Apart From Minor Technical Differences in Procedure

The application of the Companies Act 2006 (CA 2006) in regards to the reduction of share capital depends on the whether the company is a public or private company. In regards to s. 641 4(b)(ii) the main benefit is in relation to private limited companies, because the court procedure in regards to share capital reduction is no longer a necessity. This is a significant change, because it is turning the traditional common law stance set in Trevor v Whitworth [1] on its head. The rationale of the CA 2006 was to relax the rules for private limited companies in order to encourage investment in the business sector in England and Wales after a period of deregulation across Europe. As Armour [2] argues the pre-2006 regime was out-dated and overly restrictive on companies, because of a liberalising trend across the European Union. This rationale is supported by Dean [3] who identifies the system prior to the CA 2006 was expensive and directed at protecting the creditor. Therefore, prior-CA 2006 share capital regime meant in order “to reduce share capital, a company requires a court order and must also be authorised in its articles in order to adopt this procedure. The role of the court is to ensure that each creditor’s rights have been safeguarded”. [4]

The problem with this approach is that it is unduly restrictive on private limited companies that may only have £100 share capital and the only shareholders are the directors themselves. Therefore, the CA 2006 made some important changes in order to reflect the diversity of limited companies, which can be seen under section 641 of the CA 2006. However, the relaxation of the rules in part was also afforded to public companies, which can be seen in relation to section 690 of the CA 2006 where both private and public companies can enjoy the relaxation in relation to share buybacks. Therefore, when considering if the nature and purpose of s. 690 of the CA 2006 and s. 641 4(b)(ii) are similar there are two questions that need to be considered; 1) the role of the creditor; and 2) the nature of the company. The following essay is going to consider these two questions and then answer the title question.

The traditional approach:

The traditional approach to capital maintenance and the restrictions on companies reducing share capital can be seen in the case of Trevor v Whitworth [5] where Lord Watson held “[p]aid-up capital may be diminished or lost in the course of the company’s trading; that is a result which no legislation can prevent [6] ; but persons who deal with, and give credit to a limited company, naturally rely upon the fact that the company is trading with a certain amount of capital already paid, as well as upon the responsibility of its members for the capital remaining at call; and they are entitled to assume that no part of the capital which has been paid into the coffers of the company has been subsequently paid out, except in the legitimate course of its business”. [7] The implication of this case is that the restrictions of the traditional approach were focused on protecting creditors. One of the key concerns was the prevention of misdeeds by company facing insolvency from reducing its net assets below that of the company worth in order to benefit the shareholders. [8] Therefore, the development of the common-law capital maintenance regimes was developed to restrict actions that could threaten creditors. This was enshrined in the Companies Act 1985 (CA 1985) in sections 17-19 and 23 where share capital could only be reduced by the courts and share buybacks had to be authorised in the company’s Articles. [9]

However, in the 21st Century this regime has come under a lot of fire, because it reduced the competitiveness of business in the UK in an era where capital maintenance regimes were being relaxed across the EU. [10] However, as the case of Ridge Securities Ltd. v. IRC [11] held, under the judgement of Pennycuick J, that a “company can only lawfully deal with its assets in furtherance of its objects. The corporators may take assets out of the company by way of dividend or, with leave of the court, by way of reduction of capital, or in a winding up…. They cannot take assets out of the company by way of voluntary disposition… if they attempt to do so; the disposition is ultra vires the company” [12] . This approach was upheld in a number of cases [13] , which included Barclays Bank Plc. v. British & Commonwealth Holdings Plc [14] where the capital maintenance principles were reconfirmed. The Barclays Bank Case held that an “option agreement and in particular the covenants were said by B & C to constitute “financial assistance” for the purpose of either Caledonia’s or Tindalk’s acquisition of the preference shares”; therefore invalid as ultra vires. [15]

The rationale and purpose for CA 2006

However, with the relaxation of the capital maintenance regimes across the EC, the traditional creditor protection approach of the UK was out-dated and a new principle was developed for private companies. Sealy and Worthington [16] argue the CA 2006 was enacted because there needed to be a system that is based on responsible creditor protections. Therefore, a company’s “problem[s] [should] be settled by the business judgement and integrity of the directors” [17] . A similar principle can be reflective of the common sense approach in the cases of concerning shareholder protection; whereby Re Wragg [18] and Foss v Harbottle [19] held that the courts will not get involved unless there is dishonesty. This means that a company should have a right to manage their capital in any manner as long as it does not threaten the company’s solvency. [20] As Milman [21] argues there was a need to move “well away from the restrictive attitudes exemplified in Trevor v Whitworth (1887) 12 App. Cas. 409. Perhaps the most significant change implemented by the 2006 Act is the removal of the need for prior authorisation in the articles (s.690). Moreover, where a private company uses capital to fund the purchase (see ss.692 and 709-723), a declaration of solvency [s. 641] [22] rather than the more formalised statutory declaration will be deemed sufficient”. [23] Therefore, as Milman indicates the relaxation is mainly directed at private limited companies; however there is a benefit afforded to public companies in capital reduction areas, such as s. 690 that are less concerned with creditor protections.

