act 1985/s.415 Companies Act 2006), and this must state the amount (if any) that the directors recommend should be paid by way of a dividend (s.234ZZA(1) Companies Act 1985/s.416 Companies Act 2006).

In doing this, the directors should have regard to all classes of shareholders, and not favour one over another (Henry v Great Northern Railway Co (1887) 1 De G & J 606).

Once the directors have made their recommendation, the shareholders have the power to declare a dividend:

Art.102, Table A: “Subject to the provisions of the Act, the company may by ordinary resolution declare dividends in accordance with the respective rights of the members, but no dividend shall exceed the amount recommended by the directors”.

Art.105, Table A: “A general meeting declaring a dividend, may, upon the recommendation of the directors, direct that it shall be satisfied wholly or partly by the distribution of assets…”

However, no dividend is payable until it is declared, even for preference shareholders (Bond v Barrow Haematite Steel Co [1902] 1 Ch 353), and once it is declared it is treated as a debt owed by the company.

See further, textbook:

Company Law - Shares and Dividends (Part 2)

Potential to circumvent class protection

Under the topic of "Share capital and issuing shares", class right-holders are given additional protection to prevent the overall majority of shareholders removing class rights (s.125/s.127 Companies Act 1985 and s.630/s.633 Companies Act 2006). However, it may be possible to circumvent this protection by creating extra shares with the same class rights following the procedure outlined above. If enough shares are issued, it is possible to push the original class shareholders into a minority of less than 15% thereby rendering the extra protection useless.

The reason why this is possible is that the statutory protection applies to a ‘variation’ or ‘abrogation’ of class rights. However, the courts have held that diluting the original class shareholders’ voting power (by creating more shares with the same rights) is NOT a variation or abrogation, and so the consent of the class is NOT required to issue the extra shares:

“There is to my mind a distinction, and a sensible distinction, between an affecting of the rights and an effecting of the enjoyment of those rights” – White v Bristol Aeroplane Co Ltd ([1953] Ch 65).

Once the extra shares are issued to a party who agrees to vote in favour of abolishing the class rights (this agreement can take the form of a shareholders’ agreement, rendering it contractually binding – Russell v Northern Bank [1992] 1 WLR 588, it is possible to call a class meeting under s.125 Companies Act 1985/s.630 Companies Act 2006. Because this class meeting is now under control of the party in favour of the abolition or variation, the resolution will succeed.

Furthermore, provided the original class shareholders have been pushed into a less than 15% minority, the additional protection of s.127 Companies Act 1985/s.633 Companies Act 2006 will be unavailable.

Reduction of share capital

In contrast to the above example, there may be times when a company wishes to reduce the number of shares. This could occur where it has a surplus of assets – essentially it is possible to hand some of this back to the members in exchange for their shares. Alternatively, it could reflect a diminution in the value of its assets.

 

Maintenance of share capital

There is a general rule that a company must ‘maintain’ its share capital. This doctrine was developed to protect creditors. “The creditor… gives credit to the company on the faith of the representation that the capital shall be applied only for the purposes of the business, and he has therefore a right to say that the corporation shall keep its capital and not return it to the shareholders, though it may which he cannot enforce otherwise than by a winding up order” – Re Exchange Banking Co., Flitcroft’s Case (1882) 21 Chd 519. It ensures that capital is maintained as a secure fund which cannot be distributed to shareholders except on winding up – essentially, the liability of members is limited but not absolute – i.e. members are still liable up to the amount they paid for the shares.

However, there are limits on this doctrine:

- capital need only be maintained so far as ordinary business risks allow. If it is lost through bad luck or even negligence, there has been no breach of the doctrine;

- there is no requirement that debt is taken in proportion to capital – therefore, a company with an authorised share capital of 1,000 shares of £1 each could, in theory, take out a loan of £1,000,000;

- there is no basic requirement that the company is adequately capitalised.

The practical effect of this is that there are times where capital may be paid to, or returned to, members.

One such example is found in the companies legislation:

Reduction of share capital

s.135 (1) Companies Act 1985: “Subject to confirmation by the court, a company limited by shares or a company limited by guarantee and having share capital may, if authorised to do so by its articles, by special resolution reduce its share capital in any way”.

Art.34 Table A: “Subject to the provisions of the Act, the company may by special resolution reduce its share capital in any way”.

The phrase ‘in any way’ gives the company wide powers of reduction:

British and American Trustee v Couper [1884] AC 399

“The statute has not prescribed the manner in which the reduction is to be carried out, nor has it prohibited any method of effecting that object”.

Ex Parte Westburn Sugar Refineries Ltd [1951] AC 625

“The general rule is that the prescribed majority of the shareholders are entitled to decide whether there should be a reduction of capital and if so in what manner and to what extent it should be carried into effect”. 

See further, textbooks:

Company Law - Shares and Dividends (Part 1)

Introduction – the alteration of share capital

Even once a company is up and running, it may desire to alter its share capital. There are two primary ways in which this can take place: an increase of share capital, or a reduction of share capital

Increase of share capital

The company may wish to increase its share capital in order to attract further investment and expand. Although this is a perfectly legitimate action, there is the possibility that this could be abused.

Increase of share capital

The first step in issuing extra shares is to identify whether there are any authorised, unissued shares. If there are not, then it becomes necessary to increase the authorised share capital of the company:

s.121 (1) Companies Act 1985: “A company… if so authorised by its articles may… (a) increase its share capital of such amount as it thinks expedient”.

Art.32 Table A: “The company may by ordinary resolution (a) increase its share capital… of such amount as the resolution proscribes”.

s.617 Companies Act 2006 provides a similar mechanism.

