In English company law, capital maintenance rules require the share capital of a company to be preserved. These rules stem from a cardinal principle of law which that is that the share capital of a company limited by shares belongs to the company and not its shareholders. This provides protection to the company's creditors as the share capital should prevent any unpaid debts. In practice, and in spite of this principle, companies tend to utilise capital reduction as a means to achieve certain objectives such as mergers and acquisitions or the payment of dividends to its shareholders. However, capital maintenance rules still affect capital reduction and its requirements
1. Why reduce your share capital?
Capital reduction can be used as a tool to achieve various company objectives:
- Paying dividends: The most common objective is the payment of dividends. Capital reduction allows the elimination of accumulated losses, which would otherwise prevent the payment of dividends, to create distributable reserves. Indeed, since a company may only pay dividends out of profits available for that purpose, accumulated losses may have a negative effect on a company's retained profit and loss reserves and may prevent the payment of dividends to shareholders. Clearing these losses with a capital reduction may be the appropriate route if the value of the company's assets has fallen, if an acquisition has proved unsuccessful or if the company has experienced a prolonged period of trading losses.
- Returning surplus capital: A company may have capital which is surplus to its requirements for the foreseeable future and which it may therefore wish to return to its shareholders. This would usually follow the issue of a number of shares to fund a transaction, which never came to fruition. Return of surplus capital can be used to release a liability to pay-up unpaid share capital or repay paid-up share capital to shareholders. Note that this will not amount to a distribution of dividends.
- Redeeming shares: A company may wish to redeem its shares but it cannot do so if it has insufficient distributable reserves. Subject to certain exceptions, English company law stipulates that shares may only be redeemed out of the company's distributable profits or out of the proceeds of a fresh issue of shares. If a company has accumulated losses or insufficient distributable reserves to redeem the shares and if it does not want to make a fresh issue of new shares, it can opt for a capital reduction. The shares would then be cancelled in consideration for the payment in cash of an amount equal to the redemption monies.
- Distributing non-cash assets: A company may also use a capital reduction to transfer non-cash assets that it owns to its shareholders, although this is relatively unusual. In this case, shares can be cancelled or their nominal value reduced. The assets would be distributed to shareholders in return. Provided that appropriate safeguards are in place to protect the creditors, the value of the assets being distributed may exceed the amount by which the share capital is reduced.
- Structuring mergers and acquisitions as part of a scheme of arrangement: Capital reductions have become a popular method of structuring mergers and acquisitions or group restructurings. A scheme of arrangement is a process that must be approved at a meeting of shareholders of the target company and sanctioned by the court as it involves reducing the company's capital to zero. Under this scheme the shares in the target company are cancelled and reissued (or alternatively transferred) to the bidding company in exchange for consideration (cash, securities) for shareholders of the target company. If the shares in the target company were to be cancelled and reissued (rather than transferred), this would be achieved by reducing the target's share capital. The reserve created by the cancellation would then be capitalised and applied in paid up shares issued to the bidder. Note that in the case of a takeover, such a scheme is only permitted where the target company is inserted in the bidding group and all the shareholders become members of the target company (Companies Act 2006 (Amendment of Part 17) Regulations 2015).
- Demergers: Capital reduction can be used to split one company's activities into different companies, called a demerger. Demergers are often used with the help of a scheme of arrangement.
If you wish to return surplus capital or to release a liability to pay up capital, the underlying trading profitability of your company or of the group's core business may in fact be strong, but you may be prevented from paying dividends because your profit and loss account has been brought into deficit by a holding in a loss-making subsidiary.
2. Alternatives to reduction
Alternative methods of achieving a company's objectives should always be considered as they may be more cost effective at the outset and quicker to implement.
The court's powers to confirm a share capital reduction are discretionary and it may help an application for confirmation of a reduction of capital to show that the reduction is the only, or best, way of achieving the company's objectives.
There are a number of alternative ways in which a company might achieve a similar effect to a reduction of capital. These include adopting a scheme of arrangement for the transfer of shares, rather than cancellation and reissue, or creating a new holding company. It is not the purpose of this note to go through these options in detail.
3. Methods of share capital reduction
There are three available options to reduce the company's share capital. You may decide to opt for one of these methods or to combine them, depending on your company's particular circumstances:
a. Where a company has issued partly paid shares, it may reduce, or cancel entirely, the liability of its members to pay the balance due in respect of those shares (section 641(4)(a) Companies Act 2016).
b. A company may reduce, or cancel entirely, its paid-up share capital (including for this purpose its share premium account) and repay that capital to its shareholders (section 641(4)(b)(ii)).
c. A company may reduce, or cancel entirely, its paid-up share capital (again including share premium account) but, instead of repaying that capital to shareholders, apply it for some other purpose (section 641(4)(b)(i)).
