Chapter 8: Capital and financing

Chapter learning objectives

Upon completion of this chapter you will be able to:

• examine the different meanings of capital
• illustrate the difference between various classes of shares
• explain the procedure for the variation of class rights
• define companies' borrowing powers
• explain the meaning of debenture
• distinguish loan capital from share capital
• explain the concept of a company charge and distinguish between fixed and floating charges
• describe the need and the procedure for registering company charges
• explain the doctrine of capital maintenance and capital reduction
• examine the effect of issuing shares at either a discount or a premium
• explain the rules governing the distribution of dividends in both private and public companies.

1 Share capital

Definition of a share

A share is 'the interest of a shareholder measured by a sum ofmoney, for the purpose of a liability in the first place, and ofinterest in the second, but also consisting of a series of mutualcovenants entered into by all the shareholders': Borland's Trustee v Steel Bros & Co Ltd (1901)

A shareholder is a member of the company and therefore has votingrights, depending on the class of shares held. They are also entitled todividends depending on the availability of profits.

In the event of liquidation, depending on the type of share, ashareholder receives payment after all other creditors, but canparticipate in surplus assets.

2 Types of shares

Test your understanding 1

Freeco is a public limited company. Geoffrey owns 11,000 6% $1preference shares in the company and his sister, Gertrude, owns 10,000$1 ordinary shares.

ADelete as appropriate and complete the sentence.

BExplain why Geoffrey's investment may be seen as less risky than Gertrude's.

3 Class rights

What are they?

Class rights are the special rights attached to each class of shares,such as dividend rights, distribution of capital on a winding up andvoting. (See above concerning the different rights that normally attachto ordinary shares and preference shares.)

How can they be varied?

The procedure for varying class rights depends on whether any procedure is specified in the articles:

Minority protection

Under S633 CA06, the holders of 15% of the nominal value of thatclass, who did not consent to the variation, may ask the court to cancelthe variation within 21 days of the passing of the resolution.

The court may confirm or cancel the variation. However, it willonly cancel the variation if the petitioner proves it is unfairlyprejudicial.

The court draws a distinction between:

• a variation that affects the value, enjoyment or power derived from the rights and
• a variation that changes the rights themselves.

The court will only intervene in the latter case.

Cumbrian Newspapers Group Ltd v Cumberland & Westmorland Herald (1986)

White v Bristol Aeroplane Co (1953)

Greenhalgh v Arderne Cinemas Ltd (1950)

4 Terminology

Test your understanding 2

A public company with a stock market listing has just sold a newissue of ten million $1 ordinary shares. All the shares were bought byexisting shareholders in the company.

Which one of the following conclusions can be inferred from this statement?

AThe company has undertaken a rights issue.

BThe company has raised exactly $10 million to finance the expansion of the business.

CAs a new issue, the shares could be sold only to personal shareholders and not to institutional shareholders.

DSince there were no new shareholders, the company's share capital was not extended.

5 Issuing shares

Allotment of shares

This is where the shares are allocated to a person under a contractof allotment. Once the shares are allotted and the holder is entered inthe register of members, they become a member of the company.

Authority

The directors need authority in order to allot shares. This may be given:

• by the articles, or
• by passing an ordinary resolution.

The authority must state:

• the maximum number of shares to be allotted
• the expiry date for the authority (maximum five years).

The directors of a private company with only one class of sharesmay allot shares of that class unless it is prohibited by the articles:S550 CA06.

Issue at discount

Every share has a nominal value which is fixed at the timeof incorporation of the company in the statement of capital and initialshareholding. The nominal value of the share represents the extent of ashareholders potential liability.

The common law rule is that a company cannot issue its shares for a consideration which is at a discount on their nominal value.

Ooregum Gold Mining Co of India v Roper (1892)

The common law rule is given statutory effect in S580 CA06. Inaddition S582 CA06 states that shares are only treated as paid up to theextent that the company has received money or money's worth.

If this rule is breached the issue is still valid, but the allotteemust pay up the discount plus interest. This applied to any subsequentholder of such a share who was aware of the original underpayment: S588CA06.

Issue at premium

Where a share is allotted at a value greater than its nominalvalue, the excess over the nominal value is share premium. This is wherethe market value of the share is greater than the fixed nominal value.

S610 CA06 requires any premium to be credited to a share premium account, which may only be used for:

• writing off the expenses of the issue of those shares
• writing off any commission paid on the issue of those shares
• issuing bonus shares.

Paying for shares – private companies

Private companies may issue shares for non-cash consideration. Thecourt will interfere with the valuation only if there is fraud or theconsideration is 'illusory, past or patently inadequate'.

Paying for shares – public companies

There are a number of additional rules relating to the issue of shares in public companies contained in CA06:

Test your understanding 3

What can the share premium account be used for?

6 Capital maintenance

Purpose

The capital of a limited company is regarded as a buffer fund forcreditors. (Note that the creditors' buffer is an accounting fund, notreal money. The actual cash or assets subscribed can be used by thecompany.)

