B052286

COMPANY LAW

Critically assess the rules on capital maintenance, and their effectiveness in

protecting shareholders and creditors.

EXAM NUMBER: B052286

WORD COUNT: 6,031

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Introduction

What is Capital Maintenance?

Capital maintenance is a fundamental principle of UK company law. Before we seek

to establish what capital maintenance entails, a brief note must be made about the
concept of legal capital. Generally, legal capital can be described as the value a
company receives for the shares they have initially issued 1. Legal capital can be said
to have to two contrasting functions, which are well described by Fernando Dias
Simoes. In relation to shareholders, he concludes that legal capital is the root of
each shareholders rights.2 With regards to creditors, he concludes that legal
capital deliver[s] a cushion which helps to assure that creditors will get paid even if
the company experiences significant losses. 3 These functions of legal capital can
be seen to form the basis of the policy reasons behind the doctrine of capital
maintenance.

Capital maintenance revolves around the concept of legal capital. In simple terms, it
aims to ensure that the legal capital of the company is preserved in the hands of the
company4. This entails that it shall refrain from distributing this value to its members,
either directly or indirectly, except in circumstances prescribed by law 5.

Capital maintenance rules are found in the Companies Act 2006 (the 2006 Act).
The UK rules on capital maintenance have been influenced by the EU Second
Company Law Directive6. This paper shall first highlight the policy reasons behind
1 Davies, Paul L., and Sarah Worthington. Gower and Davies' Principles of Modern
Company Law. 2012, at p. 272.

2 Simoes, Fernando Miguel Dias. "Legal Capital Rules in Europe: Is There Still Room for
Creditor Protection?" I.C.C.L.R 24(4) (2013), pp 166-72, at p. 166.

3 Ibid.

4 Sealy, L, & Worthington, S. Sealy's Cases and Materials in Company Law. 9th ed. Oxford
UP, 2009, at p. 478.

5 Ibid.

6 Directive 77/91 [1993] OJ L31/01.

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capital maintenance, as this will help us establish the effectiveness of the protection
the doctrine offers to creditors and shareholders. The rules governing the doctrine of
capital maintenance will then be analysed under the following headings:

1. the provisions for minimum capital requirements;

2. the general prohibition on the acquisition of a companys own shares and the
exceptions to the prohibition. When analysing the exceptions, the discussion
will only focus on redemptions7 and repurchases8;
3. the rules on reduction of capital9; and
4. prohibitions and exceptions of a company providing financial assistance for
the purchase of its own shares10.

These rules will be discussed with the view of analysing their effectiveness in
protecting shareholders and creditors.

Policy Reasons Behind Capital Maintenance

To undertake a critical analysis of the effectiveness of the protectionist measures

offered by the rules pertaining to capital maintenance, we must first understand the
policy reasons behind the doctrine.

The main policy reasons behind capital maintenance can be encompassed as being
that of protecting creditors and shareholders of a company. Accordingly, we can
highlight some of the reasons behind the urge to protect creditors and shareholders.

The reasons of capital maintenance date back to the 1800s, where courts found it
illegal for a company to make any distribution which would result in the assets of the
company being lower than the companys nominal paid up capital 11. In justifying
this illegality, Lord Jessel gave the following reasons:

7 ibid, Part 18, Chapter 3, ss. 684- 689 & Chapter 5, ss 709- 723.

8 Ibid, Part 18, Chapter 4, ss, 690- 708 & Chapter 5, ss 709- 723.

9 Companies Act 2006, Part 17, Chapter 10, ss 641- 657.

10 Ibid, Part 18, Chapter 2, ss, 677- 683.

11 See, Exchange Banking Company (Fitcrofts Case), Re. (1882) L.R. 21 Ch. D. 519 CA.

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capital shall be applied for the purposes of the business, and on faith of
that statement people dealing with the company give it credit. The creditor,
therefore, I may say gives credit to that capital, gives credit to the company
on the faith that the representation that the capital shall not only be applied for
the purpose of the business, and he has, therefore a right to say that the
corporation shall keep its capital and not return it to the shareholders, though
it may be a right which he cannot enforce otherwise than by a winding up
order.12

Therefore, the reasoning of the court suggests that any rights a creditor has against
a company, in the event a company defaults on its debts for example, will be limited
to the assets of the company. If any remedy available to creditors hinges on the
availability of assets, then there is need for rules to ensure that there is maintenance
of capital of the company. When a company is solvent and carrying on business as
usual, a creditor has no form of remedy against the instance where members or
directors of a company who take actions to reduce the net asset value of the
company. Due to the unavailability of a direct remedy, creditors need to be protected
from such opportunistic actions of either the directors or the shareholders.

