INTRODUCTION TO COMPANIES

There main two types of company, a company “limited by guarantee”, and a company “limited by shares”.

Company limited by guarantee

A company limited by guarantee is most usually employed by charitable organisations (such as schools, museums) where there is no profit sharing imperative. A company is “limited by guarantee” if members’ liability is limited to such amount as the members undertake to contribute to the company’s assets in the event of its being wound up (s.3(3) CA 2006). Thus, companies limited by guarantee provide a valuable alternative to  companies  limited by shares, particularly in the case of charities and other not-for-profit organisations. This form of  company is also commonly used for property management  companies, members’ clubs and trade associations, as well as for mutual assurance  companies. The broad application of such corporate structures makes this explanatory text all the more valuable.

Company limited by shares

A company limited by guarantee is unsuitable, however, where the primary object is to carry on business for profit and to divide that profit amongst the members. Thus, a company limited by shares is the primary corporate structure used for businesses operating with a view to a profit intending to divide that profit amongst its shareholders. The fundamental rule that dividends should only be paid out of distributable profits (s.830, CA 2006).

A company is a “limited company” if the liability of its members is limited by its constitution (s.3(1), CA 2006) (“limited company”). A limited company means that the members’ liability to contribute towards the company’s debts is limited to the “nominal” value of the shares for which they have subscribed. shares must have a fixed nominal value (s.542 CA, 2006). Once the shares have been “paid up” the members/shareholders are under no further liability in the event of liquidation of the company. Thus, a company is “limited by shares” if members’ liability is limited to the amount, if any, unpaid on the shares held by them: (s.3(2), CA 2006).

Share  capital is still capable of being increased by ordinary resolution (CA  2006, s.617). Minimum share  capital for public  companies remains fixed at £50,000 (CA  2006, s.763). No minimum is prescribed for private  companies.

Unlimited Companies

It is also possible to incorporate an “unlimited” company, but these are rare creatures. In an unlimited company there is no limit, provided by the shares or a guarantee on the liability of its members. Given limited liability is a prime reason for incorporation, so as to protect the decision-making of businessmen and entrepreneurs, it is unsurprising that there are few limited companies.

Separation of corporate legal personality/limitation of liability of companies

The fundamental attribute of corporate personality is that the corporation is a legal entity distinct from its members. It is capable of enjoying rights and being subject duties which are not the same as those enjoyed or borne by its members.

A company has an “artificial” personality in the sense. It follows that a company’s members are not liable for its debts. Hence, in the absence of express provision to the contrary, the members will be completely free from any personal liability in respect of the company’s debts. Non-liability applies not only in respect of debts, but in respect of all obligations of the company. However, is separate legal personality of a company does not necessarily protected directors from personal liability to third parties. Thus, although directors are acting on behalf of the company, they may be responsible for acts which have made them personally liable to third parties and outsiders e.g. breach of fiduciary duty. There are exceptions to limited liability. It is a criminal offence to carry on business of the company with intent to defraud creditors of the company or of any other person for any other purpose (s.993 CA 2006). Every person knowingly party to the carrying on of the business in this manner commits a criminal offence. Civil liability is contained in s.213 IA 1986. S.213 requires in addition that the company being in the course of winding up (which the criminal sanctions does not). S.213 is not limited to the liability of directors. Banks and parent companies have, at times, been concerned as to their potential liability under this section by providing finance to striking companies, fearing they may fall foul of these provisions. However, so long as there is no active role in the running of the company with fraudulent intent, no liability will attach. There must be “positive steps in the carrying on of the company’s business in a fraudulent manner” (Maidstone Building Provisions Limited, Re [1971] 1 WLR 1085); Augustus Barnett & Sons Ltd, Re [1986] BCLC 170 – where an attempt against a parent company under this section also found on the same basis).

