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 in the company measured by a sum of money, for the purpose of a liability in the first place, and of interest in the second, but also consisting of a series of mutual covenants 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 voting rights, depending on the class of shares held. They are also entitled to dividends depending on the availability of profits.

In the event of liquidation, depending on the type of share, a shareholder receives payment after all other creditors, but can participate in surplus assets.

2 Types of shares

Test your understanding 1

Freeco is a public limited company. Geoffrey owns 11,000 6% £1 preference 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 and voting. (See above concerning the different rights that normally attach to 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 that class, who did not consent to the variation, may ask the court to cancel the variation within 21 days of the passing of the resolution.

The court may confirm or cancel the variation. However, it will only cancel the variation if the petitioner proves it is unfairly prejudicial.

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 new issue of ten million £1 ordinary shares. All the shares were bought by existing 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 contract of allotment. Once the shares are allotted and the holder is entered in the 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 shares may 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 time of incorporation of the company in the statement of capital and initial shareholding. The nominal value of the share represents the extent of a shareholders 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. In addition S582 CA06 states that shares are only treated as paid up to the extent that the company has received money or money's worth.

If this rule is breached the issue is still valid, but the allottee must pay up the discount plus interest. This applies to any subsequent holder of such a share who was aware of the original underpayment: S588 CA06.

Issue at premium

Where a share is allotted at a value greater than its nominal value, the excess over the nominal value is share premium. This is where the 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 new shares
• writing off any commission paid on the issue of new shares
• issuing bonus shares.

Paying for shares – private companies

Private companies may issue shares for non-cash consideration. The court will interfere with the valuation only if there is fraud or the consideration 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 share capital of a limited company is regarded as a buffer fund for creditors. (Note that the creditors' buffer is an accounting fund, not real money. The actual cash or assets subscribed can be used by the company.)

The rules on maintenance of capital exist in order to prevent a company reducing its capital by returning it to its members, whether directly or indirectly. This means that, as a general rule, a limited company cannot reduce its share capital. There is, however, an exception to this general rule 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 this off by reducing capital and thereby does not need to make good past losses.

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.

7 Treasury shares

Definition

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

General Rule

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

Exception

Under S724 CA 2006, 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 the London 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 voting rights in respect of those shares. In addition, no dividend or other form of distribution can be made in respect of them.

S728 CA 2006 prescribes that when treasury shares are sold or transferred for the purposes of an employees' share scheme, the company must deliver a return to the Registrar not later than 28 days after the shares 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, there will be a reduction in capital but there is no need for a special resolution of the members or authorisation by the court.

S730 CA 2006 states that where treasury shares are cancelled, the company must deliver a return to the Registrar not later than 28 days after the shares are cancelled. The return must state with respect to shares 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 must state with respect to the company's share capital immediately following the 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 the shares,

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

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

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

8 Distributions

Introduction

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

Distributable profits

Distributable profits are the accumulated realised profits (so far as not previously utilised by distribution or capitalisation) less the accumulated realised losses (so far as not previously written off in a reduction 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 before and after distribution its net assets are not less than the aggregate of 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 a dividend 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 at the beginning of its accounting year of losses of £3,000. During the year the company made trading profits of £7,000 and revalued its fixed assets 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 unlawful dividend he may claim indemnity from the shareholders who when they received 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.

Debentures

A debenture is a document issued by a company containing an acknowledgment of its indebtedness whether charged on the company's assets 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 to 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. They have the choice of investing by buying shares or by subscribing to an issue of debentures.

AFill in the gaps and complete the sentence.

BFill in the gaps and delete as appropriate.

CList three differences between debentures and shares.

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 without the 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 a liquidator or an administrator if it can be shown that the company sought to put a creditor in a preferential position. This is covered in more 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 a 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 in order of repayment than a fixed charge.
• It may be challenged by a liquidator 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 K Bank plc and has provided security by executing a fixed charge debenture in favour of the bank.

(2)HIJ Ltd has borrowed money from K Bank plc and has provided security by executing a floating charge debenture in favour of the bank.

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 also 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 the Land Registry.

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

Test your understanding 8

(1)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

13 Chapter summary

Test your understanding answers

Test your understanding 1

Aare

BThe dividend is fixed. Preference shares have priority when dividends are declared and on winding up. Dividends are cumulative and arrears of dividend will be paid when profits are available.

Test your understanding 2

AA sale of a new issue of shares to the existing shareholders is a rights issue.

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 £7,000 profit for the year, less the accumulated losses of £3,000. The unrealised profit on the revaluation of fixed assets is excluded.

Test your understanding 6

Aloan

Bordinary

C

Test your understanding 7

(1)A

(2)B

Test your understanding 8

(1)C

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