Equity Finance

Question 1

Capital

Answer 1

All the assets of the company.

Question 2

Legal capital

Answer 2

The value received from investors who subscribe for the company’s shares. Also referred to as share capital.

Question 3

Maximum/minimum legal capital?

Answer 3

• No maximum legal capital provision under CA 2006. Companies can have as much share capital as they wish.
• Private companies also have no minimum legal capital requirements - one share is sufficient (s 7, s 8 CA 2006)
• Public companies have a minimum legal requirement of £50,000. This is in order to protect creditors through the doctrine of maintenance of share capital.

Question 4

Benefits for shareholders

Answer 4

• Shareholders share in the profits by way of dividends
• Shareholders may also receive a capital return where the value of their share increases
• Shareholders often have voting rights therefore some input in the management of the company.

Question 5

Risks for shareholders

Answer 5

In the event of insolvency, creditors are paid first in the order of priority on winding up. This means that it is unlikely that shareholders will receive the full value of their investment.

Question 6

Protection for shareholders

Answer 6

(1) Limitations on the power of directors to issue new shares: Directors require authorisation of the shareholders in order to issue new shares, which avoids the directors issuing and subscribing new shares in order to obtain a controlling majority.
(2) Pre-emption rights: Shareholders have rights of first refusal when the company issues new shares. This means that shareholders are able to retain the same proportion of shareholding in the company if they wish to do so.
(3) Class rights: Certain classes of shares may have particular rights e.g. rights of pre-emption, enhanced voting rights or greater dividends.

Question 7

Limitations on the power of directors to issue new shares

Answer 7

• Firstly it is necessary to check whether there is a cap on the maximum number of shares that a company itself is authorised to issue. It is necessary to check the company’s articles since it is possible to insert a restriction (although this is rare for companies incorporated under CA 2006)
• The directors need to be authorised to issue shares.

Question 8

Section 549 CA 2006

Answer 8

Directors have no power to issue shares except:

(1) In accordance with s 550: gives the directors of private companies which have only a single class of shares authorisation to issue further shares of the same class, provided there is nothing to the contrary in the articles
(2) Shareholders must authorise the directors to issue shares under s 551: the shareholders may grant the directors authorisation to issue new shares by ordinary resolution. This lasts for up to 5 years and for a certain number of shares (stated in the authorisation) only.

Question 9

Pre-emption rights

Answer 9

Section 561 states that new shares should first be offered to the existing shareholders, who are given a right of first refusal. However, this only applies where the shares to be issued are “equity securities.”

Question 10

Definition of “equity securities”

Answer 10

Section 560(1):
(a) ordinary shares in the company, or
(b) rights to subscribe for, or to convert securities into, ordinary shares in the company;
“ordinary shares” means shares other than shares that as respects dividends and capital carry a right to participate only up to a specified amount
- this encompasses shares which would not usually be described as ordinary shares e.g. participating preference shares
- pre-emption rights do not apply to preference shares that have capped preference rights as to both dividends and capital.

Question 11

Exceptions and exclusion of the right to pre-emption

Answer 11

Exceptions to the right of pre-emption where the new shares to be issued are:

• bonus shares,
• issued under an employee share scheme,
• issued for non-cash consideration (s 564)
• a company may exclude the right of pre-emption by specific provision in the articles (s 567-568)

Question 12

Disapplication of pre-emption rights

Answer 12

• May be disapplied in the company’s articles, but this is not common.
• More commonly, they may be disapplied by a special resolution of the shareholders.

Question 13

Disapplication of pre-emption rights by special resolution of the shareholders (ss 569-571)

Answer 13

• Directors of a private limited company with one class of shares where the new shares to be issued are of the same class: shareholders may agree to disapply pre-emption rights by special resolution under s 569
• Pre-emption rights may also be disapplied by special resolution under s 570 where the directors of the company are acting under a general authority to issue shares. In this situation, pre-emption rights are disapplied for all shares issued in accordance with this general authority.
• Under s 571, shareholders may pass a special resolution to disapply pre-emption rights in relation to a particular share allotment only.

Question 14

Pre-emption rights on transfer of shares

Answer 14

• Where shareholders transfer their shares, in general there are no rights of pre-emption for existing shareholders.
• However, a private company may provide for pre-emption rights on transfer of shares either in the articles or a shareholder agreement. This is quite common in small private companies, where it is important to keep control of the company
• If a private company has a corporate shareholder (company A), the transfer of the corporate shareholder’s own shares will not trigger these pre-emption rights provisions because as respects the company there will be no change in ownership (Re Coroin)

Question 15

Issuing shares at a discount

Answer 15

• Shares may not be issued at a discount (e.g. issuing £1 shares for 75p each)
• This was held to be beyond the power of the company in Ooregum Gold Mining v Roper and is now prohibited by s 552 CA 2006

Question 16

Issuing shares at a premium

Answer 16

• Shares can be issued at a premium (s 610) (e.g. issuing £1 shares for £2)

Question 17

The doctrine of capital maintenance

Answer 17

The doctrine of capital maintenance states that the company must maintain and not reduce its share capital except in very limited circumstances. The share capital therefore is a permanent fund available to creditors.

