Author: TheLawStudent

Simplified order of priority between creditors

This order of priority is a simplified version.

1. Creditors with fixed charges – entitled to the first call on the proceeds from the sale of those assets charged to them under a fixed charge.
2. Preferential creditors – primarily wages (up to £800 per employee) and occupational pensions.
3. Creditors with floating charges (which will have crystallised, if not before, upon commencement of the winding up). For floating charges created on or after 15 September 2003, a proportion of the proceeds of the floating charge assets will be set aside for payment to unsecured creditors. This is commonly referred to as the ’prescribed part fund’.
4. Unsecured creditors, to the extent not paid off from the prescribed part fund.
5. Shareholders (according to the rights attaching to their shares).

Priority among secured creditors

The rules of priority are complex but, in general, if more than one creditor has a fixed charge over the same assets, the first fixed charge created has priority (provided it was properly registered in accordance with s.860 or s.859A CA 2006). Similarly, if more than one creditor has a floating charge over the same assets, the first floating charge created has priority (provided it was properly registered).

However, this order can be varied by agreement between the creditors through a document known as a Deed of Priority, an Intercreditor Agreement or a Subordination Agreement. Such an arrangement has the benefit that creditors can make specific provision for the order in which they will rank and do not need to rely on the complex and sometimes uncertain rules mentioned above.

Priority among unsecured creditors/shareholders

Shareholders and unsecured and preferential creditors rank equally among themselves (subject to any preferential rights attached to certain classes of share).

Registration of charges created on or after 6 April 2013

Changes to the CA 2006 dealing with the formalities for registering security at Companies House came into force on 6 April 2013. The relevant provisions are found in s.859A-Q CA 2006, which replaces ss.860-892 CA 2006. The ‘new’ registration regime is summarised below:

Registration formalities

Most security created by a company needs to be registered on that company’s file with Companies House. This includes charges created by an English company over assets located both within the United Kingdom and abroad. Pursuant to s.859A(2) CA 2006, the Registrar of Companies (the ‘Registrar’) shall register any security created by a company at Companies House provided that the company or any person interested in the charge (i.e. the lender) delivers to Companies House (either electronically or by paper filing) within 21 days beginning with the day after the day on which the charge is created (s.859A(4) CA 2006) the following:

• a section 859D statement of particulars in relation to the charge. This will be set out on Form MR01 (available on the Companies House website), and includes details of:
  • the company creating the charge,
  • the date of creation of the charge,
  • the persons entitled to the charge, and
  • a short description of any land, ships, aircraft or intellectual property registered (or required to be registered) in the UK which is subject to a fixed charge;
• a certified copy of the charge (s.859A(3) CA 2006); and
• the relevant fee (currently £23 for a paper filing or £15 for an electronic filing).

On receipt of the relevant documents, the Registrar must allocate to the charge a nique reference code and shall include on the register (i) a note of the unique reference code and (ii) the certified copy of the charge (s.859I(2) CA 2006). The Registrar must issue a signed/authenticated ‘certificate of registration’ stating the registered name and number of the company in respect of which the charge has been registered and the unique reference code allocated to the charge (s.859I(3),(4) and (5) CA 2006). This is conclusive evidence that the charge has been correctly registered.

Who registers?

Section 859A(2) CA 2006 provides that the s.859D statement of particulars may be delivered either by the company that created the charge or any person interested in that charge. The latter would include the lender. In practice it will usually be the lender’s solicitors who will complete the registration formalities, as it is the lender who has most to lose in the event of non-registration.

Effect of failure to register

Under s.859H CA 2006, if the charge is not registered at all, or is not registered within the 21-day period referred to in paragraph 5.1.1 above:

• the charge is void against a liquidator, administrator and any creditor of the company; and
• the debt becomes immediately payable.

As security is taken as protection against the effects of insolvency, the fact that the charge is not valid as against a liquidator or administrator means that the security will effectively be worthless if not registered.

Records to be kept by a company

Under s.859P CA 2006, a company must keep available for inspection a copy of every charge and a copy of every instrument that amends or varies any charge. Such copies may be certified copies rather than originals.

These documents must be kept at either the company’s registered office or such other location as is permitted under the Companies (Company Records) Regulations 2008 (s.859Q(2) CA 2006). A company must inform Companies House of the place where such documents are available for inspection and of any changes to that place (s.859Q(3) CA 2006). These documents must be available for inspection by any creditor or member of the company free of charge and by any other person on payment of a prescribed fee (s.859Q(4) CA 2006). If a company refuses such inspection then the court may order that the company allows an immediate inspection.

Under s.859Q(5) CA 2006, failure to comply with any of the above requirements will be an offence and the company (and every officer of the company who is in default) will be liable to a fine.

In practice

Registration of security is common trainee work. An organised and efficient trainee will have Form MR01 drafted in advance and will register the security as soon as possible after execution of the charge. This will allow time for any errors in the documents to be remedied. It is important to note that Companies House will return Form MR01 if it is incomplete or incorrect, but the 21-day period will continue to run.

