The capital which a limited company obtains from its members as consideration for their shares is sometimes called ‘the creditors’ buffer’.
No one can prevent an unsuccessful company from losing its capital by trading at a loss. However, whatever capital the company does have must be held for the payment of the company’s debts and may not be returned to members except under procedures which safeguard the interest of creditors. That is the price which members of a limited company are required to pay for the protection of limited liability.
Maintenance of Capital
The rules which dictate how a company is to manage and maintain its capital exist to maintain the delicate balance between the members’ enjoyment of limited liability and the creditors’ requirements that the company shall remain able to pay its debts.
Capital maintenance is a fundamental principle of company law that limited companies should not be allowed to make payments out of capital to the detriment of company creditors. Therefore the Companies Act contains many examples of control upon capital payments. These include provisions restricting dividend payments, and capital reduction schemes.
The issued share capital of a company limited by shares is the primary security for the company’s creditors. A limited company by its memorandum declares that its capital is to be applied for the purpose of the business.
“The creditors give credit to a company because of capital and the faith of the representation that the capital shall be applied only for the purposes of the business…” And therefore the capital of the company should not be “watered down”.
Rules Governing Maintenance of Capital
- Reduction of issued capital must comply with the strict legal requirements including confirmation by the court
- A Company will only purchase or redeem its shares out of distributable profits or out of a fresh issue shares to raise cash for that purpose.
- A Company may not issue shares to a nominee of its own
- A public limited company must sell or cancel any of its shares acquired by itself by forfeiture or surrender
- A public limited company may not in principle finance the acquisition of its own shares
- Dividends can only be paid out of profits and not out of capital
- Capital may only be distributed to members under the formal procedure of a reduction of share capital or a winding up of the company.
- A premium obtained on the allotment of shares and profits used to redeem, or purchase shares of the company are statutory reserves subject to the basic rules on capital.
The Companies Act therefore incorporated various provisions which are intended to ensure that company’s capital:
Is not “watered down” as it comes into the company; and ii) Does not go out of the company once it has been received.
Provisions Which Prevent Capital Being “Watered Down”
The following are the provisions which are intended to prevent a company’s capital being “watered down” as it comes into the company:
Issuing shares at a discount
In issuing shares, a company must fix a price which is equal to or more than the nominal value of the shares. It may not allot shares at a discount to the nominal value.
Every share has a nominal value and may not be allotted at a discount to that. In allotting shares every company is required to obtain in money or money’s worth, consideration of a value at least equal to the nominal value of the shares plus the whole of any premium. To issue shares ‘at par’ is to obtain equal value, say, sh.1 for a sh.1 share.
The Companies Act provides that the memorandum shall state the amount with which the company will be registered and “the division thereof into shares of a fixed amount”. Since the nominal value of a share is fixed by the memorandum the company cannot issue the share at a discount.
If shares are allotted at a discount on their nominal value the allottee (and subsequent owners of the shares) must nonetheless pay the full nominal value with interest at the appropriate rate. Any subsequent holder of such a share who knew of the underpayment must make good the shortfall.
Circumstances when shares can be issued at a discount
The Companies Act permits a company to issue its shares at a discount if— 1. The shares are of a class already issued.
If the shares are of a class already issued, they will most likely have a market value. The market value would provide a basis upon which the company’s directors would recommend, and the members resolve on, the amount of the discount. In the absence of such a market value any amount decided on as the new price for the shares would be as arbitrary as the original nominal value.
- The issue is authorized by a resolution passed in general meeting.
This provision places upon the company’s member’s ultimate responsibility for the issue at a discount.
- The issue will be after the court has sanctioned it.
The court will act primarily as the creditors’ watchdog to protect their interests. This is because the creditors were not represented at the general meeting which passed the resolution authorizing the company to issue the issues at a discount and so the court steps in to protect their interests.
If the issue of shares at a discount would adversely affect any creditor, the court would probably not sanction it.
- Not less than one year has elapsed since the company was entitled to commence business This provision prevents the risk of a hasty or premature issue at a discount.
The statutory assumption appears to be that, having been in business for at least one year; the company would most likely have published its first balance sheet and declared a dividend which could induce a greater demand for its shares.
- The issue is made within one month after the court’s sanction.
If a company’s members pass a resolution authorizing an issue at a discount because of the prevailing market conditions the directors must act on the resolution before the market conditions change.
