Essay: Maintenance of share capital

A share may be described as “an interest of a shareholder in a company measured by a sum of money for the purpose of liability in the first place and of interest in the second”[1].  Shares also represent the statutory contract between a shareholder and all the other shareholders of the company[2].

The share affords certain rights to the shareholder, such as to receive dividends, to vote on fundamental decisions and rights to participate in surplus assets.  Where a company is brought to an end, any surplus assets are shared after creditors have been discharged[3].  In practice, where the Company has gone into liquidation, there is often insufficient money to pay its creditors  and since the creditors’ rights come before those of the shareholders, the investment can be seen as a risky one in which the investor may lose all of their money[4].

Similarly, creditors considering lending funds to a limited company will need to be aware that under the Companies Act 2006 (“CA2006”), the liability of members of a company limited by shares to such parties, is the balance that remains unpaid on any shares held by them[5].  Such liability can only come to an end by payment in full of that balance[6], at which point the amount paid is termed ‘paid up’ capital[7].  Once all capital is paid up, in the absence of any other agreement (such as a director personally securing his assets against a bank loan), the members will not owe the creditors any unpaid amounts – but the creditors have access to this information and so can make an informed decision on whether to lend or not, although in practice, other factors will usually have more bearing on this decision.

Where a lending institution or creditor is considering offering facilities to a company, they may want to know how much the shareholders paid for their shares, and the amount that remains unpaid.  Under Section 542(1)[8], shares in a limited company must have a fixed nominal, or ‘par’, value.  This indicates the minimum price to be paid for the shares.  When the Company is registered, certain information is required which will be available to others to view, including the names and addresses of the original members of the Company, the total number of shares in the Company, the aggregate nominal value and the amount paid/unpaid on each share[9].  For most private companies this will be £1, and this is unaffected by the market performance of the Company[10].

If it were possible for a company to return the equity that its shareholders had invested to them during its lifetime, the rules discussed that put a creditor’s interests first would be undermined.   If the equity was returned to the shareholders and then the Company went into liquidation, the remaining assets would be insufficient to pay the liabilities to the creditors, and the shareholders’ interests would have taken priority in effect[11].  Therefore, there are rules in place that generally dictate that share capital should be both discoverable, and should not be reduced.

Where the company is limited by shares or by guarantee, the fixed amount of the company’s capital cannot be changed, except by alteration of the memorandum of association by one of the methods that the CA2006 permits[12].  For private companies, there is no minimum share capital, whereas for public companies there must be a minimum authorised and issued share capital for it to carry on business, currently £50,000[13].  Under CA2006, companies must comply with certain requirements regarding the maintenance and reduction of share capital, for the benefit of creditors in a winding up.

Over time, the rules relating to the maintenance of share capital have changed, and  various provisions have been introduced which allow share capital to be reduced in certain circumstances.  Companies have the power to buy back shares they have issued before.  They can also finance an outside party’s purchase of shares, which has the effect of reducing assets.  Sometimes, reducing the capital is a good option for the Company’s health and does not affect the creditor’s interests – for example, where the Company has issued more shares than it needs, or has made significant losses, a reduction would effectively recognise the Company’s true position.  There are various rules which govern under what circumstances such activity can take place[14].

A company may reduce its share capital, for example, by extinguishing or reducing the outstanding liability on unpaid or partly paid shares; cancelling unpaid share capital which is lost or unrepresented; or repaying unpaid share capital that is in excess of the company’s needs[15]. Its members must pass a special resolution and directors must make a statement as to solvency within 15 days before the resolution, to say the Company can pay its debts within a year of the statement being made[16].  This applies to private companies; but there is a second method for private and all other companies whereby the shareholders pass the special resolution and then the Company applies to Court to confirm the reduction.  This will be approved if satisfactory arrangements have been put in place to protect the Company’s creditors[17].

