Equity finance

Question 1

Difference between capital and legal capital?

Answer 1

Capital:
All of the assets of the company (including debt finance, shares, assets)
Legal capital:
This is the value received from investors who subscribe for the company’s shares. It is also referred to as the share capital.

• -»Private companies also have no minimum legal capital requirements – one share is sufficient (s 7, s 8 CA 2006).
• ->However, s 761/763 CA 2006 states that public companies have a minimum legal requirement of £50,000.

Question 2

Benefits and risks to shareholders?

Answer 2

Benefits:

1. Shareholders share in the profits of the company by way of dividends.
2. If the company does well, the shareholders may also receive a capital return where the value of their shares increases. However, shareholders in a private limited company may have difficulty selling their shares.
3. Shareholders often have voting rights therefore they have some input into the management of the company.

Risks:
- Company has a separate legal personality, so creditors are paid from the company’s assets. 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 3

Protection for shareholders?

Answer 3

1. Limitations on the power of directors to issue new shares:
   - Directors require authorisation of the shareholders in order to issue new shares - avoids the directors themselves issuing and subscribing for 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 in most circumstances - means that the shareholders are able to retain the same proportion of their shareholding in the company if they wish to do so, without dilution.
3. Class rights:
   - Certain classes of shares may have particular rights, enhanced voting rights or greater dividends.

Question 4

1. Limitations on the power of directors to issue new shares?

Answer 4

Firstly it is necessary to check whether there is any cap on the maximum number of shares that a company itself is authorised to issue. This would be unusual for a company incorporated under CA 2006.

Secondly, the directors need to be authorised to issue shares. Section 549 CA 2006 states that the directors have NO power to issue shares except:
1. In accordance with s 550:
Gives directors of a private company which has only a single class of shares authorisation to issue further shares of the same class (as long as articles ok)
2. Shareholders authorise the directors to issue new shares under s 551:
They 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 (as stated in the authorisation) only.

Question 5

2. Pre-emption rights?

Answer 5

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 6

What are ‘equity securities’?

Answer 6

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 in a distribution.
This means that pre-emption rights apply where the new shares to be issued are ordinary shares. The definition of “ordinary shares” under s 560 encompasses shares which would not normally be described as ordinary shares eg participating preference shares.
!!!-> Pre-emption rights only do not apply to preference shares that have capped preference rights as to BOTH dividends and capital.

Question 7

Exceptions and exclusion of the right of pre- emption?

Answer 7

EXCEPTIONS
There are exceptions to the right of pre-emption which apply where the new shares to be issued are:
• bonus shares,
• issued under an employee share scheme, or
• Issued for non-cash consideration (s 564).

EXCLUSION
A company may exclude the right of pre-emption by specific provision in the articles (s 567 – 568).

Question 8

Can companies disapply pre-emption rights?

Answer 8

May be disapplied in the company’s articles, but this is not common.

But - More commonly, the pre-emption rights may be disapplied by SPECIAL RESOLUTION of the shareholders. Sections 569 – 571.

s 569: Directors of a private limited company with only class of shares where the new shares to be issued are of the same class: shareholders may agree to disapply
s 570: directors of the company are acting under a general authority to issue shares. 
s 571: may pass a special resolution to disapply pre-emption rights in relation to a particular share allotment only.

Question 9

Pre-emption rights on transfer of shares?

Answer 9

In general there are no rights of pre-emption
for existing shareholders.

HOWEVER - private company may provide for pre-emption rights on transfer of shares in either the articles or a shareholder agreement. This is quite common in small private companies.

BUT IF private company has a corporate shareholder (company A), the transfer of the corporate shareholder (A)’s own shares will not trigger these pre-emption rights provisions for the company, because as respects the company there has been no change in ownership. Re Coroin.

Question 10

Issuing shares at a discount /premium?

Answer 10

Issue at a discount

Shares may not be issued at a discount (eg issuing £1 shares for 75p each).
HoL held that issuing shares at a discount was beyond the power of the company in Ooregum Gold Mining Co of India v Roper.
Now prohibited by s 552 CA 2006.

Issue at a premium

Shares can be issued at a premium (s 610) (eg issuing £1 shares for £2)
This is allowed but is not required, as confirmed in the case of Hilder v Dexter.

Question 11

Allotted share capital?

Answer 11

s 558 CA 2006
Shares are deemed to be allotted when a person acquires the unconditional right to be included in the company’s register of members.

Question 12

Origins of the doctrine of capital maintenance?

