CAPITAL MAINTENANCE AND DISTRIBUTIONS

8

Capital maintenance and distributions

AIMS AND OBJECTIVES

After reading this chapter you should be able to:

  Understand how share capital can protect a creditor and why its relevance declines over the life of a company

  Explain the scope of ‘capital maintenance’ laws

  State the minimum share capital requirements

  Appreciate the exceptions to the prohibition on reduction of share capital

  Advise on the court approval and solvency statement procedures for reducing share capital

  Advise on the procedures available to acquire and redeem shares, including out of capital and for the purposes of an employees’ share scheme

  Appreciate statutory and common law restrictions on distributions

  Recognise potentially disguised distributions

  Understand how the legal restrictions are relaxed for distributions in kind

  Discuss the remedies available for payment of unlawful distributions

  State the shareholder last principle

  Know the rules governing company political donations

  Recognise financial assistance and know when it is prohibited

8.1 Introduction

In the previous chapter we learned about a company’s share capital. We know that the share capital of a company is the number of issued shares × nominal value of those shares (100 × £1 = £100, for example). On registration, a company begins life with its initial share capital, which it can increase from time to time by issuing more shares. The company uses its share capital to fund its trading operations with the aim of making profits. The company may supplement its share capital by incurring debt, i.e. borrowing money from creditors to fund its trading operations.

In this chapter we review the laws governing minimum share capital and the reduction of share capital. We examine the importance of share capital to creditors and we also examine the laws regulating other actions by which companies return money to shareholders, principally by distributions. Together with the shareholder last principle, these laws are often referred to as ‘capital maintenance’. We then look at the broader issue of how the law regulates gratuitous payments by a company to non-shareholders, including political donations. The final section of this chapter deals with the prohibition on a company giving financial assistance for the purchase of its own shares which is an extension to the prohibition on a company buying its own shares but is aimed at a different mischief.

8.1.1 Can share capital protect a creditor against company trading losses?

At the start of a company’s life, a financial creditor will be very interested to know how much share capital the company has before the creditor will be prepared to lend money to the company. The creditor wishes to be paid interest on any sum it lends to the company and to be paid back that sum at the point, or various points, in the future at which it becomes due and repayable.

If a company has a negligible share capital, virtually the entire risk of the company making trading losses lies with the creditor. Every £1 the company loses in trading is £1 it cannot pay back to the lender. The creditor may have a legal right to sue the company to recover the sum contractually due and payable to it but that right is only valuable if the company has the money to pay the sum due (see Example 1 below).

If, however, a company has substantial share capital, the risk of the company making trading losses lies with the shareholders up to the amount of the share capital. Every £1 the company loses, up to the amount of the share capital, is a loss borne by the shareholders. This is because the shareholders cannot insist on taking their capital back from the company whilst it is a going concern and, if the company is wound up, its shareholders are only entitled to receive money back from the company after all the creditors have been paid in full (the shareholder last principle) (see Example 2 and section 8.6).

The company may not reduce its share capital and return money to its shareholders (except as authorised by, and subject to compliance with procedures in, the 2006 Act) and the company cannot pay money to shareholders, whether in the form of dividends or otherwise, unless the company has profits out of which to make the payment.

The following examples illustrate the importance of share capital in the early stages of a company’s operation. They also introduce you to the concepts of assets, liabilities and capital in the balance sheet of a company. Understanding the basics of how share capital and profits and losses affect a company’s balance sheet is essential to understanding capital maintenance. The following examples are simplified to demonstrate the basic principles.

Example 1: A company with virtually no share capital

Company A Ltd is registered with a share capital of £1 made up of 1 × £1 ordinary shares, fully paid-up. Company A Ltd borrows £1,000 from B, repayable in 12 months. Company A Ltd has assets of £1,001. This is stated in its balance sheet as follows:

Balance sheet of Company A Ltd as at 1 January 2013

This is not equal to the share capital of £1 because there are two components to Capital: share capital and accumulated profits and losses. The accumulated profits and loss here is a loss of £500, so Capital is:

Example 3: Shares issued at a premium

8.1.2 The relevance of share capital over the life of a company

The examples in section 8.1.1 demonstrate how share capital can protect a creditor from losing money due to a company experiencing trading losses. They are based on a single, financial creditor lending money to a company at the outset of its operations and cover only the first year of the company’s life. In such a simple, somewhat unrealistic, scenario share capital is observed to represent a cushion for creditors against the risk of default of the company. In reality, a financial creditor will seek to secure any sum lent to the company. Taking security offers far greater protection to a creditor than the initial share capital contributed to a company (secured debt is explained at section 6.4.6 and in Chapter 16).