Any distribution of assets of the company to its members will reduce the cushion of
assets available to satisfy creditor needs. If shareholders receive assets of a
company before creditors, then the normal system of ranking of priorities upon
insolvency is distorted13. Normally, the claims of creditors rank in priority to those of
shareholders.

There can be discrimination between different classes of shareholders in the event of

distribution of assets of the company. For example, the majority of the shareholders
dispense with the interests of any other classes of members and selfishly take into
account their own interests14.

12 Ibid, at pp. 533- 534.

13 Rickford, J. Reforming Capital: Report of the Interdisciplinary Group on Capital

Maintenance. [2004] EBLR 920, at p. 923.

14 This was contended in the case of Re Holders Investment Trust [1971] 1 WLR 583.

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Having established the main policy reason behind the doctrine and the reasons
behind that policy, we can now analyse the rules implemented by the legislature and
assess their effectiveness in protecting creditors and shareholders.

Minimum Capital Requirement

The minimum capital rule requires a company to have minimum capital before it
commences. UK company law prescribes a minimum capital requirement for public
companies only15. A public company must have a minimum capital of 50,000 16.

It can be noted here that the minimum capital requirement offers insignificant if not
no protection at all to shareholders. Therefore, I shall not indulge in any discussion of
the effectiveness of the rule in protecting shareholders. Turning to the effectiveness
of the rule in relation to creditor protection, it can be noted from the very beginning
that the protection offered to creditors is limited. This is because creditors of private
companies do no benefit from this protectionist measure, which dilutes the
effectiveness of the rule.

As for creditors of public companies, the 50,000 minimum capital requirement 17 will
be a buffer which can be said to perform the role of a security in favour of the
creditors for doing business with the company. This reasoning can be supported by
the fact that the claims of a creditor are limited to the assets of the company. It would
seem that the protectionist measure is, prima facie efficient in protecting creditors.
However, this is not the case. To a great extent it can be claimed that the minimum
capital requirement rule is not efficient in protecting creditors.

It can be claimed, see the rule as being artificial. Legal capital that is pumped into
the company upon its formation can be used up instantly after incorporation. If this is
the case, then the minimum capital requirement cannot be a reliable indicator about
the assets of a company in the long run for creditors. In addition, in practice creditors
generally do not bother with the legal capital or the minimum capital requirements

15 Companies Act 2006, Part 20, Chapter 2, ss 761- 763.

16 Ibid, s. 763 (1) (a).

17 Ibid.

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when seeking to engage in business with a company18. Instead a creditor would look
at more reliable indicators like the profit and loss accounts or the cash flow
statement of a company, which would give a more predictable result on whether their
debts would be settled. Creditors would also carry out credit checks of the company
they wish to do business with, which provides an accurate and up- to- date report
about the companys ability to meet its debts. Commercial practice would also seem
to be going against the reasoning of Lord Jessels in the case mentioned above 19,
who claims creditors rely on such information. This illuminates the inefficiency of the
rule in protecting creditors.

The rule does in no way guarantee that the needs of a creditor will be settled 20. It
simply demonstrates the amount of money the members pumped in upon the
founding of a company. If this guarantee is not provided by the rule, then it can be
concluded that the rule fails to achieve its purpose of being a safety net against
which they can carry on business with the company and would thus be ineffective in
protecting creditors.

It can also be argued that the 50,000 minimum capital requirement is an inadequate
amount to protect all the creditors of a company. Given the fact that it is a
requirement for public companies, it can be assumed that the business they engage
in would be rather big in terms of value and engage with several creditors. Bearing
this in mind, 50,000 would look like a drop in the ocean. Consequently, the rule
provides insufficient protection for creditors.

Following the above discussion, it can be easily concluded that the minimum capital
requirement rules that fall under the capital maintenance doctrine are inefficient
protectionist measures.

Acquisition of a Companys Own Shares

18 S, D, Fernando. "Legal Capital Rules in Europe: Is There Still Room for Creditor
Protection?" I.C.C.L.R 24(4) (2013), pp 166-72, at p. 167.

19 (1882) L.R. 21 Ch. D. 519 CA.