Failure to register security within the 21-day period will require the parties to re-execute the security documents and re-attempt a Companies House registration (although this can be legally problematic in view of the insolvency related challenges that can be made, particularly under s.245 Insolvency Act 1986). If other security has been granted in the interim, the lender will lose its priority. In this event, or if the filing is forgotten altogether, the mistake may result in major financial loss for a lending client. This will doubtless be followed by a claim against the law firm.

The nature of security

It is possible to improve the priority of a debt by taking security for it. ‘Security’, in this context, means temporary ownership, possession or other proprietary interest in an asset to ensure that a debt owed is repaid (i.e. collateral for a debt). Be careful not to confuse security for a debt with a ‘debt security’.

The main benefit of taking security is to protect the creditor in the event that the borrower enters into a formal insolvency procedure. It should not normally be necessary to enforce security if the borrower is still able to pay, although in some circumstances enforcing security may be a simpler way of obtaining repayment than suing the borrower.

The following are all forms of security.

• Pledge – With a pledge, the security provider (usually the borrower or occasionally another company in the borrower’s group) gives possession of the asset to the creditor until the debt is paid back. Pawning a watch or an item of jewellery is a form of pledge.
• Lien – With a lien, the creditor retains possession of the asset until the debt is paid back. An example is the mechanic’s lien. This arises by operation of law and allows a mechanic to retain possession of a repaired vehicle until the invoice is paid.
• Mortgage – With a mortgage, the security provider retains possession of the asset but transfers ownership to the creditor. This transfer is subject to the security provider’s right to require the creditor to transfer the asset back to it when the debt is repaid. This right is known as the ‘equity of redemption’. A type of mortgage (known as a charge by way of legal mortgage) is usually taken over land (although, unusually, ownership will remain vested in the security provider in this case).
• Charge – With a charge, as with a mortgage, the security provider retains possession of the asset. However, rather than transferring ownership, a charge simply involves the creation of an equitable proprietary interest in the asset in favour of the creditor.

As well as this equitable proprietary interest, the charging document will give the lender certain contractual rights over the asset – for example to appoint a receiver or administrator to take possession of it and sell it (or, exceptionally, to take possession of it itself to sell), if the debt is not paid back when it should be.

Fixed and floating charges

There are two types of charge: fixed charges and floating charges. From a creditor’s perspective, fixed charges are generally a better form of security, but not all assets are suitable for charging by way of fixed charge.

Fixed charges

A fixed charge is normally taken over assets such as machinery and vehicles. The key element of a fixed charge is that the creditor can control what the security provider can do with the fixed charge assets. This is usually done by the security provider undertaking not to dispose of, or create further charges over, the charged assets without the creditor’s consent. Note that ‘control’ in this context means the borrower can generally still use the asset in the ordinary course of business but is restricted from disposing or charging it.

If the charge becomes enforceable, the creditor will have the ability to appoint a receiver of that asset or to exercise a power of sale of the asset.

Floating charges

It is not always practical for a security provider to undertake not to dispose of its assets. For example, a trading company needs to be able to dispose freely of its stock (i.e. the products it sells).

In that case, a floating charge may be appropriate. A floating charge ‘floats’ over the whole of a class of circulating assets. Whatever assets in that class happen to be owned by the security provider at any given time are subject to the floating charge, and the security provider is free to dispose of the assets as it wishes until ‘crystallisation’.

Crystallisation means that the floating charge stops floating and fixes to the assets in the relevant class which are owned by the security provider at the time of crystallisation. The creditor thus acquires control of those assets and to this extent a crystallised floating charge is like a fixed charge. Crystallisation may occur by operation of law or may be triggered by certain events as contractually agreed between the creditor and security provider. Crystallisation will usually occur when the borrower has breached certain significant terms of the loan agreement (including by reason of its insolvency).

Disadvantages of the floating charge from the creditor’s perspective

1. As the security provider has freedom to dispose of the assets in the ordinary course of business, the creditor will not be sure of the value of the secured assets – they might all have been sold before crystallisation occurs.
2. A floating charge generally ranks below a fixed charge (and note that crystallisation does not change that) and below preferential creditors on the winding-up of the company. However, if the floating charge document contained a term prohibiting the creation of a later fixed charge (a ‘negative pledge’ clause) but the company nevertheless created a later fixed charge, the floating charge will have priority if the later fixed charge holder had notice of this restriction.
3. Floating charges created on or after 15 September 2003 are subject to a part of the proceeds of the assets being set aside. This is known as the ‘prescribed part fund’ for unsecured creditors.
4. Floating charges are capable of being avoided under s.245 Insolvency Act 1986.
5. An administrator is free to deal with floating charge assets in his control without reference to the charge holder or the court and to pay his remuneration and expenses out of the proceeds of those assets.

Guarantees

Strictly speaking, guarantees are not security, as guarantees do not give rights in assets. However, as their commercial effect is similar to security, security and guarantees tend to be treated together.

