Basic principles
Once a shareholder has invested in a company by the purchase of shares, that investment cannot normally be returned to him, i.e. a company is not usually permitted to return capital to its shareholders. Any payment to shareholders (including dividends) must normally be made out of profits.
The shareholders’ investment in a company is recorded in the accounts in the bottom half of the balance sheet. Generally speaking a company cannot release the sums represented in the equity account and the share premium account to return value to shareholders. The money represented in these accounts may be used to carry on the business of the company as working capital but generally it cannot be returned to the shareholders while the company is a going concern. This is known as the doctrine of maintenance of share capital.
Until any winding up of the company takes place, the only return that shareholders are usually entitled to from the company are dividends out of distributable profits (or the redemption/purchase amount on a redemption or purchase of own shares by the company, where permitted).
Because of the doctrine of maintenance of share capital, if a shareholder wants a capital return on his investment, his only recourse is to sell his shares to another individual. This sale will not affect the total shareholding of the company as the same number of shares are still in issue.
However, there are some limited exceptions to this doctrine.
Reasons for the doctrine
During the life of a company its capital (expressed as equity in the balance sheet) is a liability owed to its shareholders.
In accordance with the common law rule set out in Trevor v Whitworth (1887) 12 App Cases 409, the share capital of a company is seen as a permanent fund available to its creditors. Those creditors are entitled to assume that the full nominal value of the shares (and any premium on the shares) in the company has been paid up and that no capital of the company will be dissipated otherwise than in the ordinary course of the company’s business.
The obligation on a company to maintain its share capital mirrors the fact that the liability of its members (on a winding up) is generally limited to the amount unpaid on their shares (s.74 Insolvency Act 1986).
The common law principles established in Trevor v Whitworth have been enshrined in s.658 CA 2006. There are various statutory exceptions to s.658 which are set out in s.659. In addition, the rule in s.658 is stated to be subject to an acquisition by the company in accordance with Part 18 of CA 2006. Part 18 includes the provisions dealing with a company purchasing and redeeming its own shares.
Directors must bear in mind their statutory duties under ss.171–178 CA 2006 when considering an own share purchase or a redemption of redeemable shares by the company and in particular their duty to promote the success of the company for the benefit of the members as a whole.
In summary, the doctrine of maintenance of share capital exists for the protection of creditors.
Dividends
In keeping with this doctrine of maintenance of share capital, under s.830(1) CA 2006, a company may not make a distribution of assets (including cash) to shareholders except out of realised profit that is available for distribution.
Part 23 of CA 2006 sets out various additional provisions which stipulate how ‘profits’ (for the purposes of the law restricting the return of value to shareholders) should be determined. A company paying a dividend will have to ensure that it complies with these sections. In addition, it will also have to comply with any rules in relation to dividends set out in the company’s articles of association.
Articles typically provide (and Article 30 MA does provide) that the company can declare a dividend by ordinary resolution of the shareholders. The amount of the dividend cannot exceed the amount recommended by the directors, although the shareholders can decide on a smaller amount. In practice, therefore, the directors recommend a dividend in a board meeting and then the shareholders vote on it at a general meeting by ordinary resolution, or, if it is a private limited company, they can vote on it by using the written resolution procedure. This is commonly known as a final dividend and is typically paid after looking at the company’s financial results for the year.
Articles also usually provide that directors can decide by board resolution to pay interim dividends (e.g. Article 30 MA). ‘Interim dividend’ is basically the name given for any dividend that the directors pay without asking the shareholders for approval in a general meeting. It is usually a portion of the profits for the year and is effectively an estimate, as it is calculated before the company’s annual earnings have been determined. The final dividend can then add an appropriate amount in addition to the interim dividend to ensure that the final dividend is reasonable for the year.
Declaring and paying dividends
When considering the payment of a dividend, a company’s articles and any shareholders’ agreement should always be checked. Articles usually contain express provisions regarding the declaration and payment of dividends (although, where the articles are silent, common law gives companies an implied power to distribute profits to shareholders).
It is possible that the articles could include a restriction or prohibition on paying dividends. Alternatively the articles (or a shareholders’ agreement) could contain a mechanism requiring the payment of dividends where legally permissible. In this scenario the mechanism would usually work on the basis of a percentage of distributable profits.
Dividends do not carry interest against the company unless otherwise provided by the rights attached to the shares (see for example Article 32 of MA).
The shareholders entitled to a dividend will be those on the register of members at the time of the declaration. For some companies the articles may provide for a record date to be set to establish which shareholders are entitled to receive the dividend. This would be the case for a company where there are significant numbers of shareholders that change frequently, for example, in listed companies.
Articles will typically state that dividends are declared and paid according to the amounts paid up on the relevant shares. In the absence of such an article, the amount paid to each member would be calculated on the nominal value of each relevant share (and thus not take account of different amounts paid up on shares).
Company directors need to consider their statutory duties (in particular the duty to promote the success of the company for the benefit of the members as a whole) and the company’s future financial requirements before recommending a final dividend or resolving to pay an interim dividend. They can also set aside part of the profits as a reserve, for example, to fund dividends in any future low profit years.
Preference shares and cumulative dividends
Preference shares entitle the holder to preferred rights of some sort, usually a first fixed dividend which is often stated as a percentage of the amount paid up on the shares. The right to receive a fixed dividend is a right to be paid in priority to ordinary shareholders in any year in which the company has sufficient distributable profits.
Cumulative preference shares entitle the holder to accumulate the right to dividends where they are expressed to be payable in a year but are not then paid. The dividend accumulates as a debt owed to the cumulative preference shareholder until it is paid, unless there are provisions in the articles or shareholders’ agreement to the contrary.
Bear in mind that in practice, the above types of shares may not have the exact same names but will still function as described above.
Bonus issues of shares (also called a capitalisation issue or a scrip issue) and scrip dividends
Companies may issue shares to shareholders as an alternative to cash in respect of dividend payments. A bonus issue (otherwise known as a capitalisation issue or scrip issue) is an issue of new shares to all the existing shareholders in proportion to their existing shareholdings. The respective percentages of the shareholders therefore stay the same. A bonus issue is not usually treated as a distribution by the company for tax purposes. Shareholders benefit because they receive shares in the company without having to pay dealing costs or stamp duty.
A scrip dividend is similar to a bonus issue, however, there is a key difference. Where a scrip dividend is offered to the shareholders of the company, those existing shareholders have a choice as to whether they wish to receive their dividend wholly or partly in the form of additional shares or in cash (as is usual). The shareholders who elect to receive the additional shares are receiving a scrip dividend. The shareholders who do not elect to receive the scrip dividend and who receive their dividend in the form of cash will be diluted by the shareholders who do elect to receive the scrip dividend.