Question 18

Purpose of the doctrine of capital maintenance

Answer 18

Trevor v Whitworth: protection of creditors, since the principle of limited liability prevents creditors from seeking funds from shareholders. The share capital of a company gives an indication of its creditworthiness.

Question 19

s 658 CA 2006: Capital maintenance

Answer 19

(1) A limited company must not acquire its own shares…except in accordance with the provisions of this Part.
(2) If a company purports to act in contravention of this section–
(a) an offence is committed by (i) the company, and (ii) every officer of the company who is in default, and
(b) the purported acquisition is void.
- Section 659 sets out a series of limited exceptions to the rule.

Question 20

The impact of the doctrine of capital maintenance

Answer 20

Since it prevents a company from reducing its share capital or returning value to shareholders except in limited circumstances, it has an impact on a number of transactions:

• granting of dividends or distributions
• reduction of share capital
• purchase and redemption of own shares
• financial assistance

Question 21

Returning funds to shareholders: dividends

Answer 21

• Doctrine of capital maintenance applies here to limit the funds from which the company may pay dividends since the payment of a dividend involves the reduction of the company’s assets
• A dividend is a ‘distribution’ under the definition in s 829(1) CA 2006
• Section 830(1) states that dividends may only be paid out of ‘distributable profits’
• Distributable profits are defined in s 830(2) as the company’s ‘accumulated, realised profits…less its accumulated, realised losses’
• The share premium account is not a distributable reserve, so cannot be used to fund a distribution

Question 22

Dividends - Relevant accounts

Answer 22

Section 836 CA 2006 sets out ‘relevant accounts’ for seeing whether the company has sufficient distributable assets for the payment of a dividend. This usually means the most recent annual accounts need to be referred to. In some circumstances, specially prepared interim accounts may be appropriate e.g. where the most recent annual accounts would not justify a dividend payment but the company has realised a substantial amount of profit since then. Where the company has just started trading, initial accounts may be prepared to justify payment.

Question 23

Different types of dividend

Answer 23

(1) A dividend - distribution of profits by way of cash
(2) A scrip dividend - where a company gives the existing shareholders further shares instead of cash
(3) A dividend in specie - giving the shareholders value by assets
- When recommending a dividend, the directors must have regard to all their duties and particularly the duty to promote the success of the company under s 172

Question 24

Final and interim dividends

Answer 24

Final: typically recommended by board of directors and declared by ordinary resolution at the next GM following the annual accounts. The articles may provide that final dividends can be paid without shareholder involvement. Shareholders cannot generally vote for a dividend higher than that recommended by the board but can require a lower dividend to be paid.

Interim dividends: usually of a lesser amount and are recommended by the directors alone. Will be paid for example if a company has had a particularly profitable quarter.

Question 25

Disguised distributions

Answer 25

• Any transaction in which a shareholder receives value will be a distribution, not just payment of cash dividend
• Re Halt Garage: Director was receiving remuneration who had not worked for the company for several years. The company had gone into insolvent liquidation and the court held that the remuneration was a disguised gift out of capital and ordered it to be repaid.
• Another problematic area is intra-group transfers (transfer of property between companies in the same group)

Question 26

Unlawful distributions - liability of directors

Answer 26

When an unlawful distribution is made, both the directors who authorised it and the shareholders receiving it may be liable.
- Directors: breach of the rules in CA 2006 makes the payment unlawful. Directors who knew or ought to have known the payment amounted to breach are liable to personally repay the dividends (Bairstow v Queens Moat Houses)

Question 27

Unlawful distributions - liability of shareholders

Answer 27

Section 847(1) and (2) CA 2006 provide that where a distribution is made in contravention of the requirements of CA 2006 and at the time of the distribution, the member knows or has reasonable grounds to believe it to have been unlawful, he is liable to repay it to the company. (It’s a Wrap UK Ltd v Gula)

Question 28

Steps that the board must take before issuing a dividend/distribution

Answer 28

1. Consider their duties and whether the distribution is in accordance with them, esp. 171/172
2. Consider whether the proposed transaction is a dividend or a disguised distribution
3. Check relevant accounts if there are distributable profits. If there aren’t, the distribution is unlawful.
4. Check whether the distributable profits cover the whole amount of the distribution.

Question 29

Reduction of share capital

Answer 29

• A company may review its capital requirements and reduce its share capital. The reason for this can be:
• If the share capital is greater than actual net assets e.g. where there have been business losses. A company may wish to reduce its share capital so it corresponds to the actual net assets, with the hope it will then be able to resume paying dividends.
• Where the company has surplus cash it may wish to return to shareholders e.g. where an asset has been sold
• The doctrine of capital maintenance prevents a company from reducing its share capital, and so CA 2006 sets out stringent procedures to follow in order to reduce share capital.

