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The concept of capital
The concept of ‘capital' has a restricted and technical meaning within company law. A company's capital adds up to all of the cash or the value of assets received by a company from investors in return for the company's shares. This is an important source of finance for companies. It should be noted that the company's capital in this technical sense is calculated in terms of the value initially received by the company when the shares are first issued, rather than the current value of those received funds and assets, since this will change with the business activities of the company. Another important source of financing for a company is debt. A company may raise funds through issuing debt, by loan financing provided by banks and other lenders. This form of company financing is treated very differently to the raising of funds through issued shares. This is due to the fact that in company law, there is an important distinction made between the treatment of creditors who provide debt funds for a company and the treatment of shareholders who provide equity funding through share issues. Only the equity funds received by a company from shareholders are treated as the ‘legal capital' of the company, subject to statutory regulations and restrictions. The distinction made between the legal capital of a company and other assets is necessary, because the legal capital accounts act as a ‘buffers' for the protection and benefit of the company's creditors. The shareholder capital contributions are there to mitigate the risks to which creditors are exposed to. If for example, the company fails and it is put into liquidation, then whatever remains of the company's assets will be used to repay the company's creditors first before any of the shareholders are repaid any part of their contribution. Thus the legal capital regime aims at creating some sort of balance between the rights of the shareholders and the rights of the creditors, the regulation of this interplay of interests is critical to the success of a company.
The doctrine of maintaining and preserving the legal capital received by a company, is a long and well established principle within company law. It was first adopted in the case of Trevor v Whitworth, for the protection of creditors against the extra risk of opportunistic behaviour by company directors, brought about by the concept of limited liability. The doctrine requires that a set minimum level of equity capital is invested into a public company, no equivalent requirement is provided for private companies in the UK. Restrictions are then placed on the transfer of company assets to shareholders when the net asset value of the company falls below the value of the equity capital invested. Another function of the maintenance of capital rules is to provide protection for the minority shareholders of a company, by placing limitations on the issue of new shares, the repurchasing of shares and the issuing of redeemable shares. These mechanisms ensure that shareholders interests in the company are not diluted. In addition to the rules regarding the maintenance of capital, creditor protection is also provided for by other means, such as the normal rules of contract, security and insolvency laws.
The legal capital and maintenance rules have recently become highly relevant and frequently discussed in company law, mainly as a result of new developments introduced by the Companies Act 2006. A number of very important changes relating to the capital maintenance rules have been adopted by the Act, resulting in the de-regulation and relaxation of a number of measures. The changes were due to the fact that this long and well established doctrine in recent years had come to be challenged, questioned and harshly criticised from several directions. It has been argued that the legal capital regulations can no longer be justified with regards to either creditor protection or business development. In fact, it has even been suggested that the maintenance rules actually hinder the legitimate business activities of company's in the UK. As result it has been concluded by some scholars that the capital maintenance regime achieves very little in practice.
This essay seeks to consider and analyse the company law rules regulating the maintenance of share capital of companies, reviewing the case for and against the capital maintenance rules. An enquiry will be made into the current capital maintenance regime as provided for under the Companies Act 2006. In doing so a critical analysis will be made as to what useful purposes if any the rules on capital maintenance aim to achieve, and whether their objectives are successfully met or not. In considering whether the rules on capital maintenance achieve any useful purpose, it will be asked if these rules are economically efficient and whether they can be objectively justified. It will be argued that the need for creditor protection is critical and the objectives that the maintenance rules try to achieve are of paramount importance. However, it will be discovered that the current regime does not effectively meet the objectives that it was intended to do, in particular with regards to creditor protection, and moreover that it does not enhance the efficiency of companies. It is argued that maintenance of capital in its current regime is no longer an appropriate concept to employ in safeguarding the interests of creditors. In considering whether the rationale for capital maintenance is persuasive, it is important to determine the extent to which the legal capital rules operate as restriction on freedom of contract by burdening companies with high administrative and compliance costs. It will be concluded that a preferable regime would be one that provides much greater protection for creditors, in particular with regards to involuntary creditors. But such a system should not restrict the legitimate business activities of companies or over-burden them with administrative costs and requirements. One way, it will be suggested, that this can be accomplished is by a further deregulating of the capital maintenance rules leaving the protection of large and sophisticated creditors to contract law and insolvency provisions. Whilst at the same time, introducing new precise and targeted provisions to be put in place for the benefit of involuntary and small creditors.
Do The Rules On Capital Maintenance Achieve Any Useful Purpose?