20., D, Fernando. "Legal Capital Rules in Europe: Is There Still Room for Creditor
Protection?" I.C.C.L.R 24(4) (2013), pp 166-72, at p. 167

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The general rule

As a general rule, it is illegal for a company to purchase its own shares 21. This rule
has been in operation since the nineteenth century, as seen in the case of Trevor v
Whitworth22. In this case, the articles of the company authorised the purchase of its
own shares, however, the House of Lords found that despite this express power, it is
illegal for a limited company to purchase its own shares. The reasoning the court
gave behind this prohibition was that it is aimed to protect creditors unusual risks that
could cause a diminution in the paid up capital of the company 23. The court stated
that:

[creditors] rely upon the fact that the company is trading with a certain
amount of capital already paid up, 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 course of its business. 24

If this is the rationale behind the rule against purchase of own shares, then it would
be difficult to see how it would efficiently protect a creditor. This is because generally
creditors in todays commercial world do not rely on the information provided by the
legal capital of a company, the justification for which has been mentioned above.

A purchase of own shares normally leads to the cancellation of those shares 25. There
are some instances where the shares are not cancelled. In the event that the shares
are cancelled, the share capital account of the company must reflect the cancellation
of the shares and accordingly there is a deduction in the value of the share capital 26.

21 Companies Act 2006, Part 18, Chapter 1, s. 658 (1).

22 (1887) 12 App Cas 409.

23(1887) 12 App Cas 409. See the judgement of Lord Watson, mainly at p. 423.

24 Ibid, at pp. 423- 424.

25 See for example, Companies Act 2006, s. 662.

26 Ibid.

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The purchase of own shares will therefore result in two things: one being that the
assets of the company are being returned to the members and the overall capital
yardstick is reduced. As we have discussed earlier, since the rights of a creditor are
limited to the assets of a company, it is important to have a regime in place to protect
creditors from an extraordinary reduction of the assets of a company.

A general outright ban on purchase of own shares would be seen as going against
the interests of shareholders. A shareholder may wish to retire or he may no longer
see the company as a viable investment vehicle and would thus like to realise the
value of their investment27. In the event of any of these two occasions, there is a real
possibility of not finding another investor to take up their holding in the company and
even more so would be difficult in a private company where shares are not easily
transferable. For such a shareholder, the best exit strategy would rest in the
availability of the option of the company to purchase its owns shares. Therefore, to
ensure that the capital maintenance doctrine caters for the interests of shareholders
as well, the 2006 Act has implemented exceptions to the general rule. Some authors
have also claimed that the outright nineteenth century prohibition was over-inclusive
in its reach28 and therefore the legislature saw the need to implement exceptions to
facilitate transactions like the one mentioned above, without necessarily jeopardising
the interests of the creditor29.

There are three main exceptions to the prohibition: acquisition of own shares through
a nominee, redemptions and repurchases. Out of these three exceptions, this paper
will only consider the effectiveness of the rules relating to redemptions and
repurchases in protecting both shareholders and creditors.

Redemptions

27 Davies, Paul L., and Sarah Worthington. Gower and Davies' Principles of Modern
Company Law. 2012, at p. 321.

28 Ibid, at p. 324.

29 Ibid, at p. 324.

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The 2006 Act permits a limited company to issue redeemable shares 30. Redeemable
shares are shares which can be bought back by the company in the future. It can be
seen as temporary membership in the company.

Once a company redeems the shares, those shares are to be cancelled 31 and the
share capital accounts of the company must be reduced accordingly. This results in
returning of assets to the members, reducing the assets available for creditor claims.
Consequently, this triggers the reasons mentioned above and therefore there is need
to ensure that the process of redemption is such that the interests of creditors and
shareholders are protected.

The company must issue non- redeemable shares

The first form of protection can be seen in s. 684(4) of the 2006 Act, which indicates
that in order for a limited company to issue redeemable shares, it must issue shares
which are not redeemable. This protection can be seen to be targeting creditors as
the risk of the company culminating with no members is abolished 32. This is a prima
facie efficient protectionist measure as if a company issues all of it share capital in
the form of redeemable shares and subsequently redeems those shares, the
company will cease to exist. A company cannot continue to exist without any
members. If the company ceases to exist and the assets of the company have been
realised and returned to the members, being the companys price for redeeming the
shares, then it would be impossible for any creditor claims to be settled. Therefore,
the rule seems to guarantee the availability of a pool of assets for creditors, to
ensure that upon insolvency their claims will be settled. This achieves the purpose of
the capital maintenance doctrine.

However, there is nothing in s. 684 of the 2006 Act that indicates the minimum
number of non- redeemable shares a company must issue. Based on this, it can be
assumed, at least in theory, that issuing a single non- redeemable share would be

30 Companies Act 2006, s. 684 (1).

31 Ibid, s. 688 (a).

32 Davies, Paul L., and Sarah Worthington. Gower and Davies' Principles of Modern
Company Law. 2012, at p. 326.

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sufficient to overcome the protectionist measure. This would defeat the purpose of
containing the mischief the provision is aimed to tackle. If a single member is left in
the company, it would be difficult to see how his holding would constitute an
adequate pool of assets to satisfy the claims of creditors upon insolvency of the
company. On an overview, the lack of a provision to indicate the minimum non-
redeemable shares to be issued waters down the effectiveness offered by this rule.