Answer 12

Trevor v Whitworth (now also s 658 CA 2006)

States that the company must maintain and not reduce its share capital except in certain very limited circumstances. The share capital therefore is a permanent fund available to creditors - reason is to protect the creditors. Unsecured creditors will seek claim from capital as well as unsecured assets if the company is wound up.

Capital can of course be lost as a result of poor business decisions or market conditions, but this is a legitimate risk which both shareholders and creditors will face.

Question 13

What does s 658 say?

Answer 13

(1) A limited company must not acquire its own shares, whether by
purchase, subscription or otherwise, 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 this rule.

Question 14

Impact of the doctrine of capital maintenance?

Answer 14

Has an impact on a number of different transactions as it prevents a company from reducing its share capital or returning value to shareholders except in limited circumstances:
• The granting of dividends or distributions
• Reduction of share capital
• Purchase and redemption of own shares
• Financial assistance

Question 15

Where is the def of ‘dividend’ laid out?

Answer 15

s 829(1) CA 2006, which states that “distribution” means every description of distribution of a company’s assets to its members, whether in cash or otherwise, subject to the exceptions set out in s 829(2).

s 830(1) is for ‘distributable profits’.

Question 16

s 836 refers to the ‘relevant accounts’ - what are these?

Answer 16

Annual accounts - but in some circumstances, interim accounts may be ok - i.e. annual accounts not justify dividend payment but there’s been a recent large sell of property.
Company just started - initial accounts ok.

Question 17

3 different types of dividends?

Answer 17

1. Dividend - usually involves the distribution of profits by way of cash to shareholders.
2. Scrip dividend - is where a company gives the existing shareholders further shares in the company rather than cash.
3. Dividend in specie - involves the company giving the shareholders value by way of assets.

Note that when recommending a dividend, the directors must have regard to all of their duties, and particularly the duty to promote the success of the company under s 172.

Question 18

Final and interim dividends?

Answer 18

Final dividends:

Typically recommended by the board of directors and declared by ordinary resolution by the shareholders at the next general meeting following the annual accounts. The articles however may provide that final dividends may be paid without any shareholder involvement.
Shareholders cannot generally (subject to anything to the contrary in the articles) vote for payment of a higher dividend than that recommended by the board but they are able to require a lower dividend to be paid.

Interim dividends:

Usually (subject to anything to the contrary in the articles) of a lesser amount than a final dividend and are recommended by the directors alone. Interim dividends will be paid for example where a company has had a particularly profitable quarter.

Question 19

Disguised distributions?

Answer 19

Courts have found this (breaching maintenance of share capital) in some cases.
- Re Halt Garage

Another problematic area where disguised distributions may be found to have occurred is on intra-group transfers: Aveling Barford v Perion Ltd

Question 20

Unlawful distributions – liability of directors?

Answer 20

Directors who knew or ought to have known that the payment amounted to a breach are liable to personally repay the dividends (and the shareholders receiving it may be liable too)
Bairstow v Queens Moat Houses plc.

Question 21

Unlawful distributions – liability of shareholders

Answer 21

s 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 for believing the distribution to have been unlawful, they are liable to repay it to the company.
It's a Wrap (UK) Ltd v Gula.

Question 22

Dividends – steps that the board must take before issuing a dividend / distribution?

Answer 22

1. Directors’ duties: Directors need to consider their duties, particularly s 171 /172. Is making the distribution in accordance with those duties?
2. Restrictions on distributions: Consider whether the proposed transaction is either a dividend or a disguised distribution (Aveling Barford Ltd v Perion Ltd)
3. Are there any distributable profits?: Check the relevant accounts. If not, the distribution is unlawful.
4. Amount of distribution: Check whether the distributable profits cover the whole amount of the distribution. If not, the distribution is unlawful.

Question 23

Why do companies ever reduce their share capital? (2)

Answer 23

Normal practice:

1. If the share capital is greater than the actual net assets, eg where there have been business losses. In this situation the company may wish to reduce its share capital so that it corresponds to the actual net assets, with the hope that it will then be able to resume dividend payments.
2. Where the company has surplus cash that it may wish to return to shareholders eg where an asset has been sold. Here the company may wish to reduce its share capital and at the same time return money to shareholders.

The doctrine of maintenance of capital prevents a company from reducing its share capital, and therefore CA 2006 sets out stringent procedures that companies must follow in order to reduce their share capital.

Question 24

Where is the procedure for reducing share capital laid out?

Answer 24

s 645 - 651. This requires:
• A special resolution of the shareholders, followed by
• An order of the court.
Creditors have a right to object.