Give the directors the power to allot the shares

Once there are authorised, unissued shares available, it becomes necessary to give the directors the power to issue (or allot) them.

s.80 (1) Companies Act 1985: “The directors… shall not exercise any power… to allot… unless they are authorised to do so by (a) the company in a general meeting; or (b) the company’s articles”.

s.80 (4): “The authority must state the maximum amount… that may be allotted, and the date on which it will expire, which must not be more than 5 years”.

Similar provisions are found in s.551 Companies Act 2006.

Pre-emption rights

A danger of issuing shares to new members is that the existing members may lose their influence within the company. For example, if a member holds 75 out of 100 shares, they will be in a position to pass both ordinary and special resolutions. However, if a further 100 shares are issued to others; suddenly the member will only hold 75 out of 200 shares, meaning they will not even have sufficient influence to pass an ordinary resolution.

In order to combat this danger, the companies legislation provide for rights of pre-emption – essentially, that if new shares are to be issued, they should first be offered to existing members in proportion to their existing shareholding to at least give them the opportunity to preserve their voting power.

s.89 (1) Companies Act 1985: “A company proposing to allot equity securities:

(a) shall not allot any of them… unless it has made an offer to each person who holds relevant shares… to allot to him on the same or more favourable terms a proportion of those securities which is as nearly practicable equal to the proportion… held by him;

(b) shall not allot any of those securities… unless the period [21 days] during which any such offer may be accepted has elapsed”.

Similar provisions are found in s.561 Companies Act 2006.

Removal of the right to pre-emption

It may be that members do not wish to purchase additional shares, and indeed may be inexpedient to wait for the 21-day period to expire. As such, it is possible to remove the right of pre-emption:

s.95 Companies Act 1985: “[directors] may be given power by the articles or by special resolution to allot [shares] as if… s.89 (1) did not apply”.

A similar provision is found in s.570 Companies Act 2006.

Issue shares

At this point, there are unissued shares available, the directors have the authority to allot them, and there is no need to offer them to existing members. Therefore, the directors may by ordinary resolution resolve to issue the shares.

See further, textbooks:

Company Law - Share Capital and Issuing Shares (Part 2)

Types of class right

Essentially, a class right is any right enjoyed by some members but not others. The case of Cumbrian Newspapers v Cumberland ([1986] 2 All ER 816) has identified three different types of class right, but only two of these are enforceable:

1) rights or benefits which are annexed to particular shares. For example:

- The right to a preferential dividend (aka ‘preference share’);

- The right to a preferential dividend plus a share of the ordinary dividend (aka participating preference share);

- The right to a preferential return of capital upon winding up.

2) rights or benefits conferred on individuals not in the capacity of members [invalid as an ‘outsider’ right as per Hickman];

3) rights or benefits that, although not attached to any particular shares are nonetheless conferred in the capacity of member

- this includes Bushell v Faith and Cumbrian Newspapers clauses.

Protection of class rights

Often, the holders of a preference share represent a minority within the company, or may even hold shares which do not have the right to vote (this will depend upon the specific terms of the class, most likely set out in the articles). Despite this, they may be treated in a preferential manner compared to the ‘ordinary’ majority.

As a result, there is a big incentive for the majority to remove these class rights. Ordinarily, the alteration of the articles requires a special resolution (s.9 Companies Act 1985/s.21 (1) Companies Act 2006) done bona fide in the interests of the company as a whole (Allen v Gold Reefs [1900] 1 Ch 656). 
 
Therefore, in order to provide greater protection, if the variation involves varying or abrogating a class right, then the consent of the class is required (s.125 Companies Act 1985/s.630 Companies Act 2006). Generally, this requires a special resolution of that class.

Even if this is passed, a class minority of 15% or more may still apply to the court to have the variation disallowed if it can be shown that it would ‘unfairly prejudice’ the class (s.127 Companies Act 1985/s.633 Companies Act 2006).

Voting rights

Unlike directors, shareholders are not subject to fiduciary duties when voting:

“The shareholders are not trustees for one another and, unlike directors; they occupy no fiduciary position and are under no fiduciary duties”. (Dixon J, Peters’ American Delicacy Co Ltd v Heath (1939) 61 CLR 457)
As a result, they may vote in their own interests:

“The right to vote is attached to the share itself as an incident of property to be enjoyed and exercised for the owner’s personal advantage”. (Dixon J, Peters’ American Delicacy Co Ltd v Heath (1939) 61 CLR 457)

In addition, the shareholder is not subject to the ‘no conflict’ rule:

“Every shareholder has a perfect right to vote upon any… question, although he may have a personal interest in the subject matter opposed to, or different from, the general interests of the company”. (North-West Transportation Co Ltd v Beatty (1887) 12 App Cas 589) Indeed, it has been said that “a man may be actuated in giving his vote by interests entirely adverse to the interests of the company as a whole”.(Pender v Lushington (1887) 6 ChD 70) 
 
Limits 
 
Despite the above, there are some limitations on how a shareholder may vote on a particular issue:

- When exercising the power to amend the articles under s.9 Companies Act 1985/ s.21(1) Companies Act 2006, it must be done bone fide in the interests of the company as a whole;( Allen v Gold Reefs [1900] 1 Ch 656)

- An appointment of a director must be made for the benefit of the company as a whole and not for an ulterior purpose;( Re Harmer Ltd [1959] 1 WLR 62)

- At a class meeting, the majority must vote for the benefit of the class as a whole; (Re Holder’s Investment Trust Ltd [1971] 1 WLR 583)

- When voting on whether the company should take legal proceedings regarding an illegal, fraudulent or ultra vires matter, the vote must be bona fide in the interests of the company and not for some other purpose (e.g. to protect the proposed defendant). (Taylor v NUM (Derbyshire) [1985] BCLC 237) 

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