Comparing the legal mechanisms of redemption of shares, repurchase of shares, and reduction of capital by special resolution, which mechanism is the most effective one in the United Kingdom regime of capital maintenance, and why?
Essay 2019 18 Pages
Table of Contents
2. General Prohibition of Acquiring Own Shares
3. Redemption of Shares
4. Repurchase of Shares
5. Reduction of Capital by Special Resolution
6. Effectiveness of the Mechanisms
6.4Evaluation of the Most Effective Mechanism
One of the advantages that encourage entrepreneurs to incorporate is limited liability. In a company limited by shares1, the liability of the members is limited to the nominal value2of the subscribed shares3, and once the shares are paid up4, the members are not subject to any further liability with respect to the debts of the company.5Thus, the claims of the company’s creditors are confined to the assets of the company.6It must therefore be ensured that the members contribute and maintain sufficient assets in the company in order to safeguard the satisfaction of the creditors’ claims.7The value of these assets, which the company receives from investors in exchange for the subscribed shares, is the “legal capital”.8
On the other hand, a company that opts for equity funding by issuing shares9instead of debt funding must also protect the interests of its shareholders.10If no shareholders can be attracted to provide sufficient capital, creditors are reluctant to do business with the company. In return for the risk associated with the provision of capital, shareholders expect a capital contribution.
Hence, in the lifecycle of a company there are situations in which the company may wish to return assets to its members.11The most common option is the distribution of capital by way of a dividend.12However, the company is not entirely free in this respect as the diminution of the company’s assets would undermine creditor protection.13Thus, the Companies Act 2006 provides for capital distribution rules which limit the amount a company can distribute to its members.14Furthermore, the company may also consider to redeem or repurchase shares.15This may be the case, for example, if the company wants to return unneeded equity capital to its members because it can finance its investments out of generated profits, or it wants to replace equity financing with debt financing.16In addition, the management may want to buy out a reluctant group of shareholders, or give shareholders the opportunity to exit the company. By contrast, a company may reduce the amounts stated in the capital accounts either to reflect a diminution of the asset value or when the equity capital is over the company’s needs.17The Companies Act 2006 provides specific procedures for each of these mechanisms to ensure that the interests of creditors and shareholders concerned are adequately protected and that the capital distribution rules cannot simply be circumvented.
In this essay, I will compare the legal mechanisms of redemption of shares, repurchase of shares and reduction of capital by special resolution. First of all, I will discuss the general prohibition of acquiring own shares. The following chapters then deal with the individual mechanisms and highlight the extent to which they effectively serve the principle of capital maintenance. When analysing which mechanism is the most effective one, the focus is on creditor protection, since this is ultimately the primary objective of capital maintenance. However, when considering effectiveness, the interests of shareholders as well as the practicability must also be taken into account.
2. General Prohibition of Acquiring Own Shares
In 1988, the House of Lords held inTrevor v Whitworththat a company is not permitted to acquire its own shares as this would constitute a capital reduction.18Lord Watson said that creditors dealing with a limited company ‘naturally rely upon the fact that the company is trading with a certain amount of capital paid, as well as upon the responsibility of its members for the capital remaining at call’.19Two conclusions can be drawn from this. First, the main reason for the prohibition on buying own shares was creditor protection. Second, the members must ensure an effective capital maintenance in the company.