From an accounting point of view, the reduction of capital will happen as follows:
- To the extent that the surplus capital comprises the share premium account, this can be achieved by reducing the share premium account by the appropriate amount (section 610(4)).
- Where the amount of capital to be returned is greater than the amount in credit in the share premium account, the nominal value of each share can be reduced and the difference between the original nominal value and the reduced nominal value of each issued share paid to shareholders (section 641(4)(b)(ii)). Provided that enough share capital remains to meet the minimum requirements, shares can be cancelled entirely and shareholders can be repaid the whole amount which they originally subscribed (section 617).
- Releasing a liability to pay up capital. Similarly, a company that has issued partly paid shares may decide that it has no use for some or all of the further unpaid capital and that the liability to pay those further amounts should be reduced or extinguished.
The company needs to be able to demonstrate to the court that, in the opinion of the directors, the loss of assets is permanent (and as a result the reduction will not adversely affect creditors who have already been adversely affected by the event which has resulted in the permanent loss). The reduction is then merely a restructuring of the balance sheet so that it reflects the reality of the company's financial and trading position. Evidence of the reasons for and details of the depletion in assets is not always essential but since the court's confirmation of a reduction of capital is discretionary, it is usually desirable to provide it.
A company will need to consider the following issues as part of the reduction process:
- Class rights: In addition to obtaining shareholder approval for a proposed reduction in share capital, a company with separate classes of shares must ensure that the proposed reduction is in accordance with the rights attaching to each class. A reduction which is inconsistent with the capital rights attaching to a class of shares will amount to a variation of the rights attaching to that class. It would therefore be necessary for, say, preference shareholders with a priority right to repayment of capital to be asked to give their consent to a repayment of ordinary share capital or reduction of unpaid ordinary share capital.
- Written consents: The terms of any debenture, warrant, loan stock and bank facilities should be checked in case consents are required to a reduction of capital.
4. General requirements
The Companies Act 2006 sets out the requirements applicable to capital reduction. It should be noted that some companies may still be subject to the old act (Companies Act 1985) and therefore a different set of requirements in relation to capital reduction.
A private limited liability company will be entitled to utilise the power to reduce its capital (under section 641 of the Companies Act 2006) unless it is prohibited from doing so, or its rights to do so are restricted, by its Articles of Association.
A private limited liability company is entitled to reduce its share capital by special resolution supported by a solvency statement (section 641(1)(a)). This procedure (sections 642 to 644) is only available if there is at least one member holding a non-redeemable share following the reduction. Companies which do not meet this requirement, private companies that are not limited by shares and public companies are required to follow the court approval route.
5. The solvency statement route
Private limited liability companies can reduce their capital by shareholder approval (special resolution) supported by a solvency statement of the directors (section 641(1)(a)). However, this procedure (sections 642 to 644) will only be possible if there is at least one member holding a non-redeemable share following the reduction.
The solvency statement is a statement that each of the directors;
- has formed the opinion, as regards the company's situation at the date of the statement, that there is no ground on which the company could then be found to be unable to pay (or otherwise discharge) its debts; and
- has formed the opinion:
a. If it is intended to commence the winding up of the company within 12 months of the date of the statement, that the company will be able to pay (or otherwise discharge) its debts in full within 12 months of the commencement of the winding up; or
b. in any other case, that the company will be able to pay (or otherwise discharge) its debts as they fall due during the year immediately after the date of the statement (section 643(1)).
The solvency statement will need to be made available to the shareholders before the resolution is passed and it must be made 15 days before the resolution is passed (section 642(1)(a)).
Under sections 641(1)(b) of the Companies Act 2006, the reduction of capital must be approved by a special resolution of the shareholders in general meeting or by written resolution (section 288).
In the case of a general meeting, the solvency statement should be circulated and available throughout the meeting. In the case of a written resolution, the statement should be sent either before or at the time the resolution is circulated. The resolution must be passed within 15 days of the statement being made.
The resolution (prepared by the board of directors) must normally specify the exact amount of the proposed reduction. It will be necessary to explain to shareholders the background to and reasons for the reduction. This is generally done by way of a circular to shareholders (compulsory for companies subject to the listing rules).
The special resolution will need to be filed with Companies House within 15 days of it being passed.
6. The court approval route
The court approval route remains compulsory for public limited liability companies or private liability companies if there is not at least one member holding a non-redeemable share following the reduction.
Once the shareholders have approved the capital reduction, their special resolution has to be approved by the Companies Court.
