6. Company Capital, Share and Raising Funds

6. Company capital, share and raising funds

6.1. Learning objectives

Learners to;

(a)be able to discuss in detail the capital maintenance rule and the capital reduction doctrine

(b)Discuss the solvency and liquidity test as applied in company law.

(c)Identify and explain the legal implications of different share types

(d)Identify the main statutory books of company accounts

(e)Foss v Habottle and minority protection

(f)Understand the Legal rules relating to loan capital

(g)Understand the law as relating to the appointment, statutory duties and removal of company auditors.

6.2. This Chapter will introduce learners to various aspects of the law relating to capital, shares and raising of funds. It must be pointed out most of the aspects that will be referred to in this chapter are not legal matters but either of business or accounting nature hence precaution will be taken in trying to isolate only those issues that have a bearing on the law. Learners are thus advised to pay particular attention to the objectives highlighted above.

6.2. The concept of capital

A company gets capital (funds) by issuing shares to the first shareholders/members who risk their investment.
Borrowing (loans) is another way in which a company can raise capital.
The power to borrow is normally bestowed upon all companies if they are entitled to do business.
The ability to raise capital through issuing of shares to the public is limited to only private companies.
And the power to raise capital through borrowing (loans) is also subject to limitations, eg, company directors may require prior authorisation of the general meeting if the total amount of outstanding loans exceeds issued share capital (see the Turquand rule).
Issuing of debentures is a particular way of borrowing money for which entitlement is not required
There is need to distinguish between internal and external sources of raising money.
Share capital is the primary source and in accountancy terms is referred to as shareholder equity.
Loan capital is external equity in accountancy terms being the secondary source of financing a company.
Capital is used to acquire assets that can either be fixed which are those assets that are kept for more or less a permanent basis or floating or current assets or stock/shares.
In terms of accounting theory, for every credit entry on a balance sheet eg credits from shareholders or shareholders’ equity or external equity and liabilities (current to be repaid soon, that is, within less than 12 months, or long term),there must be a debit entry in form of assets or cash in the bank or other sources.
The amount with which a company intends to commence business with is called nominal capital or authorised capital. This is determined in terms of the memorandum. Although there is no maximum this determines the registration fees.
Shares issued to members have a nominal value, that is, value at which they are being sold. Eg $ per share.
The portion of nominal shares issued to investors is called issued share capital or subscribed capital.
Issued share capital is a portion of authorised capital.

6.3. Nature of shares

They are movable incorporeal property (cannot be seen by eyes but can be perceived by other senses).
Ownership of shares is evidenced by documents, eg share certificates or share statements.
A share is also an interest in a company but not co-ownership of property. Shares give the holder personal right to claim dividends of declared. A dividend isa payment made to the members of a company out of profits. Shareholders do not necessarily have an automatic right to receive dividends even though profits have been made. Company directors may decide to plough back the profits into the company, that is, reinvest the profits.
A dividend is thus not a debt to the company until it is declared by the directors.

6.3. Classes of shares

Shares have different classes with varying implications on the rights on the holders thereof.
Shareholders A and B hold the same class of shares if their shareholders’ rights are exactly the same.
Classes are created by either the company’s memorandum or articles or directors’ resolution. However, in practice, companies today avoid complicating their capital structure by creating many classes of shares.
There can be an innumerate of classes but the most basic classes will be dealt with below.

(a)Ordinary shares

These usually form the largest portion of the company capital.
Holders of these shares bear the major risk of the company.
In the event of company being insolvent, they are paid after all other parties that are entitled to be paid are paid, eg, after the statutory and secured creditor and holders of other classes of shares.
As a result of their seemingly unfavourable position in relation to risks, ordinary shareholders determine most of the company’s issues.
They enjoy rights to vote at company’s meetings. They can only be paid dividends after preference shareholders have been paid. If they is not enough profit they might not be paid at all.

(b). Preference shares

As the name suggests, holders of this class enjoy preference to other classes
They are entitled to a fixed preferent dividend
However, only get a dividend if so declared.
The general rule is that all shares must carry with them voting rights. However, the articles may exclude or limit voting rights attached to preference shares.
However, the exception does not apply if (a) a dividend is in arrears and remains unpaid for 6 months after the date it is due and payable; (b) the resolution in question materially affects holders’ interests ( more than rights- Du Plessis Utopia)
They are different types of preference shares and the most important types are ;
(i) Cumulative: preference shares are cumulative unless expressly stipulated otherwise. This means that dividends in previous years not declared accumulate and must be paid out first whenever there are again, profits available.

(ii).Participating: preference shares are not participating unless so stipulated. The shareholders get in addition to a preferent dividend, the different between the preferent dividend and the dividend paid to the ordinary shareholders.