A guarantee for a loan means an agreement that the guarantor will pay the borrower’s debt if the borrower fails to do so.

Guarantees can come from companies or individuals (such as directors).

Consider the basic example of a group of three companies; A, B and C, where B and C are subsidiaries of A. A guarantee given by A of a loan made to B is a downstream guarantee. A guarantee given by B of a loan made to A is an upstream guarantee. A guarantee given by B of a loan made to C is a cross-stream guarantee.

Debentures

The word ‘debenture’ has two different meanings. Under s.738 Companies Act 2006 (CA 2006), it has a wide definition covering any form of debt security issued by a company.

However, when the term is used in this course and by bankers and debt financiers, they usually mean the document creating security (normally a collection of mortgages and fixed and floating charges over all the borrower’s assets). This document should be separate from the document creating the loan facility itself (which is usually referred to as a ‘loan agreement’, ‘credit agreement’ or ‘facility agreement’).

Whilst this may seem confusing, the context should clarify which definition is appropriate.

Examples of securities

Fixed charge

Bigbank plc has made a loan of £100,000 to Blue Moon Limited to facilitate the purchase of machinery. The loan has to be repaid over a period of five years. Blue Moon has given a fixed charge over its machinery to Bigbank.

Effect on Blue Moon

Blue Moon cannot sell the machinery or charge it to another bank without Bigbank’s consent. It can continue to use the machinery for its business as it retains possession.

Effect on Bigbank

Bigbank has rights in the machinery. If the loan is not repaid, Bigbank can appoint a receiver to sell the machinery (or, exceptionally, may itself sell the machinery) and must apply the sale proceeds to satisfy the unpaid debt.

Floating charge

Floyds Bank is the clearing bank for Blue Moon Limited, operating the company’s current account and has also provided a loan facility of £50,000 which is currently fully borrowed. To secure all monies due, Floyds Bank has a floating charge over all the assets of Blue Moon present and future.

Effect on Blue Moon

Blue Moon can continue to deal with its assets in the ordinary course of its business until such time as the floating charge crystallises.

Effect on Floyds Bank

Floyds Bank has rights in the assets, but cannot exercise control over them. If Blue Moon defaults on the loan, then Floyds Bank can crystallise the floating charge. This will give Floyds Bank control over the assets and allow it to recover its money by appointing an administrator (or exceptionally exercising its power of sale over them).

Guarantees

Northshire Bank is intending to lend £20,000 to 3dGraph Limited. 3dGraph was recently incorporated by Brian Jones to market 3d printing software which he designs. The money is to be used to purchase computer hardware which will be used in software design. The bank will be granted a fixed charge over this hardware. However, the bank is concerned that the value of the hardware might depreciate rapidly, leaving it exposed. Brian is the majority shareholder in the company and is its managing director.

As the company is newly incorporated, it may not have substantial assets. The asset over which Northshire Bank has a fixed charge is likely to quickly lose its value. Northshire Bank could take security over future assets, but this will only be useful if 3dGraph acquires valuable assets. Northshire Bank could also look to take a personal guarantee from Brian Jones if he has valuable assets. If the company defaulted, Northshire Bank could call on the guarantee and, if Brian refused to pay, sue him for the money. Brian may also give security for the loan (e.g. by granting a mortgage over his home, subject to any rights of any other person living there with him).

Lending money to a company – a typical package

Southern Bank plc has been asked to provide finance for a new company called Workskill Videos Limited (‘WV’). It is 100% owned by Workskill Training plc, the holding company for a very successful group of companies dealing in areas such as the training of various groups of professionals in personal skills. WV is seeking £200,000 to finance the purchase of a studio, editing suite and miscellaneous video equipment.

Southern could look to take a fixed charge over (amongst other assets) the new and future equipment and a floating charge over all other assets of WV. This is a typical security package. It would be documented in a debenture. In addition, the bank may want to take a guarantee from the parent company (Workskill Training plc). The guarantor may also grant security. In this case, such security might take the form of a fixed charge over Workskill Training plc’s shares in WV, allowing Southern to enforce its security through the sale of WV if both WV and Workskill Training defaulted.

An investor invests £1,000 in Blue Moon Limited by buying 1,000 ordinary shares of £1 each issued by the company.

By way of illustration (and assuming no other figures are relevant), this would show on the company’s balance sheet as follows:

Blue Moon Limited Balance Sheet as at 31 March
	£
ASSETS (cash and cash equivalents)	1,000
Less LIABILITIES	(0)
NET ASSETS	1,000
SHARE CAPITAL	1,000
RETAINED EARNINGS	0
TOTAL EQUITY	1,000

 Blue Moon Limited then takes out a loan of £750, repayable over five years:

Blue Moon Limited Balance Sheet as at 31 March
	£
ASSETS (cash and cash equivalents)	1,750
Less LIABILITIES	(750)
NET ASSETS	1,000
SHARE CAPITAL	1,000
RETAINED EARNINGS	0
TOTAL EQUITY	1,000

 The accounts above show that when a company takes out a loan, the net assets figure is not affected. The company’s liabilities are increased by the amount of the loan but, as the company’s assets (cash and cash equivalents) are also increased by the loan funds, the net assets remain unchanged. Also, because the company has taken out a loan (debt) rather than issued new shares (equity), total equity is also unchanged.