6.1 The application process
The company must apply for approval of the special resolution of its shareholders with the Companies Court. This is done by submitting a Part 8 claim form.
The first step before submitting such a claim form is to agree a timetable with the Companies Court. There are three key dates in the court timetable:
- the date of issue of the claim form applying for confirmation of reduction;
- the date of the directions hearing in the Registrar of the Companies Court; and
- the date of the hearing of the petition.
The claim form sets out the capital structure of the company (including any alterations since incorporation), relevant provisions of its articles of association, its financial position and details of the reduction approved by the shareholders. A draft statement of capital should be attached.
The claim form must be supported by written evidence, in the form of a witness statement usually sworn by the company's chairperson, the purpose of which is to verify and expand on the contents of the petition. Typically, the written evidence will deal with the confirmation of the manner in which the resolution was passed; an explanation of the background to and purpose of the reduction and an explanation of the manner in which it is proposed to safeguard the interests of the company's creditors.
Where a circular has been sent to shareholders in relation to the proposed reduction, the company must show that all persons entitled to receive notice of the meeting did receive notice in accordance with the company's articles of association. If a company has a small number of members and a director or the company secretary has direct knowledge of the method of service, for example, having personally served the members, written evidence from that person will be sufficient. However, where the company has a substantial number of shareholders, it will be necessary to produce written evidence from the company's registrars and the printers involved in the distribution of the notice.
Upon submission of the claim form the company must also issue an application setting out various directions to be sought from the court at the directions hearing.
The Registrar of the Companies Court hears the claim in open court. It is unusual for an application to be opposed but if an opposition is formed, the Registrar will adjourn the matter to be heard by a judge. If the Registrar considers that the opposition has little or no substance, he will hear the argument at that time.
6.2 The Court's directions hearing
At the directions hearing the court considers two main issues: whether the appropriate approvals and consents have been obtained and the position of creditors. If it is satisfied that the claim should proceed, the court will list it for final hearing and give various directions. These may include a dispensation with the settlement of the list of creditors and/or directions for the advertisement of the hearing.
If the court is satisfied that the claim should proceed, it will list the petition for final hearing and give various directions.
6.3 List of creditors
Where the reduction involves the reduction or extinguishing of a liability on unpaid shares, or a repayment of capital to shareholders, there is a specific requirement for the court to ascertain the name of every creditor and the amount of their claims (section 646(3)). The term creditor is therefore given a wide meaning and includes not only actual creditors but also contingent and prospective creditors.
The court has discretion to make an exception with regards to the list of creditors and, in practice, most reductions of capital avoid this time consuming and burdensome procedure by adopting one or more of the following accepted protections for creditors:
- Obtaining written consent from creditors. The court will dispense with the settlement of a list of creditors if the company can show that all of its creditors have given their consent to a proposed reduction. The consent must set out the name of the creditor and the nature and amount of its debt.
- Having sufficient liquid assets. If the company can show that it has sufficient liquid assets to cover the aggregate of any amount of capital proposed to be repaid to members and the total sum due to creditors plus a margin of at least 10% the court will dispense with the settlement of a list of creditors.
- Setting aside an escrow account. The company can set aside a cash sum equal to the value of its non-consenting creditors in a blocked bank account which the company undertakes to the court will be used solely for discharging those creditors. The company's undertaking should create a trust preventing such account being treated as an asset of the company on any subsequent winding up.
- Bank guarantee. The amount of the guarantee must be the lesser of the amount of the reduction and the aggregate amount of the value of the debt owed to the non-consenting creditors. The guarantee must be from a UK clearing bank or a foreign bank with a substantial presence within the UK. The bank guarantee will not usually be in place for more than 12 months. If the company has long term creditors, a two-tier guarantee can be established where the value of the guarantee diminishes upon the expiry of the period during which the short-term creditors are anticipated to be discharged.
- Providing an undertaking. The company can provide an undertaking to the court that either:
a. the company will not make any repayment of capital until such time as all creditors have either been paid off or consented to the reduction; or
b. the company, insofar as it has distributable reserves, will finance the repayment from distributable reserves (to the extent that it has distributable reserves) and will create a reserve similar to a capital redemption reserve. The reserve will fall away when all the creditors have consented or been paid off.
6.4 The Court's final hearing
Under section 648 of the Companies Act 2006, a court confirming the reduction of share capital is a discretionary remedy. Confirmation may be refused if, amongst other things:
- The interests of creditors are not adequately protected;
- if the necessary formalities have not been complied with;
- if the reasons for and implications of the proposed reduction have not been fully described to shareholders; or
- if the reduction of share capital which was solely tax driven.
The court will not confirm a proposed reduction of capital unless it is satisfied that the interests of the company's creditors are not adversely affected by the proposal, which may depend upon the type of reduction of capital.