As mentioned above a fundamental doctrine of capital maintenance exists in our company law. This doctrine requires that a company must receive proper consideration for its issued shares and having received that capital it must not repay it back to members except in certain circumstances. Thus the capital maintenance rules can be seen as a device aimed at protecting creditors from shareholder misconduct and post contractual opportunistic behaviour in relation to a company's capital. The general principles of maintenance of capital were originally developed by nineteenth century case law. The aim in applying this doctrine was to protect creditors from the risk that shareholders, after having placed funds into the company, would subsequently withdraw their capital investment as soon as the company had any financial difficulties. These common law rules where then subsequently superimposed by more restrictive provisions derived form the Second EC Directive on Company Law. The Directive, a framework regime applying to all member states, only regulates public companies, leaving the regulation of private companies to member states.
In understanding the way in which legal capital operates and in trying to ascertain what useful purpose it serves, it is important to distinguish between those creditors who are able to change the terms on which they transact with the company, and those who are not able to do so. Also an valuable distinction to make is between those sophisticated, repeat lenders such as banks and those small creditors not so sophisticated and experienced such as trade suppliers. Those sophisticated creditors voluntarily advancing large sums of money to a company will have greater bargaining power and resources available to them in negotiating with the company, compared to involuntary creditors or small voluntary creditors. Involuntary creditors can not alter the terms on which they extend credit to a company, delict victims, the tax authorities, environmental authorities, employees, consumers are some examples. These creditors are unable to adjust their terms easily to respond to the company, and therefore, it will be argued, require greater protection from legislation.
The rules governing the preservation of a company's capital can broadly be divided into five sub-headings: the rules on minimum capital requirements and nominal share requirements; the rules preventing a company paying out distributions out of anything other than distributable profits; the provisions on reduction of capital; the restrictions on a company providing financial assistance to potential shareholders; and the rules on redemption and repurchase of a companies own shares. We shall now turn to a discussion of each of these provisions and the purposes they aim to achieve.
Minimum Capital Requirement And Nominal Share Requirement
The minimum capital rule requires that those incorporating a business must place assets of at least a specified minimum value into the corporate asset pool, in the UK this has been placed at £50,000 for public companies and no minimum capital requirement is imposed on private companies. Moreover, this contribution does not all have to be handed over to the company at the time of issue of the shares. It is enough that only one quarter of the nominal value of the share and the whole of any premium to be paid is contributed. This compulsory share capital requirement exists for the benefit of creditors, it is intended to provide a safety net for creditors and some sort of guarantee as to a company's creditworthiness. In addition to this minimum requirement, another rule is that if a public company's net assets fall below one-half of its called up share capital, then the company is required to convene a shareholders meeting ‘for the purposes of considering whether any, and if so what, steps should be taken in order to deal with the situation'. However, this provision does not require the shareholders or the directors to take any particular action in this situation, for example cause the company to cease trading, thus the effectiveness of this section in practice must therefore be doubted.
The rule on minimum legal capital is considered to be the weakest of the legal capital provisions aimed at protecting creditors. One of the main criticisms expressed is that the legal capital put into the company can be used up quickly soon after incorporation, so the minimum capital requirement is not reliable as a benchmark for informing creditors about the assets of the company in the long term. In addition, as the company grows, there will be less and less similarities between the value of the company's assets and the initial value of the shareholder's contributions as stated in the capital accounts. It has also been stressed by several authors that there is no meaningful link between the financial needs of an enterprise and the amount of its legal capital. This is primarily due to the fact that the diversity of enterprises makes it impossible for legislatures to tailor legal capital requirements to fit the financial needs of every enterprise. It is artificial to set a mandatory ‘one size fits all' approach to the regulation of something as significant as a company's capital structure. Looked at from the point of view of creditors, several authors have observed that the minimum legal capital rule provides no useful protection either to voluntary creditors or to involuntary creditors. Sophisticated voluntary creditors in practice seem to rely on contractual means, e.g loan agreements, using the risk of insolvency and the quality and certainty of future cash flow as benchmarks. Other categories of voluntary creditors, such as trade creditors seem to rely on self-protection mechanisms, such as retention of title clauses and not relying too heavily on one large debtor. As for personal injury victims, it is not possible to determine in advance the amount of capital necessary to cover a firm's future liabilities and the amount required is too small to be able to meet any significant claims. Moreover, it is doubtful whether any of the minimum capital is likely ever to be received by involuntary creditors who may well be ranked as unsecured creditors in a winding up. So to sum up it is hard to find a category of involuntary creditors for whom the minimum capital rule offers any useful protection. It is argued that the relatively low requirement of only 50,000 for public companies is insufficient and trivial to effectively meet any significant creditor protection. Also the exception of private companies to the minimum capital requirement rule undermines its value and effectiveness. The only function of the minimum legal capital requirement it has been suggested, is to deter individuals from light-heartedly starting a public limited company, imposing only an ‘entry price' for limited liability.