This is important because the ratio of liabilities to shareholder funds (total equity in the balance sheet), or in simpler terms, the ratio of debt to equity, is an important indicator of the financial health of a company. This ratio is known as a company’s gearing (or leverage). The higher the ratio of debt to equity, the more highly a company is geared.

Gearing is calculated by the formula:

Long term debt (Non-current liabilities) x 100%
Equity (Total Equity)

Looking at the example above, the gearing ratio of Blue Moon Limited after it has taken out the loan for £750 is as follows:

750 x 100% = 75%
1000

This illustrates that, at this moment in time, Blue Moon Limited has a very high level of gearing, i.e. the amount of long-term loan capital is very high compared to the amount of shareholder funds (total equity in the balance sheet) in the company.

Highly geared companies are seen as more of a credit risk by banks, so they might find it more difficult to raise further loans in the future. This is because they have less equity to absorb any losses the company might make. Because shareholders are paid last in the statutory order of priority on a winding up of a company, a company with a lot of equity can make substantial losses before it runs out of money to pay back its creditors. A highly geared company has less equity to protect the creditors and so poses a higher risk.

In addition, a highly geared company will need to make more profits before interest and tax (PBIT) in order to meet the demands for interest payments. This can be especially dangerous when economic conditions are bad or interest rates are high. All of a company’s profit could be swallowed up by the interest payments which need to be made under the terms of any loan agreements. Also, a company with a lot of debt is less likely to have assets which can be secured in favour of any new lender(s) (as these will probably already have been secured in respect of the existing debt).

You might be wondering why a company would choose to be highly geared. Suppose a company has a highly profitable investment opportunity available to it. By borrowing money, it can make a far bigger investment than it could have made if it was just using its own resources. If the investment performs well, all the profit from that investment (after interest has been paid on that debt) will belong to the company. It will have made more money than it could have done if it had only used its own resources. On the other hand, if the investment performs badly, it will have lost more money and it will still have to pay the interest on the debt.

Increasing gearing can also enhance the return to shareholders because raising money through debt finance does not require share dilution through the issue of new shares. A finance professional within a company will often recommend that debt finance should be raised due to the fact that this will have no effect on the returns to shareholders. Issuing more shares on the other hand will mean that the profits are shared between more shareholders.

Consider the following example:

Balance sheet extract			Low gearing £	High gearing £
Loans (10% interest)			10,000	50,000
Equity			100,000	60,000
Total capital			110,000	110,000
Profit and loss extract
Profit before interest and tax			25,000	25,000
Interest paid			1,000	5,000
Profit before tax			24,000	20,000
Tax (assumed 20%)			4,800	4,000
Profit after tax			19,200	16,000
Earnings per share			19.2p	26.6p

 The high level of loan capital compared to equity in the higher geared company improves the earnings per share of the shareholders (earnings is the same as profit).

However, in bad times, gearing works in reverse and is therefore risky. Higher gearing increases the scope for a company to make larger losses, by increasing the size of the company’s operations compared to shareholders’ funds. If borrowed capital is deployed badly, the company may lose much more than if it had deployed only its own money. In addition, the loan interest has to be paid whether a profit is made or not.

Term sheet

At the start of the financing transaction, the bank and the borrower (or issuer in the case of the bond issue) will agree a term sheet. This is a statement of the key terms of the transaction (e.g. loan amount, interest rate, fees to be paid, key representations, undertakings and events of default to be included in the loan agreement/bond terms and conditions). The term sheet is equivalent to heads of terms in other transactions. It is not intended to be a legally binding document, rather a statement of the understanding on which the parties agree to enter into the transaction.

Loan agreement

The loan agreement sets out the main commercial terms of the loan such as amount of interest, dates on which interest will be paid, the date(s) on which principal needs to be repaid and any fees due. It will also include most of the other information from the term sheet but in much more detail. The loan agreement is one of the most heavily negotiated documents in a debt finance transaction.

This type of loan agreement tends to be used primarily for committed facilities (i.e. term loans). On-demand facilities on the other hand (i.e. overdrafts) tend to use much more straightforward and informal documentation. They are often signed up on the bank’s standard terms which are rarely negotiated and include minimal information in relation to interest rates (which tend to be high) and other payment obligations.

Debt securities have their own set of documentation which includes extensive information to enable investors to make an informed decision on whether or not to invest.

Security document

If a loan/bond is secured, a separate security document will be negotiated and entered into. This document will set out what assets are being given by way of security and the specific type of security which will be taken over each asset. It will also set out any specific provisions or undertakings relating to the secured assets (for example, an obligation to insure any property and a restriction on the chargor’s ability to sell the assets).