In reality, the ability of the share capital to protect creditors and the importance of share capital to creditors reduces over the life of a company. First, the initial share capital becomes an increasingly historic figure, eroded in real terms by inflation. Second, creditors who extend credit to a company with a trading record will have more information about the company available to them than the limited information available on formation. The relevance of share capital to creditors is picked up again below, at section 8.4, after we have reviewed the rules designed to prevent it being returned to shareholders.

8.1.3 The meaning of ‘capital maintenance’

Capital maintenance is referred to as a ‘principle’, ‘doctrine’ or ‘core concept’ of company law. It is not a straightforward concept and its precise scope is unclear. It is necessary to break the concept down into its components.

Lord Russell identified the two key components of capital maintenance (when a company is not being wound up) in Hill v Permanent Trustee Company of New South Wales [1930] AC 720 (PC):

The two fundamental legal principles identified in Lord Russell’s judgment can now be found in the Companies Act 2006:

  a limited company having a share capital may not reduce its share capital except as authorised by statute (s 617);

  distributions of a company’s assets to its members, whether in cash or otherwise, may only be made out of profits available for the purpose (s 830 and see also s 831 in relation to public companies).

To appreciate the operation and role played by capital maintenance in company law, it is important also to be aware of legal rules supporting and refining these key principles. Accordingly, the capital maintenance concept can be regarded as shorthand for:

  minimum share capital rules (ss 763–767);

  the basic prohibition on a company reducing its share capital (s 617);

  detailed exceptions to the prohibition on a company reducing its share capital (Pts 17 and 18 of the 2006 Act);

  the requirement that distributions to shareholders may only be paid out of profits available for the purpose (ss 829–853);

  the shareholder last principle on winding up (Insolvency Act 1986 ss 107 and 143(1); Ayerst (Inspector of Taxes) v C & K (Construction) Ltd [1976] AC 167).

Each of these components of capital maintenance is considered in turn in the following sections of this chapter.

8.2 Minimum share capital requirement

8.2.1 Requirement to have a share capital

Public companies and private companies limited by shares must have a share capital. Incorporators are required to register a statement of capital and initial shareholdings on registration indicating the number of shares to be taken on formation by the subscribers and their nominal value (s 10).

8.2.2 Private companies

The share capital of a private company can be as small as the incorporators choose, for example, one share of one penny.

8.2.3 Public companies

Public companies must have allotted shares of no less than the authorised minimum as a condition of the registrar of companies issuing a trading certificate and a public company must not do business without having a trading certificate (s 761). The authorised minimum nominal value of the issued shares of a public company is £50,000 or the prescribed euro equivalent (ss 761(2) and 763).

Public companies may not issue shares unless they are paid up as to at least one-quarter nominal value (s 586) and shares issued at the time of incorporation must be paid for in cash (s 584). The result is that a company registered as a public company must have at least £12,500 in cash when it commences business and the right to call for at least a further £37,500 from shareholders. Laws governing payment for shares, considered in section 7.5.1, are important to ensure that the company is entitled to receive from a shareholder at least the nominal value of his shares: shares may not be issued at a discount (s 580).

The importance to creditors of the requirement that a company has a share capital and the minimum required for public companies are considered in section 8.4.

8.3 Statutory prohibition on reduction of share capital except in accordance with the Act and company articles

Once a company has been registered with its initial share capital, the company may not alter its share capital except in the ways set out in s 617. Section 617 permits reduction of share capital in accordance with ss 641–657. There is no need for specific authorisation in a company’s articles to reduce its share capital in accordance with the Act. If, however, articles contain any restriction or prohibition on reduction of share capital, the provisions in the articles must be complied with (s 641(6)).

8.3.1 Private company reduction of share capital

A private company may reduce its share capital by either of two procedures. It may use the old procedure (the only procedure available to a public company to reduce its share capital), which requires confirmation by court order and is considered in the next subsection. Alternatively, it can use the new procedure, first introduced by the Companies Act 2006 and contained in ss 641–644. This procedure is part of the deregulation of company law for private companies as the old rules were regarded as unnecessarily complicated. No court confirmation of the reduction is required and the fact that the procedure has been introduced essentially acknowledges that maintaining share capital is not important to the creditors of private companies. The critical basis for a reduction is the opinion of the directors that the company is solvent and will remain solvent for the following year.

In contrast with a reduction of capital by confirmation of the court (ss 645 and 646), neither creditors nor those shareholders who do not support the reduction of share capital have an opportunity during the process to object to a reduction of capital effected by the solvency statement route. Note, however, the need to ensure that if there is a variation of class rights, the variation of class rights procedure is gone through (see Chapter 7.3.2). Also note that if the directors have breached their duties in the course of the reduction, minority shareholders who object may be able to bring a derivative claim, and, furthermore, the circumstances may found a successful unfair prejudice petition. Each of these procedures are examined in Chapter 14.