The rules on maintenance of capital exist in order to prevent acompany reducing its capital by returning it to its members, whetherdirectly or indirectly. This means that, as a general rule, alimited company cannot reduce its share capital or purchase its ownshares. There are, however, an exception to this general rule and theseare which is discussed below.

Exception

Reduction of capital

Under S641 CA06, a company can reduce its capital at any time, for any reason.

Reduce or cancel liabilities on partly-paid shares, i.e. the company gives up any claim for money owing.

Return capital in excess of the company's needs, i.e. the company reduces its assets by repaying cash to its shareholders.

Cancel the paid-up capital that is no longer represented by the assets,i.e. if the company has a debit balance on reserves it can write thisoff by reducing capital and thereby does not need to make good pastlosses.

Procedure for public companies:

Simplified procedure for private companies:

Test your understanding 4

(1)A public company limited by shares may reduce capital by:

(2)Under S641 Companies Act 2006 a private limited company can reduce its issued share capital if certain conditions are fulfilled.

Which one of the following is not a necessary condition?

7 Treasury shares

Definition

These are created when a public company purchases its own sharesfrom distributable profits. The shares do not have to be cancelled. Upto 10% of the shares can be held 'in treasury' which means they can bere-issued without the usual formalities.

General Rule

Shares which are purchased by a company must be cancelled and theamount of the company's share capital account reduced by the nominalvalue of the cancelled shares.

Exception

Companies listed on the Stock Exchange or the Alternative Investment Market can buy, hold and resell their shares.

The shares must be qualifying shares which are shares listed on theLondon Stock Exchange or traded on the Alternative Investment Market.

The shares must be purchased from distributable profits and the company can cancel or sell them at any time.

Under S726 CA 2006, the shares will not give the company any votingrights in respect of those shares. In addition, no dividend or otherform of distribution can be made in respect of them.

S728 CA 2006, prescribes that when treasury shares are sold ortransferred for the purpose of an employee's share scheme, the companymust deliver a return to the Registrar not later than 28 days after theshares are disposed of.

Any consideration received on a sale of treasury shares is to be treated as profits for distribution purposes.

Under S729 CA 2006, in the event the shares are cancelled, therewill be a reduction in capital but there is no need for a specialresolution of the members or authorisation by the court.

S730 CA 2006 states that where treasury shares are cancelled, thecompany must deliver a return to the Registrar not later than 28 daysafter the shares are cancelled. The return must state with respect toshares of each class cancelled:

(a)the number and nominal value of the shares, and

(b)the date on which they were cancelled.

The notice must be accompanied by a statement of capital which muststate with respect to the company's share capital immediately followingthe cancellation:

(a)the total number of shares of the company,

(b)the aggregate nominal value of those shares,

(c)for each class of shares-

(i)  prescribed particulars of the rights attached to those shares

(ii) the total number of shares of that class, and

(iii)the aggregate nominal value of shares of that class

(d)the amount paid up and theamount (if any) unpaid on each share (whether on account of the nominalvalue of the share or by way or premium).

Treasury shares can also be created when a company initiallyissues shares to the public but keeps a portion in its treasury to besold at a later date.

8 Distributions

Introduction

A company can only make a distribution (e.g. pay a dividend) out ofprofits available for that purpose, i.e. distributable profits.

Distributable profits

Distributable profits are the accumulated realised profits (so faras not previously utilised by distribution or capitalisation) less theaccumulated realised losses (so far as not previously written off in areduction of capital): S830 CA06.

• Profit/loss – trading or capital.
• Accumulated – overall profit/loss, not just one year in isolation.
• Realised – not revaluation reserve. However, provisions (e.g. depreciation) are deemed realised.

Additional rules for a public company

A public limited company can only declare a dividend if both beforeand after distribution its net assets are not less than the aggregateof its called up share capital and undistributable reserves.

Undistributable reserves are:

• share premium account
• capital redemption reserve
• unrealised profits (i.e. revaluation reserve)
• reserves that the company is forbidden to distribute.

The latest audited accounts are used to make the calculations.

Model articles

Under the model articles, the directors recommend the payment of adividend and the company declares it by passing an ordinary resolution.The amount paid cannot exceed the amount recommended by the directors.

However, a shareholder is not entitled to a dividend as of right.

Test your understanding 5

A company had a balance on its profit and loss account reserve atthe beginning of its accounting year of losses of $3,000. During theyear the company made trading profits of $7,000 and revalued its fixedassets by $5,000.

What are the profits available for distribution?

Consequences of an unlawful dividend

If a dividend is not paid in accordance with the rules on distributions then the company can recover the distribution from:

• shareholders who knew or had reasonable grounds to know the dividend was unlawful
• any director unless he can show he exercised reasonable care in relying on properly prepared accounts
• the auditors if the dividend was paid in reliance on erroneous accounts.

However, if a director has to make good to the company an unlawfuldividend he may claim indemnity from the shareholders who when theyreceived the dividend knew it was an unlawful dividend.

9 Loan Capital

All companies have the implied power to borrow for the purpose of business.

Loan capital comprises all the longer term borrowing of a company such as:

• permanent overdrafts at the bank
• unsecured loans either from a bank or other party
• loans secured on assets either from a bank or other party.