In the case of a reduction of capital that does involves a repayment of capital to shareholders or a reduction of liability in respect of unpaid capital (usually where the reduction is to eliminate accumulated losses), the court has discretion to allow creditors to object. Creditors must then show that there is a real likelihood that the proposed reduction would result in the company being unable to discharge its debt.
The court will give confirmation of the reduction on such terms and conditions as it thinks fit (section 648(1)).
6.5 Registration of the court order
Provided the company has satisfied all jurisdictional and procedural requirements, the Registrar will confirm the reduction. The order of the court will provide for publication of the reduction. The reduction becomes effective upon registration of the order with the Registrar of Companies as follows:
- The Court order must be registered with the Registrar of the Companies as soon as the Court office has stamped them, along with a statement of capital on form SH19 (which must be approved by the court).
- The reduction will only take effect upon the registration with the Registrar of Companies.
- Once registered the reduction is a matter of public knowledge.
- The court may also order that a notice of the court order and statement of capital must be published.
7. Documents and information required
7.1 Company documents
The following documents may be required:
- Minutes from the board meeting detailing: the board of directors' proposal of the shareholders' resolution of reduction of share capital.
- Report from board of directors: The Board of Directors proposes the shareholders' resolution of reduction of share capital. The report includes the reasons for the reduction and other main aspects such as how the reduction will affect the company.
- Report from Auditors: The Auditors give their opinion of the reduction in terms of how it will affect the company's financial position.
- Insolvency statement by the directors to be made 15 days before the special resolution of the shareholders is passed.
- Circular to shareholders (included with the notice if general meeting): The circular must be accurate at the time of despatch as well as at the time of the meeting and provide an adequate explanation of the background to and reasons for the reduction.
- Notice of the general meeting to the auditors and shareholders (if necessary) to be circulated at least 14 days before the general meeting (section 307).
- Proxy forms (if necessary).
- Minutes of the general meeting or written resolution: The reduction of capital must be approved by a special resolution of the company's shareholders in a general meeting. The resolution must specify the exact amount of the proposed reduction.
7.2 Documents to be filed with the Companies' Court (if necessary)
With the court approval route, it is common practice for the claim and related documents to be prepared in advance and in anticipation of the special resolution being passed at the general meeting, so that the following documents can be filed with the court either the same day or the following day:
- Claim form setting out:
a. Date of incorporation of the company;
b. name and previous names of the company;
c. registered office;
d. the capital structure of the company;
e. its main objects (if relevant);
f. relevant provisions of its articles of association;
g. its financial position;
h. confirmation that it is not prohibited from reducing its share capital;
i. details of the reduction approved by the shareholders; and
j. brief statement of the purpose of the reduction.
- Written evidence taking the form of a witness statement sworn by the Chairman. The following matters must be included in the written evidence:
a. Verification of the matters set out in the claim form;
b. confirmation of the manner in which the resolution was passed;
c. a detailed explanation of the background to and purpose of the reduction;
d. an explanation of the manner in which it is proposed to safeguard the interests of the company's creditors; and
e. an exhibit of the company's certificate of incorporation, a certified copy of the special resolution or minutes of the meeting at which it was passed, and the company's financial statements.
- Evidence of notice of the general meeting: Where a circular has been sent to the shareholders the company must show the court that all persons entitled to receive notice of the meeting did receive such notice. This is done by written evidence from the company's registrars and the printers involved in the distribution (see 6.1 above).
- Application for directions: the company must issue an application setting out various directions to be sought from the court at the directions hearing.
- Consent from landlord: the position of long-term or contingent creditors must be considered, such as the landlord of leasehold premises guaranteed by the company. It is much more straightforward if consents to the reduction can be obtained from such creditors as the bank guarantee is often limited to one year.
7.3 Documents to be filed with Companies House
Within 15 days of the shareholders' resolution to reduce capital being passed, the company must file the following at Companies House:
- The special resolution to reduce capital (sections 29 and 30). There may be other, related filing requirements, for example, if a special resolution adopting new articles has been passed to remove an article prohibiting reductions of capital, such resolution and a copy of the newly adopted articles must also be filed.
- A copy of the signed solvency statement (section 644(1)(a)).
- A statement of capital (section 644(1)(b)) using Form SH19 which meets the content requirements of section 644(2). A fee applies to the filing of a Form SH19 (£10, or £50 for same day service).
- A statement of compliance by the directors confirming that the solvency statement was made not more than 15 days before the date on which the resolution was passed and was provided to members in accordance with either sections 642(2) or 642(3) (section 644(5)). All directors must sign this statement.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.