The Companies Act 2006 confirms this common law rule, but allows for statutory exceptions.20In particular, the Act legitimates two variants of share buy-backs, namely redemption and repurchase of shares, which are discussed below. This was made possible by the fact that creditor protection is guaranteed by various regulations and procedures.21However, any acquisitions of shares by way of redemption or repurchase, which are not in compliance with the procedures laid down in the Act, are void.22
3. Redemption of Shares
A company may issue shares which will be redeemed at a specific point in time by the company or may be redeemed at the option either of the company or the shareholder.23
Terms and Conditions
Certain rights and obligations are associated with the redemption of shares. Thus, redeemable shares could be designed to compel a shareholder to sell his shares or a company to buy them back.24
Basically, the terms of the redemption must be stated in the company’s articles.25However, the directors may instead determine the terms if they are authorised to do so either by the articles or by ordinary26resolution.27In this case, they must do so before the shares are allotted, and the company’s statement of capital must include the terms.28
Requirements and Restrictions
A private company has by default the power to issue redeemable shares unless it is excluded or restricted in its articles.29By contrast, a public company may not issue redeemable shares by default unless it is authorised to do so in its articles.30Thus, as far as the latter is concerned, the power to issue redeemable shares must either be agreed by all subscribers to the memorandum during the formation of the company or be introduced in the articles later on by special resolution of the members.31
A company cannot issue redeemable shares unless it has also issued shares that are not redeemable.32This is to ensure that the company will not be without members if all shares are redeemed.33Furthermore, redeemable shares may not be redeemed unless they are fully paid.34However, the terms of the redeemable shares may provide that the amount payable on redemption may be paid on a later date than the redemption date.35
Basically, redeemable shares may only be redeemed out of distributable profits or the proceeds of a fresh issue of shares made for the purpose of the redemption.36However, the Companies Act 2006 provides for a relaxation to private companies according to which redeemable shares may be redeemed out of capital, subject to any restriction or prohibition in its articles.37Out of capital means payments otherwise than out of distributable profits or the proceeds of a fresh issue of shares made for the purpose of the redemption.38The payments in this respect are limited to the "permissible capital payment". In a nutshell, the company must first use the distributable profits and any proceeds of fresh issue of shares made for the purposes of the redemption before a payment out of capital can be made.39In addition, a payment out of capital may only be made if the following requirements are met.40First, the company’s directors must make a statement that they have formed the opinion that the company will be able to continue to carry on business as a going concern as well as to pay its debts as they fall due throughout the year, taking into account the contingent and prospect liabilities of the company.41The director’s statement must be accompanied by an auditor’s report which states that the permissible capital payment amount has been properly determined, and that there is no evidence that the opinion expressed in the directors’ statement is unreasonable.42Second, the payment must be approved by a special43resolution passed within one week of the director’s statement.44The resolution is ineffective either when a member holding shares to which the resolution relates votes on the resolution, and this vote is necessary to pass the resolution, or a copy of the director’s statement and auditor’s report has not been made available to the members.45Furthermore, any member who has not voted for the resolution as well as any creditor of the company may apply to the court for the cancellation of the resolution.46Finally, the company must publish the proposed payment in the Gazette and make available the director’s statement and auditor’s report for inspection.47
Treatment of Shares
Once the shares are redeemed, they are treated as cancelled and the amount of the issued share capital is diminished accordingly by the nominal value of the redeemed shares.48However, the company must transfer amounts to an undistributable “capital redemption reserve” depending on whether the shares are redeemed wholly out of the company’s profits or wholly or partly out of the proceeds of a fresh issue.49Insofar as the former applies, the amount to be transferred corresponds to the amount by which the issued share capital of the company is diminished.50In the latter case, the difference between the aggregate amount of the proceeds and the aggregate nominal value of the shares redeemed must be transferred.51If a private company redeems shares out of capital, it does not have to transfer a corresponding amount to the capital redemption reserve unless the permissible capital payment is less than the nominal amount of the redeemed shares, and distributable profits or the proceeds of a fresh issue have been partly used to fund the redemption.52
4. Repurchase of Shares
A company may purchase its own shares, including redeemable shares, under certain conditions.53
Terms and Conditions
The company and the shareholders are free to agree when and under what terms a repurchase of shares takes place, and there is no need to determine this in advance.54Neither is the company obliged to make an offer to repurchase shares nor is the shareholder obliged to accept an offer made by the company.55
Requirements and Restrictions
A company, whether private or public, has default powers to purchase its own shares subject to any restriction or prohibition in its articles.56
A repurchase is not possible when, as a result, there would no longer be any issued shares other than redeemable shares or treasury shares.57Furthermore, the company may not purchase its own shares unless they are fully paid, and the shares must be paid for on purchase.58
1Wherever reference is made solely to a “company”, it shall be a “company limited by shares” or a “limited company having a share capital” within the meaning of the Companies Act 2006 (CA 2006), ss 1, 2, 3(1),(2) and 545 for the purpose of this essay. Unless a distinction is made, the explanations apply to both private and public companies pursuant to CA 2006, s 4.
2CA 2006, s 542.
3CA 2006, ss 540 and 546(2).
4CA 2006, s 583(2).
5CA 2006, s 3(2); Insolvency Act 1986, s 74(2)(d).
