One of the most publicised aspects of the new Companies Act has been the abolition of the prohibition on financial assistance contained in Section 151 of the Companies Act 85.
Sections 151 to 153 and 155 to 158 of the 85 Act were repealed on 1 October 2008 in relation to private companies. The repeal applies in relation to financial assistance given on or after 1 October 2008 even if the shares in question were acquired and the relevant liability incurred prior to 1 October 2008. Chapter 2 of Part 18 of the 2006 Act contains the provisions regarding financial assistance, which are contained in Section 677 to 683 of the Act, which will be brought into force in October 2009.
Although financial assistance in its most common forms will no longer be prohibited for private companies, there are still situations in which the validity of transactions and the way they are structured under more general rules of law, requires review.
Outlined below are issues of legality to be looked at in the context of transactions, and then some examples of common situations and how these provisions may apply.
A. RULES AFFECTING THE LEGALITY OF TRANSACTIONS
1. Public companies
The repeal of the prohibition is only in respect of financial assistance for the acquisition of shares in private companies. Sections 151 to 153 continue to apply to public companies. It is still illegal for any company, public or private, to give financial assistance where the shares being acquired are those of a public company. The test is whether the company is public at the time the assistance is given so a public company can be turned private after acquisition and then be provided with financial assistance after the acquisition.
It is also prohibited for a public company to give financial assistance for the acquisition of shares in a private company.
Reregistration of a company may impact on timing, as the application for reregistration must be followed by a 28-day period for any member to object. Although it is the registrars practice to issue the certificate earlier if the company can show all the members agreed to the change, this is a discretion (which will become part of the law when the equivalent provisions of the 2006 Act come into force in October 2009).
2. Illegal reduction of capital
The use by a company of company funds to fund the acquisition of its own shares is an illegal reduction of capital at common law. Companies do not have the power to deal with all of their assets in any way they choose. A company may only reduce its capital in ways permitted by the statutes.
The abolition of the financial assistance prohibition, which embodied in statute one of the ways that capital may not be reduced, does not, in the Government's view, revive the pre-existing prohibition on financial assistance. Private companies can give financial assistance to which the prohibition in section 151 applies. This is because the statutory provision in the 85 Act replaced the common law rule and once statute has provided for the matter, the repeal of those statutory provisions does not, in accordance with section 16(1)(a) of the Interpretation Act 1978, revive that case law. There is no need to test whether the financial assistance was capable of whitewash.
However, if the transaction was illegal for another reason then it remains so. Therefore a transaction which amounts to a reduction of capital is still illegal unless it is within one of the permitted ways of reducing capital. These are: -
- Reduction of capital by way of a court scheme
- The new reduction of capital by way of a solvency statement for private companies
- Purchase of own shares out of capital or distributable profits, in accordance with the statutes
- A redemption of shares out of distributable reserves
- A cancellation of a liability to pay up partly paid shares by way of a properly sanctioned scheme
3. Unlawful Dividends
A company may only pay a dividend if it has sufficient distributable reserves. An unlawful dividend is an illegal transaction regardless of any financial assistance considerations. However it is often the case that transactions which contain transfers of value (often property transfers) between companies and their shareholders (which may be other companies within a group) will raise issues of whether they amount to a dividend being paid to the shareholder and, if so, whether there are sufficient distributable reserves to cover this. This can be a particularly difficult question when the dividend is not made in cash. The provisions regarding dividends are contained in sections 829 – 853 of the 2006 Act, which came into force in April 2008.
The major change made by the 2006 Act relates to the treatment of distributions in kind. The Act confirms that, where the transferring company has positive distributable reserves, the amount of any distribution arising from the sale, transfer or other disposition by a company of a non-cash asset to a shareholder should be calculated by reference to the asset's book value. Where a company makes a transfer of an asset at book value where the market value is higher than book value, this is a distribution. Provided the company has distributable reserves (of any amount), the value of the distribution is deemed to be zero and the distribution is lawful. If the asset is transferred for less than its book value, the amount of the distribution is equal to the difference between its book value and the actual consideration given for it, and must be covered by the company's distributable profits.
4. Breach of Fiduciary Duty
A transaction by directors that is in breach of their fiduciary duties is not illegal, however such a breach may result in them being personally liable. The inclusion in the 2006 Act of a statutory statement of duties will focus directors' minds on those matters to consider when approving a transaction. The new procedure for making derivative claims may make it easier for shareholders to pursue directors when companies fail to do so, if they have made decisions which breach their fiduciary duties. Additionally, directors need to remember to consider these duties on a company by company basis and not on a group wide basis when considering the interests of individual companies.
(a) Group charges and cross guarantees to secure a loan for the acquisition of a company
Where all the companies are private companies, including the company whose shares were acquired, this is no longer prohibited financial assistance. There is generally no reduction in net assets of any of the companies that might give rise to dividend or maintenance of capital issues.
(b) Refinancing of borrowings
If the borrowings were incurred for an acquisition then it is necessary to check there are no public companies in the group, as financial assistance given after the acquisition is still prohibited for public companies. Such financial assistance would include the granting of security and the giving of a guarantee. Otherwise, if all the companies are private companies then the giving of security will benefit from the repeal of the financial assistance prohibition.
Refinancing of non-acquisition related indebtedness should not be relevant for financial assistance consideration.
(c) Arrangements for the return of capital to shareholders
Companies looking at ways of returning funds to shareholders they will generally be considering a statutory format of a purchase or redemption of shares, which was not and is not (for public companies) financial assistance.