To conclude, the minimum capital rule in its current form serves no useful purpose, neither as a creditor protection method or an indication of a company's worth and financial position. For the minimum capital requirement to meet its objective in securing sufficient funds for creditors, it must be significantly increased from the trivial 50,000 in the case of public companies and a sufficient amount introduced as a requirement for private companies. It has been observed by several commentators that there are other more efficient methods, than the minimum capital requirement to meet the objective of effective creditor protection this rule tries to achieve. Methods, especially aimed at preserving the interests of involuntary creditors and personal injury victims would be more effective. These methods could include tailor-made means intended to give involuntary creditors greater protection and priority over voluntary creditors in the liquidation process. In the UK these methods are already used, for example the Third Party (Rights against Insurers) Act 1930 transfers liability for insurance claims against an insurer of an insolvent firm from the firm to the insurer, ensuring that involuntary victim need not share their recoveries with the debtor's other creditors. Other tailor-made schemes also include, the requirement of mandatory insurance policies to be carried out by certain companies involved in hazardous or risky activities, and that priority is given to personal injury victims over voluntary creditors in insolvency proceedings. So we can that the objectives the minimum capital requirement was intended to realize, are actually being met by other more effective methods of regulation, it therefore serves no real useful purpose. The conclusion is that the minimum legal capital rule serves no useful creditor protection, it neither helps to prevent the financial failure of a company nor the insufficiency of assets in insolvency proceedings. Ferran suggests that the minimum capital requirement should be abolished and should be left to the markets to regulate, as the capital markets represent a powerful tool for regulation in this regard. Alternative and additional creditor protection devices can be introduced for involuntary creditors, who have weaker bargaining powers and for whom the market mechanisms would not work.
The second function that the minimum capital rule was intended to serve, was the protection of shareholders in the company. By establishing a legal capital account and fixing the value of the shares it is possible to assign a nominal value to every share. The 2006 Act requires shares in a limited company to each have a fixed nominal (or monetary) value and that an allotment of shares not meeting this requirement is void. This nominal value concept is of doubtful use, because it does not indicate in any way the price at which the share is likely to be issued to investors, still less the price at which the share is likely to trade in the market after issue. The par value requirement serves to measure the shareholders rights in the company, a yardstick of the portion of legal capital of the company held by that shareholder, the notion of a par value share is intended to protect shareholders interest against the ‘watering down' of their interest in the company. However, as useful as the nominal share requirement at first appears, it has been strongly advocated by the financial services industry and legal professions that the requirement to have a nominal value for shares should be scrapped all together. This would consequently mean that shares would correspond to a realistic economic fraction of the company in terms of its assets, rather than reference being made to a notional unrealistic amount created by the company members. The benefit of this would be that companies could apply a premium as well as a discount to different issues of the same class of shares. A strong criticism of par value shares, is that is prevents a company from issuing new shares of an existing class where their real value is below par value, in order to make an issue at the real value, the company must go through expensive and complex processes. No par value shares would make it easier for companies suffering financial distress to raise money quickly through a fresh issue of shares where the price of the company shares on the market were less than their par value. Currently companies can only issue shares with a premium and not at a value bellow the nominal value of the company's shares. The par value does not reflect the reality of company shares, and it can be argued that the rule against discounts of shares to nominal value actually harms rather than protects creditors. The rule serves no useful purpose and its abolition has strongly been advocated for. Having no par value shares would provide a more accurate picture of the actual value of shares on the Market, helping to provide more accurate information. Also having no par value shares would get rid of the restrictions placed on companies, making it easier for a company facing financial trouble to raise funds quickly through a new issue of shares, promoting business efficiency and simplicity. Additionally, protecting creditor interest by preventing the company form going into liquidation.