The “wrongful-trading” provisions under s.214 IA 1986 also provide an exception to the principle of limited liability. The court can make a declaration, where a company is gone into insolvent liquidation for a “contribution” against a person who, at the some time before the commencement of the winding up, was a director or shadow director of the company. The declaration is not to be made if the court is satisfied that the person concerned to every step with a view to minimising the potential loss to the company’s creditors as, on the assumption that he knew there was no reasonable prospect of avoiding insolvent liquidation, he ought to have taken (s.214(2) IA 1986). In judging what facts the director ought to have known or ascertained, what conclusions the director should have drawn or what steps should have been taken, the director is assumed to be a reasonably diligent person having both the general knowledge, skill and experience to be expected of the person carrying out the director’s functions in relation to the company and the general knowledge, skill and experience that the director in fact has (s.214(4) IA 1986). Section 214 applies to “shadow” directors as well as to directors. This greatly widens the class of persons who may be caught by this section. A shadow director includes a person who influences at least a certain category of board decisions on a continuing basis (Secretary of State for Trade and Industry v Becker (2003) 1 BLCL 565). It sometimes happens that real controllers, or “directing minds” of companies, will often lurk in the shadows of companies directing “nominee” directors in an attempt to conceal their control of a company. This will often be because a director is subject to an order of disqualification from being a director. There are many instances where such directors are described as “puppet-masters”.

Many creditors, particularly banks, in lending to companies will therefore seek to circumvent the absence of responsibility for the debts by members and directors of companies by seeking “personal guarantees” from those running companies secure lending. Moreover, lenders may seek to enhance the party of their claims by taking security against the company’s assets e.g. fixed and floating charges over the company’s assets.

The Company’s Constitution: Articles of Association

Articles of Association regulate the internal allocation of powers between the company directors and shareholders. Articles often deal with the division of powers between shareholders, the Board of Directors, and the composition, structure and operation of the bord of directors. Articles often adopt a “model” articles for private and public companies

S.33 of the 2006 Act provides that:

“The provisions of the company’s constitution by the company and its members to the same extent as if there were a covenant on the part of the company and of each member to observe it”.

Thus, although the articles have a contractual status, there are more in the nature of a private bargain among the company and its members. The company’s articles become a public document at the moment formation. The articles cannot be later rectified to give effect to what the incorporate is actually intended but failed to embody in the registered document, since the reader of the registered documents that have no way of guessing that any error had been made in transposing the incorporators’ agreement into the document (Scott v Frank F Scott (London) Ltd (1940) Ch 794). For the same reason, a court will not implied terms into the statutory contract comprised in the articles, since such evidence would not be known to third parties who would therefore have no basis for anticipating that any such implication had been made, or as appropriate (Bratton v Seymour Service Ltd v Oxborough [1992] BCLC 693).

Shareholders often, in addition to the articles, bind themselves, in relation to their rights and duties by an extraneous agreement inter se known as a Shareholders’ Agreement. This will often provide for rights of pre-emption between shareholders (ie first refusal on the sale of shares on a given valuation). The main disadvantages of shareholders agreement is that it does not automatically bind new members of the company, as the articles do (s.33(1) CA 2006).

Memorandum

A memorandum is defined as a document stating that the subscribers wish to form a company under the Companies 2006 Act. The subscribers also agree to become members of the company, and in the case of a company that is to have a share capital, to take at least one share each. The  memorandum is required to be in the prescribed form and must be authenticated by each subscriber (s.8, CA 2006). A company’s  memorandum will essentially be a “snapshot” of part of the company’s constitution upon registration. Companies formed under CA 2006 and existing  companies will have unrestricted objects unless they specifically restrict them: cl.33.

Private/Public Limited Companies

Most smaller companies are private limited companies. They are millions of private limited companies registered in England and Wales. A “private” company is any company that is not a public company (s.4(1), CA 2006). A private company must not offered to the public any securities (s.755 CA 2006).

A company purchasing its own shares

The courts have always been astute to guard against companies being used as instruments of illegality, fraud, corporate asset stripping, or to defeat the claims of creditors. This policy lies behind the historic rules against companies using their own capital to purchase their own shares; and also in the rule against gratuitous transfers.

Lord Watson in Trevor v Whitworth (1887) 12 App Cas 409 at 423 said this:

“Paid-up capital may be diminished or lost in the course of the company’s trading, that is a result which no legislation can prevent; but the persons who deal with, and give credit to a limited company, naturally rely upon the fact that the company is trading with a certain amount of capital already paid, as well as 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 in to the coffers of the company has been subsequently paid out, except in the legitimate course of its business”

This is the rule in Trevor v Whitworth. It underlines the concern of the law to protect the creditor of a company against the diminution of the company’s assets. The case concerned an article in the company’s articles of association, purporting to allow the company to purchase its own shares. The House of Lords in Trevor v Whitworth held that such a purchase offended the principle that no part of the capital of a company may be returned to a member, save by a reduction of capital sanctioned by the court, in order to prevent the dissipation of funds, of which the creditors have a right to be paid. Thus, in the absence of such a power under  company legislation, the purchase was ultra vires. This principle applies even if the  company’s memorandum of association expressly provides for such a return (Barclays Bank plc v British & Commonwealth Holdings plc [1995] BCC 19 at 22). Harman J concluded in Barclays Bank that:

“All these cases therefore apply the same principle that a transaction which upon examination can be seen to involve a return of capital in whatever form, under whatever label, and whether directly or indirectly, to a member, is void. In none of them was the payment made (using those words deliberately loosely) other than to or for the benefit of a shareholder and the constant use of the word “return” is a clear indication of the constant existence of the member/company relationship underlying the transaction”

And:

“that any agreement which is only likely to be called upon if the company has no distributable profits and which will, if called upon when the  company becomes insolvent, have the effect of increasing the liabilities of the  company, by substituting, for rights which are rights held by shareholders ranking behind creditors, rights held by a creditor, ranking equally with other creditors, is objectionable by reason of the rule in Trevor v Whitworth”

Kitto J in Davis Investments Pty Ltd v Commissioner of Stamp Duties (1957-8) 100 CLR 392 at 413:
‘The fundamental principle of company law that the whole of the subscribed capital of a  company … unless diminished by expenditure upon the  company’s objects (or by means sanctioned by the court) shall remain available for the discharge of its liabilities … Trevor v Whitworth; Re Walter’s Deed of Guarantee”

Today, however, many thousands of reductions of  capital take place every year. The procedures, as outlined in the  Companies  Act 1985, ss.135-138, are convoluted and expensive: every  reduction requires the passing of a special resolution, implementation of transparency measures and finally the obtaining of the sanction of the court. However, for private companies, they are permitted, by virtue of ss.642-644 CA 2006, to reduce  capital on the back of a “declaration of solvency”. Prior authorisation in the articles is no longer a necessity (s.690, CA 2006). the removal of the need for prior authorisation in the articles (s.690).

Thus, the law has moved well away from some regarded as the “restrictive attitudes” exemplified in Trevor v Whitworth. The current position is that companies can purchase their own shares provided they comply with the statutory safeguards imposed by the Companies Act 2006. Thus, the brutal truth is that many of the share  capital maintenance rules no longer offer any real protection to creditors of limited companies.

Gratuitous dispositions by companies

No company may make truly gratuitous dispositions of its assets. This principle can be seen operating by analogy with the rule prohibiting the return of capital to a member: both are designed to ensure the assets of a  company are maintained for the creditors. In Barclays Bank plc v British & Commonwealth Holdings plc [1995] BCC 19 Harman J, held:-

“as it seems to me it must equally be unlawful to make an agreement expressed to impose a liability to make a gratuitous payment, that is not one for the advancement of a company’s business nor made out of distributable profits, at a future date when in the event the  company has no distributable profits”

Such an agreement would be unenforceable by being beyond the capacity of the company (although Harman J does not rely on the ultra vires principle, that is implicit from the above). That this is the basis of his reasoning is apparent from the authorities he cites. Returning to Harman J cites the following;

“A company can only lawfully deal with its assets in furtherance of its objects. The corporators may take assets out of the  company by way of dividends, or with leave of the court, by way of reduction of capital or in a winding up. They may, of course, acquire them for full consideration. They cannot take assets out of the  company by way of voluntary disposition, however described, and if they attempt to do so the disposition is ultra vires the  company” (Pennycuick J, in Ridge Securities Ltd v IRC [1964] 1 WLR 479 at 495)

“In its broadest terms the principle is that a company cannot give away its assets. So stated, it is subject to the qualification that in the realm of theory a memorandum of association may authorise a  company to give away all its assets to whomsoever it pleases, including the shareholders” (Nourse J, in Brady v Brady (1987) 3 BCC 535 at 550).
This is subject to the caveat that provided the granting of a guarantee could be construed as being “within the constitution” of a given company, it cannot be a gratuitous disposition by being ultra vires the company (Rolled Steel Ltd v British Steel Corp [1986] 1 Ch 246; Aveling Barford Ltd v Perion Ltd (1989) 5 BCC 677).

The underlying “mischief” that the courts are astute to guard against in relation to gratuitous payments is that creditors may stand to be prejudiced if corporate assets are given away. The courts are be astute to intervene indirectly on behalf of creditors of companies and to seek to upset such transactions, especially in cases where the  company has become insolvent not long after the gifts were made.