Such arrangements generally utilise the company's distributable reserves, but may, in the case of private companies, be out of capital. Any return that exceeds the amount of distributable reserves must be either a court-sanctioned scheme, reduction under the new solvency statement route or a private company purchase out of capital. There is no other route to achieve the return that would not amount to an illegal reduction of capital at common law.
Any arrangements should be carefully scrutinised if they involve the payment of company funds to shareholders in excess of distributable reserves, without using one of the statutory procedures - particularly if the difficulty with using the reduction of capital or purchase out of capital procedure is related to the making of the solvency statement.
(d) Payment of underwriting commission and advisers fees on an issue of shares
We have been asked before to advise whether this amounts to financial assistance. The view was generally held that, the payment of commission being permitted by statute, was not prohibited financial assistance. The payment of fees was considered a grey area. However now this will not be financial assistance where the payment is by a private company. For public companies the repeal of the prohibition does not assist and the payment of fees will still be a grey area as regards financial assistance.
(e) Loans to shareholders and directors for the acquisition of shares.
A company can lend money to its directors in accordance with the provision of the 2006 Act, which permit this subject to the need in some cases for shareholder approval. If the loan is for the purpose of the director subscribing or buying more shares in the company, or repaying indebtedness he incurred for the purpose of acquiring shares then provided that the company is a private company this is no longer prohibited as financial assistance (as it would have been previously). The scope seems to exist for the company to refinance the loans incurred by directors as part of a management buyout. However, the board will need to take care as to the issues of conflicts of interest and also adhering to their fiduciary duties
If the loan is to a shareholder then if this is for the purchase or subscription of shares then, again, for private companies this should no longer be prohibited financial assistance. However the board must be careful that 'loan' is the genuine nature of the transaction and that it is not a payment that there is little or no chance of recovering, or which they know will not be recovered. In such a situation the payment of the money to the shareholder is actually a return of capital or dividend and not a loan, no matter what terminology is used to categorise the transaction. Where it is not genuinely a loan when the transaction is analysed then there may be a risk of an illegal return of capital. A company with sufficient distributable reserves could make a distribution to the shareholder (subject to the class rights of all shareholders) .
(f) Transfer of assets for no consideration and gifts to shareholders
A gift to a shareholder by a private company in connection with the acquisition of shares will no longer be prohibited financial assistance, even although for a company with no net assets such a transaction would not have been capable of a whitewash. However if he company has no or insufficient distributable reserves to cover the gift, this will still be an illegal reduction of capital at common law. This is because the company cannot return funds to shareholders other than in ways permitted by law.
A gift would also be something that the directors should carefully consider in terms of their promoting the success of the business. Any transfer of value to a shareholder for no consideration is a transaction that should be carefully considered.
(g) Transfer of assets to a shareholder at less than market value
In connection with an acquisition of shares, often as part of a reorganisation, assets may be transferred around a group and this may be done at the book value rather than market value. Such a transaction was previously one which it was difficult to ensure was not financial assistance by virtue of the element of reduced value. Such a transaction by a private company or in respect of an arrangement for the transfer of shares in a private company will no longer raise issues of financial assistance. If the company transferring or the shares acquired are those of a public company then financial assistance issues still arise.
The structure gave rise to a second issue as to whether, to the extent the consideration was less than market value, the transaction was a dividend and therefore the company making the transfer required distributable reserves to cover it. The 2006 Act has clarified the position on this. Such a transfer is a dividend so the company making the transfer must have distributable reserves. However, provided the company has distributable reserves (of any amount) the amount of the distribution is deemed to be zero. If the transfer is at less than book value, then the amount of the distribution is the amount by which the consideration is less than book value and this must be covered by distributable reserves.
If the company has no distributable reserves than the transaction may amount to an illegal distribution and needs to be looked at carefully.
(h) Early repayment of debt in connection with an acquisition
It is not uncommon to find that as part of an acquisition a company will make arrangements for early repayment of indebtedness. Such an arrangement by a company has previously raised question of whether this amounts to financial assistance, particularly if it is replaced by debt on less favourable terms. For private companies, and in connection with the acquisition of shares in a private company, these arrangements are no longer subject to the financial assistance prohibition. The issue will be only one for the proper exercise of directors' fiduciary duties.
(i) Employee share schemes and options
There was an exception in the financial assistance prohibition in respect of arrangements for an employee share scheme. To benefit from the exemption, the scheme had to fall within the statutory definition of an employee share scheme, which generally required that it be open to all employees. With other arrangements for employee participation that did not come within the statutory exemption the question of financial assistance arose.
However, with the abolition of financial assistance for private companies there will be no financial assistance problems for employee schemes that do not meet the statutory definition for private companies. Schemes for acquiring public company shares will still need to look to the financial assistance exemption for employee share schemes.
Where companies grant option over their shares then previously they could not make arrangements to financially assist the option holder with the acquisition of the shares ( unless they were a bank lending them the money in the ordinary course of their business). It would appear that now it may be possible for companies to lend their executives the money to exercise options.
Whereas such arrangements may now be possible from a financial assistance point of view it would need to comply with any rules on loans to, or transactions with directors, and more importantly extreme care would need to be taken on the tax consequences of such arrangements where they are made with employees.
Watch out for arrangements involving: -
- Public companies
- Companies with no net assets or distributable reserves
- Gifts or loans to shareholders
- Intra group transfers of assets below market value
- Companies agreeing to take steps which it is difficult to justify as being likely to promote the success of the company
In such circumstances check to ensure the transaction is not prohibited by statute and in all cases directors should be considering whether the action is in breach of their statutory duties.
Catherine Feechan is a partner at Biggart Baillie LLP who specialises in Corporate Finance.
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.