Authority to issue redeemable shares

Private companies have the default power to issue redeemable shares in their
articles33 and on the other hand, for public companies there must be an express
provision in the articles specifically authorising it to issue redeemable shares 34. If a
private company does not wish to include the power to issue redeemable shares it
must have a provision to that effect in its articles.

This rule aims to protect different classes of shareholders from the actions of
opportunistic directors and shareholders. The rules for both private and public
companies dictates the need for shareholder consent 35. In the event a company
redeems shares, the resources of the company will be directly affected as money will
be paid out to members who hold the redeemable shares and not to other members.
This money could have been used to pay dividends or if retained by the company, it
could have been injected into projects that would benefit the company as a whole 36.
Therefore, the shareholder consent to the authority to issue redeemable shares will
protect their monetary interests.

The terms of redemptions

33 Companies Act 2006, s. 684(2).

34 Ibid, s. 684(3).

35 Davies, Paul L., and Sarah Worthington. Gower and Davies' Principles of Modern
Company Law. 2012, at p. 327.

36 Ibid.

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The terms of a redemption are agreed before the shares are issued 37. The directors
can set the terms if the companys articles 38 or an ordinary resolution 39 of the
company authorises them to do so.

Shareholders are protected by the implementation of this rule. Given the fact that the
terms of the redemption are known in advance, shareholders will be aware of the
exact consequences of a redemption on their interests. This would allow a member
to plan his commercial affairs accordingly. The effectiveness of the protection can be
called to question given the fact that a simple ordinary resolution can give powers to
the directors to determine the terms of a redemption, where these powers have not
been allocated to them by the articles. For an ordinary resolution to be passed it
must secure a simple majority of the vote 40, which entails only 50% of the vote. This
would not protect the interests of minority shareholders as the majority of the
members can influence whether or not to give the directors authority to determine
the terms of the resolution whilst only considering their commercial interests, and not
what would benefit all classes of members.

There is a default term imposed on all companies by statute. S. 686 (1) of the 2006
Act stipulates that only fully paid shares can be redeemed. This is an effective
provision in protecting creditors and shareholders. The rule ensures that any
uncalled liability a member has will not be extinguished by a redemption.
Shareholder interests, will be comforted by knowing that another member has not
been given more than what he deserves and that there is no reduction of the share
capital of the company then what was originally desired by the terms of redemption.
On the same note, creditors will also be protected against an over reduction of the
assets available to settle their claims. This default term is also imposed on any
repurchase of a companys own shares 41, consequently it would be safe to say that
the provisions offer effective creditor and shareholder protection.

37Companies Act 2006, s. 685.

38 Ibid, s. 685 (1) (a).

39 Ibid, s. 685 (1) (b).

40 Ibid, ss. 282 (2), (3) and (4).

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Repurchases

s. 690 (1) of the 2006 Act permits a limited company to purchase its own shares, so
long as the articles of the company do not prohibit the repurchase of its own shares 42
and if the repurchase is carried out in accordance with the provisions found in Part
18, Chapter 4 of the 2006 Act 43. This is an exception to the above mentioned rule
prohibiting the purchase of own shares and it would be mandatory to have rules in
place to ensure that the creditors and shareholders are protected.

Off- market and on- market purchases

There are specific protectionist measures in place aimed at defending certain

classes of shareholders. It has been contended that there are possibilities where the
board of directors would wish to get rid of certain shareholders, consequently those
shareholders could have been offered terms of a repurchase that are more
favourable than those offered to other members or the other members can be
excluded altogether44. To avoid such events, there are provisions to protect
shareholders depending on whether the repurchase was carried out off the market or
on the market. The latter of the two relates to a repurchase taking place on a
recognised investment exchange45 that is authorised by the Financial Conduct
Authority.