Introduction

Why does a company need capital?

In order to fund:

• start-up expenses;
• working capital; and
• expansion and growth (e.g. purchasing new premises or another business).

Capital can come from:

• equity (shareholder funds);
• debt;
• hybrids (such as preference shares and convertible bonds); and
• retained profits (also known as ‘retained earnings’).

What is debt finance?

A simple definition is ‘borrowing money’ from banks, other financial institutions or other lenders (such as directors or other group companies).

Types of debt finance

Although there are many types of debt finance available under different names, they can all be classified as either loan facilities or debt securities. In general terms, a loan facility is an agreement between a borrower and a lender which gives the borrower the right to borrow money on terms set out in the agreement.

A debt security (bond) is in many ways similar to an equity security (share). In return for the finance provided by an investor, a company (known as the ‘issuer’) issues a piece of paper acknowledging the investor’s rights against the company. This piece of paper (a security) can either be kept or sold to another investor. However, as we shall see below, investors in debt securities have rather different rights from investors in equity securities. The terms ‘equity security’ and ‘debt security’ should not be confused with a security interest granted by a company to the lender(s) over one or more of its assets.

Some of the basic types of debt are detailed below:

Loan facilities

• Overdraft – This is a form of loan facility that is familiar to most individuals. It is an on-demand facility (which means that the bank can call for all the money owed to it to be paid back at any time) and is usually not used as a long-term borrowing facility. Companies also use overdraft facilities. Interest is paid to the bank on the amount that the customer is ‘overdrawn’.
• Term loan – A term loan is borrowed for a fixed period of time and repaid on a certain date (‘maturity date’). For example, a company may borrow a sum of money to purchase new machinery for the business. The loan is to be repaid in five years’ time. The lender will not be able to call for repayment before the agreed repayment date in five years unless the borrower breaches the terms of the loan agreement. The borrower pays interest to the lender on the amount borrowed for the duration of the loan.

Term loans which are repayable in a single lump sum at the end of the agreement are referred to as having a ‘bullet repayment’. Alternatively, the loan may be repayable in instalments, in which case it is referred to as ‘amortising’.

Debt securities

• Bonds – A bond is a debt security. Each bond is represented by a piece of paper (a security) which records the rights of the investor. As bonds are a form of debt, those rights are similar to the rights of a lender under a loan facility. The issuer promises to repay the value of the bond to the holder of the bond at maturity. Until then, the issuer promises to pay interest to the holder on a periodic basis (often bi-annually).

Bonds are usually issued with a view to being traded. Whoever holds the bond on maturity will receive the value of the bond back from the issuer. The markets on which bonds are traded, whether physical or virtual, are referred to as the ‘capital markets’.

Debt/equity hybrids

• Convertible bonds

Convertible bonds are bonds which can be converted into shares in the issuer. On conversion, the issuer issues shares to the bondholder in return for its agreement to give up its right to receive interest and repayment of the principal amount invested.

Note that a convertible bond has the characteristics of both debt and equity, but not at the same time. It starts off as a debt security: a bond. The investor receives interest. Later on, if the investor so elects (in accordance with the terms of the bond issue) the bond is swapped for shares. The investor then enjoys all the characteristics associated with shares. At that point there is no longer any debt element to his holding: he has become an ordinary shareholder. Therefore, convertible bonds have the characteristics of debt until they are converted into shares. After that, the holders receive shares with all the characteristics of equity.

• Preference shares

Preference shares are an anomaly. In fact, a preference share is wholly equity, but it is often called a hybrid because it has elements that make it look similar to debt. Indeed, depending on the rights attached to the preference shares, the International Financial Reporting Standards (commonly used by many companies today) provide that there are times when preference shares should be treated as debt for accounting purposes.

The holder of a preference share commonly has no voting rights, and will usually get a definite amount of dividend ahead of other shareholders (making it look similar to interest). So, if the preference share has a fixed maturity date on which the company must redeem or purchase the share and/or such preference dividend is fixed (for example, must be paid if the company has sufficient distributable profits), then the preference share actually looks more like debt.

In my previous post, I detailed the considerations applying to companies proposing to issue shares. The following is a very brief overview of the main rules and guidelines that must be considered in addition to the considerations discussed previously, by public/listed companies proposing to issue shares.

Listing, Prospectus, Disclosure and Transparency Rules (‘LPDT Rules’)

The LPDT Rules apply to listed companies (and some of the rules apply to companies applying for listing) and their provisions set out not only procedures for listing but also continuing obligations to which the listed company and its directors are subject from the date of listing. The LPDT Rules need to be considered when a listed company is considering a fresh issue of shares.

Share Capital Management Guidelines (‘SCM Guidelines’) and Pre-emption Group Statement of Principles

Companies will also have regard to (i) the SCM guidelines issued by The Investment Association (formerly known as The Investment Management Association) in relation to the appropriate level of directors’ authority to allot shares, and (ii) the statement of principles issued by the Pre-emption Group, which is made up of representatives from listed companies and their investors in relation to the disapplication of pre-emption rights. A listed company must consider all of these guidelines whenever seeking s.551 CA 2006 authority or the disapplication of pre-emption rights under s.570 CA 2006. Although the guidelines do not have force of law, the effective sanction for non-compliance is that institutional investors may sell their shares or vote the resolution down.

