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What Are ‘Disguised Returns of Capital’ and Has the Common Law Effectively Addressed the Issue?

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Published: 27th Nov 2020

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What are ‘disguised returns of capital’ and has the common law effectively addressed the issue?

‘The creditor gives credit to the company on the faith of the representation that the capital shall be applied only for the purpose of the business, and he therefore has the right to say that the corporation shall keep its capital and not return it to the shareholders.” [1]

Introduction

Return of Capital fundamentally demonstrates the total contribution made towards the company by its shareholders and such return on this investment is not considered to be a dividend because the shareholders are merely getting back their initial contributed corpus. This process could be viewed as equivalent to the return of principal on a loan and thus, lacks any element of economic gain.

Several principles of capital maintenance were devised over time by the Judiciary as a means of protecting creditors from unforeseen risks posed by the existence of limited liability[2]. Under English common law, a company may only distribute its capital to its shareholders in accordance with the specific statutory provisions which allow it to do so. A distribution that is not done in accordance with those provisions renders it unlawful and invalid – that is known as “disguised return of capital”. Originally, the unlawful distribution rule was an extension of provisions in the English companies legislations that were implemented in the maintenance of capital.  This rule sought to preserve the assets of a company to ensure that it would be available to satisfy the claims of its creditors, as and when required.

Thus, to reiterate, the common law rule devised for the protection of the creditors of a company takes a  well settled stance: a distribution of a company's assets to a shareholder, except in winding up of the company or in accordance with such other specific statutory procedures, is a return of capital, which is ultra vires the company.

The basic prohibition is contained in Section 830 of the Companies Act 2006: it provides that a company may not make a distribution except out of profits available for the purpose. ‘Distribution’ is defined as meaning every description of distribution of a company’s assets to its members, whether in cash or otherwise; thereby including the said ‘disguised’ distributions. As such, the court looks into the substance of a transaction, rather than its form, to determine whether it should properly be classified as a distribution.

This fundamental company law principle was examined by the Supreme Court in the recent decision in Progress Property Co. Ltd. v Moorgarth Group Ltd[3]. The court considered the circumstances in which a sale of assets at an undervalue to a shareholder in that company should be held null and void on the ground that the sale was an unlawful distribution in disguise. The Court had to establish whether there had been an unlawful distribution of capital where the claimant company, sold the whole issued share capital of a wholly-owned subsidiary to another company under the same control.  

The importance of the decision lies in its clarification of the scope of the common law rules on capital maintenance. It was at this time that the courts proceeded tp formulate a test to enable a distinction to be drawn between lawful transactions with shareholders and disguised returns of capital[4]. The decision elucidates upon the issue of how an unlawful distribution is to be identified. In particular, it clarifies whether, in characterising the transaction, the ‘subjective intention’ of the directors is a relevant factor for consideration or whether the courts should take an objective path and independently look at the effect of the transaction.

The Judiciary’s approach to the issue

The basic prohibition is contained in Section 830 of the Companies Act 2006: it provides that a company may not make a distribution except out of profits available for the purpose. ‘Distribution’ is defined as meaning every description of distribution of a company’s assets to its members, whether in cash or otherwise; thereby including the said ‘disguised’ distributions. As such, the court looks into the substance of a transaction and not the form, to determine whether it should properly be classified as a distribution.

This fundamental company law principle was scrutinized by the Supreme Court in the fairly recent decision in Progress Property Co. Ltd. v Moorgarth Group Ltd[5]. The court considered the circumstances in which a sale of assets at an undervalue to a shareholder in that company should be held null and void on the ground that the sale was an unlawful distribution in disguise. The Court had to establish whether there had been an unlawful distribution of capital where the claimant company, sold the whole issued share capital of a wholly-owned subsidiary to another company under the same control.  

The importance of the decision lies in its clarification of the scope of the common law rules on capital maintenance. It was at this time that the courts proceeded to formulate a test to enable a distinction between lawful transactions with shareholders and disguised returns of capital[6]. The decision elucidates upon the issue of how an unlawful distribution is to be identified. In particular, it clarifies whether, in characterising the transaction, the ‘subjective intention’ of the directors is a relevant factor for consideration or whether the courts should take an objective path and independently look at the effect of the transaction.

Subjective Approach

In choosing a subjective approach, the court takes into consideration whether the individual regulating the transaction knew and intended that an asset would be transferred to a shareholder at an undervalue. If so, the transaction was characterised as a disguised return of capital and was thus unlawful and ultra vires[7]

 Interestingly, Oliver J. in Re Halt Garage[8] considered that the preferred approach should be an objective one yet proceeded to consider the subjective intentions of both the company and its shareholders. For him, the real test was “whether the transaction in question was a genuine exercise of the power”. The motive is of primary importance. The court in that case considered that the correct approach was to look to the true nature and substance of the payments and assess the bona fide of the transactions as payments of remuneration. 