Question 30

Reduction of capital using the court procedure (s 645-651) - (public and private companies)

Answer 30

This requires:

(a) A special resolution of the shareholders, followed by
(b) An order of the court.
- The creditors have a right to object before the court makes an order
- The court may make an order on such terms and conditions as it thinks fit (s 648(1))
- The court must be satisfied that every creditor entitled to object has either consented to the reduction or that his debt has been repaid or secured (s 648(2))
- The reduction of capital will take effect on registration of the court order confirming the reduction and statement of capital at Companies House (s 649(5))

Question 31

Reduction of capital by special resolution and solvency statement (private companies only)

Answer 31

• CA 2006 simplifies the procedure for reducing share capital for private companies under s 642-644
• It is an offence for directors to make a solvency statement without having reasonable grounds for the opinions expressed in it. The solvency statement:
• (a) Must be made not more than 15 days before the date on which the special resolution is passed (s 642(1));
• (b) Must be signed by all directors;
• (c) Must confirm:
• (i) There is no ground on which the company could be found to be unable to pay its debts (s 643(1)(a)), and
• (ii) The company will be able to pay its debts for 12 months from the date of the solvency statement (s 643(1)(b)(ii).

Question 32

Redemption and purchase of own shares

Answer 32

• CA 2006 sets out exceptions to the doctrine of capital maintenance, under which companies are able to:
• Issue shares that are redeemable at the option of either the company or the shareholder (s 684(1)). A public company must have express authorisation in its articles to issue redeemable shares, whereas private companies have statutory authorisation to issue redeemable shares
• Purchase their own shares (subject to any restriction or prohibition in the articles) (s 690(1))

Question 33

Redemption of shares - s 685-689

Answer 33

• Redeemable shares are issued as such, and the terms of redemption are set out at the time of issue.
• For redeemable shares to be issued, there must be at least one other class of shares in issue (s 684(4))
• Shares may not be redeemed unless they are fully paid
• Redemption will usually be out of distributable profits, but private limited companies can redeem out of capital provided that they can comply with the procedural requirements in CA 2006 for redemption out of capital
• Creditors must be notified and have a period in which to object

Question 34

Purchase or buyback of shares - s 690-708

Answer 34

• Similar to redemption but applies to non-redeemable shares. A company may purchase its own shares subject to any restrictions or limitations in the articles.
• The company must draw up a contract with the shareholder(s) selling the shares for the purchase of their shares, which needs to be approved by an ordinary resolution of shareholders. The purchase may be funded by:
• (a) Distributable profits (all companies)
• (b) Capital (private companies only)
• There are further requirements, similar to those required for redemption of shares out of capital
• Creditors must be notified and have a period in which to object.

Question 35

Financial assistance

Answer 35

A company providing financial assistance for the purchase of its own shares.

Question 36

Prohibition on financial assistance

Answer 36

• CA 2006 removed the prohibition in relation to private companies. The prohibition therefore now only applies in general to public companies.
• Both public companies and their private limited subsidiaries are prohibited from providing financial assistance for the purchase of shares in the public company (s 678)
• Public companies are prohibited from providing financial assistance for the purchase of shares in their private limited holding companies (s 679)

Question 37

Consequences of unlawful financial assistance

Answer 37

• The transaction will be held void and the company and any officer in default will be liable to a fine and/or up to two years in prison
• There are a number of exceptions to the prohibition but these are narrowly construed and so difficult to rely on.

Question 38

Section 681 - Unconditional exceptions to prohibition financial assistance

Answer 38

Section 681 contains a wide list of unconditional exceptions, which relate mainly to financial assistance being offered for procedures which are authorised in other sections of CA 2006 e.g. redemption of shares or reduction of capital.

Question 39

Section 682 - Conditional exceptions to prohibition on financial assistance

Answer 39

Section 682: a list of conditional exceptions, which apply only if the company has net assets and either:

(a) those assets are not reduced by the giving of financial assistance,
(b) to the extent that those assets are reduced, the assistance is provided out of distributable profits
- One example of a conditional exception is financial assistance by a company for the purposes of an employee share scheme provided this is made in good faith in the interests of the company or its holding company (s 682(2)(b))

Question 40

The principal purpose and incidental part of a large purpose defences - s 678(2) and (3) and s 679(2) and (3)

Answer 40

• Designed to ensure that the prohibition does not prohibit genuine commercial transactions that are in the interest of the company.
• Financial assistance is not prohibited:
• (a) if the principal purpose of the assistance is not to give it for the purpose of an acquisition of shares, or where this assistance is incidental to some other larger purpose of the company; and
• (b) in either case, where the financial assistance is given in good faith in the interests of the company.
• Brady v Brady: case involved the division of a company’s business between its two shareholders, J and B, who had fallen out. It was decided that J would take the haulage business and B the soft drinks business, but assets had to be transferred between the companies. This was done by the company transferring assets to a new company controlled by B. This was held to be financial assistance, but the court had to consider whether it was incidental to the larger purpose to remove the deadlock. The HoL held that the exception did not apply because the essence of the reorganisation was for J to acquire B’s shares, so the acquisition of shares could not be said to be ‘incidental.’