Valuation of non-cash consideration

Under s.593 CA 2006, subject to certain exceptions, a public company cannot receive non-cash consideration on the allotment of shares without ensuring that the consideration has been independently valued, and a report on that valuation produced, in accordance with the provisions of CA 2006 (see in particular s.596 CA 2006 which sets out what the report should cover). Note that this section of CA 2006 applies to all public companies, not just listed companies.

The s.755 restriction

Under s.755 CA 2006 a private company limited by shares is prohibited from offering its shares to the public. As a result, private companies are essentially restricted to offering their shares to targeted investors only and not to the public indiscriminately.

The expression ‘offer to the public’ (as defined in s.756 CA 2006) covers offers to ‘any section of the public’, but excludes offers which are intended only for the person receiving them, and offers which are a ‘private concern’ of the persons making and receiving them. This latter exclusion covers offers made to existing shareholders, employees of the company and certain family members of those persons, and offers of shares to be held under an employee’s share scheme. These excluded offers will not fall foul of the s.755 restriction.

This restriction must be considered carefully when a private company is proposing to allot shares.

The requirement for a prospectus

Every time that a company (private or public) offers shares you will need to consider whether or not it is required to publish a prospectus to would-be investors. Below is a very brief overview of the rules relating to prospectuses.

What are the governing rules?

At the time of writing, the rules on prospectuses are derived from the European Union’s Prospectus Directive (the ‘Directive’), as amended by subsequent amending directives, which affects, amongst other things, the content and disclosure requirements for prospectuses.

The Directive has been implemented in the UK through the Prospectus Regulation (which has direct effect in the UK); the Prospectus Regulation Rules (PRRs) drawn up by the City regulator, the Financial Conduct Authority (FCA) and amendments to the Financial Services and Markets Act 2000 (FSMA).

Where shares are being offered overseas, overseas law must be considered, and you should note that within the European Economic Area (EEA), mirroring provisions will apply.

Note that the rules on prospectuses are also relevant to offers of debt securities.

What is a prospectus?

A prospectus is essentially an explanatory circular giving investors details about the company they are investing in and about the investment itself on which to base their investment decision. A prospectus should contain all the information necessary to enable investors to make an informed assessment of the financial status of the company and the rights attaching to the shares (s.87A(2) FSMA), and preparing a prospectus is therefore an expensive and time-consuming process.

When is a prospectus required?

In an offer of shares by a private company, it will usually be the case that a prospectus will not be required. However you will need to consider the rules each time.

In outline, the legislation sets out two tests. If either test is satisfied then the company will have to publish a prospectus which will need to be approved by the FCA.

In summary, the tests (set out in s.85 FSMA) are whether the shares are:

1. being offered to the public in the UK (s.85(1) FSMA); or
2. being admitted to trading on a regulated market in the UK (s.85(2) FSMA).

The definition of ‘offer to the public’ for the purposes of the first test (set out in s.102B FSMA) is very wide and capable of covering a range of communications that are not intended to be offers to the public (such as a newspaper article by a financial journalist). Note that (because of the differing definitions of ‘offer to the public’) it is possible that a private company could offer shares to investors without contravening s.755 CA 2006, but that a prospectus could still be required. Usually, however, a private company will be able to rely on one of the exemptions set out below.

For the purposes of Test 2, the Main Market of the London Stock Exchange is a regulated market, although AIM is not. A private company will clearly only be concerned with Test 1, not with Test 2.

Are there any exemptions?

There are different exemptions for Test 1 and Test 2. The Test 1 exemptions are referenced in s.86(1)(aa) FSMA and the PRRs 1.2.3R Article1(4).

The exemption most likely to be relied upon by a private company is the exemption for offers made to or directed at fewer than 150 persons (other than ‘qualified investors’), per EEA State. This exemption will cover the vast majority of share offers by private limited companies.

Another exemption of particular application to offers by private companies is that covering offers made to or directed at ‘qualified investors’ (as defined in the Markets in Financial Instruments Directive (MiFID), essentially covering certain professional or institutional investors) only.

Financial Promotions

Under s.21 FSMA a financial promotion is any invitation or inducement (in the course of business) to engage in investment activity (which includes buying shares). Financial promotions are prohibited (for all companies) unless certain requirements set out in FSMA are fulfilled. Clearly this is potentially relevant when a company is considering issuing shares to investors. Communications made by a company when issuing its shares must, either be within an exemption from the s.21 FSMA prohibition, or be issued or approved by an authorised person.

Price for shares

In simple terms, the price of a share is calculated by working out the value of the company as a whole and dividing it between the number of shares in issue. This will give a value per share, which can be used to determine the price.

