Company Law: Articles of Association, what is Entrenchment?

What is entrenchment?

For companies incorporated prior to 1 October 2009, memoranda and articles of association may specify a provision can only be acted upon, amended, or removed by means that are more restrictive than a special resolution (75% of the voting membership must agree). If the provision falls under this description, it is deemed an ‘entrenched provision’ and falls under the Companies Act 2006, s 22.

In terms of changing the articles of association, the courts are opposed to entrenched provisions. By statute, a company is free to change its articles. Jessel MR in Walker v London Tramways Company declared:

‘every one of the articles should be deemed to be a regulation capable of alteration’. This approach was agreed by Lord Lindley MR who stated, ‘the company is empowered by the statute to alter the regulations contained in its articles from time to time by special resolutions ‒ and any regulation or article purporting to deprive the company of this power is invalid’.

External Contracts

It should be noted that a company and its members are curtailed from entering into extrinsic contracts preventing alteration of the articles, in Punt v Symons and Co Ltd [1903] 2 Ch 506, the members entered into a private agreement that stated:

‘The company shall not at any time alter or attempt to alter the clauses of the articles of association relating to the appointment of the vendor as governing director as originally framed or do or suffer anything to be done in contravention of the provisions contained in these clauses respectively.’

Bryne J proclaimed

‘I am prepared to hold that in the circumstances of the present case the contract could not operate to prevent the article being altered.’

Shareholder Agreements

It is common practice today, for members to draft extrinsic contracts by way of a ‘shareholder agreement’. In Russell v Northern Bank Development Corp Ltd [1992] 1 WLR 588, it was held that a provision in a company's articles of association which restricted its statutory power to alter those articles was invalid, but an agreement outside the articles between shareholders as to how they would exercise their voting rights on a resolution to alter the articles was not necessarily invalid.

The articles bind new members without alteration or amendment – a new investor taking shares in a private limited company would be deemed bound by the company’s existing articles. This principal is different with contractual, extrinsic agreements, as new members or investors would not be party to any previous agreement.

It is clear from the case law that the company is free to change its articles and is prevented from restricting changes through extrinsic member agreements based on contract law. The courts allow some leeway for members to exercise shareholder agreements that specify how shareholders may exercise their votes in a particular way in relation to a specific action.

Companies incorporated prior to 1 October 2009 attempted to entrench or bind future members by including provisions in the memorandum. This course of action for companies incorporated under the Companies Act 2006 would be futile because the importance of the memorandum is diminished as it no longer forms part of the constitution.

When drafting the new model articles under the Companies Act 2006, The Company Law Review recommended that members should hold the option to entrench provisions, this was duly enshrined into the Companies Act 2006 in Chapter 2, alteration of articles, section 22.

  • A company's articles may contain provision (“provision for entrenchment”) to the effect that specified provisions of the articles may be amended or repealed only if conditions are met, or procedures are complied with, that are more restrictive than those applicable in the case of a special resolution. 

Entrenched provisions of the articles

Absolute entrenchment is no longer available for companies incorporated after 1 October 2009. To interpret the legislation, a company's articles may contain provision for entrenchment, in terms that specified provisions may be amended or repealed only if they are more restrictive than passing a special resolution. Therefore, an article requiring 80% of the eligible votes to pass would be described as entrenched, or alternatively ‘all members’ must agree.

It was the intention of the Act to allow for ‘absolute entrenchment’ due to section 22(3)(a) being added at committee stage (and being at odds with absolute entrenchment), the original clause, that specified articles could not be amended or repealed, was removed.

Memorandum, entrenchment and amendment (companies incorporated before 1 October 2009)

Case example

In May 1987, the owner and engineer of Widgets Limited, Mrs Singh, had two sons who were directors and minority shareholders of the company. Mrs Singh was very proud of the patented products they manufactured and when eventually she transitioned her business to the family she did not want the company to diversify into new products (which her sons had pressured their mother to do). After taking legal advice on formation, a clause in the company memorandum contained an ‘absolute entrenchment’ clause stating the memorandum (and therefore the company objects) was irrevocable.

In 2018 Mrs Singh died. The two sons were then the majority shareholders and wished to expand their business and amend the memorandum and update the articles of association to the new model articles under the Companies Act 2006.

The problem

For companies who have entrenched provisions that form part of their memorandum, the provisions are now automatically deemed part of the articles of association. The Companies Act 2006, s 22(3)(a) allows amendment of the articles and the entrenched provision on the basis all the members of the company agree. Both sons agreed, however, that this did not solve the problem. The company was prevented from amending using section 22(3)(a) by statutory instrument. The two sons’ only course of action was to apply to the courts for an order to amend the memorandum.

Overview

It has been noted that the entrenchment provisions detailed in the Companies Act 2006, s 22, are drafted with an element of flawed thinking. Companies formed after 1 October 2009 are prevented from utilising absolute entrenched articles; the case law discussed prevents unalterable articles; and the legislation provides a dumbed down version of entrenchment that merely requires provisions in the articles to be amended or repealed, if conditions or procedures are followed, that requires 75% or more of the votes cast by members to pass.

The only recourse for small private companies incorporated before 1 October 2009 with irrevocable provisions in their memorandum is to seek an order of the courts. Section 28 is the root cause of the problem, by deemed incorporation of the memorandum for companies incorporated before 1 October 2009 into the articles, the absolute entrenchment is caught by the case law that allows complete freedom for a company to amend its articles.

Companies Act 1986, s 22

In January 2012 the memorandum to the Business, Innovation and Skills Select Committee   prevented section 22(2) (see below) being brought into force; the article limits when a company’s entrenchment provisions may be included:

‘Entrenched provisions of the articles

(2)          Provision for entrenchment may only be made—

(a)          in the company's articles on formation, or

(b)          by an amendment of the company's articles agreed to by all the members of the company.’

It was suggested the two methods of introducing entrenchment were limiting and together with section 22(1) may fetter rights attached to share classes and make changing such provisions difficult as it required unanimous consent.

Today, the position remains the same and no date has been suggested for the implementation of section 22(2).

Richard C. Bishop is the author of Articles of Association: Guidance and Precedents and Articles of Association for Charities and Not for Profit Organisations: Guidance and Precedents.

Richard C. Bishop

Written by Richard C. Bishop

Richard is lecturer in finance at Leeds Beckett University teaching in the Centre for Tourism and Hospitality Management. Prior to working at Leeds Beckett, Richard taught marketing and business strategy at Wolverhampton University, specializing in delivering CIM modules and lead the financial service degree program at Coventry University College.

Subscribe to the Bloomsbury Professional Law Newsletter

Law Online

Bloomsburyprofessionallaw Online research for solicitors and barristers practising in English law Free Trial

Need Help?

Bloomsburyprofessionallaw If you need any help with finding publications or just ask a question. Talk to an Advisor: 01444 416119
customerservices@bloomsburyprofessional.com
or send us a message