The Undue Delay In Bankruptcy Law Company Business Partnership Essay

Published Date: 02 Nov 2017

Submitted to: Laura Benett

Viraj C. Visaria

Introduction:

The concept of ‘capital' has a restricted and technical meaning within company law. A company's capital adds up to all of the cash or the value of assets received by a company from investors in return for the company's shares. This is an important source of finance for companies1. This legal capital or equity raised by a company cannot be repaid unless in some circumstances2. The quintessence of the legal capital policy is that capital paid by shareholders and certain other reserves should not be paid back to them except in securely controlled circumstances. The widely used routes for return of capital are in the form of dividends, purchase or redemption of company’s shares or restructuring of company’s capital structure or financial assistance by a company. An additional important source of financing for a company is debt or money contributed by the creditors. Capital Maintenance Rules were got in for two things:

Creditor Protection 2. Shareholder Protection

The legal capital regime aims at creating some sort of balance between the rights of the shareholders and the rights of the creditors, the regulation of this interplay of interests is critical to the success of a company. This article will stress ore on the capital maintenance rules in relation to creditor protection.

Capital maintenance through profit distribution has its advantages and disadvantages. A German scholar stated it to be a cultural accomplishment of present society3. Authors in scholarly traditional books on law and economics state it to be an incompetent regulation maintained by specific rent seeking interest groups4.

One of the first cases that highlighted the development of capital maintenance rules was Trevor v Whitworth5. Lord Herschell said the following: "If the claim under consideration can be supported, the result would seem to be this, that the whole of the shareholders, with the exception of those holding seven individual shares, might now be claiming payment of the sums paid upon their shares as against the creditors, who had a right to look to the moneys subscribed as the source out of which the company’s liabilities to them were to be met. And the stringent precautions to prevent the reduction of the capital of a limited company, without due notice and judicial sanction, would be idle if the company might purchase its own shares wholesale, and so effect the desired result...

I cannot think that the employment of the company’s money in the purchase of shares for any such purpose was legitimate."

What happened here was a zero sum game6; where a snake tries to swallow its own tail. To better understand the above situation what happened was that the company was trying to buy its own shares. In the balance sheet the share capital was on the liability side and the cash on the asset side. After this buyout the cash would be converted into investment in its own share capital at par value, thus it squares the assets as well as the liabilities side.

A company can make loss in its normal course of business for which the court cannot interfere, but in case where it spends its cash in buying back its own shares, the court will intervene7. In the case what happened was that the company had to pay the shareholder; when he appealed to the court that as the company had bought back a quarter of its shares. Now during liquidation he had a right to ask for the payment of those shares. He claim had now become like that of a creditor. Therefore now a company must not acquire its own shares. Such a purchase would return the seller of the shares the capital that has been paid up on the shares.8

The Act included two provisions of particular interest to the Lords. Firstly, there was a requirement that the company should specify its nominal capital9. Secondly, the Act provided for a comprehensive procedure for reducing ‘capital’ - the assets of the company10. The capital maintenance doctrine which the Lords recognised in Trevor v Whitworth was borne out of a concern for the position of creditors9 in the wake of the development of the concept of limited liability. As noted earlier in the wake of liquidation the creditor would be along the lines of the shareholder in demanding money back from the company. For the importance of creditor’s interest it was thus important to preserve the asset base as much as possible. The courts and thereafter the legislature recognised that capital reduction was inconsistent with the concept of limited liability11.

Another example for capital maintenance rule is providing loans to shareholders and directors for the acquisition of shares. CA 2006 allows the company to give money as loans to its directors under some approvals by shareholders. But if this money is used to buy more shares in the company or repay loans he/she had taken for acquiring shares then until and unless is a private company it can no longer provide the financial assistance12 (but it would have been allowed in the previous CA 1985). Although there is a scope when the company to refinance the loans for the directors in case of a management buyout. But it has to take care that it does not conflict with the interests and also that fiduciary duties of the directors are adhered to.

If the company provides loan to a shareholder then for private companies the shareholder could use that money to buy or subscribe to its own shares. In this however the main goal of recovering the money from the shareholder should not be forgotten. If the transaction has not been properly accounted for it can come under illegal return of capital under the act.