6Paul L Davies and Sarah Worthington,Gower’s Principles of Modern Company Law(10th edn, Sweet & Maxwell 2016) para 8-1.
7John Armour, ‘Share Capital and Creditor Protection: Efficient Rules for a Modern Company Law?’ (2000) 63 The Modern Law Review 355, 365; Federico Clementelli, ‘(Under)valuing the Rules on Capital Maintenance’  International Company and Commercial Law Review 191; Davies and Worthington (n 6) para 11-1.
8Davies and Worthington (n 6) para 11-1.
9CA 2006, s 548.
10Sarah Worthington,Sealy and Worthington’s Text, Cases, and Materials in Company Law(11th edn, Oxford University Press 2016) 508.
11CA 2006, s 829(1).
12Ellis Ferran and Look Chan Ho,Principles of Corporate Finance Law(2nd edn, Oxford University Press 2014) 159.
13Re Exchange Company, Flitcroft’s Case 21 Ch D 519 (CA) 533–534; Armour (n 7) 367–368; David Kershaw, ‘Involuntary Creditors and the Case for Accounting-Based Distribution Regulation’  Journal of Business Law 140, 144; Clementelli (n 7) 192; Worthington (n 10) 533.
14CA 2006, ss 829–831; Kershaw (n 13) 143; Davies and Worthington (n 6) paras 11-1, 12-11–12-14.
15CA 2006, s 829(2)(c).
16Ferran and Ho (n 12) 178–183; Davies and Worthington (n 6) para 13-7.
17CA 2006, s 829 (2)(b); Ferran and Ho (n 12) 165–166; Davies and Worthington (n 6) para 13-32.
18 12 App Cas 409 (HL).
20CA 2006, ss 658(1) and 659; see also Davies and Worthington (n 6) paras 13-5–13-6.
21Ferran and Ho (n 12) 183–184.
22CA 2006, s 658(2)(b).
23CA 2006, s 684(1).
24Davies and Worthington (n 6) para 13-7.
25CA 2006, s 685(4).
26CA 2006, s 282.
27CA 2006, s 685(1),(2).
28CA 2006, s 685(3).
29CA 2006, s 684(2).
30CA 2006, s 684(3).
31Davies and Worthington (n 6) para 13-9.
32CA 2006, s 684(4).
33Davies and Worthington (n 6) para 13-9.
34CA 2006, s 686(1).
35CA 2006, s 686(2).
36CA 2006, s 687(2).
37CA 2006, s 687(1).
38CA 2006, s 709(1),(2).
39CA 2006, ss 710–712; Ferran and Ho (n 12) 194–195; Davies and Worthington (n 6) para 13-13.
40CA 2006, s 713(1).
41CA 2006, s 714(1)–(4).
42CA 2006, s 714(6).
43CA 2006, s 283.
44CA 2006, s 716(1),(2).
45CA 2006, ss 716(3), 717 and 718.
46CA 2006, s 721.
47CA 2006, ss 719 and 720.
48CA 2006, s 688.
49CA 2006, s 733(1); Ferran and Ho (n 12) 192; Davies and Worthington (n 6) para 13-11.
50CA 2006, s 733(2)(a).
51CA 2006, s 733(3).
52CA 2006, s 734(2),(4); Davies and Worthington (n 6) para 13-17.
53CA 2006, s 690(1)(a).
54Davies and Worthington (n 6) para 13-7.
56CA 2006, s 690(1)(b).
57CA 2006, s 690(2).
58CA 2006, s 691(1),(2).
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- University of Edinburgh – Edinburgh Law School
- Company Law Companies Act 2006 Capital Maintenance Redemption of Shares Repurchase of Shares Capital Reduction United Kingdom UK Company Corporation Corporate Law Legal Capital Shareholder Member Equity Funding Issue Shares Capital Share Capital Contribution Distribution Dividend Redeem Repurchase Capital Account Aquiring Aquire Own Shares Trevor v Whitworth Aquisition Redeemable Articles Resolution Statement Account Financing Distributable Profits Permissible Capital Payment Auditor Report Capital Redemption Reserve Treasury Shares Off-market Market Purchase Diminution of Liability Solvency Statement Practicability Protection Creditor Buy-Back Distributable Undistributable Objection Court