1 Chapter 6. Capital Maintenance Updated by John Armour School ...

Chapter 6. Capital Maintenance
Updated by John Armour
School of Law, University of Nottingham, and ESRC Centre for Business Research,
University of Cambridge
May 2000
Ferran (1999a) is a major new company law text. It is of particular interest for the
purposes of this update because of the unrivalled depth and clarity of its coverage of
the complex and technical law relating to capital maintenance, making this area far
more accessible to the non-specialist than has hitherto been the case. Particularly
useful is an introductory chapter covering basic accounting and corporate finance
concepts.
Ferran (1999b) summarises the policy arguments that are found in Ferran (1999a).
She begins by asking why companies choose to raise debt finance. Having considered
three theoretical explanations – (i) debt is a governance mechanism; (ii) debt is a
signal of confidence; and (iii) debt does not dilute shareholdings – she then asks to
what extent ‘core’ company law ought to seek to protect the interests of creditors. In
the course of doing so, she makes a number of points.
Capital maintenance rules are not capital adequacy requirements. Capital maintenance
rules are about the priority of creditors’ claims to those of shareholders in insolvency.
Hence they restrict transfers out of capital to shareholders. They do not require the
company to maintain a specified level of net assets (although CA 1985 s 142 tries to
impose something approaching a capital adequacy requirement, it rarely applies
because a very low threshold is set).
Should company law impose capital adequacy requirements? Ferran considers
theoretical treatments of bank capital adequacy regulation and notes that banks play a
pivotal role in the economy which justifies this sort of intervention, a justification
which is absent for non-financial companies. She argues that contractual mechanisms
available to creditors provide better means of protecting creditors’ interests than
interventionist regulation of this sort. The minimum capital requirement is not a
means of protecting creditors, because it is so readily avoided. Ferran argues that it
might be better left for the market to regulate this matter.
Ferran also argues that the capital maintenance doctrine proper is an antiquated and
unnecessarily restrictive means of preserving creditors’ priority to shareholders, and
that in light of the improvements in accounting standards, the enhancement of
directors’ accountability and the greater availability of ‘clawback’ remedies, the
rationale for the protection has largely disappeared. Ferran recommends its
replacement with a ‘solvency test’ which transfers to shareholders out of capital
would have to satisfy.
Ferran considers the law relating to financial assistance at some length, noting that its
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ambit is broader than is necessary to implement the capital maintenance principle. She
considers and rejects three possible rationales for the rules: (i) the prevention of
market manipulation; (ii) the prevention of ‘share support’ schemes in relation to
takeovers, and (iii) the protection of creditors. She suggests that, in the light of other,
more clearly targeted regulatory measures and creditors’ greater sophistication, the
extensive financial assistance rules are no longer required. She suggests that creditors
could be adequately protected through the introduction of a ‘solvency’ requirement, as
for the capital maintenance rules.
Ferran acknowledges the restrictive effect of the Second Company Law Directive, but
suggests that this should not be allowed to inhibit reform (i) in respect of private
companies, at all ; (ii) in respect of public companies, any further than is necessary to
achieve minimum compliance with the Directive.
Armour (2000) notes that the promotion of ‘efficiency’ is central to the aims of the
Company Law Review’s Strategic Framework document, and asks whether the body
of rules known as ‘capital maintenance’ are likely to be an appropriate means of doing
this. He suggests that whilst the current rules are unlikely, on the whole, to be justified
in terms of efficiency, a case may be made for a framework within which companies
may ‘opt in’ to customised restrictions on dealings in their share capital.
The paper suggests that the ‘presumption against prescription’ set out in the Strategic
Framework implies that a case for legal intervention on the grounds of enhancing
efficiency must be made out on the grounds that a market subject to a given legal rule
will function in a more efficient manner than one without such a rule.
The analysis of the law is conducted in three stages. The first considers possible
rationales for legal intervention. The second asks whether any of these might in theory
underpin the rules of capital maintenance. Third, the author asks whether the rules are
likely to be successful in enhancing efficiency— ie that the benefits they confer
through remedying market imperfections will outweigh any attendant costs that they
generate for parties.
The rules regulating the raising of capital (the par value rule, and the ‘expert
valuation’ rules for public companies) might be understood as responding to
information asymmetries in markets for corporate credit, by making it more likely that
capital figures stated in firms’ public documents will actually have been represented
by assets paid into the company by shareholders. In practice, however, this
information is unlikely to be of relevance to creditors, and the costs of compliance
with the rules therefore almost certainly outweigh any benefits they confer.
The rules mandating public companies to be formed with a minimum capital, when
viewed in conjunction with the ‘expert valuation’ rules, and CA 1985 s 142, might be
understood as a primitive means of protecting ‘involuntary’ creditors from the use of
limited liability companies as an easy ‘judgment-proofing’ strategy for those
conducting hazardous activities. However, this is at once likely to be both under and
over-inclusive. The more useful the measure as a means of preventing judgmentproofing
(ie the higher it is set) the more restrictive it will be on firms’ ability to make
use of limited liability. If this were the only technique available for internalising the
costs which judgement-proofing may impose on involuntary creditors, then we would
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have cause for a detailed enquiry into costs and benefits. However, there are a variety
of more finely-tuned regulatory techniques which might be adopted instead— such as
unlimited shareholder liability, superpriority for involuntary creditors, and mandatory
insurance regimes.
Armour argues that the capital maintenance rules can be understood as supplying
‘terms’ into bargains between creditors and shareholders. Empirical studies show that
creditors and firms do in fact spend resources drafting loan covenants which restrict
companies’ distributions to shareholders. In the US, where distributions rules no
longer have any teeth, some studies suggest that such covenants take a form which
bears a striking resemblance to the restriction found in the Companies Act 1985. Thus
the case for the legal protection of creditors should not be dismissed out of hand.
However, the capital maintenance rules also generate costs, particularly in small
firms, where shareholders are unable to withdraw capital from the firm when it has no
good projects to pursue. There is some evidence that this may actually encourage
undercapitalisation in small firms. Even so, if the current rules were the only possible
regulatory solution, we would have cause for more detailed investigation of the costs
and benefits.
Armour suggests, however, that a superior alternative exists in the form of default
rules restricting distributions. Because one term is unlikely to suit all parties’ needs,
these could be offered in the form of a ‘menu’ into which firms could opt in on
incorporation, and could perhaps subsequently switch through a collective creditor
decision-making mechanism.
Financial assistance can be seen as combating the unusually severe conflicts of
interest which arise in the case of leveraged buy-outs (LBOs). Where a firm is
purchased by a heavily-indebted buyer, and the former’s assets are used to underwrite
the latter’s loan, then ‘old’ creditors of the firm will experience a sudden and dramatic
increase in the riskiness of their debt. The American experience proves instructive
once more, where there are no financial assistance laws, but there have been calls for
mandatory rules designed to protect creditors from precisely this sort of risk. Armour
again suggests, however, that the case for mandatory rules is probably not made out.
Whilst they might (perhaps) be better than no rules, default rules (in the form of an
opt-in menu) would clearly be superior to both.
The author concludes with a call for serious consideration to be given to his proposal
for a ‘menu’ of creditor terms to be made available by the law to firms and their
creditors.
Bibliography
Armour, J. (2000) ‘Share capital and creditor protection: efficient rules for a modern
company law’ Modern Law Review, 63: 355-378.
Ferran, E. (1999a) Company Law and Corporate Finance Oxford: Oxford University
Press.
Ferran, E. (1999b) ‘Creditors’ interests and “core” company law’, Company Lawyer,
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20: 314-323.
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