Redeemable Shares and Buy Backs

Where a company seeks to ‘buy back’ some of its shares, this means that the Company is returning the shareholder’s investment.  This appears primie facie to breach the rules regarding maintenance of capital; and there is a provision in the CA2006[18] relating to this which states that the Company may not acquire its own shares.  There are, however, exceptions, subject to stringent rules.

Under Section 684(1)[19], companies may issue redeemable shares (i.e. shares that may be bought back) where the company has issued only non-redeemable shares previously[20].    Where the Company is public, they may only issue redeemable shares if this is permitted in their Articles of Association.  The terms, conditions and manner of redemption of the redeemable shares is set by the Directors before the shares are alloted[21], authorised by an ordinary resolution of the Company’s members or by the Articles[22].

On redemption, the shares to be redeemed have to be fully paid up[23].  The effect of redemption is that the shares are cancelled, and the nominal value of them is deducted from the Company’s issued share capital[24].

A company may also want to buy back its shares as an investment, perhaps because a major shareholder wishes to leave the business.  Under s.690(1)[25], this is possible regardless of whether the shares were issued as redeemable or not.  There are rules regulating this as for redemptions; for example, that the articles must not prohibit the buy-back[26] and a special resolution must be made before the contract to buy-back the shares is created[27].  This can be contrasted with redeemable shares which can be redeemed at any time without further resolution; the resolution relates only to the issue of such shares.

Redemption and buy-back does not always reduce capital.  Under the CA2006, it is preferable that sources other than capital are used to fund such activities.  Only when no such sources exist can a Company resort to using capital to make the transactions.

Companies may use distributable profits (usually available for payment of dividends), or the proceeds of a new issue of shares made especially for the purpose of funding redemption or buy-back[28].  Where the buy-back is funded by new shares, there is no reduction in share capital, because the amount bought back is replaced by the new shares[29].  Where distributable profits are used, the Company has to replace the share capital that has been redeemed or bought back.  It is required to record that the payment has reduced the amount available for dividends, and must therefore transfer an amount equal to the nominal value of the shares being bought back, from the account representing distributable profits, into a capital redemption reserve.  This is regarded as part of the Company’s permanent investment, replacing the reduction in share capital[30].

Private companies who find that distributable profits and the proceeds of an issue of shares will not cover the purchase price required for the buy back, can fund the transaction from capital where the Articles of the Company permit this[31].  Because the reduction could potentially harm creditors’ interests, there are a number of requirements; for example, that the payment of capital has to be approved by special resolution[32], and the directors have to make a statement of solvency[33] supported by an auditor’s report[34].

Financing the Acquisition of Shares

There is a general prohibition on the giving of financial assistance to acquire shares under Sections 678 and 679 CA2006.  This is because such a transaction could reduce share capital.  However, this applies only to public companies, and their subsidiaries[35]; not to private companies.

Assistance given to purchase shares before or at the time of the acquisition of shares will be unlawful[36]. Further, assistance given after the acquisition to reduce or discharge a liability in connection with the acquisition, will also be unlawful[37].  For example, if the Company paid off a loan that the shareholder used to acquire the shares, this would have the effect of indirectly returning the shareholder’s investment, which would reduce share capital.  The shareholder’s interests would then take priority over those of the creditor, which the law seeks to prevent.  There are, however, some exceptions to the rule at Section 681(2) CA2006; for example, where lawful dividends are paid to a shareholder (even if these are to be used to purchase further shares[38]).

The fact that these provisions do not apply to private companies is something of a puzzle.  If providing financial assistance in acquiring shares risks prejudicing the interests of the creditor, as well as of any shareholder who does not accept the offer to acquire their shares or to whom the offer is not made[39], why abolish the restriction in its entirely for private companies?  The reasons given by the Company Law Steering Group are that the  financial assistance prohibition is not required for capital maintenance purposes, and that existing company and insolvency law is sufficient to create the protections which the prohibition would provide if it covered private companies also.  Further, there is wide agreement that the old provisions of ss 151–158 of CA1985 cause inconvenience, cost and irritation in the course of private company share sales, particularly in relation to situations where reasonable commercial terms could be agreed that were non-prejudicial to shareholders and creditors alike, but which fell under the head of “unlawful financial assistance”[40].

