Chapter 11 : Maintenance of capital and the payment of dividends

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1 Chapter 11 : Maintenance of capital and the payment of dividends TUTORIAL QUESTIONS 1 Historically, a company had to strictly maintain its capital base. What was the logic behind this principle? 2 Why is there now some accommodation under legislation allowing companies to in fact buy back shares and give financial assistance? 3 What are the (safeguard) principles behind the statutory exceptions allowing a company to reduce its capital? 4 List the types of share buyback permitted under the Corporations Act. 5 Ping is a company director in a proprietary company. He is proposing to put a resolution to his company that it buy out the smaller holdings. Ping reasons that there are a number of quite large shareholdings and many of the smaller members have little interest in the company. Ping does not want to force any member to sell their shares but would like to clean up the register by buying out the smaller holdings. Advise Ping on the legal implications of his plan. 6 What is the meaning of giving financial assistance? Why is it so regulated by legislation? 7 What is the basic nature of a share issued by a company? 8 What are the significance and legal implications (to a shareholder) of a company issuing shares that are only partly paid? 9 What distinguishes different types of shares? How are these differences created? 10 What rights exist under law to protect members holding certain classes of shares from having those rights changed or erased by a majority of members in the company? PROBLEM 1 Read the case of ASIC v Adler. There were a number of offences committed by the officers in this case. Explain how the issue of improper provision of financial assistance arose and how the particular officer was dealt with. Summarise some of the main points made by the court in relation to this issue. 1

2 CORPORTE LAW Suggested Answers TUTORIAL QUESTIONS 1 Historically, a company had to strictly maintain its capital base. What was the logic behind this principle? The principle that a company preserve its capital flows from the case of Trevor v Whitworth. The historical principle was that creditors supplied lending, goods and service on credit, and this was based on the worth of the company in particular, the assets or capital that it contained. Similarly, investors who purchased shares in the company did so on the basis that the company would use their capital for profit-making purposes and would not dissipate the value of the company, given that the share value was based on the capital value of the company. The company was therefore under an obligation to preserve its capital base for creditors and shareholders respectively. 2 Why is there now some accommodation under legislation allowing companies to in fact buy back shares and give financial assistance? The Corporations Act recognises that there are good commercial reasons for allowing a company to reduce its capital, or at least to buy back shares or conduct transactions which would otherwise be considered in breach of the capital maintenance rules. A company may wish to purchase its own shares to bolster a falling share price. Another reason may be to allow the company to gear up its capital by using more borrowed funds than shareholder funds; this allows for a tax deduction for interest on borrowing and, furthermore, fewer complications in dealing with members. A company may also wish to give back capital it no longer needs, or it may wish to buy out smaller holdings in order to save administrative costs in maintaining multiple small holdings by members. 3 What are the (safeguard) principles behind the statutory exceptions allowing a company to reduce its capital? Any re-purchase of shares must be conducted according to the provisions of the Corporations Act and, under the common law, any such acquisition must be fair and equitable to all members. The company must ensure that any buyback does not affect the solvency of the company or the creditor s interests, and that it is fair to all shareholders in how much is offered for shares and who gets an offer. Any offer to purchase shares requires the company to ensure that a majority of members agree and that they are fully informed in making the decision to sanction a buyback. There are particular provisions for different buybacks a selective buyback which is on offer to only one class of shareholder is particularly regulated. Any unfair conduct by a company may be deemed to be so, and a disgruntled member may invoke various remedies available to them under the Corporations Act. 2