 In the leading case of Aveling Barford Ltd v Perion Ltd.[9], the claimant company sold a significant asset at a gross undervalue through a ‘controlling shareholder’ to another company controlled by the same individual. Looking at the matter ‘objectively’ Hoffman J. found the sale was a ‘dressed up distribution’ and was mala fide. However, he then introduced a subjective requirement. He concluded that though the transaction was not a sham and was in law a sale ‘it was the fact that it was known and intended to be a sale at an undervalue which made it an unlawful distribution’. The parties’ knowledge and intention was essential to his reasoning.

The Aveling Barford decision has proved to be pivotal because of its impact on companies in a group who want to transfer assets to each other. Later on, Part VIII of the Companies Act 1985 was changed to enable more straightforward intra-group transfer of assets and implemented by sections 845 and 846 of the Companies Act 2006.

Objective Approach

The saliency of this approach lies in the court’s characterisation of transactions based on the effect they have. If the effect was to transfer company assets to a shareholder at an undervalue, the transaction was labelled as a ‘disguised return of capital’ and was thus null and void[10]. The approach is called objective because the shareholders’ knowledge and intention that the transaction was at an undervalue was not evaluated to be relevant to the reasoning of the judge in each case. In Clydebank Football Club Ltd v Steedman 2002 SLT 109, Lord Hamilton did not look to the parties’ subjective intention when characterising the transaction but instead focused on whether the undervalue could be justified on business grounds. The judges did not explain why subjective intentions were not relevant. Thus, the position was unclear as to which approach should be taken in identifying unlawful distributions.

The distribution legislations in common law are a significant component of the capital maintenance regime. They address concerns that, if the directors and shareholders are able to collude in the distribution of the company’s assets to the members during the company’s existence, the creditors will no share in any of its assets. On liquidation, the creditors must be paid in full before any capital can be returned to the shareholders and an out-of-turn distribution of assets ahead of winding up defeats this priority waterfall. similarly, these rules protect shareholders against dissipation of the company’s assets by the directors for improper purposes in breach of duty. Where a company wishes to return capital to its shareholders, it must do so via a purchase or redemption of shares or reduction of capital in accordance with the statutory methods and not by way of an improper distribution of assets to its members. In the words of Pennycuick J. in Ridge Securities Ltd v IRC:

“A company can only lawfully deal with its assets in furtherance of its objects. Th e corporators may take assets out of the company by way of dividend or, with leave of the court, by way of reduction of capital, or in a winding up. They may of course acquire them for full consideration. They cannot take assets out of the company by way of voluntary disposition, however described, and, if they attempt to do so, the disposition is ultra vires the company.”

Consequences of unlawful distributions of capital

There are two main targets for any action by the company:

“(1) the recipient of the unlawful distribution; and (2) the directors who authorised the unlawful distribution.”

 As the shareholder beneficiaries, particularly in bigger open organizations, are habitually ignorant of the conditions encompassing a dispersion as a profit and depend on the executives to act appropriately, there is little probability of effectively seeking after the shareholders to recuperate unlawful profits (other than investors who are additionally chiefs or where the investor is a parent organization). It is more probable, however still nearly uncommon, for the organization (a liquidator or new board of directors is in place) to seek after recuperation from the chiefs who approved the inappropriate installments. Another plausibility is that a creditor, for example, the Inland Revenue, may bring a case for misfeasance under Insolvency Act 1986, section 212 against directors who approve ill-advised profits. Preclusion is likewise a probability.