(iii).Redeemable preference shares: these are a hybrid between shares and debentures. Can be created or other classes be converted into redeemable preference shares if authorised in the articles and by special resolution. A special resolution is defined in section 2 read with section 133(1), (2) and (3) of the Companies Act as a resolution passed at a general meeting of a company by way of a majority of not less that three-fourth (3/4) of such members entitled to vote as are present in person or by proxy (representation).

They can be redeemed (bought back) by a company.
In order to protect the company’s capital in the interest of creditors, their redemption if financed from (aa) surplus profits transferred to the capital redemption reserve fund or (bb) a fresh issue of shares taking the place of those redeemed; and (cc) any premium, if such shares are to be redeemed, may be paid from the share premium account (an account created when shares are issued at premium).

(c). Deferred shares

Holders are considered for a dividend after holders of ordinary shares have received a stated minimum.

6.4. Borrowing

6.4.1. Issuing of debentures

Conventional borrowing bestows the power to a company to do so but only if it is entitled to do business.
However, a company may offer and issue debentures before being entitled to do business
Debentures are written acknowledgements of liability stating ;(a) the amount owed, (b) interest rate, (c) whether secured (not to be), (d) repayment date(s), and (e) debenture certificates showing the creditor’s name.

(i). Debenture versus shares (similarities and differences).

Both may be issued before the company is entitled to commence business
The same rules apply relating to issue and transfer
However, debentures unlike shares, may be issued at a discount, that is, below their face value
Unlike a shareholder who is owner of a company, a debentureholder is a creditor of company, hence, (a) can get an interest at a fixed rate and date(s) irrespective of available profits, and (b) can get his/her capital back irrespective of the company’s business fortunes.
Security for debenture may be given in form of pledge (in respect o movables), cession (of rights) or mortgage (immovable) BUT a debenture may in itself be notarially executed and registered as if a notarial bond.
A debentureholder has rights against the company but not in the company.
A debentureholder does not attend meetings.

6.4.2. Conventional borrowing

A company that is entitled to do business is given borrowing powers
The details of the company’s borrowing powers are contained in its Articles and specify; (a) the extent to which it can borrow, (b) the procedure that must be followed before it borrows, (c) to whom it may borrow from (d) any limitations in respect if the seemingly inherent powers to borrow.

6.5. Maintenance and reduction of capital

A company represents the interest of various groups.
The law thus aims at protecting these interests by, inter alia, prescribing rules relating to how a company can deal with its capital.
These rules are discussed below.

(a). Rules relating to payment from company’s various (share) capital accounts.

Funds in the share capital, share premium and stated capital accounts and any other funds should be paidto shareholders only in legitimate course of business. Case- Trevor v Whitworth.

(b)Restrictions on issuing shares at a discount

(c)Prohibition against reducing capital and replacing them with new shares.

(d)Prohibition against giving loans to company’s directors if the loans are not given in the company’s ordinary course of business. Eg. Company A cannot issue loans to its directors if company A’s core business is not issuing of loans.

(e)Restrictions on acquisition of company of its own shares. Common law prohibits a company from buying back its own shares (repurchases) (Trevor v Whitworth).(s79 of the Companies Act).

(f)Restrictions on reduction of issued share capital. A company, as the case with share repurchases, can only reduce its issued share capital if, (i) approved by a special resolution and authorised by Articles, (ii) or authorised by a general authorisation valid only for a particular purpose and validity of such authorisation is subject to revocation at any time and period of such validation only until the next annual general meeting.

Why regulate share repurchases and reduction? If not properly reflected, may portray an inaccurate picture of the company’s capital accounts.
Thus, if issued shares are repurchased, need to be cancelled and reflected as part of its nominal (authorised) share capital.
These rules are designed to protect the creditors.
The company may only acquire shares (repurchases) if (i) there is a reasonable belief that after the acquisition it can or will be able to pay its debts as they become due and payable in the ordinary course of events ( the liquidity test) and (ii)that its consolidated assets will after the acquisition, still exceed its consolidated liabilities ( the solvency test).

(g)The capital maintenance rule

The effects of limited liabity on a company’s creditors are that upon its liquidation, there can only get what is left in the business and thus cannot proceed against the private assets of the members.
This undoubtedly places the creditors at a risk.
In order to mitigate the effects of this scenario, the capital of the company is viewed as offering a guarantee to the creditors that upon the company’s liquidation, they will get something.
The company’s capital is usually the first point of security when creditors are contemplating extending lines of credit.
It is because of this that the capital maintance rule was designed.
This rule simply states that the capital of a company must be maintained.
Maintenance means that the company must at any given point in time, meet a certain capital threshold.
This applies to reduction of the company’s capital hence the requirement that certain procedures need to be met before a company reduces its capital. These have been alluded to above in (f).
Section 92 of the Companies Act requires a company wishing to reduce its capital to (i) be authorised by its Articles, (ii) authorised by a special resolution (ii) have the resolution confirmed by the court in form of a court order.
The additional requirement that the special resolution be confirmed by a court order is meant to ensure that noon, especially the minority shareholders, is prejudiced.
Section 93 allows creditors of a company to object to the proposed share reduction.
The court can only confirm the proposed reduction is it had sight of the list of the creditors.
Failure to reveal or put differently, concealment of a name of a creditor amounts to an offence.