A company can only purchase their own shares in an off- market purchase as per the
terms of a contract46. The terms of contract must be authorised by an ordinary

41 Ibid, s. 691 (1).

42 Ibid, s. 690 (1) (b).

43 Ibid, s. 690 (1) (a).

44 Davies, Paul L., and Sarah Worthington. Gower and Davies' Principles of Modern
Company Law. 2012, at p. 337.

45 Companies Act 2006, s. 693 (4).

46 Ibid, s. 694 (1).

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resolution of the company47. This ensures that shareholder consent is sought before
terms of the contract are set. Prior to 2013, a special resolution was required to
authorise the terms of the contract. It can be argued that the change in law, from the
requirement of a special resolution to that of an ordinary resolution dilutes the
protection for shareholders. This is because only 50% of the vote will be required to
pass the resolution and accordingly the interests of minority shareholders may be
ignored. However, there is an important condition in the stature that could overcome
these injustices. As per s. 695 of the 2006 Act, members who hold shares that are
the subject to the repurchase are not eligible members48. This means that the
member who holds shares that the subject of the resolution are excluded from the
voting of that resolution and therefore ensures that they cannot influence the terms
of the contract of the repurchase. Not being able to influence the outcome of the vote
on the resolution means that the interests of all classes of shareholders will be
accounted for, which is effective shareholder protection. In addition to this, the
company must adhere to procedural requirements set out in s. 696 of the 2006 Act.
Failing to comply with these procedural requirements renders the resolution void 49.
The procedural requirements ensure that a member is made aware of terms of the
contract, which will allow him to make a more informed decision on whether to vote
for or against the resolution based on whether the resolution is in the interest of all
the classes of shareholders or in his own commercial interests. This is effective
shareholder protection.

For repurchases made via an on- market purchase, there must be authority to make
the repurchase, which is given by the members of a company through an ordinary
resolution50. Similar to the rules for off- market purchases, the member whose shares
are subject of the resolution are barred from voting on that resolution and as such
the same effectiveness for shareholder protection is secured. Moreover, since the
repurchase is being carried out on a recognised and authorised exchange market,
47 Ibid, s. 694 (2).

48 Ibid, ss. 695 (2) and (3).

49 Ibid, s. 696 (5).

50 Ibid, s. 701 (4).

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there are fewer risks for shareholders as the prices of these shares will be
determined by market conditions. The on- market repurchase rules also demand for
the availability of the resolution Furthermore; the resolution must be made available
for inspection, which allows members to make an informed vote. The statutory rules
are supplemented by Listing Rules 51. Under these rules, where the repurchase
involves a purchase of 15% or more of the companys equity shares, this must be
done by way of a tender offer. Offering the repurchase by way of a tender offer
facilitates the equal treatment of all shareholders as the balance of power of the
company may be distorted by the substantial market repurchase 52, being useful
shareholder protection.

Financing of redemptions and repurchases

The main form of creditor protection offered by the rules relating to redemptions and
repurchases rest in the provisions regarding the way in which a company can
finance the purchase of the redeemable shares and repurchases. The financing
rules for redeemable shares are the same as those for repurchases and thus it
would be adequate to provide a single analysis on their effectiveness in protecting
creditors and shareholders.

As a general rule for both private and public companies, a redemption or a

repurchase of own shares can only be financed through distributable profits 53 or the
proceeds of a fresh issue of shares made for the purpose of either a redemption or a
repurchase54. The premiums payable for the redemption or repurchase can only be
paid out of distributable reserves55. If the shares were issued initially with a premium,

51 Listing Rules 2016, R. 12.4, prepared by the Financial Conduct Authority.

52 Davies, Paul L., and Sarah Worthington. Gower and Davies' Principles of Modern
Company Law. 2012, at p. 340.

53 Companies Act 2006. For redemptions see s. 687 (2) (a). For repurchases see s. 692 (2)
(a) (i).

54 Ibid. For redemptions see s. 687 (2) (b). For repurchases see s. 692 (2) (a) (ii).

55 Ibid. For redemptions see s. 687 (3). For repurchases see s. 692 (2) (b).

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then the proceeds of a fresh issue can be used to pay the premiums 56. This rule is
specifically designed to protect creditors. There is no reason for a creditor to object
to redemptions or repurchases that are made out of distributable profits as this asset
pool is made available only for the members of the company. Secondly, the purpose
of the fresh issue is known in advance and when the proceeds of this issue are
consumed the overall capital yardstick remains unaffected.

Generally, once shares have been redeemed or repurchased, they must be

cancelled57. For repurchases, companies have an option of holding the shares in
treasury, the effect of which is that the shares are not cancelled but retained by the
company with a view of reissuing them in the future 58. When shares are cancelled,
there will be a reduction in the legal capital value of the company which invokes the
interests of creditors and triggers the problems mentioned above. To overcome this,
the law dictates that the company must create a capital redemption reserve
(CRR)59. The CRR acts like the counter balancing force of a reduction in the legal
capital of the company. In this reserve, the company must place an amount that is
equal to the amount of distributable profits used to finance the redemption or
repurchase60, which will safeguard against a reduction of the companys overall
capital yardstick. If the redemption or repurchase is financed out of proceeds of a
fresh issue issued for that purpose, the legal capital of the company will remain
unaffected as the money received from the fresh issue will be cancelled out by
payments of redemptions and repurchases. Therefore, the rules can be seen as
providing adequate protection for creditors.