Companies often issue long-term loans in the form of debentures.

A debenture is a document issued by a company containing anacknowledgment of its indebtedness whether charged on the company'sassets or not.

There are three main types of debentures:

• a single debenture e.g. a company obtains a secured loan or overdraft facility.
• debentures issued as a series and usually registered.
• debenture stock subscribed by a large number of lenders.

Advantages of debentures

• The board does not (usually) need the authority of a general meeting to issue debentures.
• As debentures carry no votes they do not dilute or affect the control of the company.
• Interest is chargeable against the profit before tax.
• Debentures may be cheaper to service than shares.
• There are no restrictions on issuing debentures at a discount or on redemption.

Disadvantages of debentures

• Interest must be paid out of pre-tax profits, irrespective of the profits of the company. If necessary must be paid out of capital.
• Default may precipitate liquidation and/or administration if the debentures are secured.
• High gearing will affect the share price.

Test your understanding 6

Edward and Frederick wish to invest in Fizz, a listed plc. Theyhave the choice of investing by buying shares or by subscribing to anissue of debentures.

A Fill in the gaps and complete the sentence.

B Fill in the gaps and delete as appropriate.

C Fill in the gaps and delete as appropriate.

10 Fixed versus floating charges

Fixed charge

A fixed charge is a legal or equitable mortgage on a specific asset(e.g. land), which prevents the company dealing with the asset withoutthe consent of the mortgagee.

A fixed charge has three main characteristics:

• It is on an identified asset.
• The asset is intended to be retained permanently in the business.
• The company has no general freedom to deal with (e.g. sell) the asset.

In certain circumstances a fixed charge can be set aside by aliquidator or an administrator if it can be shown that the companysought to put a creditor in a preferential position. This is covered inmore detail in Chapter 13 Section 4.

Floating charge

The judge in Re Yorkshire Woolcombers' Association (1903) stated that a floating charge has three main characteristics:

• It is on a class of assets, present and future.
• The assets within the class will change from time to time.
• The company has freedom to deal with the charged assets in the ordinary course of its business.

A floating charge cannot be created by an ordinary partnership.

Crystallisation

A floating charge does not attach to any particular asset until crystallisation.

Crystallisation means the company can no longer deal freely with the assets. It occurs in the following cases:

• liquidation
• the company ceases to carry on business
• any event specified (e.g. the company is unable to pay its debts; the company fails to look after its property; the company fails to keep stock levels sufficiently high).

Advantages of a floating charge

A floating charge has the following advantages for the company:

• The company can deal freely with the assets.
• A wider class of assets can be charged.

Disadvantages of a floating charge

A floating charge has a number of disadvantages for the chargee:

• The value of the security is uncertain until it crystallises.
• It has a lower priority than a fixed charge.
• A liquidator can ignore it if it was created within 12 months preceding a winding up. This is to prevent a company from giving preference to one of its unsecured creditors by giving a floating charge over its assets.

Test your understanding 7

(1)JIH Ltd has borrowed money from KBank plc and has provided security by executing a fixed chargedebenture in favour of the bank.

A fixed charge is:

(2)HIJ Ltd has borrowed money from KBank plc and has provided security by executing a floating chargedebenture in favour of the bank.

A floating charge is:

11 Priority and registration of charges

Priority

The priority of a charge depends on the type of charge and whether or not it has been registered:

• Equal charges – first created has priority.
• Fixed charge – has priority over a floating charge.
• An unregistered registerable charge has no priority over a registered charge.
• A chargeholder can prohibit the creation of a later charge with priority, but the prohibition is only effective if a subsequent chargee has notice of the prohibition as well as the charge.

Registration

The company must notify the registrar within 21 days of the creation of the charge.

Registration can be undertaken by:

• the company
• the chargeholder.

Failure to register:

• renders the charge void against the liquidator
• results in a fine on the company and every officer in default
• renders the money secured immediately repayable. If the charge relates to land it must also be registered with HM Revenue and Customs.

If the change relates to land it must also be registered with the Land Registry.

The company must also include the charge in its own register ofcharges. However, failure to include the charge in the company's ownregister does not invalidate the charge.

Test your understanding 8

(1)Which one of the following statements is correct?

(2)Which of the following is the correct period within which company charges must be registered with the registrar of companies?

12 Loan capital versus share capital

Loan capital versus share capital

Chapter summary

Test your understanding answers

Test your understanding 1

A are

B The dividend is fixed. Preferenceshares have priority when dividends are declared and on winding up.Dividends are cumulative and arrears of dividend will be paid whenprofits are available.

Test your understanding 2

Test your understanding 3

The share premium account may only be used for:

• writing off the expenses of the issue of those shares
• writing off any commission paid on the issue of those shares
• issuing bonus shares

Test your understanding 4

(1)B

(2)D

Test your understanding 5

The company can distribute up to $4,000.This represents the $7,000profit for the year, less the accumulated losses of $3,000. Theunrealised profit on the revaluation of fixed assets is excluded.

Test your understanding 6

A loan

B ordinary

Test your understanding 7

(1)A

(2)B

Test your understanding 8

(1)C

(2)C

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