The minimum capital rule coupled with the nominal share requirement under the 2006 Act regime, can be understood as a system of creditor and minority shareholder protection, with regards to the raising of company capital. Together they seek to ensure that at least a minimum level of assets is contributed to a public company by its shareholders. These rules are often criticized that they fail to adequately protect creditors, who are not so much interested in the minimum capital of a company or the price at which it issues its shares but much more in its cash flow and ability to pay short term debts. The existence of capital as shown once a year in the company's annual accounts is a very inaccurate indication of the company's ability to pay its debts. It is suggested that these rules are unnecessary either for voluntary or involuntary creditors, as they provide no effective means of protection. Thus the justification for these rules must be sought in relation to involuntary or small creditors. It has been demonstrated above that there are other better more effective means of creditor protection than a fixed rate minimum capital requirement, in the form of targeted solutions. As for shareholder protection, it has been shown that these provisions serve limited, if not, no useful functions in relation to shareholders. There are other provisions available requiring the company to provide sufficient information about a company's accounts, allowing greater levels of transparency and disclosure, which ensure that shareholders and investors are not mislead
Payment Of Distributions To Shareholders
The rules on legal capital have their main impact as a control on the amount a company may distribute to its shareholders by setting a maximum limit on what may be so distributed. Distributions to shareholders reduce a company's net assets, making it more exposed to the risk of default. However, there may be circumstances in which transfers to shareholders are efficient, so rather than simply ban all asset transfers to shareholders, restrictions and limitations are placed on when such transfers can be made. The law has long sought to ensure that distributions paid by a company to its members are not whole or in part a return of the capital they have contributed. This is due to the fact that returning capital to shareholders may harm creditor's interests, even if the company does not actually become insolvent. Such transfers will still reduce the expected value of the creditors' claims. So a rule prohibiting a company from making distributions of corporate assets to its shareholders, other than out of profits available for the purpose, has been put in place. Distributable profits being defined very widely, as the company's ‘accumulated realised profits so far as not previously utilised by distribution or capitalisation, less its accumulated realised losses so far as not previously written off in a reduction or reorganisation of capital duly made'. In addition to this fundamental capital maintenance rule, there is a further restriction applicable to distributions by public companies which does not apply to private companies. A public company may only make a distribution, if following the distribution, the amount of its net assets is not less than the aggregate of its called up share capital and undistributable reserves.
The underlying purpose that the distribution rule is intended to achieve is to ensure that creditors are not prejudiced by the distribution to shareholders of funds part of the company's capital buffer. This rule, permitting distributions only out of profits, can be viewed as a beneficial constraint. It seeks to provide a guarantee to creditors that there is a certain amount of capital left in the company and that capital is not diminished by distributions to shareholders.
The current distribution regime, employing a balance sheet test for the legality of distributions, leads to a greater preservation of legal capital. It states that a company must not make a distribution if its net assets (assets minus liabilities) are or would be after the distribution less than its called up share capital and undistributable reserves, undistributable reserves including other accounts such as the share premium account. Therefore in order to make a distribution a company must have positive net assets to meet the divided payment and still have assets in balance with its liabilities, share capital accounts and other undistributable reserves such as the share premium account and the capital redemption reserve. In addition, the rule requires the company to consider the state of its profit and loss account, as well as its balance sheet. First, the company will need to assess its accumulated profits and losses over the years to determine whether at the point a dividend is under consideration, there are profits to support it. Then the company must subtract from the profits it has made over the years any amounts already paid out by way of dividend or any profits which have been capitalized, but it may also deduct from its losses it had made over the years any amount properly written off through a reduction or reorganisation of capital. If the company's aggregate profits over the years exceed its aggregate losses over the years, a distribution may be made to the extent of the surplus profits. The rule laid down in s.830 applies to all companies and the rule laid down in s.831 applies only to public companies. The aim of the distribution provisions is to require companies to take into account legal capital when determining distributions. In doing so, public companies will have to take into account unrealized losses when determining the maximum amount payable by way of dividend but private companies need not do this.
It is clearly a sensible measure of creditor protection that a company should be subject to constraints on its freedom to transfer assets back to its shareholders by way of distribution. There would be little point in giving creditors priority over shareholders in a winding up if there were no limits on the company's freedom to return assets to members whilst it was a going concern. It has been expressed by some authors is that the distribution restrictions are very useful, due to the fact that they save a company significant amounts in the drafting of loan agreements. The suggestion is that even if there were no distribution rules, creditors would in fact provide for much the same rules under contract. Thus commercial parties are therefore spared the costs of writing such terms themselves. In the US for example, where relationships between creditor and companies are left to contract law, provisions on equity cushions and distribution limits quite similar to the UK legal capital provisions are inserted into lending contracts. The statutory provisions for distributions under the 2006 Act serves a useful and valid function in preventing the swindling away of company assets. They should be retained as an effective method of enforcing creditor protection and preventing the indirect return of capital to shareholders. In addition to the distribution provisions other rules banning transactions whereby assets are directly or indirectly transferred to shareholders for less than value are also provided for. This is to supplement the distribution rules and also to reinforce a genuine restriction on a company's ability to make unlawful payments to shareholders. We shall now move on to consider some of these other provisions, to analyse what useful purpose they serve in the legal capital structure, and if there functions can be justified.