Rules for private companies only

56 Ibid. For redemptions see s. 687 (3). For repurchases see s. 692 (3).

57 Ibid. For redemptions see s. 688. For repurchases see s.706 (b).

58 Ibid, s. 706 (a).

59 Ibid, s. 733.

60 Ibid, ss. 733 (2) and (3).

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Private companies are permitted to finance a redemption or a repurchase out of

capital, unless they have been restricted to do so expressly by the articles of the
company61. The extent to which a company can use its capital to finance the
redemption of repurchase. This is restricted to the permissible capital payment
(PCP)62. Under this rule, to make a payment out of capital, the company must first
use up any distributable profits and proceeds of a fresh issue, after which they can
resort to making a payment out of capital.

On the face of it, the exception for private companies seems to be going against the
mischief the capital maintenance doctrine is aimed at protecting, that is creditor
protection, as using capital to finance a redemption or repurchase will directly reduce
the legal capital available, in turn diminishing the assets a creditor can rely on to
satisfy his claims upon insolvency of a company. However, to cater for the interests
of shareholders who wish to revoke their membership, payments out of capital make
this possible where the company has insufficient distributable profits or there is no
investor to take on the shares 63. Therefore, specific rules have been implemented to
ensure that both the interests of creditors and shareholders are protected when a
private company makes a payment out of capital.

There is a requirement for the directors to provide a solvency statement and an audit
report to compliment it64. In summary, the directors must indicate in the statement
that the company will be able to meet their financial obligations immediately after the
date the payment out of capital is made 65. When making this assessment they must
take into account contingent and prospective liabilities 66. Additionally, they must
make a forward looking assessment for the one year following the payment, where

61 Ibid, s. 709 (1).

62 Ibid, s. 710.

63 This especially relates to private companies.

64 Companies Act 2006, s. 714

65 Ibid, s. 714 (3) (a).

66 Ibid, s. 714(4).

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they should be able to state management intentions, the amount and character of
financial resources available and whether the business will be able to carry on as a
going concern67. This provides adequate protection for creditors, as the statement
provides valuable information that will allow them to re-assess their positions and
likelihood of their claims being settled. Moreover, it gives the creditors greater
reassurances and as a result it can be assumed that the creditors will continue the
commercial relationship they have with the company. The auditors report
strengthens the view portrayed by the directors, which adds to the effectiveness of
the rule in protecting creditors68. This is because it confirms the financial accuracy of
the solvency statement and the audit report is compiled by profession financial
experts.

There are sanctions imposed on directors and the company itself. Directors can be
found criminally liable if they have been negligent when forming the statement 69. This
enhances both shareholder protection and creditor protection as the sanctions would
coerce a director to take prudent actions that are in the interest of the company. The
company can be faced with civil liability in the form of a fine, if the company is wound
up within one year of making the payment 70. This is, at least in theory, not an
effective protectionist measure for creditors as imposing a fine will lead to a depletion
of the assets of the company, which is the main thing the capital maintenance
doctrine is aimed at preventing.

Shareholders are protected by s. 716 of the 2006 Act. Under this provision the
payment out of capital must be approved by a special resolution.71 Also, the
members shares to which the resolution relates are forbidden from voting on the

67 Ibid, s. 714 (3) (b).

68 Ibid, s. 714 (6).

69 Ibid, s. 715.

70 Insolvency Act 1986, s. 76.

71 Companies Act 2006, s. 716 (1).

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resolution72. Since a special resolution is required and the restriction on interested

members from voting, the rule proves to be efficient protection for shareholders. A
special resolution will almost ensure that minority shareholder interests are well
represented and are in fact given a voice, as a vote of 75% or more is needed for the
resolution to pass. This makes the decision to pay out of capital more inclusive.
Restricting interested members from voting bars their ability to influence the
decision, accordingly the resolution can be said to be made in the interests of all
classes of members.

The last resort of protection available to creditors and shareholders comes in the
form an application to court to cancel the resolution authorising the payment out of
capital73. Court scrutiny of the resolution will allow for an independent and impartial
analysis to see if indeed a payment out of capital does not endanger the interests of
creditors or shareholders, adding to the effectiveness of the protectionist measures.