Other examples where the capital maintenance rule may apply are:

Refinancing of the borrowed capital

Intergroup charges and guarantees given in group to secure a loan13

Payment for underwriting commission and advisory fees in a group14

Assets transferred to shareholders for free and other gifts given

Asset transferred to shareholders for lesser amount than the market value

Repayment of debt before the due date in merger or acquisition

Share schemes and options for employees

Creditor Protection:

An important aspect of capital maintenance rule is creditor protection. Creditor protection rules create a barrier to retreat money from a company to creditor's disadvantage. They may also indicate how money should be put into a company, and pose minimum capital requirements. A certain amount of protection of creditor interests is adamant for their interest in supporting businesses, and ensures that their information on a company's situation remains reliable. However, many creditors still protect themselves the best by means of contract.15

The unrestricted transfer of liability from the corporate sphere to the liability-free sphere of shareholders redistributes assets to the detriment of creditors, which runs contrary to creditor protection and can be associated with an avoidable waste of assets known as efficiency losses16. As it is feasible that investment guiding principle harmful to the creditors will be pursued, or that the borrowing will be extended, it is in any case worth restraining the scope of externally financed as well as liquidation-financed dividend payouts. Furthermore, equivalent asset transfers prior to bankruptcy must not be permitted if the latter is caused largely by corporate policy. Evidently, a dividend payout cannot be authorized if it is definite that it will lead to insolvency. Alternatively, shareholders cannot be deprived of their dividend rights only for the reason that of an increased possibility of insolvency, since each dividend payout inevitably increases this risk17.

One point of view to look at the importance of these rules for creditor protection could be:

Creditors could be categorized into voluntary and ‘involuntary’ creditors. Banks and other secured or unsecured creditors who have voluntarily lent money to the company and other involuntary may include employees or suppliers who haven’t been paid or other legal claimants pending to receive their money from the company. The second group has very less bargaining power. For their benefit a certain minimum capital requirement rule would be beneficial.

Creditors could be safeguarded by the mandatory disclosure clause and the minimum nominal capital level. Some companies however choose a much higher level of capital for nominal level, than that given by law. This effect shows the signalling mechanism adopted by companies18. Other moral hazards which are avoided by the rule are19:

Cash in and run

Undue delay in bankruptcy

Gambling for resurrection

Enhancement of incumbent creditor’s risk by increased debt-raising

Conclusion:

The key changes in the CA2006 will help reduce time for various procedure time and cost of private companies. To conclude we get a positive review of the capital maintenance rule for creditor protection. But the rule may hamper the effectiveness of share holder protection in case of capital lying unutilized. Also the accounting rules for calculating the realised profits are getting more complex and difficult to come to the true figure; to find out whether a company can redistribute wealth back or no. When a company needs to apply to court for capital repayment to its shareholders a lot of management time and costs are incurred in doing so, considering the above fact importance should be given to make the law and guidance more simple.

FootNotes:

1 Law Teacher https://www.lawteacher.net/company-law/essays/the-concept-of-capital

2 Part V of the Companies Act 1985 (CA 1985) and, from the applicable dates of implementation, Parts 17, 18 and 23 of the Companies Act 2006 (CA 2006)

3 Wiedemann , Gesllschaftsrecht, Band 1, (1980) 566

4 Carney, The Political Economy of Competition for Corporate Charters, 26 J. Legal Sutdies 303 (1997)

5 Trevor v Whitworth (1887) 12 App Cas 409

6 http://moneyterms.co.uk/zero-sum-game/

7 in context to what Lord Watson mentioned in Trevor v Whitworth

8 CA2006 , S.658

9 Found at Section 8 Companies Act 1862.

10Magner E S ‘The Power of a Company to Purchase its own Shares: A Comparative Approach’ (1984) 2 C & SLJ 7

11 Companies and Securities Law Review Committee Discussion Paper No 5 June 1986 ‘A Company’s Purchase of its own Shares’

12 Steen v Law [1964] AC 987, acc to S 54 [CA 2006 s 678]

13 Anglo Petroleum Ltd v TFB (Mortgages) Ltd [2007] EWCA CIV 456, [2007] BCC 407 (Court of Appeal)

14 Chaston v SWPGroup Ltd [2002] EWCA CIV 1999, [2003] 1 BCLC 675

15 Trevor v Whitworth above at 416 per Lord Herschell

16 For a more thorough discussion on different creditor protection, see Merkt, 'Creditor Protection and Capital Maintenance from a German Perspective', (2004) 15 EBLR and Payne, Smith, 'Legal Capital and Creditor Protection in UK Private Companies', 5(5) ECL.

17 See Bernhard Pellens, Nils Crasselt & Thorsten Sellhorn, Solvenztest zur Ausschüttungsbemessung— Berücksichtigung unsicherer Zukunftserwartungen, 59 ZEITSCHRIFT FÜR BETRIEBSWIRTSCHAFTLICHE FORSCHUNG 264, 270 (2007).

18 Peterson/Hawker, Does Corporate Law Matter?, 31 Akron Law review, 175 (1997).

19 For detail look into ‘The Future of Creditor Protection through Capital Maintenance Rules in European Company Law - An Economic Perspective’ by Christoph Kuhner