The statutory assumption appears to be that the market conditions would have materially changed within one month after the court’s confirmation. If the directors were to issue the shares at a discount despite the changed conditions, the issue could not be justified. Another general meeting should be held to enable the members to reconsider their decision in the context of the changed conditions. The directors may ask the court the time for issuing the shares at the prescribed discount if they are of the view, and the court concurs, that the market conditions have not materially changed.
Are Allotment of shares at a premium (Sec 385)
This is provided under Section 385 of the Companies Act.
If shares are issued at a premium, the excess must be credited to a share premium account. Share premium is the excess received, either in cash or other consideration, over the nominal value of the shares issued.
An established company may be able to obtain consideration for new shares in excess of their nominal value. The excess, called ‘share premium’, must be credited to a share premium account. The share premium account shall be governed by the provisions of the Companies Act relating to the reduction of the share capital of a company as if the share premium account were paid share capital of the company.
This means, in effect, that the funds credited to the share premium account are not paid out by the company except in the legitimate course of its business.
Use of the share premium account
Use of the share premium account is limited. It is most often used for bonus issues.
The permitted uses of share premium:
- To pay up for shares to be allotted to members as fully paid bonus issue
- To pay for expenses and commission in respect of a new share issue
- To provide for the premium payable on redemption of any redeemable preference shares or debentures of the company.
- Write off preliminary expenses of Company
- Write off any discount allowed on any issues of shares or debentures of the Company
N/B The premium is strictly controlled by the Act and must be disclosed in the balance sheet and only used for specified purposes.
Provisions Which Prevent Capital Going Out of the Company
Various provisions of the Companies Act, and case law, are intended to ensure that no part of the company’s paid-up capital is paid out by the company except in the legitimate course of its business.
Purchase of Own Shares
A company’s paid-up capital may leave the company other than in the ordinary course of the company’s business if the company purchased its own shares.
It was therefore held in Trevor v Whitworth that it is illegal for a limited company to purchase its own shares. Such a purchase, if permitted, would constitute an indirect reduction of the paid-up capital without compliance with the statutory provisions relating to reduction of capital.
FactsTrevor v Whitworth
In this case a shareholder sold back his shares to the Company upon which he was paid part of the price. Before being paid the balance, the Company went into liquidation and he claimed from liquidator the balance of his money on the shares he sold back to the Company. The claim was dismissed and the court observed that a registered Company had no power to purchase its own shares and that the claim was ultra vires. It was further held that the object of Company legislation was to prevent this in order to preserve capital intact, this being virtually the only fund on which a limited Company’s creditors could rely since they cannot proceed against the private estate of the members. The rule in Trevor v Whitworth
The rule restricting a Company from buying its own shares or financing the acquisition of its own shares was laid down in Trevor vs. Whitworth.
The effect of the statutory restriction is to prohibit any transaction between a Company and a shareholder by means of which money already paid to the Company in respect of its shares is returned to him unless the court has sanctioned the transaction.
According to a leading case Trevor vs. Whitworth, it is illegal for a limited company to purchase its own shares. Such a purchase, if permitted would constitute an indirect reduction of the paid up capital. It is presumed that whenever a company buys its shares it would do so by utilizing its paid up capital without compliance with the statutory provisions relating to reduction of capital.
Exception of the rule Trevor V Whitworth
Despite the rule in Trevor V Whitworth a company may purchase or acquire its own shares in the following cases:
Where it acquires its own fully paid shares otherwise than for valuable consideration.
Where it is a purchase of redeemable shares
This is permitted because the redemption shall not be taken as reducing the amount of the company’s authorized share capital.
- Where the shares are acquired pursuant to the resolution for reducing the company’s Such acquisition is permitted because the interests of the company’s creditors would have been protected by the court at the time of confirming the proposed reduction.
- Where the shares are purchased in pursuance of a court order on an application by the oppressed members. The shares purchased would be cancelled and the company’s capital reduced accordingly.
- Where the shares are forfeited for non-payment of a call, or where they are surrendered in lieu of forfeiture.
Financial Assistance for Purchase of Own Shares
S.441of the Act renders it unlawful for a company to give, whether directly or indirectly and whether by means of a loan, guarantee, the provision of security or otherwise, any financial assistance for the purpose of or in connection with a purchase or subscription made or to be made by any person of or for any shares in the company, or, where the company is a subsidiary company, in its holding company.
The consequences of a contravention of the section are:
- The contract for the financial assistance is void and illegal,
- and cannot be enforced against a party thereto.
- The company and every officer of the company who is in default shall be liable to a fine.
