From 1 October 2008, the prohibition of financial assistance by a private company for the purchase of shares in itself or its holding company has been abolished.
The prohibition of financial assistance by a public company (or by its private company subsidiary) for the purchase of shares in the public company remains.
Now the restriction has been lifted for private companies, it is likely that transactions will become simpler, and directors will no longer have to worry about the possibility of committing a criminal offence if a private company gives financial assistance.
However, private company directors will still need to give consideration to:
- whether the transaction is for the company's benefit;
- their directors duties (which are now codified in the Act);
and
- the solvency of the company
before they allow a company to give security. This includes security that constitutes financial assistance which will typically constitute a guarantee supported by a charge.
Whilst the "whitewash" procedure previously required might have been seen as unduly onerous in some circumstances, it did provide a checklist for directors and banks to follow to ensure that any security granted to the bank would be valid and enforceable. Under the new regime banks need to be certain that the security is given for the company's benefit and that the company is solvent after the giving of security that constitutes financial assistance to ensure that it is valid.
Corporate Benefit
Section 172 of the Companies Act 2006 provides that a director "must act in a way he considers, in good faith, would be most likely to promote the success of the company for the benefit of its members as a whole". In doing so regard (amongst other matters) must be given to:-
- the likely consequences of any decision in the long term;
- the interests of the company's employees;
- the need to foster the company's business relationships
with suppliers, customers and others;
- the impact of the company's operations on the community and
the environment;
- the desirability of the company maintaining a reputation for
high standards of business conduct; and
- the need to act fairly as between members of the company.
Case law provides that when considering whether to enter into a transaction, (eg giving security) the directors must act in a way they believe to be in the best interests of the company and for the benefit of the company and not just in the best interests of and for the benefit of the group as a whole (Rolled Steel Products (Holdings) Ltd v British Steel Corporation).
If corporate benefit cannot be clearly established then the directors will be in breach of their duties and the company may not have the capacity to enter into the transaction. If the recipient of the security is on actual or constructive notice of this breach, the security itself will be unenforceable.
It is established practice for the directors to record in the board minutes the reasons why they believe granting the security is in the best interests of the company and for the benefit of the company.
In addition, if there is any doubt as to whether granting the security is for the benefit of the company, the members of the company should be asked to pass a special resolution, directing that the security be given. It is prudent to require that the special resolution should be passed unanimously by members of the Company in general meeting. A written resolution signed by all the members of the Company would also be sufficient.
Section 239 of the Act deals with ratification of acts of directors and provides that the director in question, or a person connected with them cannot vote on the resolution to ratify their own actions.
Section 239 only specifies that an ordinary resolution needs to be passed to ratify the acts of the directors, however, by passing a unanimous special resolution, the concern regarding corporate benefit should be dealt with on the basis that the shareholders have sanctioned any breach of the directors duties and determined that the company has capacity to enter into the transaction. This greatly limits the scope for an individual member to come back and challenge the action at a later date.
Solvency of the Company
In addition to corporate benefit, the directors of the company and the bank being granted security should require comfort that the company is solvent and will remain solvent immediately after the security is given.
The dangers for the bank, if the company is not solvent immediately after the security is given are:
- the security may be treated as amounting to a preference under
section 239 of the Insolvency Act 1986; and
- the security may be treated as being a transaction at an
undervalue under section 238 of the Insolvency Act 1986.
Preferences
For the security to amount to a preference, the company must:
- put the recipient of the security in a better position in a
subsequent insolvency than the position in which the recipient
would otherwise have been; and
- the company must be influenced by a desire to better the
recipient's position.
Security that amounts to a preference will be voidable if within six months of granting the security (or two years if the recipient is a person connected with the company, other than by being an employee) the company becomes insolvent.
Transactions at an undervalue
Security would be a transaction at an undervalue if the company received no consideration or such consideration was considerably less than the value of the security. In such a case, the security could be set aside if the company became insolvent within two years of granting the security.
However if it can be shown that the security was given in good faith for the purpose of carrying on its business and at the time it did so there were reasonable grounds for believing that the transaction would benefit the company giving the security then the Court will not make an order to set the transaction aside.
Conclusion
It is therefore necessary for the board minutes to record both the corporate benefit and the Directors' belief that the company is solvent following the giving of the security. Where the solvency of the Company may be in doubt, it would be prudent to ask for the auditors to confirm the solvency of the company.
Whilst the abolition of the prohibition of financial assistance in private companies is welcomed, as it will rid us of an unnecessary procedure in some cases, there are still risks for the unwary.
It would, therefore, be wise for banks to formulate a policy on the procedures that they require to be satisfied to establish the solvency of the borrower to minimise the risk of the security being invalidly given or being subsequently set aside.
This may give rise to an informal practice which is similar to the "whitewash" procedure and which some have dubbed "son of whitewash". We can only wait to see how market practice develops.
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.