Reduction of capital

The 2006 Act permits a company to reduce its capital, which does not involve return
of assets to the members74. For public companies, a special resolution authorising
the reduction will be required to be confirmed by the court 75. Private companies will
require a special resolution authorising the reduction supported by a directors
solvency statement76.

For private companies, the protection for creditors come from the solvency
statement. The requirements of what opinions need to be formed are the same as
those in relation to a solvency statement for payments out of capital mentioned

72 Ibid, s. 717.

73 Ibid, s. 721 (1).

74 Ibid, s. 641.

75 Ibid, s. 641 (1) (b).

76 Ibid, s. 641 (1) (a).

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above. Consequently, the effectiveness of the protectionist measures will not be

considered here as it has been discussed above.

The court confirmation process for public companies is where protection for creditors
rests. The protection is limited to creditors who can show that there is a real
likelihood that the reduction of capital would result in the company being unable to
discharge his debt.77 This requirement increases the burden of proof on creditors
and could possibly exclude creditors from being able to object to the reduction of
capital. This waters down the efficiency of the protection the rule offers.

Before the court confirms the order, it must be satisfied that either the objecting
creditor has consented to the reduction 78 or his debt has been discharged or
secured79. This provides a creditor with effective protection. If the objecting creditor
does not consent to the reduction, his debt would have to be discharged or secured,
which places him in a better financial position then he was in prior to the reduction 80.

During the confirmation process, even if there are no objections, minority

shareholders are also afforded protection 81. The court must be satisfied during the
confirmation that the reduction of capital treats every shareholder equitably and the
proposals of reduction of capital must be properly explained to the shareholders 82.
An equitable reduction entails that there will be a reduction of shares proportionate to
every members holding. Additionally, for both private and public companies, the
supermajority vote will ensure that the interests of minority as well as majority

77 Ibid, s. 646 (1) (b).

78 Ibid, s. 648 (2) (a).

79 Ibid, s. 648 (2) (b).

80 Davies, Paul L., and Sarah Worthington. Gower and Davies' Principles of Modern
Company Law. 2012, at p. 351.

81 As per the case of Ransomes Plc, Re [1999] 2 B.C.L.C. 591, at p. 602.

82 See, Scottish Insurance Corporation Limited v Wilson & Clyde Coal Company Limited
[1949] AC 462. Also see, Davies, Paul L., and Sarah Worthington. Gower and Davies'
Principles of Modern Company Law. 2012, at p. 360.

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shareholders will be taken into account, giving a more inclusive decision. This
provides adequate protection for shareholders.

Financial Assistance

The financial assistance rule prohibits public companies from giving any form of
financial assistance, to a person to facilitate the purchase of the companys shares,
whether directly or indirectly and whether the assistance is provided before or after
the purchase83.

It is often wondered how this rule fits within the doctrine of capital maintenance, as in
theory a company providing financial assistance for the purchase of its own shares
does not affect the companys capital yardstick. What really happens is one asset:
money given in the form assistance is replaced with another asset: a debt. If there is
no depletion in the assets of the company, it would be difficult to see how the rule
offers creditors any protection as the creditors interests only come into play when
the there is a diminution of the companys assets. The risk for the creditor may
increase as there could be a real possibility of the person to whom assistance was
given may not be able to pay the debt and the companys gearing will increase.
Despite this, there is no general principle in company law which prohibits the
company from altering the risk characteristics of its assets. 84 This analysis already
indicates towards the inefficiency of the rule in protecting creditors.

The Jenkins committees rationale suggests that the prohibition is aimed at

protecting creditors and shareholders from an already indebted person who gets
assistance from the company to gain control of the company and thereafter use the
resources of the company to repay the debt 85. This reasoning postulates that the rule
is aimed at protecting very specific transactions, however the rule fails to achieve

83 Companies Act 2006, s. 678 (1).

84 Davies, Paul L., and Sarah Worthington. Gower and Davies' Principles of Modern
Company Law. 2012, at p. 360.

85 Jenkins Committee. Report of the Company Law (Jenkins) Committee. 1962, para 173.
Also see, S, Mercouris. The prohibition on financial assistance: the case for a commercially
pragmatic interpretation. 2014. Company Lawyer. 321, at p. 323.

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this. The definition of financial assistance provided by the 2006 Act has a wide net 86
and is therefore capable of catching innocent transactions which would be of benefit
to the creditors and the shareholders, which has been confirmed by Lord Toulson 87.
We can employ common law to prove that the wide definition weakens the protection
offered to creditors and shareholders. In the case of Chaston v SWP Group Limited88
, the company paid an audit firm for a report crafted to aid the purchasers in a
takeover bid. This was deemed to be unlawful financial assistance, despite the fact
that the amount deemed as financial assistance was insignificant in comparison to
the takeover price. It would be difficult to see how a shareholders interests are
protected in such an instance, where the transaction was struck down and the
purchase would allow the members to realise their investments.