4.5.1. Do we need the capital maintance rule in modern business?

The rationale behind capital maintenance is clear: to ensure that creditors have something to fall back on in the event of a company running into trouble.
BUT, the something that will only be required ONLY when trouble is real MUST, in terms of the rule, be readily available even when the company is not in trouble.
It is submitted that the rule that the company, at any given point, be in possession of certain amount of capital limits the company’s flexibility and is a great burden in the modern day business world.
The rule that, with its noble intentions, is archaic for it fails to take into account, one of the most significance pillars of modern day business, risk taking. A company can reasonably take business risks including placing its capital in the line of business for the greater good. One can imagine a company with large capital reserves that it cannot reinvest just because, when the time of trouble comes, it must have it.
The continued usefulness of the rule is largely out of touch with modern day business trends hence such jurisdictions as South Africa has moved away from it and replaced it with the more flexible and modern liquidity and solvency test.
The Liquidity and solvency test in short, requires that it not a matter of whether a company has in its reserves, so much capital, but rather whether if it will be able to pay its debts should they become due and payable (the liquidity test) and whether its consolidated assets (not necessary its capital) will exceed its liabilities (solvency test).

6.6. Shareholders and company’s share capital management

Shareholders being the owners of a company are affected by any move to alter the share structure of the company.
The company can alter its share structure by either cancelling issued out shares or later the class of a certain shares.
The law thus provides for several mechanism aimed at protecting affected shareholders.
It is also important at this point to get acquainted with mechanics of company membership and the rules aimed at protecting of the minority for this have a bearing on the protection of the latter group in relation to capital management.

6.6.1. Membership

A member is anyone who agrees to become a member by subscribing to a company memorandum and whose name is entered in the register of members (section 30(1) of the Companies Act).
A body corporate cannot be a member of a company which is its holding company (section 31(1)).
Section 32 imputes personal liability on any person who knowingly causes the company to carry on business without members for more than 6 months.
Section 115 provides for the register and indexing of members. Every company shall keep a register of members containing the details of each member.
Failure to keep the register and observe any matters incidental thereto renders the company and any person responsible guilty of an offence (section 115 (7)).
The one with majority shares, that is, one who has invested more capital is the controlling shareholder.
Being a controlling shareholder usually gives one the power to act in any manner that one wishes. The courts generally are reluctant to question why a controlling shareholder acted in such a manner.
In Foss v Harbottle (1843) it was stated that in cases where a wrong has been committed to the company or where there is an irregularity in the management of the company, in the event that there is a need to enforce the rights of the company, the company decides what action to take as the plaintiff in the matter.
The shareholders are not the proper plaintiff unless they act through the general meeting.
Simply put, a shareholder cannot sue for the wrong done to the company.
The fact that the action has to be done through a general meeting means that the decision of the majority as voted thereon will bind the company.
The rule in Foss v Harbottle is thus that a resolution validly passed or ratified by a simple majority (even less than 50% + 1 of all votes as a result of disinterest from small investors) binds the minority.
However, such a decision cannot bind the minority if it is illegal, unconstitutional or amounts to ‘fraud on minority’, that is, abuse of power. And then a minority can approach the court with a personal or representative action, that is, on own behalf or on behalf of the others who might be in the same predicament.

6.6.2. The rationale of the rule

The company as a separate legal entity is the one that suffers the harm thus must sue
The majority rule hence their decisions binds the company
Allowing each and every shareholder to bring an action will result in multi- actions

6.6.3. Implications of Foss v Harbottle and minority

The rule places the majority in a strong position and the minority will be in at a serious disadvantage
It is risky for the minority to bring an action in the company’s name since the majority as the controllers of the company can simply stop (bar) it.
However, to avoid the reality of injustices that can be perpetrated by the rule, there are limitations to its applications. These are;

(a)In case of utra vires transactions, that is, those acts beyond the company’s powers. Here the minority would be allowed to sue the majority

(b)Failure to comply with certain requirements, eg. If a special resolution is required before the majority can make the adverse decision. A special resolution is defined in section 2 read with section 133 of the Companies Act as a resolution passed at the company’s general meeting whereby the majority of not less than ¾ of such members entitled to vote as are present in person or through proxy (representation) following the giving of the required 21 day notice for such a meeting.