The rules relating to the maintenance of share capital have been criticised as an unnecessary restriction of companies, since in practice, share capital is regarded as a “relatively unimportant measure of a company’s ability to repay its creditors”[41].  The argument here is that creditors can, and do, ‘look after themselves’ by inserting provisions in loan agreements to protect their interests.  These might prevent the Company from disposing of certain assets until the debt is repaid in full.  Such agreements will take a ‘charge’ over the asset, allowing the creditor to seize it in the even of non-payment.  It is also possible for a creditor to retain ownership of the goods they are supplying until the Company has paid the price for them[42].  The fact that in practice, the share capital has no particular relevance to lenders and the way that the rules are relaxed, for example, in relation to private companies who may fund the acquisition of shares in effect reducing the share capital, shows that the assertion by Lord Watson in Trevor v Whitworth as to the state of the law is incorrect, but also that the law is evolving to reflect the fact that share capital maintenance provisions are somewhat unnecessary since creditors do not tend to base their lending decisions on share capital values, and have other means in which to secure their loans.

Bibliography

Bedford, J (3 March 2006) Throwing the baby out with the bath water? New Law Journal 156 NLJ 354

Halsbury’s Laws of England: Companies (Volume 7(1) (2004 Reissue)

Hill, C., Hubble, P., Longshaw, A., Morgan, T., and Roberts, S. (2007) Company Law and Practice, Manual 2, The Open University

Footnotes:

[1] Borland’s Trustee v Steel Bros and Co Ltd (1901) 1 Ch 279, in Hill (2007) pp.7-8

[2] Borland’s Trustee, ibid; CA2006 s.33

[3] Hill (2007) p.9

[4] Hill (2007) p.28

[5] CA2006 s.74(2)

[6] Ooregum Gold Mining Co of India v Roper [1892] AC 125 at 145, HL, per Lord Macnaghten

[7] Halsbury’s Laws of England: Companies (Volume 7(1) (2004 Reissue) 522. Paid up capital

[8] CA2006 s.542(1)

[9] CA2006 ss9(1), 9(4)(a), 761-763; Hill (2007) p.30

[10] Hill (2007) p.29

[11] Hill (2007) p.28

[12]Halsbury’s Laws of England: Companies (Volume 7(1) (2004 Reissue) 528. Alterations to capital.

[13] CA2006 s761, 763

[14] Hill (2007) p34

[15] CA2006 s.641 in Hill (2007) p35

[16] CA2006 ss.641(1)(a) and 642(1); Hill (2007) pp.36-37

[17] CA2006 s.645(2); Hill (2007) pp.36-40

[18] CA2006 s658(1)

[19] CA2006 s.684(1)

[20] CA2006 s.684(4)

[21] CA2006 s.685(3)

[22] CA2006 s.685(1)

[23] CA2006 s686(1)

[24] CA2006 s.688

[25] CA2006 s.690(1)

[26] CA2006 s.690(1)(b)

[27] CA2006 s.694(2)

[28] CA2006 s.692

[29] Hill (2007) p.64

[30] CA2006 ss.733(1) and (2)

[31] CA2006 s.709(1), s.710(1)

[32] CA2006 s.716(1)

[33] CA2006 s.715

[34] CA2006 s.714(6); Hill (2007) pp.66

[35] CA2006 s.678

[36] CA2006 s.678(1) and 678(2)

[37] CA2006 s.678(3) and 678(4)

[38] CA2006 s.681(2)(a)

[39] Chaston v SWP Group Ltd [2002] EWCA Civ 1999, [2002] All ER (D) 345 (Dec) per Arden LJ

[40] Bedford, J (3 March 2006) Throwing the baby out with the bath water? New Law Journal 156 NLJ 354

[41] Hill (2007) p34

[42] Hill (2007) p34

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