8.3.2 Public company reduction of share capital

A public company (and a private company, although it seems unlikely that a private company will use this more cumbersome procedure in future) may reduce its share capital by special resolution but must secure a confirmation order from the court (ss 641(1)(b) and 645–651).

The process

1.  A special resolution must be passed.

2.  The company must settle a list of creditors for the court and either:

  obtain the consent of all creditors; or

  pay off, or set aside a sum to pay off, any creditor who does not consent.

3.  The company must present a petition to the court to confirm the reduction.

4.  The court may make an order confirming the reduction ‘on such terms and conditions as it thinks fit’ (s 648(1)).

5.  The following must be registered with the registrar (s 649):

  special resolution;

  copy of the court order;

  statement of capital as reduced, approved by the court.

The reduction does not take effect until the required documents and statements have been registered.

Court confirmation

When the court is considering a petition to reduce share capital it must consider the interests of the creditors, the shareholders and members of the public who may invest or become creditors of the company (Ex parte Westburn Sugar Refineries Ltd [1951] AC 625). In relation to creditors, the court must not confirm the reduction unless it is satisfied in relation to every creditor who has not consented to the reduction that either his debt has been paid off or a sum has been set aside by the company to pay him off (s 648(2)). An offence is committed, punishable by fine, by every officer of the company who intentionally or recklessly conceals the name of a creditor or misrepresents the nature or amount of a creditor’s debt or claim (s 647). Section 646 of the Act, which entitles a creditor to object to the reduction, has been amended to require that to succeed, the creditor must demonstrate that its claim is at risk and that the company has not provided adequate safeguards (a mandatory requirement arising from European Directive 2006/68, implemented by the Companies (Share Capital and Acquisition by Company of Its Own Shares) Regulations 2009 (SI 2009/2022)).

In relation to shareholders, the court must consider whether or not the reduction is fair and equitable as between shareholders, whether of the same or different classes (see Scottish Insurance Corporation Ltd v Wilsons & Clyde Coal Co Ltd [1949] AC 462 (HL)). Note that where the reduction involves a particular class of shareholders, the variation of rights procedure may have to be gone through (see section 7.3.2 and the cases considered there).

8.3.3 Acquisition of own shares

Section 617 expressly states that the statutory prohibition on a company reducing its share capital does not affect the power of a company to acquire its own shares in accordance with Pt 18 of the Act. This is supported in Pt 18 by s 658 which prohibits the acquisition by a company of its own shares, ‘except in accordance with the provisions of this Part’. Pt 18 contains provisions permitting a company to acquire its own shares either by purchasing them or redeeming redeemable shares. The rules for private companies are more relaxed than the rules for public companies.

In relation to the acquisition by a public company of its own shares using distributable profits, again no effective reduction of share capital occurs as a result of the operation of s 733. Where shares are bought by a company using distributable profits, the acquired shares are held as treasury shares or cancelled. If the acquired shares are cancelled, the share capital is reduced (ss 688 and 706), but s 733 requires a sum equal to the nominal value of the shares acquired (the reduction in capital), to be transferred to an account called the ‘capital redemption reserve’. Section 733(6) provides that, with one exception, the provisions of the Act relating to the reduction of share capital apply to the capital redemption reserve. Consequently, the capital redemption reserve is treated like share capital and may not be distributed. If the share capital account and the capital redemption reserve account are added together they equal the share capital amount before the acquisition of the shares. This means that the company’s share capital is technically reduced but in practical terms the company must be operated as if its share capital remained the same as before the reduction.

A public company seeking to acquire shares out of capital must use the reduction of capital procedure considered at section 8.3.2 for which court confirmation is required.

Private companies

A private company is permitted to acquire its own shares (ss 684 and 690):

  using distributable profits or the proceeds of a new issue of shares made for the purpose (in accordance with Chapters 3 and 4 of Pt 18) (ss 687(2) (redemption) and 692(2) (purchase));

  ‘with cash’ up to a limit of the lower of £15,000 or 5 per cent of the value of its share capital in accordance with Chapter 4 (s 692(1)(b) (purchase only, not redemption)); and

  out of capital (in accordance with Chapter 5 of Pt 18) (ss 687(1) (redemption) and 692(1)(a) (purchase)).

When a company purchases its own shares with distributable profits or cash, the shares may be held as treasury shares (s 724(1)) or cancelled. If cancelled, a sum equal to the reduction in share capital must be transferred to the capital redemption reserve and, as explained above, the capital redemption reserve is treated like capital and cannot be distributed. In other cases, the shares must be cancelled. If shares that have been acquired using capital are cancelled, a real reduction in share capital occurs.

