12 - The Capital Maintenance Rules

Question 1

What are the two methods by which a company can reduce its share capital?

Answer 1

The courts have long held that a company may only reduce its share capital in a manner permitted by the Companies Act (TREVOR v WHITWORTH (1887)), with the CA2006 providing for two methods to reduce capital:

• special resolution followed by court confirmation; and
• special resolution followed by solvency statement.

Question 2

What two limitations are placed on company’s ability to reduce its share capital?

Answer 2

1. A company that seeks to reduce its share capital by special resolution supported by solvency statement cannot do so if the result of the reduction is that there would be no members of the company holding shares other than redeemable shares (s. 641(2)); and
2. A company may not reduce its share capital by either method if the reduction is part of a scheme under which a person is to acquire all the shares in the company or all the shares in one or more classes, other than those they already hold (s. 641(2A)).

Question 3

When deciding whether to confirm a reduction, what is the court’s principal concern?

Answer 3

When deciding whether to confirm the reduction, the primary concern of the court is the interests of the company creditors.

Question 4

What does a solvency statement state?

Answer 4

The solvency statement is a statement that each of the directors has formed the opinion that:

• as regards the company’s situation at the date of the statement, there is no ground on which the company could then be found to be unable to pay (or otherwise discharge) its debts; and
• the company will be able to pay (or otherwise discharge) its debts as they fall due during the year immediately following the date of the statement.

Question 5

Why are companies generally prohibited from acquiring their own shares?

Answer 5

• Such an acquisition would return capital to the shareholders, which is generally prohibited under the capital maintenance rules;
• A company could purchase its own shares in an attempt to manipulate its own share price; and
• Such an acquisition would reduce the company’s share capital, and could therefore allow a company to avoid the procedures for reducing share capital discussed in the previous section.

Question 6

What are redeemable shares?

Answer 6

Redeemable shares and shares issued by the company on the condition that they will be redeemed (brought back) by the company if the company or the shareholder so requires.

Question 7

Does a company require authorisation in its articles in order to issue redeemable shares?

Answer 7

A public company may only issue redeemable shares if authorised to do so by its articles (s. 684(3)). A private company does not require authorisation from its articles, but its articles may exclude or restrict the company’s ability to issue redeemable shares (s. 684(2)).

Question 8

If a company wishes to redeem or purchase its own shares, where must the payment come from?

Answer 8

The payment for redeemable shares must come from the company’s distributable profits or from the proceeds of a fresh issue of shares made for the purpose of the redemption (s. 687(2)).

Question 9

What happens to a company’s shares when it redeems or purchases them?

Answer 9

When redeemable shares are redeemed, they are cancelled and the company’s share capital must be reduced by the nominal value of the shares redeemed (s. 688).

Question 10

Why was the prohibition on providing financial assistance introduced?

Answer 10

• To prevent a company from being able to manipulate its share price; and
• To prevent a company (A) from providing financial assistance to another company (B), and B then using that money to purchase shares in A and take it over.

Question 11

What types of company are prohibited from providing financial assistance to acquire their shares?

Answer 11

The prohibition on providing financial assistance only applies to public companies.

Question 12

What is ‘financial assistance’? Provide three examples of such assistance.

Answer 12

Section 677(1) of CA2006 provides that ‘financial assistance’ means financial assistance given by way of gift, guarantee, security, indemnity, release or waiver, or loan, and any other financial assistance given by a company where the net assets of the company are reduced to a material extent by the giving of the assistance or the company has no assets. Examples of financial assistance include:

• where a company lends money to a person and that person uses that money to buy shares in the company;
• where a company guarantees a loan made by a bank to another person (A) and A uses that money to buy shares in the company; and
• where a person (X) borrows money from a bank and uses it to buy enough shares to control a company. X then uses the resources of the company to repay the money loaned by the bank.

Question 13

Explain the ‘principal purpose’ and ‘incidental part’ exceptions.

Answer 13

Financial assistance will not be prohibited where:

• the assistance is given in good faith in the interests of the company; and
• the company’s principal purpose in giving the assistance is not for the purpose of acquiring the shares, or the giving of assistance is for the purpose of acquiring shares but this is only an incidental party of some larger purpose of the company (ss. 678(2) and (4) and 679(2) and (4)).

Question 14

What are the consequences of a company providing prohibited financial assistance?

Answer 14

CA2006 only states one consequence of a company engaging in prohibited financial assistance - that the company and every officer in default commits a criminal offence (s. 680(1)). However, a number of civil consequences have been established by the courts, including:

• an agreement to provide unlawful financial assistance is unenforceable in its entirety (HEALD v O’CONNOR (1971));
• a director who is party to a transaction that amounts to a prohibited financial assistance may be held in breach of duty (IN A FLAP ENVELOPE CO LTD (2003)), or disqualified (CONTINENTAL ASSURANCE CO OF LONDON PLC (NO 1) (1996)); and
• the court in BELMONT FINANCE CORP v WILLIAMS FURNITURE LTD (NO 2) (1980) held that (i) a recipient of prohibited financial assistance will be liable to account for the sum received if they knew or ought to have known of the impropriety of the transaction; and (ii) a person who knowingly assists the directors to cause the company to provide prohibited financial assistance can be personally liable to the company.

Question 15

How does the CA2006 define a ‘distribution’?

Answer 15

The definition of ‘distribution’ in CA2006 is extremely wide and means ‘every description of distribution of a company’s assets to its members, whether in cash or otherwise’ (s. 829(1)).

Question 16

What is a dividend? Explain the differences between a final dividend and an interim dividend.

Answer 16

A dividend is simply a distribution of part or all of the company’s profits to its members, with each member usually getting X pence for each share they own. There are two types of dividend payment:

1. Final Dividend - a dividend paid out once the company’s final accounts have been prepared (i.e. it is paid following the end of relevant financial year).
2. Interim Dividend - a dividend paid out before the company’s final accounts have been prepared (i.e. it is paid during the relevant financial year).

Question 17

A distribution must be paid out of what assets of the company?

Answer 17

Section 830(1) of CA2006 states that ‘[a] company may only make a distribution out of profits available for the purpose’, which are defined by s. 830(2) 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’.

Question 18

What is the usual three-stage process for paying a final dividend?

Answer 18

1. The directors will recommend an amount of distributable profit to be distributed by way of a dividend;
2. The company will ‘declare’ the dividend by the members passing a resolution; and
3. The dividend will be paid out based on the rights of the members.

Question 19

Do dividends have to be paid in cash?

Answer 19

Dividends must generally be paid in cash (WOOD v ODESSA WATERWORKS CO (1889)), unless the company’s articles provide for some other form of payment.

Question 20

If an unlawful dividend is paid, to what extent will the company’s directors and members be liable?

Answer 20

If an unlawful dividend is paid, then:

1. a director who authorises the payment of an unlawful distribution is jointly and severally liable to repay the amount of the distribution to the company (EXCHANGE BANKING CO, FLITCROFT’S CASE (1882));
2. if, at the time of the distribution, a member knows or has reasonable grounds for believing that it was made unlawfully, the member is liable:

• to repay the distribution (or part of it, as the case may be) to the company; or
• in the case of a distribution not made in cash, to repay the company a sum equal to the value of the distribution (or part) at the time (s. 847).