3 CHAPTER 11 MAINTENANCE OF CAPITAL AND THE PAYMENT OF DIVIDENDS 4 List the types of share buy-back permitted under the Corporations Act. The basic types of share buybacks are through: an equal share capital reduction a selective share capital reduction (s 256B(2)). Both these types of share capital reduction require shareholder approval (s 256C) and must follow strict procedures regarding information given to a company meeting, informing ASIC, and so on. As listed in s 257B, the other main types of buybacks are: minimum holding, designed to buy out small holdings of shares employee shares schemes, allowing employees who have participated in an employee share participation scheme to sell their shares back to the company on market, entailing a purchase of shares by a company by making an offer on the ASX equal-access schemes, allowing all members to offer their shares for sale in equal amounts selective buybacks, in which the company offers to purchase the shares of a particular class. There are some other types of capital reduction: 1 Share capital reduction by unlimited companies (s 258A). 2 Where a company has a right to grant a lease or right of occupy, property belonging to the company. 3 A company may pay brokerage or commission to a person in respect of that person or another person agreeing to take up the shares in the company. 4 Cancellation of shares forfeiture (s 258D). 5 Redeemable Preference Shares (ss 254J K). 6 Cancellation of paid-up shares, capital that is lost, or not represented by available assets (s 258F). 5 Ping is a company director in a proprietary company. He is proposing to put a resolution to his company that it buy out the smaller holdings. Ping reasons that there are a number of quite large shareholdings and many of the smaller members have little interest in the company. Ping does not want to force any member to sell their shares but would like to clean up the register by buying out the smaller holdings. Advise Ping on the legal implications of his plan. Ping can propose a share buyback, and there are probably good reasons for doing this. However, the company will need to ensure that it chooses an appropriate method and complies strictly with prescribed statutory procedures (s 256B). The company will have to hold a meeting at which it puts a special resolution, which must be passed by 75 per cent of the members. Before the meeting takes place, there must be adequate information given to the members and, presumably, the creditors. The directors will need to ensure that the company will be solvent after any such buyback, lest the directors be liable. The buyback cannot take place if it will materially prejudice the 3

4 CORPORTE LAW interests of creditors, or if it is unfair or discriminatory to the members; if a selective buyback is to take place, then all of the members must vote unanimously on the proposal (s 256C). If the company does become insolvent, or there are breaches of the Corporations Act, then the directors may be subject to various civil penalties. 6 What is the meaning of giving financial assistance? Why is it so regulated by legislation? A company may indirectly reduce its share capital when it financially assists a person to purchase shares in the company. Giving financial assistance includes actions such as: making a loan to someone who then purchases shares in the company (s 260) company money leaves the company and then returns, so the company is not better off giving a guarantee this is an indirect means whereby company money may be available to pay for the purchase of its shares if the borrower does not pay the loan back release from an obligation or the forgiving of a debt company providing its own asset as security for a person s loan to buy shares in the company. The purpose of this principle is that the company preserves its capital and does not give away capital. If company money is used to purchase the company s securities, it would mean that the company is diluting the value of each share, since the company s capital has not increased if purchases of shares is completed using the company s own money. The giving of financial assistance is therefore very regulated, and provisions exist to maintain creditor and shareholder protection (ss 260A-260D). However, a company may financially assist a person to acquire shares in the company or its holding company provided(s 260): the assistance does not materially prejudice the company, its shareholders or the company s ability to pay its creditors (s 260A(1)(a)) a notice of the meeting and the accompanying documents are lodged with ASIC before being sent to members (s 260B(5)) a special resolution giving the financial assistance is with ASIC within 14 days after being passed (s 260B(7)) notice is given to the shareholders of a meeting (s 260B(4)) the shareholders approval is obtained by special resolution(s 260C), or the assistance is exempted under s 260C, which covers both general and specific exemptions. 7 What is the basic nature of a share issued by a company? Shares are a form of personal, intangible property that, together with debentures and options, are included in the definition of a security under s 92. This collection of personal rights and obligations is referred to as a chose in action ; that is, an enforceable right. Shares are characterised by being: a form of personal property (s107a) transferable (through sale and purchase) 4

5 CHAPTER 11 MAINTENANCE OF CAPITAL AND THE PAYMENT OF DIVIDENDS capable of transmission to a personal representative in the event of death, mental incapacity or bankruptcy capable of being used as security for borrowing, etc. 8 What are the significance and legal implications (to a shareholder) of a company issuing shares that are only partly paid? Issued shares may be partly paid under s 254A(1)(C), which allows a member to purchase the shares but pay later, or perhaps not at all if the company does not require the rest of the price of the share. Significantly, therefore: different members may owe different unpaid amounts according to when the share was paid a company may limit its ability to issue shares under its constitution if shares are partly paid, the member will still be liable for the unpaid amount on a call-up (s 254M), which might be by a liquidator in the event of a company wind-up a member need not pay any further if the share is fully paid-up. 9 What distinguishes different types of shares? How are these differences created? Different shares may carry different rights and obligations; for example, some shares have a preferential dividend paid, but do not allow for the member to vote. For a company to have different types of shares, it must specify that difference within its constitution (and, therefore, it must have a constitution). For preference shares (and, indeed, for all other shares), rights attached as set out in a company constitution or otherwise approved by special resolution must be specified in relation to: repayment of capital participation in surplus assets and profits cumulative or non-cumulative dividends voting priority of payment of capital and dividends in relation to other shares or other classes of preference shares (s 254A(2) & s 254G(2)). Note that the main feature of preference shares is that a member receives a preferential dividend before other members but has no other rights unless they are actually specified in the constitution. If a company has different classes of shares: the application for registration of a company must include the class of shares that members agree to take up (s117(2)(k)) a company must lodge a notice with ASIC setting out details of shares divided into different classes (s 246F(1)) a public company must lodge with ASIC a copy of a document or resolution that attaches rights to shares, or varies or cancels rights attaching to shares (s 246F(3)). Some of the different shares are: preference shares, with which members may receive: a dividend ahead of ordinary shareholders 5