There is an exception to the rule: a company may provide financial assistance if the
principle purpose of the assistance is not to give financial assistance 89 or the
assistance is incidental to a larger corporate purpose 90. This seems to overcome the
difficulties that stem from the wide definition of financial assistance. However, when
the rule has been put into operation it does not achieve what it was intended to. The
leading case of Brady v Brady91 illustrates this. Here due to a shareholder deadlock a
decision was made to split the business into two. The structure of the transaction
involved the use of assets of one of the companies to discharge its liabilities in the
parent company and this was deemed to be financial assistance, striking down the
transaction. This cannot be seen as efficient creditor or shareholder protection as the
alternative option would be to close down the company which would negatively affect
the interests of both creditors and shareholders.
86Companies Act 2006, s. 677.

87 See, Anglo Petroleum Limited v TFB (Mortgages) Limited [2007] EWCA Civ 456,
judgement of Lord Toulson at para. 26.

88 [2002] EWCA Civ 1999.

89 Companies Act 2006, s. 678 (2) (b).

90 Ibid, s. 678 (2) (b).

91 [1989] AC 755.

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Conclusion

In summary, the capital maintenance doctrine does indeed offer creditors and
shareholders an added level of protection. This protection to a large extent is efficient
as has been illustrated by the rules pertaining to redemptions, repurchases and the
general reduction of capital. This is based on the fact that the rules largely tackle the
mischief they were designed to protect against.

The minimum capital requirement and the rules on financial assistance waters down
the efficiency of protection the capital maintenance doctrine offers. The former is
very illusory and should be scrapped off altogether. The rules for financial assistance
can achieve the purpose for which they were designed to achieve so long as the
courts take on a commercially pragmatic stance and interpret the exceptions
narrowly to allow innocent transaction to be effected.

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BIBLIOGRAPHY

Primary Sources

Legislation:

Companies Act, 2006.

Insolvency Act, 1986.
The EU Second Company Law Directive, 77/91 [1993] OJ L31/01

Regulations:

Listing Rules 2016.

Case Law:

Anglo Petroleum Limited v TFB (Mortgages) Limited [2007] EWCA Civ 456.
Brady v Brady [1989] AC 755.
Chaston v SWP Group Limited [2002] EWCA Civ 1999.
Exchange Banking Company (Fitcrofts Case), Re. (1882) L.R. 21 Ch. D. 519
CA.
M T Realisations Limited (in liquidation) v Digital Equipment Company Limited
[2002] EWHC 1628 (Ch).
Ransomes Plc, Re [1999] 2 B.C.L.C. 591
Re Chatterley Whitfield Collieries Limited [1948] 2 All ER 593.
Re Holders Investment Trust Limited [1971] 1 WLR 583.
Scottish Insurance Corporation Limited v Wilson & Clyde Coal Company
Limited [1949] AC 462.
Trevor v Whitworth (1887) 12 App Cas 409.

Secondary Sources

Reports:

Company Law Review Steering Group. Modern Company Law for a

Competitive Economy: Company Formation and Capital Maintenance. 1999.
Company Law Review Steering Group. Modern Company Law for a
Competitive Economy: Final Report. Vol. 1. 2001.
Department of Trade and Industry. Company Law Reform. 2005.
Jenkins Committee. Report of the Company Law (Jenkins) Committee. 1962.

Books:

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Davies, Paul L., and Sarah Worthington. Gower and Davies' Principles of
Modern Company Law. Sweet and Maxwell. 2012.
Grier, N. Company Law. 4th ed. W Green and Son. 2014.
Sealy, L, & Worthington, S. Sealy's Cases and Materials in Company Law. 9th
ed. Oxford UP. 2009.

Articles:

Kershaw, D. Involuntary Creditors and the Case for Accounting- Based

Distribution Regulation. Journal of Business Law, 140. 2009.
Mercouris, S. The Prohibition on Financial Assistance: The Case for a
Commercially Pragmatic Interpretation. Company Lawyer, 321. 2014.
Rickford, J. Reforming Capital: Report of the Interdisciplinary Group on
Capital Maintenance. European Business Law Review, 920. 2004.
Simoes, Fernando Miguel Dias. "Legal Capital Rules in Europe: Is There Still
Room for Creditor Protection?" International Company and Commercial Law
Review. Vol 24 (issue 4), 162. 2013.

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