- Every director who is a party to the contravention is guilty of a breach of trust and is liable to recoup any losses which the company suffers as a result
Section 442 provides that it shall not be lawful for a Company whether directly or indirectly and whether by means of a loan or guarantee or otherwise to provide any financial assistance for the purpose of or in connection with the purchase or subscription made for any shares of the Company and where the Company is a subsidiary, in its holding Company.
A company however may give financial assistance in the following circumstances: as held in Trevor
Where the lending of money is part of the ordinary business of the company and the money is lent by the company in the ordinary course of its business
Where the loan is given to trustees to enable them to purchase fully paid shares in the company to be held under an employees’ share scheme. iii) Where the loan is to employees’ (other than directors) to enable them to purchase or subscribe for fully-paid shares in the company or its holding company to be held by themselves by way of beneficial ownership.
Alteration of Capital
This is a modification of the capital clause of the company’s memorandum of association. It is an increase, reduction or any other change in the authorized capital of a company.
Power to alter capital (S.404): A company is empowered to alter the provisions of its memorandum of association which relates to its registered or authorized capital.
Conditions of Alteration
This power is exercisable subject to the following conditions:
- The articles must confer the authority to alter the capital. If they do not, they may be altered by special resolution and the authority incorporated therein.
- The company must hold a general meeting for the purpose of altering the capital.
- The alteration must be authorized by an ordinary resolution
Mode of Alteration
The alteration of capital may be made by –
- Issuing of new shares: a company limited by shares or guarantee and having a share
capital may, if authorized by its Articles increasing the company’s share capital by new shares of such amount as the resolution prescribes; or
- Consolidation of shares: This is the process of combining a number of shares to form one large share whose nominal value is the aggregate of the shares consolidated.
- Subdivision of shares: a company with a share capital is allowed if authorized by its Articles to subdivide its shares to shares of a smaller amount than fixed by the memorandum; or
- Diminution of capital: this is the Canceling of shares which have not been taken or agreed to be taken by any person, and diminish the amount of the capital. This mode of alteration is also known as diminution of capital. A company having a share capital may diminish its capital if the Articles so authorizes. The cancellation requires an ordinary resolution and the Registrar be notified within 30 days.
The registrar must be notified of an alteration of capital within thirty days after the passing of the resolution authorizing the alteration. In the event of a failure to do so, the company and every officer of the company who is in default shall be liable to a default fine of Ksh. 10,000,000.
Reduction of Capital
Section 407 of the Companies Act provides that a limited company that has a share capital may reduce its share capital by special resolution.
Why reduce share capital?
A company may wish to reduce its capital for one or more of the following reasons:
- The company has suffered a loss in the value of its assets and it reduces its capital to reflect that fact.
- The company wishes to extinguish the interests of some members entirely.
- The capital reduction is part of a complicated arrangement of capital which may involve, for instance, replacing share capital with loan capital.
A limited company is permitted without restriction to cancel unissued shares as that change does not alter its financial position.
If a limited company with a share capital wishes to reduce its issued share capital it may do if:
- It has power to do so in its articles. (If it does not have power in the articles, these may be amended by a special resolution).
- It passes a special resolution. (If the articles have been amended, this is another special resolution)
- It obtains confirmation of the reduction from the court
Mode of Reduction
Sec 407(3) expressly states that a company may reduce its capital “in any way”. There is therefore no statutorily prescribed mode of reduction and the actual scheme adopted by the company will depend on the ingenuity of its directors or accountants. However, the Act gives the company an option of reducing its capital in one of the following ways:
- By extinguishing the liability on any of its shares in respect of Share Capital not paid up. or
- By reducing the liability on any of its shares in respect of share capital not paid up: or
- By canceling any paid-up share capital which is lost or unrepresented by available assets without extinguishing or reducing liability on any shares: or
- By canceling any paid up share capital which is lost or unrepresented by available assets and also reducing liability on any shares: or
- By cancelling any paid-up share capital which is lost or unrepresented by available assets and also extinguishing liability on any shares: or
- By paying off paid-up share capital which is in excess of the wants of the company without extinguishing or reducing liability on any shares: or
- By paying off paid-up capital which is in excess of the company’s needs by extinguishing liability on any shares: or
- By paying off paid-up capital which is in excess of the company’s needs and reducing liability on any shares
Private companies: reduction of capital supported by solvency statement
A private company need not apply to the court if it supports its special resolution with a solvency statement. A solvency statement is a declaration by the directors, provided 14 days in advance of the meeting where the special resolution is to be voted on.
It states there is no ground to suspect the company is currently unable or will be unlikely to be able to pay its debts for the next twelve months. All possible liabilities must be taken into account and the statement should be in the prescribed form, naming all the directors.