Liability of recipients of the Disguised Returns of Capital

Where a distribution is, or some portion of a conveyance is made in negation of the prerequisites according to Companies Act 2006, any part who, at the hour of the appropriation, knows or has sensible reason for accepting that it is so made is subject to reimburse the dissemination (or part of it, all things considered) to the organization. This statutory risk is without partiality to any commitment forced separated from the statutory arrangements on a part to reimburse an appropriation unlawfully made to him, for example as a knowing beneficiary of trust reserves. A representation of obligation dependent on 'knowing receipt' can be found in Precision Dippings Ltd v Precision Dippings Marketing Ltd where a profit was paid by an organization (Dippings) to its parent organization (Marketing) and the chiefs of Dippings were the main executives and investors of Marketing. Th e Court of Appeal held that the installment of the profit in break of the statutory arrangements was a ultra vires demonstration of the organization. Advertising, when it got the cash, had notice of the realities and held the £60,000 profit on helpful trust for the organization which was qualified for reimbursement. The adaptability to continue either under the statutory arrangement or the custom-based law is important since, as examined, it is workable for a dissemination to a part to be legitimate under Companies Act 2006 (there are accessible benefits and the bookkeeping necessities are met) so no statutory risk emerges, however the installment is in rupture of the custom-based law (on the grounds that, for instance, at the hour of the installment, the organization's position has intensified) or the organization's articles. Additionally, the trial of risk as a beneficiary is distinctive under the rule and at customary law. Statutory risk emerges where the investor knows the realities which lead to the end that the dispersion is in repudiation of the Act, however it isn't vital that the part knows the lawful guidelines and the results of those standards when applied to the realities. Obligation as a helpful trustee emerges where the investor knows or should realize that the dissemination is unlawful. Consequently, contingent upon the realities, one or other course may offer the most obvious opportunity with regards to recuperation.

The statutory liability was considered by the Court of Appeal in It's a Wrap (UK) Ltd v Gula where the attention was on the importance of the necessity that the part 'knows or has sensible reason for accepting' that the distribution is in negation of the Act (presently Companies Act 2006, section 847(2)). The organization had two individuals, a couple, who were likewise the executives. The organization made no benefits during its concise (four years) presence however the executives each took profits of £14,000 per annum as a duty productive option in contrast to getting a compensation from the organization. On the organization going into ruined liquidation, the vendor looked to recoup £56,000 altogether from them, yet they were found not subject from the start occasion on the premise that the segment required information on the lawful position. The Court of Appeal quickly overruled the choice and affirmed that it isn't important to show that the investors know the statutory arrangements. It is sufficient that the investors know the realities which lead to the end that the circulation contravenes the statutory arrangements. The respondents realized the organization had no benefits, along these lines they was aware of the contradiction with the end goal of the statutory obligation and they needed to reimburse the entireties which they had received.

Conclusion

A difficult problem lies in identifying undervalued transactions. Courts have adopted two different approaches, all of which have significant shortcomings. This leads to the default position that companies need contract with shareholders at market value. When determining market value courts need to take into account that the value of an asset can sometimes not be determined with scientific precision. If more than one view on the value of an asset is supported by good reasons any value within this range of prices is acceptable. A price below market value may be supported by reasons relating to the business of the company such as a requirement to complete a transaction within a certain time window. Thus, the final conclusion of the article is that shareholders are unable to rely on the provisions of Companies Act 2006, with the consequence that they must repay what they have received as a result of a disguised return of capital irrespective of whether they knew or had reasonable grounds for believing that the transaction was unlawful.

Bibliography

  • Micheler, E. ‘Disguised Returns of Capital – An Arm’s Length Approach’ (2010) Cambridge Law Journal 151.
  • Armour, J. ‘Share Capital and Creditor Protection: Efficient Rules for a Modern Company Law’ (2000) 63 Modern Law Review 355.
  • Davies, P. Gower and Davies’ ‘Principles of Modern Company Law’ (8th ed., Sweet and Maxwell, London, 2008).
  • Hannigan, B. ‘Company Law’ (2nd ed., Oxford University Press, 2009).
  • Sealy L. and Worthington S. ‘Cases and Materials in Company Law’ (10th ed., Oxford University Press, 2013).
  • Ferran, E. ‘Creditors’ Interests and “Core” Company Law’ (1999) 20 Company Lawyer 314.
  • Calnan, R. ‘Corporate Gifts and Creditors’ Rights’ (1990) 11 Company Lawyer 91. 
  • McGoldrick, C. – ‘Clarifying the Law on Unlawful Distributions: Transfers at an Undervalue – Objective or Subjective Approach?’ Bris LJ (2011) 140.

[1] Re Exchange Banking Co., Flitcroft’s Case (1882) 21 ChD 519

[2] (Armour, 2000: 367

[3] [2010] UK SC 55, [2011] 1 WLR. 1

[4] (Micheler, 2010: 152)

[5] [2010] UK SC 55, [2011] 1 WLR. 1

[6] Micheler, 2010: 152

[7] Re Lee, Behrens [1932] 2 Ch. 46; Re W&M Roith [1967] 1 All E.R. 427

[8] [1982] 3 All ER 1016

[9] [1989] BCLC 626

[10] Ridge Securities Ltd v I.R.C. [1964] 1 WLR 479; Re George Newman & Co. [1895] 1 Ch 674; Barclays Bank v British Commonwealth Holdings [1996] B.C.L.C. 1; MacPherson v European Strategic Bureau [2000] 2 B.C.L.C. 683)

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