The Reduction Of Capital
A reduction of capital is were a company writes off some of the money stated to be in the company's capital accounts or decides not to seek payment of a sum due to be paid to a capital account. As this potentially means that there is less money available for its creditors, specific procedures under the Companies Act ss.641 to 657 must be followed so creditors or investors have no grounds for complaint. Companies can reduce share capital for a number of reasons. The main reasons are where: the nominal value of the company's share capital is greater than the value of its assets; the company wishes to be rid of a certain class of shareholders; the company has more capital than it knows what to do with and wishes to return some to the members; or the company wishes to use unused funds held in a capital account for some other purpose. CA 2006, s641 permit's a company to carry out a reduction of capital by special resolution, provided the resolution is either supported by a solvency statement (an option only available for private companies) or is confirmed by the court. The reduction of the share premium account, capital redemption reserve, and other undistributable reserves is subject to the same rules as reductions of issued share capital, except that share premium account and capital redemption reserve can be used to pay up new shares to be issued as fully paid bonus shares.
The purpose of the capital reduction provisions is to put in place mechanisms that are designed to ensure that a company's creditors and not unnecessarily prejudiced when a reduction of capital is performed. The object of requiring a courts sanction in a reduction of capital for public companies is threefold: to protect creditors dealing with the company, so that the fund available for satisfying their claims shall not be diminished except by ordinary business risks; to ensure that the reduction is equitable as between the various classes of shareholders in the company; and to protect the interests of the public by requiring disclosure. A procedure for settling a list of creditors and checking that each one of them has consented to the reduction or has had their claim adequately secured, is provided for. The court has discretion to dispense with this procedure, and in practice will usually do so if the company can show that all of its creditors have consented to the reduction or that, to the extent that such consent has not been obtained, an adequate form of creditor protection is in place. If a reduction of a public company's capital brings the nominal value of the company's allotted share capital below 50,000 the company must be re-registered as a private company. Also in relation to public companies, if the net assets of a public company fall to half or less of it's called up share capital, the directors must within twenty eight days convene a general meeting to discuss what steps can be taken to resolve the problem.
Some criticisms of capital reduction, with regards to public companies, is that it is a timely and costly procedure to undergo. In addition, it exposes the company to potential creditor claims and litigation in relation to debts that are not yet due. It has been commented that excessively favourable conditions are provided for creditors, allowing them the opportunity to frustrate a useful capital restructuring in order to obtain a personal advantage or security for the debt. To a certain extent this has now been dealt with by the new provision that requires creditors to demonstrate that they would be prejudiced by a capital reduction, rather than the company having to establish that the creditors position would be secure. It is also argued that the capital reduction rules with regards to public companies are not needed, since most creditors lending to these public institutions will be highly sophisticated and more than capable of ensuring protection themselves through typically demanding stringent covenants, guarantees and contract terms. The majority of sophisticated lenders have sufficient bargaining power in securing their lending, and don't need such extreme statutory protection. The regime is unnecessarily excessive and restricts a companies flexibility in relation to legitimate business transactions. The need to protect creditors, especially involuntary creditors, is paramount. However, the methods that are adopted in the current regime cannot be justified as the need for court confirmation is time consuming and expensive, it is suggested that more flexible solutions should be used. The requirement for court confirmation in cases involving public companies should be removed, and instead targeted provisions to ensure the protection of involuntary creditors should be put in place. The provisions for reduction of capital without court confirmation apply only to private companies. These were introduced to mitigate the delay and cost involved in court confirmation, it is advocated that the same deregulation and simplification should be adopted for public companies.
To conclude, creditor protection is an important and re-acquiring theme in the capital maintenance provisions. As a result to monitor and scrutinize capital reductions by companies has been put in place within the capital maintenance regime. On the other hand, the same creditor protection objectives can easily be met by means, more efficient and with greater flexibility than the current reduction of capital provisions. The provisions are excessive in comparison to the objectives they aim to achieve. They are also outdated and don't take into account the fact that in today's business world there are sufficient rules requiring accurate and transparent company account information, that would make it very difficult for companies (especially public companies) to indirectly return capital to shareholders.
