UK: Capital reduction (Company law)

Introduction
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 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.

• 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.

• 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.

• 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:

• 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.

• 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:

• 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 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.

• 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.

• Claim form setting out:

• Written evidence taking the form of a witness statement sworn by the Chairman. The following matters must be included in the written evidence:

• 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.

• 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.

 
For more information, please contact:

Steen Rosenfalck, Senior Partner

ebl miller rosenfalck, London

e: sr@millerrosenfalck.com

t: +44 (0)20 7553 9931

The material contained in this guide is provided for general purposes only and does not constitute legal or other professional advice. Appropriate legal advice should be sought for specific circumstances and before action is taken.