The Nature and Purpose of s. 690 and S 641 (4)(b)(ii):

In the case of s. 690, which deals with share buybacks, there has never been the requirement to go to court. [24] However, this is because the protection in this area has been concerned with the company’s integrity and shareholder protection; therefore the reliance is on the Company Articles [25] . Prior to s. 690 the requirement was that the Articles authorised a share buyback scheme; however s. 690 has turned this requirement on its head. Therefore, the Article must prohibit a share buyback scheme; so a “company can buy its own shares subject to statute or restrictions in the Articles”. The development of this section was inevitable, because the courts were liberalising the approach for both public and private companies. This is confirmed in the case of Kinlan v. Crimmin [26] . This case held that a buyback scheme was valid even though it did not meet the requirement of a special resolution in the Articles. The court applied Re Duomatic Ltd [27] as the substance of the resolution was met, as there was a majority vote and the result would have been the same regardless.

In the case of s. 641 there is a marked difference, because as Milman [28] identifies the provisions are a restatement for public companies; however for private companies there has been a marked relaxation of the rules in order to make it easier for private companies to reduce their share capital. [29] The development of the solvency statement method under s. 641(1)(a), which enables the company to reduce share capital, as long as a special resolution has been passed. However, there remains a concern for creditors so the solvency statement method to allow creditors the potential to object [30] . This means that all creditors must be notified and have the power to block the reduction. [31] The failure to comply with these provisions can result in criminal action [32] . Criminal liability can also arise if the wrong accounting methods are used or after the reduction of the share capital the company’s solvency is threatened [33] . Therefore, by using the solvency statement method means that there is a greater liability owed, which is seen in s. 653, which enables those creditors omitted from the list to recover from the shareholders who benefitted up to the amount of the reduction. Therefore, although the system has been relaxed for private companies, public companies must use the court method. However, there is a strong rationale for this because an abuse of share capital could threaten the wider economy, which has been seen in the recent global financial crisis. This has meant stringent EU capital maintenance protections must be maintained for public companies. [34]

Conclusion:

Therefore, if one returns to the original questions asked in determining the answer to the nature and purpose of the s. 641 (4)(b)(ii) and s. 690 it can be identified that in regards to s. 690 that it does not matter what the company type is in this relaxation. This is because s. 690 is a protection that is more concerned with the company and shareholders; therefore the common sense approach of Re Wragg is applied. To contrast s. 641 (4)(b)(ii) indicates that relaxation is only to private companies, with the introduction of the solvency statement method. However, this method can attract criminal liability if not applied properly, because the centre of protection is the creditors; therefore there is a lower level of Trevor v Whitworth applied. The protections under s. 641 (4)(b)(ii) is even more marked in the case of public companies as Trevor v Whitworth remains the ruling principle. However, the rationale for this can be seen in the need to stabilise the economy, because due to the size and nature of pubic limited companies failure can impact the whole economy adversely. Also the creditor’s integrity may be threatened significantly if a large company fails and uses a relaxed share reduction method to protect the shareholders.

References:

• Armour, J (2006) Legal Capital: An Outdated Concept? CBR University of Cambridge, Working Paper 320
• Armour, J (2000) Capital Maintenance in ERSC working paper available at: http://webarchive.nationalarchives.gov.uk/tna/+/http://www.dti.gov.uk/cld/esrc6.pdf/
• Burton, A. ‘Dispensing with Formalities: The Duomatic Principle’ [2000] Company Lawyer 186.
• PL Davies (2008) Gower & Davies’ Principles of Modern Company Law 8th edn, Sweet & Maxwell, London
• Dean, R (2007) “The Companies Act 2006 and deregulation for private companies”, Strategic Direction 24(11)
• Digman, A and Lowry, J (2006) Company Law 4th Edition, Oxford University Press
• Ferren, E (1999) “Creditors interests and Core” Company Lawyer 314
• French, D (2009) Blackstone Statutes on Company Law 2009-2010, Oxford University Press
• McGrath, P (1995) “Law Report: Company’s Liability was for Breach of Covenant” The Independent 25th August 1995 http://www.independent.co.uk/news/people/law-report-companys-liability-was-for-breach-of-covenant-1597828.html Milman, D (2007) “Share Capital Maintenance: Current Developments and Future Horizons”, Co L N 2007 4 pg. 1-4
• Sealy, L and Worthington, S (2007) Cases and Materials in Company Law, Oxford University Press
• Rickford, J (2004) “Reforming Capital: Report of the Interdisciplinary Group on Capital Maintenance”, 15 European Business Law Review 919