There is a prohibition against public companies or their subsidiaries from giving financial assistance, either directly or indirectly, for the purpose of the acquisition of its shares. The significant change brought in by the 2006 Act is that the prohibition on the giving of financial assistance by private companies in most circumstances has been repealed. In addition, a private company will continue to be unable to give financial assistance for the acquisition of shares in its (direct or indirect) public holding company. These rules are part of the controls on distributions. Financial assistance is defined so as to include the widest imaginable range of transactions, any assistance given by way of gift, guarantee, security or loan, and any other financial assistance which reduces, to a material extent, the net assets of the company giving the assistance, and any other financial assistance given by a company with no net assets. Various legitimate business transactions are excepted from the general prohibition against financial assistance by ss.681 and 682. These include distributions by way of dividend lawfully made, reductions of capital by special resolution, allotment of bonus shares, redemption and repurchase of shares, and money lent in the ordinary course of a company's money-lending business. The fact that financial assistance given by a company is not detrimental to the company does not in itself mean that it is legal. Though, it is provided in certain circumstances where financial assistance is given by a company for the purchase of its shares and the assistance is given in good faith and in the interests of the company then the assistance will not be unlawful. If the company contravenes these sections and gives financial assistance contrary to the provisions, an offence is committed by the company and every officer of the company in default.
The original rationale for introducing the provisions on financial assistance was to prevent ‘asset stripping' takeovers (which was seen as an indirect return of capital) and to prevent fraudulent market manipulations of the value of a company's shares. The principle can now be viewed as part of the capital maintenance provisions, since its main aim to preserve the capital of a company by preventing share transactions that would undermine the amount in the company capital accounts. The initial introduction of the financial assistance rule was heavily under-estimated; in practice it has proved capable of rending unlawful what seem from any perspective to be perfectly harmless transactions. The prohibition has been sternly criticized, because the solution which has been put in place is quite disproportionate to the problem it tries to tackle. The conclusion is that the risks of abusive financial assistance can be reduced by better targeted legal provisions, including remedies for wrongful trading, directors' fiduciary duties, derivative action remedies, and rules on conflicts of interest and on the protection of minority shareholders. There is no need or justification to impose excessive and restrictive provisions on the company.
The financial assistance provision is broader than is necessary to ensure capital is not returned to shareholders. The major difficulty is the immense complexity of arrangements that must be unravelled to discover whether or not the prohibition against financial assistance has been contravened. The recent exclusion of private companies from the prohibition is a great step forward, the amendments that have been made have now given private companies more freedom without compromising creditor protection. The same approach should be adopted for public companies. The purposes the financial assistance provisions aim to achieve are important to successful operation of companies and the protection of creditor rights, but the same objectives can be met through more efficient and business friendly mechanisms. Tight regulation of the markets today suggests that maintaining the ban on financial assistance can now not be justified. For example measures such as the offence of market manipulation now under the Financial Services and Markets Act, provide for better methods of effectively realising the purposes the financial assistance provisions were meant to.
Redemption And Repurchase Of Shares
There is a general rule that prohibits the purchase by a company of its own shares, which is backed by criminal penalties both for the company and any individual involved. This apparently comprehensive set of prohibitions is then immediately followed by a list of exceptions. These exceptions are now so wide that it could be said that there is a general rule that a company may purchase its own shares; it is in the exceptional case that this manoeuvre is forbidden. However, although there are many situations in which it is permissible for a company to purchase its own shares, the correct procedures must be followed otherwise the purchase is illegal. The strictness of the rules and the prohibition of using this method to reduce the capital of a public company, strikes a reasonable balance between the need for creditor protection and also the need to offer companies some flexibility in their legitimate business transactions. So a company is permitted to purchase its own shares, but its articles may prohibit this. Members are required to approve the terms of purchases, and there are different approval requirements depending on whether the purchase is to be made on a UK recognized investment exchange (a market purchase) or otherwise (an off market purchase). The money to repurchase a public company's shares must come from distributable profits or from the proceeds of a new share issue. A company which repurchases shares must cancel them and reduce its issued share capital by the nominal value of the cancelled shares.