Courts may make order declaring permitted with T&Cs (s648(1)) - will consider creditors first (s648(2)).
Reduction of share capital will need to be confirmed at Companies House (s649(5)).

Question 25

Private companies only – reduction of capital by special resolution and solvency statement?

Answer 25

This is instead of the court procedure - CA 2006 s 642 - 644 simplified the procedure.
Solvency statement of the directors and a special resolution of the shareholders.

• Must be made not more than 15 days before the date on which the special resolution is passed (s 642(1));
• Must be signed by all directors;
• Must confirm:
  
  • There is no ground on which the company could be found to be unable to pay its debts (s 643(1)(a)), and
  • 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 26

Although the common law prohibited a company from acquiring its own shares because of the risk to creditors (Trevor v Whitworth), CA 2006 sets out exceptions to the doctrine of capital maintenance - what are the exceptions that a company is able to do?

Answer 26

1. 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, subject to any specific restriction in their articles.
2. Purchase their own shares (subject to any restriction or prohibition in the articles) (s 690(1)).

Question 27

1. Redemption of shares – s 685 – 689 CA 2006?

Answer 27

Terms of redemption are set out at the time of issue. There is therefore no need for a contract to be prepared. 
Must be at least one other class of shares in issue (s 684(4)).

Redemption will usually be out of distributable profits, but private limited companies can redeem out of capital provided that they comply with the detailed procedural requirements in CA 2006 for redemption out of capital (accounts must be no more than three months old, directors’ statement, auditors’ report and a special resolution of the shareholders are also required – s 687(1)). Creditors must be notified and have a period in which to object.

Question 28

2. Purchase (or buyback) of shares – s 690 - 708?

Answer 28

Similar to redemption but applies to non- redeemable shares.
MUST draw contract - needs to be approved by an ordinary resolution of the shareholders.
The purchase may be funded by:
• Distributable profits (all companies), or
• Capital (private companies only).

Where a company seeks to purchase its own shares using capital, there are further requirements, similar to those required for redemption of shares out of capital (accounts must be no more than three months old, directors’ statement, auditors’ report and a special resolution of the shareholders are required –s 692(1)(a)). Creditors must be notified and have a period in which to object.

Question 29

What does the term ‘financial assistance’ refer to?

Answer 29

British and Commonwealth Holding PLC v Barclays Bank plc: “The section requires that there should be assistance or help for the purpose of acquiring the shares and that that assistance should be financial”.

Company providing financial assistance for the purchase of its own shares. There are a variety of different types of financial assistance which are covered by the prohibitions – these include financial assistance given by way of a gift, loan, guarantee, security or indemnity.

Question 30

Prohibitions of financial assistance?

Answer 30

CA 2006 REMOVED prohibition for private companies - therefore only applies TO PUBLIC COMPANIES.

s678: public companies and their private limited subsidiaries are prohibited from providing financial assistance for the purchase of shares in the public company.
s 679: also prohibited from providing financial assistance for the purchase of shares in their private limited holding companies.

Consequences of unlawful financial assistance is that 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.

Question 31

General rule for exceptions to financial assistance for public companies?

Answer 31

Narrowly construed, meaning that they are difficult to rely on.

The general rule is that public companies must be extremely careful to avoid providing financial assistance for the purchase of their shares.

Question 32

Exceptions – conditional and unconditional?

Answer 32

Section 681 – unconditional exceptions:
“Unconditional” exceptions, which relate mainly to financial assistance being offered for procedures which are authorised in other sections of CA 2006.

Section 682 – conditional exceptions:
Number 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, or
(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 33

Principal purpose and incidental part of a larger purpose defences – s 678(2) and (3) and s 679(2) and (3)?

Answer 33

Designed to ensure that the prohibition in s 678(1) and s 679 (1) does not prohibit genuine commercial transactions that are in the interests of the company.
These exceptions provide that financial assistance is NOT prohibited:
• 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
• In either case, where the financial assistance is given in good faith in the interests of the company.

Question 34

Difficulty in relying on these exceptions set out in s 678(2) and (3) and s 679(2) and (3)?

Answer 34

The court needs to determine whether the giving of assistance for the purpose of an acquisition of shares is an incidental part of some larger purpose.

Brady v Brady:
Split of assets/shares between two imbalanced companies following deadlock: one worth more.
Acquisition of these shares could not be said to be “incidental” to the reorganisation.
Following this case it is clear that the principal purpose and incidental exceptions will be very narrowly construed.