Is the acquisition of shares using capital provisions in Chapter 5 of Pt 18 redundant?

The procedure in Chapter 5 of Pt 18 of the Act (ss 709–723), by which a private company may use capital to acquire its own shares, existed, albeit in a slightly different form, before the 2006 Act. It is more onerous than the solvency statement procedure introduced by the Companies Act 2006 by which a private company may reduce its share capital but remains an important procedure. One reason for a company to go through the more onerous ss 709–723 procedure is to allow the company to pay a premium out of capital on a purchase of its own shares.

Acquisition of shares using capital (not for an employees’ share scheme)

If a private company intends to redeem (s 687) or purchase (s 690) its own shares using capital, the shares must be fully paid-up and paid for on acquisition (although on a redemption of shares, payment may be deferred if the terms of redemption so provide and this requirement does not apply to shares purchased for the purposes of or pursuant to an employees’ share scheme) (ss 686 and 691). In addition to ss 709–723 (the provisions specifically relevant to the use of capital to pay for a share acquisition), redeemable shares will be redeemed in accordance with their terms of redemption, and non-redeemable shares must be purchased in accordance with the ‘off-market’ purchase procedure set out in the Act (ss 693–700 and 702–708). Note that before any capital may be used, all profits available for distribution and the proceeds of any fresh issue of shares must be applied to pay for an acquisition or redemption (s 710).

  a solvency statement as in s 643 (see section 8.3.1) (s 714).

  An auditor’s report must be obtained and annexed to the directors’ statement (s 714(6)) stating that:

  the amount of the permissible capital payment is in his view properly determined; and

  he is not aware of anything to indicate that the opinion expressed by the directors in their statement is unreasonable in the circumstances.

  The directors’ statement and auditor’s report must be available for inspection (s 720).

  Public notice of any proposed payment out of capital is required, both in the Gazette and in an appropriate national newspaper (s 719(1) and (2)).

  The terms of the purchase or buyback contract (s 696) and the directors’ statement and auditor’s report (s 718) must be made available to shareholders at the meeting at which the relevant resolution is to be passed or must be sent to shareholders with the written resolution.

  A special resolution must be passed authorising payment out of capital (s 716).

  An ordinary resolution must be passed authorising the terms of the purchase or buyback contract (s 694).

  The purchase or buyback contract must be executed.

  The purchased shares are treated as cancelled (s 706).

  The following must be sent to the registrar:

  copies of the directors’ statement and auditor’s report (s 719(4));

  notice of purchase of shares (s 707);

  notice of cancellation and a statement of capital (s 708);

  a copy of the special resolution authorising payment out of capital (s 30).

The directors’ statement must be in prescribed form containing the prescribed information and paragraph 5 of the Companies (Shares and Share Capital) Order 2009 (SI No 2009/388) states that it must be signed by all directors.

Creditors and any shareholder who has not consented have five weeks from the date of the special resolution authorising the payment of capital within which to object to the use of the capital to redeem or acquire the company’s shares. The objection is made by application to the court to cancel the special resolution (s 721).

Acquisition of shares using capital for an employees’ share scheme

If shares are being acquired by a private company using capital for the purposes of or pursuant to an employees’ share scheme, the process outlined in the previous section may be simplified in two respects as a result of the changes introduced by the Companies Act 2006 (Amendment of Part 18) Regulations 2013 (SI 2013/999). First, a s 693A resolution may already be in place authorising the purchase of shares for the purposes of or pursuant to an employees’ share scheme and, second, ss 720A and B may be relied on which remove the need for a directors’ statement, auditor’s report and public notice, substituting a process (similar to that for a reduction in share capital pursuant to s 641(1) (a)), simply requiring a directors’ solvency statement and a special resolution.

8.4 Is capital maintenance important to creditors?

Focusing on share capital, private companies must have a share capital but it may be wholly minimal, such as, in theory, one share of one penny. Although public companies are required to have a minimum share capital of £50,000, this is not a substantial sum of money for a company in business in today’s world.

In practice, of the approximately 480,000 companies first registered in 2013–14, close to 98 per cent had issued share capital of under £10,000. Of all companies on the register at the beginning of 2014, 78 per cent had issued share capital of £100 or less and 93 per cent had issued share capital under £10,000.

The rules and facts above indicate that in relation to most companies share capital offers little comfort to creditors that the company will be able to pay its debts. Evidence received by the Company Law Review Steering Group suggests creditors do not regard a company’s share capital as particularly important.

QUOTATION