A company as well as purchasing its own shares may issue redeemable shares. Redeemable shares in a company offer temporary membership of the company with repayment of the nominal value of the shares (and in some cases a redemption premium) at the end of the period of membership. On cancellation of its redeemed shares, a company must reduce its issued share capital by the nominal value of the cancelled shares and transfer that amount to a new capital account called the ‘capital redemption' reserve. The purpose of having these provisions is that they ensure there is no over all reduction of the company's capital yardstick, as one type of capital is substituted for another. The increase in the ‘capital redemption reserve' is balanced by the money paid out of profit and loss account to redeem the shares. The amount recorded in a capital redemption reserve may be reduced by transfer to a share capital account to pay up fully paid bonus shares, but otherwise the reserve is subject to the same rules on reduction of issued share capital.
From the point of view of creditor protection, the crucial point about the redemption and repurchase provisions is the creation of a capital redemption reserve, and the requirement for public companies to redeem and repurchase out of distributable reserves. The redemption and repurchase of company shares are an indirect way of transferring capital from the company to its members, the result is a reduction of capital. Assuming that on a re-purchase the shares were cancelled and nothing was put in their place, this would reduce the capital yardstick represented by issued share capital and it would also be regarded as a diversion of the company's assets to the shareholder. Also, when a company cancels redeemed shares, this entails a drain on the company's cash resources, and therefore its share capital account is diminished. Thus, if no contravening steps are taken the company's capital would be indirectly reduced.
As well as providing creditor protection, the provisions on repurchase and redemption of shares were aimed at preventing greater abuses, such as directors manipulating the company's share price and enhancing the value of their own holding and control without any personal expense to themselves. Another shareholder protection put in place by these provisions is that whilst the shares are still held by the company as ‘treasury shares' it may not exercise any of the rights attached to them and any such purported exercise if void, nor may a dividend be paid on the shares.
The redemption and repurchase provisions are also aimed at providing shareholder protection. It is clear that re-purchases have implications on the relations of shareholders among themselves, there is greater scope for inequitable treatment of shareholders. There is room for directors to give controlling shareholders favorable terms compared to minority shareholders. The Act contains some provisions aimed at controlling such abuses. These protections vary according to whether the purchase is “off-market” or “market” purchase. This means that a market purchase will create fewer risks of abuse since the rules of the FSMA or the Exchange will apply and purchases will be effected at an objectively determined market price. Also redemptions reduce the cash available to pay dividends to other shareholders, this impact redemption has on the non-redeeming shareholders lies behind the need for protective mechanisms under the capital maintenance regime. Also, redeemable shares may not be redeemed until they are fully paid, this avoids redemption wiping out the personal liability of the holders in respect of uncalled capital and therefore indirectly returning company capital.
A private company may pay for redeemable shares out of capital, this will mean that the company's shares will be redeemed with less than the full counterbalancing increase in the capital accounts and as a result some or all of the cancelled capital written off will not be replaced and so the company will reduce its capital. Public companies may only use distributable profits or the proceeds of a share issue made for the purposes of the redemption. The principle protective techniques used in the Act in respect of the ‘permissible capital payment' route available to private companies are: in the case of creditors the requirement for a solvency statement from the directors; and in the case of shareholders the requirement for approval of the proposed redemption or repurchase by special resolution; and in both cases the availability of a right of objection to the court. In addition, the directors solvency statement will need to be accompanied by a report from the company's auditors stating their opinion that the amount of the permissible capital payment has been properly. The final protective device for both creditors and dissenting members is court scrutiny. The Act entitles any member of the company who has not consented to or voted for the resolution and any creditor of the company, within five weeks of the passing of the resolution to apply to the court for the cancellation of the resolution.
Our company law establishes a system of rules based on the concept of legal capital. The rules on the maintenance of this legal capital are intended to avoid or reduce the risk that in the event of a company's insolvency, unpaid creditors are not satisfied. The main aims of the regime is to provide a cushion intended to help ensure that creditors are paid in full, even if the company suffers substantial losses, and to protect the interests of non-controlling shareholders. However, the functions these rules actually achieve in practice have come to be questioned, and challenges and criticisms from various sides have been put forward. Some commentators strongly advocate for the removal of the capital maintenance regime all together, replacing them with alternative and more effective creditor protection mechanisms. These scholars are skeptical about the ability of legal capital to protect creditors, using for example arguments based on the economic efficiency of the legal capital rules. According to the authors, the costs associated with the legal capital rules, particularly the costs to shareholders, creditors and society as a whole, significantly outweigh any benefits to creditors. It is suggested that the notion of legal capital should be abandoned, in favour of a more flexible contract based system in order to be rid of the restrictions the current rules place on companies, thus facilitating more efficient business development.