There are various ways in which a company can be valued. For example: the ‘Balance Sheet’ valuation, looking at the value of the company’s assets minus its liabilities, or the ‘multiplier’ valuation, looking at the average profit of a company and multiplying it by a factor relevant to the particular industry. The value of a listed company (known as its ‘market capitalisation’) can be ascertained by multiplying the number of shares in issue by the share price at a given time.

The price of a share will comprise the nominal value of the share, plus a premium, although shares can trade at a discount to nominal value (which does not contravene the prohibition on their issue at a discount).

Effect of issuing a share for more than its nominal value on the Balance Sheet

Blue Moon Limited issues an additional 100 £1 ordinary shares for 150p each in cash, i.e. at a premium of 50p per share.

Blue Moon Limited Balance Sheet as at [date]
	Before issue	After issue
ASSETS (cash)	100	250
Less LIABILITIES	(0)	(0)
NET ASSETS	100	250
SHARE CAPITAL	100	200
SHARE PREMIUM ACCOUNT		50
RETAINED EARNINGS	(0)	(0)
SHAREHOLDER FUNDS	100	250

The cash received is shown by an increase in the assets. The nominal amount of the new shares is shown by the increase of 100 in the share capital. The premium of 50p per share (totalling £50) is shown in the newly-created share premium account. The share premium must be shown in a separate share premium account pursuant to s.610(1) CA 2006.

Earnings per share

‘Earnings per share’ is a commonly used ratio that can be used to measure the financial performance of a company. It shows the return due to the ordinary shareholders and is calculated by dividing profit after tax by the average number of ordinary shares in issue whilst the profit was generated. An increase in the number of shares in issue will result in a dilution of the earnings per share figure.

Maintenance of share capital

Once a shareholder has decided to invest in shares in a company, that investment cannot normally be returned to the shareholder. In other words, a company is not usually permitted to return capital to its shareholders – all payments by a company to its shareholders should be made out of distributable profits. This is primarily for the benefit of the company’s creditors. In practice, many private companies have only a small issued share capital so this capital maintenance regime is of little relevance. There are some exceptions to the maintenance of capital rule. These include court-approved reductions of capital and a new procedure introduced for private companies to make out-of-court reductions under Part 17 CA 2006 (ss.642 – 644). Such exceptions will be explored later in the module.

Transfer/Transmission of shares

Circumstances

Shares may be transferred by way of sale or gift or transmitted following death or bankruptcy.

‘Transmission’ means that following death, legal title to shares will vest automatically in the personal representative; and, following bankruptcy, title will vest automatically in the trustee in bankruptcy.

Restrictions on transfer

Shareholders are free to transfer their shares subject to any provisions in the articles (s.544(1) CA 2006).

The two most common forms of restriction on the transfer of shares are:

1. Directors’ power to refuse to register

Article 26(5) MA states:

“The directors may refuse to register the transfer of a share, and if they do so, the instrument of transfer must be returned to the transferee with the notice of refusal unless they suspect that the proposed transfer may be fraudulent”

Under s.771 CA 2006, a company must give reasons if it refuses to register a transfer.

2. Pre-emption clauses

Here we are looking at pre-emption rights on a transfer of shares (which should not be confused with pre-emption rights on allotment under s.561 CA 2006). Such rights are usually set out in the articles. CA 2006 and MA do not contain any pre-emption rights on transfer, so they must be specially inserted into the articles of any company wishing to establish them.

Pre-emption rights on transfer will often require that a shareholder wishing to sell shares must offer them to the other existing shareholders before being able to offer them to an outsider.

A listed company must have freely transferable shares. Therefore such restrictions on transfer are not permitted in a listed company.

Method of transfer

1. Instrument of transfer

A transfer of shares must be made by a ‘proper instrument of transfer’ – s.770(1) CA 2006. The usual method is by way of a stock transfer form, which has to be signed by the transferor and submitted, with the share certificate, to the company.

2. Stamp duty

The stock transfer form must be stamped before the new owner can be registered as the holder of those shares. Stamp duty is payable at 0.5% of the consideration rounded up to the nearest £5. Since 13 March 2008 (when the Finance Act 2008 came into force), no stamp duty is payable where the consideration is £1000 or less; but where the consideration is more than £1000, a minimum fee of £5 is payable.

3. Legal and equitable ownership

Legal title to shares passes on the registration of the member as the owner of those shares in the register of members (s.112 CA 2006). Beneficial title passes on the execution of the stock transfer form.

Types of share

In this post, I present a list of a variety of types of share. It should be noted that these are descriptions and not legal definitions. As there are no set types of share and the elements below can be mixed, it will always be necessary to refer to the articles of association of a company in order to ascertain the rights attaching to a specified class of share.
Therefore, it is important when you read through this post that you concentrate not so much on the names but on the features and rights that can be accorded to shares in general.

Ordinary shares

This is the most common form of share and usually carries a right to one vote per share held, a right to a dividend if one is declared and a right to a portion of any surplus assets of the company on a winding-up. A company may have more than one class of ordinary share, with differing rights, and perhaps differing nominal values.