Cases

• Trevor v Whitworth (1887) 12 App Cas 409
• Re Wragg [1897] 1 Ch 796
• Foss v Harbottle (1843) 2 Hare 461
• Kinlan v. Crimmin [2007] BCC 106
• Re Duomatic Ltd. [1969] 1 All ER 16;
• Ridge Securities Ltd. v. IRC [1964] 1 WLR 479 at 475
• Re Halt Garage (1964) Ltd. [1982] 3 All ER 1016
• Barclays Bank Plc. v. British & Commonwealth Holdings Plc. [1995] BCC 19
• MacPherson v. European Strategic Bureau [2000] 2 BCLC 683
• Aveling Barford Ltd. v. Perion Ltd. [1989] BCLC 626

2. Sprat Ltd. was formed in 2002 to run a small chain of jewellery shops and appeared to have financial problems from the very beginning. In 2004, Sprat borrows £500,000 from First Bank plc (FB) and the loan is secured by a floating charge over Sprat’s vehicles. All registration requirements for the floating charge are completed on time.

In October 2006, Nadine, a director of Sprat, lends £130,000 to Sprat without obtaining any form of security over Sprat’s property. On 2 December 2010, a creditor of Sprat delivers to the court a petition for compulsory winding up but the court does not issue it for service until 6 December 2010. A winding up order is granted on 15 June 2011.

State the legal position in each of the following situations

a) The sale of the vehicles is likely to raise a great deal less than £500,000. The unsecured creditors want a share of the proceeds and wonder if First Bank may also benefit from the ‘Prescribed Part’ rules. One unsecured creditor also wants to know if Revenue and Customs now have any right to rank above floating charge holders in the order distribution:

In the case of the rights of First Bank in regards to the “Prescribed Part” s. 176A(2) of the Insolvency Act 1986 (IA 1986) holds that the administrator shall “set aside the prescribed part for the satisfaction of unsecured debts; and not distribute that part of the floating charge unless it exceeds the amount required for the satisfaction of the “unsecured debts”. Therefore the prima facie facts of the case indicate as the value of the proceeds of sale is less than £5000, 000 it may be possible for FB to get some of the prescribed part. However, it depends on how much the prescribed part is and how much unsecured debt there is.

If the prescribed part is not more than the unsecured credit then the answer is no. However, it seems that the cases of Re Permacell Finesse (in liquidation) and Re Airbase have taken this further and held that “the prescribed part is unavailable to meet any shortfall under a creditor’s fixed charge. Therefore, secured creditors are not entitled to a share in the prescribed part”. [35] As these cases have clarified the position of the courts it can be identified that there is no remit for FB to access the prescribed part for the shortfall expected.

In relation to the question whether the HMRC are a priority creditor the answer is no. This is because the Amendment to the IA 1986 s. 36A by the Enterprise Act 2002 is that all cases whose petition is made after September 15th 2003 will no longer have priority status. This includes the HMRC. [36]

b) Nigel, a retired accountant, has been giving general guidance to the Sprat board since Sprat’s formation although Nigel has never been appointed as a director. The liquidator views Nigel as totally honest but somewhat foolish and Nigel is concerned that he could be made liable under ss.213-214 Insolvency Act 1986 for Sprat’s debts:

Sections 213 and 214 of the IA 1986 refer to fraudulent misrepresentations; therefore, the question that will be asked in the case of Nigel is whether he has been fraudulent. Section 213 holds that “any business of the company has been carried on with intent to defraud creditors of the company or of any other person, or for any fraudulent purpose… [and] any persons who were knowingly parties to the carrying on of the business in the manner above-mentioned are to be liable to make contributions (if any) to the company’s assets as the court thinks proper”.

