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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 sur 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
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