Within fourteen days after the resolution for reducing share capital is passed the company shall lodge with the Registrar for registration a statement of capital.
Reduction of capital in public companies
Court confirmation is required for public companies.
The court considers the interests of creditors and different classes of shareholder.
If the Court makes an order confirming a reduction of a public company’s capital that has the effect of bringing the nominal value of its allotted share capital minimum’ below the authorised minimum, the Registrar may register the order only if —
- The Court so directs; or
- The company first converts itself into a private company and applies to the Registrar for registration of the conversion.
The Function of the Court
When the court receives an application for reduction of capital its first concern is the effect of the reduction on the company’s ability to pay its debts, that is, that the creditors are protected Protection of Creditors
Where the reduction of capital involves diminution of unpaid capital or repayment to shareholders of paid-up capital, creditors have a statutory right under Sec 409(1) to object to the proposed reduction and, upon objection; a list of creditors must be given to the court. The court will then confirm the reduction if satisfied that the creditors:
- Have consented thereto; or,
- Have been secured (i.e. given alternative security so that they will no longer rely on the reduced capital as their security), or
- Have been discharged or paid off
Protection of Members
- A majority of the company’s members are protected by the requirement that a special resolution must be passed by the company’s members in order to initiate the reduction process. It is most unlikely that a three-fourths majority of members could freely pass a resolution for reducing capital if the resolution is detrimental to their interests.
- A minority of the company’s members are protected by their judicially acknowledged right to seek the court’s protection where they are of the view that the resolution passed by the majority is not “fair and equitable”:
Protection of General Public
It is desirable that the general public, as potential members of the company, should be told the truth about the reduction. Section 785 empowers the court where appropriate, to make an order requiring the company to publish, as the court directs, the reason for reduction or such other information in regard thereto as the court may think expedient with a view to giving proper information to the public, and, if the court thinks fit, the causes which led to the reduction.
If, for any special reason, the Court considers it appropriate to do so, it may make an order directing the company, during a specified period, to add at the end of its name the words “and reduced”. If a company is ordered to add to its name the words “and reduced”, those words form part of the name of the company until the end of the period specified in the Court’s order.
Liability of Members
In the case of a reduction of share capital a member of the company, past or present, shall not be liable in respect of any share to any call or contribution exceeding in amount the difference, if any, between the amount of the share as fixed by the minute and the amount paid, or the reduced amount, if any, which is deemed to have been paid on the shares.
Confirmation by the court
If the court is satisfied that the reduction is in order, it confirms the reduction by making an order to that effect. A copy of the court order and a statement of capital, approved by the court, to show the altered share capital is delivered to the Registrar who issues a certificate of registration.
As a commercial term, the word “dividends” has a variable meaning which depends on the context in which it is used. For purposes of company law, it denotes the payments which a company makes out of its profits to the shareholders in the company.
The basic rule is that “dividends must not be paid out of capital”: For purposes of this rule “Capital” means the money subscribed pursuant to the memorandum of association, or what represents that money.
Rules relating to Dividends
There are several rules that a company should adhere to when it comes to the issue of dividends. These rules include:
- Dividend can only be paid out of profits and not out of capital. This is to prevent reduction of capital of the company
- Dividend is declared by a resolution passed at the AGM. The directors determine the rate of the dividend but have to be confirmed by the shareholders in the AGM
- Dividend cannot be declared if this would result in the company being unable to pay its debts as they fall due
- The dividend is only payable in cash. In the absence of express authority in the articles the company must pay dividends in cash and may not pay e.g. by the distribution of its own shares in another company
- A company may if authorized by its articles pay dividends in proportion to the amount paid on each share where a large amount is paid up on some shares than on others
- Unrealized profits cannot be declared or distributed by way of dividend
- Losses on circulating assets, made in previous accounting periods need not be made good. A dividend can be paid provided there is a profit on the year’s trading
- A realized profit on the sale of fixed assets may be treated as profit available for dividend, or any rate if there is an overall surplus of fixed and circulating capital over assets
- Losses of circulating assets in the current accounting period must be made good before a dividend can be declared
- Where the dividend has been declared but has not been paid or the warrant in respect thereof has not been posted within 42 days from the date of the declaration of the dividend to any shareholder entitled to payment of the dividends, every director, who is knowingly a party to the default, is punishable
- An interim dividend may be paid. An interim dividend is one declared between two AGMS of the company. They do not need the sanction of the AGM and are usually declared by the directors if authorized by the articles
- A dividend once declared becomes a debt on the company each shareholder is entitled to sue the company for his proportion.