This means that s. 214 reflects the occurrence of wrongful trading, but applies to directors and shadow directors only. Therefore, s. 214 would not apply in this case, as Nigel was only giving advice and gained no benefit. This means that it is s. 213 that the administrator must consider as it extend to any persons who were knowingly parties to the carrying on of the business. Therefore, it is important to identify if Nigel had intent to defraud. The primary case in this area is Contex Drouzhba [37] held that the primary concern is to determine is whether there is fraudulent or wrongful trading. The case identified that decisions needs to be made in line with the Tenterden’s Act 1828. However, as this act requires for Nigel to be purposely acting fraudulently in a way that affected the financial status of the company. This means that as Nigel was honest but foolish it is very unlikely that there is a possible action against him. This is because it must be shown that there must be a proof of fraud, as defined under the Tenterden’s Act 1828. As he was honest it would fail both under ss. 213 – 214 of the act and the case of Contex Drouzhba:

“Certainly, if the judge is right, it appears that there may be situations in which, by the signing of contracts by directors where those directors are guilty of fraudulent trading, creditors may have a direct remedy against the director in deceit, and a remedy that avoids the consequences of sections 213 and 214. Those consequences flow from the finding of an implied representation of the type found in this case (against which there is now no appeal), together with a finding that the contract satisfies the above section of Lord Tenterden’s Act.” [38]

This deceit cannot be applied to Nigel; therefore there would be no direct course of action against him as he was honest and foolish.

c) On 3 December 2010 Sprat sells a diamond ring to Mervin, another jeweller, for a trade sale price of £9,000 which is a true reflection of its trade sale value. The Sprat board are not aware of the presentation of the petition when the ring is sold to Mervin:

Under s. 227 of the IA 1986 this transaction is voidable, therefore it is up to the court to determine whether it should be upheld or not. Therefore it on the onus of Mervin to show that the Sprat Board was unaware of the petition; otherwise the ring (or value of the ring) can be reclaimed from Mervin. Although the petition was delivered on the 2nd December 2010 Sprat was unaware of it until the 6th December 2010. On this basis there is a strong chance that the courts will uphold the sale. This is because the case of Re Gray’s Inn Construction Co Ltd [39] that upheld the principles of Re Wiltshire Iron Co [40] . The case held that a sale that has been done in good faith during the ordinary course of the business where the parties are unaware of the petition should be validated. As the £9000 is the trade price for such sales are common then it would indicate that the sale would be upheld. There is no reason to think that the sale was on the basis of selling assets at a lower rate to reduce the value of the company; therefore it stands to reason that the sale is valid. [41]

d) In 2003, after a particularly bad month of trading, the board of directors sell a few valuable pieces of Sprat jewellery to their relatives for a nominal sum of £1 per item, thinking that creditors would soon be circling the company. Later, in February 2009, Sprat donates a very old necklace to the local museum in the hope of producing some good publicity for the Sprat brand. The liquidator is now investigating the validity of these disposals:

Transactions that are undervalued are dealt with s. 286 of the IA 1986. It holds that a transaction is under-value if; 1) the company makes a gift or otherwise enters into a transaction that receives no consideration; or 2) the company enters into a transaction that the value is significantly less than money’s worth [42] . If either of these two tests is satisfied then the administrator can gain an order for restoring the items to the position in the company. However, the transaction must be in the relevant time, which is within two years of the company being liquidated. [43] Therefore, in the case of the valuable pieces these are outside of the time period, even though they fall in to category 2 and there is no claim for them. In regards to the old necklace the question is whether there is consideration. The indication is that they did this act for publicity and therefore it was “free advertising” for the price of an old necklace; therefore there was a benefit derived which would mean that the necklace has no claim either.

e) In April 2009 Sprat grants a fixed charge in favour of Nadine to secure the £130,000 loan, hoping that she will then be willing to lend more money to Sprat in the future. The charge is duly registered with the Registrar of Companies but not in Sprat’s own charges register kept on its premises. The liquidator is looking for a way to challenge the validity of this charge:

As the charge, in this case, has been properly registered with the Registrar of Companies it is a valid charge. Therefore the necessary formalities have been maintained. [44] This would indicate that the company is bound by the charge; however the Brumark Case [45] it was held that a creditor could not claim a fixed charge over book debts if those funds were available during the normal course of trading. This case may have a significant implication for Nadine as a director, because it can be imputed that she had those funds available for the normal course of trading. This approach was upheld in National Westminster Bank plc v Spectrum Plus Limited [46] . It must be noted that the case of Harmony Care Homes Limited [47] identified in a limited set of circumstances that a fixed charge could be allowed when there was control over the proceedings. However, this case had a specific set of circumstances that are not applicable in this case [48] as it also held that the Brumark Case remained good law in a general scenario such as Nadine’s case.