Given the substantial protections potentially provided to creditors by minimum capital, financial assistance and capital maintenance rules, discuss whether divergences in treatment between public and private companies in respect of those rules is unjustified.
Although minimum capital, financial assistance and capital maintenance rules aim to protect creditors, it is argued that the protection is insubstantial in practice and only increase costs for firms. Moreover, public companies should not be held to a higher standard than private firms, so separate rules for public companies are unnecessary. Thus, divergence here is unjustified and the rules should be reformed.
Divergences in treatment
Under the Companies Act 2006 (CA), public companies are subject to a minimum capital requirement of £50,000, of which one-quarter must be paid up (s.761-767 and s.91). Public companies are also prohibited from giving, directly or indirectly, financial assistance to a person for the acquisition of their shares (s.678), and otherwise face criminal and civil liability. Moreover, public companies face different rules regarding capital maintenance; private companies can purchase their own shares (up to £15,000 or 5% of share capital) whilst public companies cannot. Public companies additionally can only make a distribution of profits if the amount of its net assets is not less than the aggregate of its called up share capital and undistributable reserves (s.831(1)).
It is argued that public companies should not be held at a higher standard than private firms. Although it may be easier for public companies to raise capital by selling securities and offering lower risk, there is unlimited liability for a company’s owners which incentivises the proper execution of company duties. It will be discussed that the additional divergences above do little to protect creditors further and only impose unnecessary complexities and costs for public companies.
Protections are not substantial
(i) Minimum capital requirements
Minimum capital rules aim to protect creditors if the company faces unexpected loss or insolvency. However, these are unnecessary, creditors in fact derive very minimal benefit from these rules. Armour notes that adjusting creditors do not need this protection as they are able to alter the terms on which they extend their credit depending on the debtor’s riskiness. Removing these requirements would incentivise more businesses to be formed, which would increase the demand for credit. Creditors would thus benefit from greater information as to the riskiness of projects. The requirement only imposes a social cost here, by preventing some projects from being taken where a company cannot afford this.
The requirement is also unnecessary for non-adjusting creditors like the state (as a creditor in tax claims). Companies would not be able to finance operations based solely on unpaid tax claims; initial finance for a business will come from adjusting creditors. Thus, Armour argues that the state can free-ride off information that these creditors acquire concerning riskiness. Moreover, when tax claims emerge, adjusting creditors will press for payment and any unpaid tax money can be used to finance continuation of the business. Therefore, minimum capital will be irrelevant to the state – equity capital will have been lost at this point.
The minimum capital requirements ultimately do not provide greater protection to creditors compared to the social cost of preventing some businesses occurring. Divergence between public and private companies here is therefore unjustified and the rule should be abolished.
(ii) Financial assistance
Preventing public companies from offering financial assistance has been justified as it prevents leveraged buyouts and protects creditors. This prohibition is from the Second EU Company Law Directive (77/91/EEC). Arden LJ notes in Chaston that the resources of a target company should not be used to assist a purchaser to make the acquisition. This would otherwise prejudice the interests of the creditors and shareholders who do not accept acquisition. In this case, a market-focused test of financial assistance was taken, looking at the ‘commercial substance and reality’ of the facts. This approach was followed in subsequent cases like Charterhouse.
However, the approach means that there is often less certainty under the law in the application of this test. Hoffman J in Charterhouse noted that there is no definition of giving financial assistance (in the old CA 1948), meaning the words have no technical meaning and their frame of reference is the language of ordinary commerce. Sealy and Worthington note that the uncertainty is very costly, over £20 million a year is spent on obtaining legal advice to understand the rule. Moreover, as private companies are exempted from the rule, it becomes easier to evade, suggesting the rule for public companies is unjustifiable as it does not actually achieve its aim in protecting creditors but instead just creates costly administration for firms.
It is argued that this rule should be reformed or abolished after the EU obligation no longer binds the UK post-Brexit. This will enable greater clarity for public companies and ensure that the purpose of the rule is actually achieved.
(iii) Capital maintenance
The capital maintenance rules aim to ensure the capital of the company is not simply returned to the shareholders (Trevor v Whitworth). In theory, this protects creditors from devaluation of the company, particularly weaker or involuntary creditors who may not be in a strong bargaining position. The rules also protect directors from undue shareholder pressure to pay out dividends. However, this principle is not absolute, and it does not prevent capital being returned through other methods. Under the CA, companies can reduce their capital under s.641-651, commonly through share buybacks and distributions.
Firstly, companies can purchase its own shares in accordance with the s.658 exceptions. This is through the redemption or repurchase of its own shares from distributable profits or new money that the company raises. Notably, since 2013, private companies can purchase its own shares of up to £15,000 or 5% of share capital if allowed by the articles. However, the extensive conditions for this include a solvency statement (s.714), auditors report (s.714(6)), approval by special resolution (s.716), public notice (s.719-20) and the right to object by creditors and shareholders (s.721-2). Moreover, the court can object under s.721(4)). The law here is unnecessarily complicated and it is argued that the divergence between public and private companies is unjustified; the obstacles to using share capital to purchase own shares are so significant that creditors would be sufficiently protected if this rule were to expand to public companies.
Secondly, the distribution of profits rule outlined above applies stricter rules for public companies (s.830-1). The rule aims to prevent corporate assets going to shareholders unless the value of the distribution is less than the profits available. However, Armour notes that particularly for non-adjusting creditors, the restriction is of little protection. If creditors do not adjust, the optimal level of capitalisation by the shareholders is zero, so those carrying on risky businesses can structure their businesses using thinly-capitalised subsidiaries (ie. Adams v Cape). For adjusting creditors, there may be more of a relevance as lenders can adjust loans based on pre-existing levels of assets which is affected by distributions. However the rules should not be based on the previous contributions by SH, but instead based on the balance sheet at the time of the loan. This is because the utility of capital will diminish over time as the value of the company assets bear less resemblance to the amount of shareholder capital claims. Thus, the rule is likely only useful for companies which has a large proportion of value in growth opportunities, as the restriction will force shareholders to retain equity in the firm and prevent underinvestment.
Alternatives?
The UK is experimenting with a solvency test which allows any reduction of capital through a declaration of solvency. However, this is not popular with creditors or directors as it affords primacy to the shareholders. Alternatively, Armour suggests a conditional restrictions test, where a company can only make payments to shareholders when net assets exceed its capital accounts. This test is used in the US and encourages shareholders to consider expected impact of future liabilities. This may be preferable as the current test is based on accounting rules which are far from an optimal basis to decide how dividends should be paid out. This would also provide more long-term protection in comparison to solvency rules which are be based on solvency forecasts over short time periods.
To conclude, the minimum capital, financial assistance and capital maintenance rules provide insubstantial protection to creditors. Divergences between public and private companies are hence unjustified, and the rules should be changed or abolished in favour of a protection mechanism which practically protects creditors without imposing unnecessary costs on firms.
The writer, Simrhan Khetani, is a law graduate from the University of Cambridge and future trainee solicitor at Akin Gump LLP. She has a keen interest in Equity and Trust law and will be pursuing this interest in her work as a solicitor.
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