Sole director companies in the spotlight – what do we need to see from them in finance transactions?

Background

Sole director companies have come under the spotlight this year in two High Court cases: Hashmi v Lorimer-Wing and Fore Fitness Investment Holdings Limited [2022] EWHC 191 (Ch) (known as Fore Fitness) and Re Active Wear Limited [2022] EWHC 2340 (Ch) (Active Wear). Both cases considered the position of a sole director of a private company limited by shares, with, in relation to Fore Fitness, the Model Articles with bespoke amendments (including in relation to quorum) and in relation to Active Wear, the Model Articles in unamended form. Although the cases can be distinguished from each other in certain ways, this article attempts to draw out some key principles and to provide guidance on what a lender should require from a sole director company approving entry into finance documents.

What are the options for private companies when choosing their articles?

A private company limited by shares is permitted to choose to adopt the terms of the Model Articles in their entirety as its own articles (and they will in fact be automatically incorporated into its constitution, to the extent not excluded or modified); to adopt a combination of the Model Articles and bespoke articles (for example a common adaptation is to disallow the chairman's casting vote in Model Article 13) or to adopt entirely bespoke articles. If the Model Articles are adopted, the following articles will be relevant to quorum:

Article 7(1): decisions of the company's directors must be either by majority decision at a meeting or a decision made in accordance with article 8 (unanimous decision of eligible directors).
Article 7(2): where a company has only one director, and the company's articles do not otherwise require it to have more than one director, the general rule (in Article 7(1)) does not apply and the sole director can take decisions "without regard to any of the provisions of the articles relating to director's decision making".
Article 11(2): the quorum for board meetings may be fixed from time to time by a decision of the directors but cannot be less than two and unless otherwise fixed, will be two directors by default.
Article 11(3): where the total number of directors is less than the quorum required, the directors are restricted from taking any decision other than a decision to appoint further directors, or to call a general meeting to enable the shareholders to appoint further directors.

The Model Articles are intended, and drafted to be, internally consistent, in unamended form. The generally accepted view (prior to Fore Fitness) was that Model Articles 11(2) and 11(3) form part of the general rule on decision making and therefore at any time when the company has a single director, they do not apply. Model Article 7(2) then allows the sole director to take all decisions.

What did the High Court decide in the two cases?

Fore Fitness related to an unfair prejudice claim under section 994 of the Companies Act 2006 (CA 2006) and a counterclaim by the company. The company had (1) a sole director at the time of the claim, and on incorporation, but had had more than one between those times and (2) a combination of the Model Articles and bespoke articles; one of the bespoke articles specifically relating to quorum. The High Court held that the sole director lacked the requisite power under the company's articles to commence the counterclaim on behalf of the company.
Active Wear related to the purported out-of-court appointment of an administrator. The company had always had (1) unamended Model Articles and (2) one director. The decision to appoint had been taken by a sole director, despite the existence of board minutes at which a chairman was stated to be present and a quorum was stated to be met. The appointment of an administrator by that sole director was considered and approved.
As two High Court decisions, neither can be said to take precedence over the other. While Fore Fitness dealt with a company with a combination of the Model Articles and bespoke articles, the comments of the judge did appear to be directed at a company with unamended Model Articles too, and the court did suggest that the unamended Model Articles would need to be adapted to permit a sole director to run a company. However, Fore Fitness was specifically distinguished in Active Wear on the ground Fore Fitness considered a company with a combination of the Model Articles and bespoke articles, including a bespoke article relating to quorum, whereas in Active Wear the company had adopted the Model Articles in unamended form.

How are these cases relevant to finance transactions?

The lender's advisers will conduct due diligence in relation to each Obligor, including checking the articles of association. The ruling in Fore Fitness suggested if the check revealed that the company had adopted the Model Articles without amendment and had a sole director, such sole director could not approve the finance documents without amendment to the articles. Active Wear suggested the Model Articles would be acceptable where a sole director is approving the documents, with the judgment given in the context of a company that had always had the Model Articles and had always been a sole director company.
The corporate approvals required from a corporate entity will be specified as conditions precedent to drawing down the loan. It is important therefore to determine at the outset whether the company's articles "work" in conjunction with a sole director, and what the lender should require from that company in terms of approvals. In the absence of clarity on this, a decision taken by a sole director, deemed to have lacked the requisite power under the company's articles to make that decision, would present a particular concern to a lender where security granted in its favour is "approved" by that sole director. Section 40 CA 2006 is unlikely to offer much assistance to lenders given there is some doubt that it applies to dealings with an inquorate board.

Key takeaways for finance transactions

When dealing with a sole director company, particularly one with a combination of the Model Articles and bespoke articles, and/or one which has had more than one director at some point since its incorporation, we would advise continuing to act with caution where approvals are to be provided pursuant to a finance transaction. The options below may be considered.

A second director may be appointed, in accordance with the company’s articles. Model Article 11(3) permits the appointment of a further director or the calling of a general meeting to enable the shareholders to appoint a second director.
The shareholders may amend the articles to confirm that Model Article 11(2) or its equivalent does not require more than one director and/or is subject to Model Article 7(2) or its equivalent. They may amend the articles by written resolution or at a shareholder meeting provided a second director has been appointed who can call the meeting or circulate the resolution to amend the articles. If this route is not possible, they could consider whether amendment to the articles by sole shareholder decision or unanimous shareholder assent on the Duomatic principle (which while not codified in CA 2006, was preserved by section 281(4) CA 2006) would be an option.

Further, it may be advisable to consider previous approvals made by the sole director company, particularly where such approvals were made without a shareholder resolution in support, and to consider taking the opportunity to ratify them.

Active Wear offers some comfort where the company has always had a sole director and the Model Articles, without amendment that a sole director can validly take decisions. It is suggested it should only be relied upon cautiously however, and only in these circumstances. Director appointments on incorporation and subsequently, and the articles adopted on incorporation plus any subsequent amendments would need to be checked for and examined carefully.