Disguised Returns of Capital - An Arm's Length Approach

Abstract:     
This paper analyses a fundamental principle of company law which recently came to the attention of the Court of Appeal. One of the basic features of modern company law is limited liability. Shareholders are not personally liable for debt incurred by the company. Shareholders are only liable to make the contribution they have undertaken to make when they first subscribed for shares. Limited liability is a privilege that enables shareholders to invest in a business without personally carrying the risk that the business fails. If the business fails they will only have lost the contribution they originally promised to make to the business, but not more. Because shareholders are not personally liable for debts incurred by the company, the law has implemented rules protecting the interests of creditors of companies. These rules are directed towards maintaining the capital of the company. The law maintains the capital of a company by subordinating the claims of shareholders to the claims of creditors. This is a fundamental principle of company law which will be explored further in this paper.
Companies are only permitted to make payments to their investors out of funds that are not needed to satisfy the claims of creditors. There are rules determining how companies calculate profit that is available for distribution to shareholders. Those rules make provisions for debt owed by the company. Payments that are not out of distributable profits can only be made to shareholders under the rules on reducing capital or on winding up companies. These rules set up procedures that ensure that creditors are paid before any payments to shareholders are made.

Payments to shareholders that are not out of distributable profit or in the course of a reduction of capital or a winding-up procedure are unlawful. An unlawful payment occurs, for example, if a company makes a distribution without having applied the rules on calculating profit. An unlawful payment also occurs if a company enters into a transaction with a shareholder that is not a distribution, but that transfers an asset to the shareholder without the company receiving an adequate consideration in return. In both cases shareholders have skipped the queue and received value from the company ahead of the company's creditors.

This paper will focus on unlawful payments that occur in the course of a transaction that has been entered into between the company and a shareholder. This was also the subject matter of the recent Court of Appeal decision. An unlawful payment occurs if the company did not have distributable profits and if the payment was not made in the course of a reduction of capital or in the course of a winding up. Such payments are sometimes referred to as disguised returns of capital. The idea that a transfer of value away from the company to a shareholder depletes the company of that value and involves a shareholder receiving treatment preferential to the company's creditors is straightforward. The courts have, nevertheless, struggled to articulate a test distinguishing lawful transactions with shareholders from disguised returns of capital. This paper identifies the issues that have emerged around the rule prohibiting disguised returns of capital and puts forward a solution to these issues.

The question analysed in this paper is of academic as well as practical importance. It is of academic importance because it defines the boundaries of the principle of capital maintenance. It demarcates the borderline between creditor and shareholder interests. It is of significant practical importance because it affects transactions between companies and their shareholders. Such transactions frequently occur in relation to private companies and also within groups of companies.

The analysis presented in this paper first identifies the historic roots of the rule prohibiting disguised returns of capital and examines the rule in this context and against the background of the modern law of capital maintenance. It also shows that the law is still fluid. Judges have adopted differing approaches to the rule. The paper puts forward an approach that fits with the historic roots of the rule and does justice to the way in which the modern law approaches decisions that are taken by companies and their directors. It argues that transactions with shareholders have to be carried out at arm's length.

The structure of the paper is as follows. The rule prohibiting disguised returns of capital has been said to have emerged from cases that were decided around the time when the external effect of the ultra vires doctrine was abolished. It will be shown in section II. that the rule existed before then, but was stated under the umbrella of that doctrine. In particular, the cases that evolved around the decision In re Lee, Behrens & Co, which has long puzzled academic commentators, can be explained by reference to disguised returns of capital. These historic roots of the rule have implications for the modern law which are referred to throughout the paper.

Section III. shows that disguised returns of capital have now become the subject of an independent rule that prohibits companies from entering into transactions at an undervalue with their shareholders in circumstances where the company does not have distributable profits. This rule could be stated as involving an abuse of power on the part of the directors. It could also be stated as rendering transactions illegal. Section IV. of the paper concludes that transactions in breach of the rule are illegal.

The paper will also discuss how transactions involving a disguised return of capital are to be identified. Section V. shows that the courts have used several approaches. In some decisions a subjective element testing the state of mind of the company directors or of both parties to the transactions has been applied. Other cases paid no attention to subjective criteria and focused on the effect of the transaction. The conclusion of section VI. is that the background against which the rule operates mandates an objective approach. The paper suggests that an arm's length approach should be applied. Section VII. concludes that shareholders are unable to rely on CA 2006, s 842 in order to avoid having to return assets they have received by way of a disguised return of capital.

Working Paper Series