Preference shares

A preference share may give the holder a ‘preference’ as to payment of dividend or to return of capital on a winding up of the company, or both. This means the payment will rank as higher priority than any equivalent payment to ordinary shareholders. Preference shares are normally non-voting.

If there is a preference as to dividend, this will be paid before the other shareholders receive anything. The amount of preferred dividend is usually expressed as a percentage of the par (nominal) value of the share. If the preference shares have been issued at a premium to their par value and it is intended that a fixed dividend will be paid based on the amount subscribed for the share (i.e. par plus premium), the share rights must expressly state that the dividend is to be calculated as a percentage of the total subscription price per preference share.

Example

ABC Limited has shares in issue which carry a right to receive a fixed preferential dividend of 4% of the par value of the shares per annum. The shares have a par value of £1 each.

Assuming that a dividend has been declared, the preference shareholders would be entitled to receive a dividend of 4p per share per annum before the ordinary shareholders receive any dividend.

XYZ Limited has shares in issue which carry a right to receive a fixed preferential dividend of 4% of the total subscription price per share per annum. The shares have a par value of £1 each but were subscribed for at a price of £1.50 per share.

Assuming that a dividend has been declared, the preference shareholders would be entitled to receive a dividend of 6p per share per annum before the ordinary shareholders receive any dividend.

It is presumed that a preference share is ‘cumulative’ unless otherwise stated. This means that if a dividend is not declared for a particular year, the right to the preferred amount on the share is carried forward and will be paid, together with other dividends due, when there are available profits. If this accumulation is not desired, then the share must be expressed to be non-cumulative.

Participating preference shares

‘Participating’ preference shareholders may participate, together with the holders of ordinary shares, (1) in surplus profits available for distribution after they have received their own fixed preferred dividend; and/or (2) in surplus assets of the company on a winding up.

As with preference shares, participating preference shares are almost always issued with a fixed dividend and can be cumulative if stated as such in the articles of association. Participating preference shares with these characteristics are generally called ‘fixed rate participating cumulative preference shares’.

Example

FE Limited has the following shareholders:

* Shareholder A, who holds 500,000 5% participating cumulative preference shares of £1 each in FE Limited; and
* Shareholders B, C, D and E, who each hold 500,000 ordinary shares of £1 each.

FE Limited has issued 2,000,000 ordinary shares of £1 each, so B, C, D and E each own 25% of FE Limited’s ordinary shares. But the cumulative preference shares that A owns are ‘participating’, so that A, B, C, D and E will each be entitled to receive 20% of any ordinary dividend declared by FE Limited.

Assuming the 5% preference relates to the par value of the share and a dividend of £200,000 has been declared, that £200,000 would be distributed as follows:

1) Shareholder A would receive £25,000 from his participating cumulative preference shares (5% of his investment in the 500,000 shares of £1 each).
2) As a participating preference shareholder, Shareholder A has the right to participate in surplus profits available for distribution to the ordinary shareholders after he has received his own fixed preferred dividend.
3) As a result, the remaining amount of the dividend (£175,000) would be divided equally among all the shareholders, including Shareholder A (so each of A, B, C, D and E receive £35,000).

In total, Shareholder A would receive £60,000 (comprising £25,000 from his participating cumulative preferences shares and £35,000 from his entitlement to share in the surplus profits available to the ordinary shareholders) while Shareholders B, C, D and E would each receive £35,000.

Deferred shares

These carry no voting rights and no ordinary dividend but are sometimes entitled to a share of surplus profits after other dividends have been paid (presuming there is a surplus); more usually ‘deferred’ shares carry no rights at all and are used in specific circumstances where ‘worthless’ shares are required (for example in what is known as a ‘ratchet’ provision in a private equity transaction).

Redeemable shares

Redeemable shares are shares which are issued with the intention that the company will, or may wish to, at some time in the future, buy them back and cancel them.

Convertible shares

Such shares will usually carry an option to ‘convert’ into a different class of share according to stipulated criteria.

Class rights

A company may issue different classes of share, as seen above. The rights attaching to each class are usually set out in the company’s articles of association. In relation to any type of share, you should always refer to the articles of association to find the relevant rights attaching to a share, since there are no formal, universal definitions of different types of share.

If an attempt is made to alter the articles of a company such that existing class rights are varied, the resolution in question will not be effective unless varied in accordance with provisions in the company’s articles for the variation of those rights or, where articles don’t contain such provisions, by consent in writing of holders of at least 75% of the issued shares of that class or by means of a special resolution passed at a separate general meeting of holders of that class (s.630 CA 2006). In addition, shareholders holding 15% of the relevant shares may (provided they did not vote in favour of the variation) apply to court within 21 days of the resolution to have the variation cancelled (s.633(2) CA 2006). Following such application the variation will not take effect unless and until it is confirmed by the court. The court will not confirm the variation if it feels that the variation unfairly prejudices the shareholders of the class in question.