6 CORPORTE LAW a payment of dividend usually calculated as a fixed percentage of the issue price of the shares preferential right to repayment of capital on winding up restricted voting rights relating to proposals for reductions of capital, variation of class rights, or winding-up of the company participating preference shares, which include the right to receive additional dividends as well as preferential dividends, and a presumed right at common law to receive surplus capital after repayment of capital contribution cumulative preference shares, which are presumed to be so at common law and include a right to be paid arrears of dividends in later years ahead of ordinary shareholders if the dividend is not paid in a particular year redeemable preference shares, which may be issued under s 254A(1)(b), and with which the company can pay back ( redeem ) the issue price to the shareholder out of the profits or proceeds of a new share. 10 What rights exist under law to protect members holding certain classes of shares from having those rights changed or erased by a majority of members in the company? Members with special rights attached to their shares can invoke the protection of ss 246B 246G. Procedures set out in s 246B provide for two possible courses of action: If the constitution sets out the procedure for varying or cancelling class rights, those rights may be varied or cancelled only in accordance with the procedure. If no constitution exists, there needs to be a special resolution by the company to change the rights attaching to shares, and this must receive 75 per cent of the votes of the members in that class. Possible remedies in such instances include the following: A court may set aside the variation, cancellation or modification if it is satisfied they would unfairly prejudice the applicants (s 246D(5)). A shareholder may enforce the statutory contract under s 140(1) and seek an injunction. A shareholder may apply for a remedy under s 232 if the variation, cancellation or modification is unfair or oppressive. PROBLEM 1 Read the case of ASIC v Adler. There were a number of offences committed by the officers in this case. Explain how the issue of improper provision of financial assistance arose and how the particular officer was dealt with. Summarise some of the main points made by the court in relation to this issue. An improper provision of financial assistance was demonstrated in the case of ASIC v Adler (2002) NSWSC 171, arising from the HIH Insurance collapse in which a subsidiary company was given financial assistance to buy shares in its holding company contrary to s 260A(1)(a). In this case, HIH Casual & General Insurance Co Ltd, a subsidiary of HIH Insurance, gave a $10 million unsecured loan to a Rodney Adler company called Pacific Eagle Equity P/L (PEE). At the time, Adler was a non-executive director of HIH and, through Adler Corp. Ltd, a substantial shareholder in HIH. 6

7 CHAPTER 11 MAINTENANCE OF CAPITAL AND THE PAYMENT OF DIVIDENDS PEE became a trustee of Australian Equities Unit Trust (AEUT), which was controlled by Adler Corp. PEE s $10 million loan was used to subscribe in HIH Casualty & General Insurance Co Ltd (HIHC) for the equivalent value of units in AEUT. PEE also used about $4 million to buy shares in HIH on the stock market, which it later sold for a $2 million loss. PEE s purchase of HIH shares was designed to give the market the false impression that Adler was supporting HIH s falling share price by buying shares in the company. The court found that Adler was not out to make a profit, but that Adler s intention was to shore up the HIH share price for the benefit of Adler Corp., which was a substantial shareholder in HIH. NSWSC held that the substance of the transaction was that HIHC gave PEE financial assistance to acquire shares in HIH, HIHC s holding company. Santow J held that both HIHC and HIH suffered material prejudice and, therefore, s 260A was breached. HIHC was materially prejudiced by the fact that it initially exchanged $10 million cash for either an unsecured loan to PEE or the equitable rights it obtained against PEE, which were of less value than the cash handed over. Both HIHC and HIH suffered material prejudice because of the lack of safeguards and the disadvantages of the AEUT investment. The $10 million loan also involved multiple breaches of directors duties by Adler and another officer of the company. Interestingly, even though s 260A provides a process for the giving of financial assistance, it is most unlikely that shareholders would have approved the giving of financial assistance in the context of the Adler case. 7

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