This essay has sought to discuss and analyse the capital maintenance rules. It has been discovered that some aspects of the maintenance rules do not fully achieve the purposes they were designed for. The capital maintenance regime consists of mandatory rules which impose a ‘one size fits all' approach, that can at times be over-regulatory. The capital reduction provisions in relation to public companies for example, lack efficiency and in certain situations unnecessarily frustrate the legitimate business activities of companies. They generate more costs than benefits. Just as it undesirable to offer creditors too little protection, it may be equally undesirable to mandate too much protection onto creditors, therefore restricting a company's corporate activities. It has been demonstrated that there are strong doubts about the usefulness of certain aspects of the legal capital framework, and the regime as a whole is viewed by many as primitive body of mandatory rules. A strong case exists for further reform of the capital maintenance regime, in order for it to attain a more useful and efficient purpose in a modern company law and business structure.
In relation to involuntary creditors it has been argued that the capital maintenance rules are no longer an appropriate method to employ in safeguarding the interests of involuntary creditors. It is difficult to ascertain in what ways the capital rules provide any benefits for involuntary creditors. The principle of maintaining a capital buffer for the benefit of creditors is admirable in theory, however, in practice the functions the capital maintenance provisions perform are limited. The rules have become complex and incoherence over time, especially in relation to financial assistance for example. Their existence and function must be questioned. With twenty first century standards of transparency and accountability in company accounting, there are fewer opportunities than there were in the past of hiding a company's true financial state. In addition, the problems the capital maintenance seeks to tackle, are in practice met by other means such as through loan contracts. Sophisticated creditors frequently include terms into their loan covenants that restrict a debtor's ability to engage in transactions harmful to the lenders interests. This illustrates that the same outcomes the maintenance rules seek to attain, can be achieved by other methods, it therefore calls for the justifications of their continued existence to be questioned.2
It can be said that the concept of capital maintenance has become of slender benefit to creditors and companies. When creditors decide to lend money to a company, they will usually refer to the company's financial situation, rather than rely on a historical benchmark provided by the legal capital regime. Returns of company capital to shareholders, directly or indirectly, harm creditor's interests and it is appropriate that such transactions are regulated. Whilst there are clearly good reasons and benefits for imposing distribution constraints on a company, it is hard to understand why such restrictions are regulated with reference to historic contributions made by shareholders. The utility of capital as a yardstick will diminish over time, as the value of the company's assets bears less and less resemblance to the amount of the shareholders capital claims.
The recent amendments introduced by the Companies Act simplify and relax the provisions on capital maintenance. The main reasons for introducing more flexibility into this area of law, is that there are now more sophisticated controls available that did not exist when the maintenance of capital principle was first developed. The introduction of more sophisticated, accurate and transparent information-orientated accounting systems in recent years, indicate that there is no longer a need for a capital system that is outdated. A transparency-based accounting system alleviates problems with unlawful distributions to directors, and provides valuable decision-useful information. Moreover such an accounting regime provides greater creditor protection because it allows companies to provide comprehensive unbiased information that enables creditors to assess a company's ability to pay their debts. A capital regime that is market-based is preferred to a law-based model centered on capital maintenance. This is because a market based system would be better and quicker at adapting to the business requirements of companies and thus promoting greater business efficiency.
With regard to capital formation and maintenance rules as an instrument for creditor protection, it has been shown that other measures could be considered to achieve more effective protection of creditors, especially for involuntary creditors and other creditors that are in special need of protection. Flexibility and the easing out of over-regulation has been achieved by the recent changes, however more needs to be done and there is room for improvement of the current regime. Any reform of the current capital formation and capital maintenance regime should remove the defects perceived in it, while maintaining the virtues and functions it seeks to achieve.
Armour – Legal Capital: An Outdated Concept? – March 2006, Centre for business Research University of Cambridge, Working Paper No. 320
Bennet – Reductions of Capital Simplified (?) – Greens Business Law Bulletin August 2008
Ferran – Creditors' interests and “core” company law – Company Lawyer 1999
Ferran – Corporate transactions and financial assistance: shifting policy perceptions but static law – Cambridge Law Journal 2004
Kershaw – Involuntary creditors and the case for accounting-based distribution regulation – Journal of Business Law 2009
Santella & Turrini – Capital Maintenance in the EU: Is the Second Company Law Directive Really That Restrictive? – European Business Organisation Law Review 2008
J Dine and M Koutsias – Company Law (6th ed)
Derek French, Stephen Mayson, Christopher Ryan – Mayson, French and Ryan on Company Law (25th ed)
Len Sealy and Sarah Worthington - Cases and Materials in Company Law (2007) (8th ed)