I. Introduction
This article analyses a fundamental principle of company law which recently came to the attention of the Court of Appeal.Footnote 1 One of the basic features of modern company law is limited liability. Shareholders are not personally liable for debt incurred by the company. Shareholders are only liable to make the contribution they have undertaken to make when they first subscribed for shares. Limited liability is a privilege that enables shareholders to invest in a business without personally carrying the risk that the business fails. If the business fails they will only have lost the contribution they originally promised to make to the business, but not more. Because shareholders are not personally liable for debts incurred by the company, the law has implemented rules protecting the interests of creditors of companies. These rules are directed towards maintaining the capital of the company. The law maintains the capital of a company by subordinating the claims of shareholders to the claims of creditors. This is a fundamental principle of company law which will be explored further in this paper.
Companies are only permitted to make payments to their investors out of funds that are not needed to satisfy the claims of creditors. There are rules determining how companies calculate profit that is available for distribution to shareholders. Those rules make provisions for debt owed by the company. Payments that are not out of distributable profits can only be made to shareholders under the rules on reducing capital or on winding up companies. These rules set up procedures that ensure that creditors are paid before any payments to shareholders are made.
Payments to shareholders that are not out of distributable profit or in the course of a reduction of capital or a winding-up procedure are unlawful.Footnote 2 An unlawful payment occurs, for example, if a company makes a distribution without having applied the rules on calculating profit. An unlawful payment also occurs if a company enters into a transaction with a shareholder that is not a distribution, but that transfers an asset to the shareholder without the company receiving an adequate consideration in return. In both cases shareholders have skipped the queue and received value from the company ahead of the company's creditors.
This paper will focus on unlawful payments that occur in the course of a transaction that has been entered into between the company and a shareholder. This was also the subject matter of the recent Court of Appeal decision.Footnote 3 An unlawful payment occurs if the company did not have distributable profits and if the payment was not made in the course of a reduction of capital or in the course of a winding up. Such payments are sometimes referred to as disguised returns of capital. The idea that a transfer of value away from the company to a shareholder depletes the company of that value and involves a shareholder receiving treatment preferential to the company's creditors is straightforward. The courts have, nevertheless, struggled to articulate a test distinguishing lawful transactions with shareholders from disguised returns of capital. This paper identifies the issues that have emerged around the rule prohibiting disguised returns of capital and puts forward a solution to these issues.
The question analysed in this paper is of academic as well as practical importance. It is of academic importance because it defines the boundaries of the principle of capital maintenance. It demarcates the borderline between creditor and shareholder interests. It is of significant practical importance because it affects transactions between companies and their shareholders. Such transactions frequently occur in relation to private companies and also within groups of companies.Footnote 4
The analysis presented in this paper first identifies the historic roots of the rule prohibiting disguised returns of capital and examines the rule in this context and against the background of the modern law of capital maintenance. It also shows that the law is still fluid. Judges have adopted differing approaches to the rule. The article puts forward an approach that fits with the historic roots of the rule and does justice to the way in which the modern law approaches decisions that are taken by companies and their directors. It argues that transactions with shareholders have to be carried out at arm's length.
The structure of this article is as follows. The rule prohibiting disguised returns of capital has been said to have emerged from cases that were decided around the time when the external effect of the ultra vires doctrine was abolished. It will be shown in section II that the rule existed before that time, but was stated under the umbrella of that doctrine. In particular, the cases that evolved around the decision In re Lee, Behrens & Co, which has long puzzled academic commentators, can be explained by reference to disguised returns of capital. These historic roots of the rule have implications for the modern law which will be a constant reference within the article.
Section III shows that disguised returns of capital have now become the subject of an independent rule that prohibits companies from entering into transactions at an undervalue with their shareholders in circumstances where the company does not have distributable profits. This rule could be stated as involving an abuse of power on the part of the directors. It could also be stated as rendering transactions illegal. Section IV concludes that transactions in breach of the rule are illegal.
The article will also discuss how transactions involving a disguised return of capital are to be identified. Section V shows that the courts have used two approaches. In some decisions a subjective element testing the state of mind of the company directors or of both parties to the transactions has been applied. Other cases paid no attention to subjective criteria and focused on the effect of the transaction. The conclusion of section VI is that the background against which the rule operates mandates an objective approach. The article suggests that an arm's length approach should be applied. Section VII concludes that shareholders are unable to rely on the Companies Act 2006 (CA 2006), s. 842 in order to avoid having to return assets they have received by way of a disguised return of capital.
In the following section it will be shown that the principle against disguised returns of capital explain the conundrum that evolved around the rule in In re Lee, Behrens & Co.Footnote 5
II. Disguised returns of capital and the ultra vires doctrine
Transactions involving disguised returns of capital to shareholders were traditionally regulated by the ultra vires doctrine. Courts decided whether a particular transaction was within the objects and powers of a company. They interpreted the memorandum and the articles of association of the company concerned. Typically this did not involve an enquiry into whether the transaction was beneficial to the business of the company.
Judges applied the ultra vires doctrine with a view to ensuring that companies were run in the interests of their shareholders, but also with a view to protecting the assets and the capital of companies.Footnote 6 This caused judges to examine gratuitous transactions with particular care.Footnote 7 An added level of scrutiny applied in cases that involved gratuitous or undervalue transactions with shareholders. This later group of cases will be examined further below. The analysis will focus on a number of cases that arose around three tests stated by Eve J. in In re Lee, Behrens & Co. Ltd. Footnote 8
A. In re Lee, Behrens & Co. Ltd
The case concerned a pension agreement concluded between a company and the widow of a longstanding and now deceased managing director of the company. A question arose as to whether this agreement was ultra vires the company. Clause 3 of the company's memorandum contained a power to provide for the welfare of persons in the employment of the company or formerly in its employment, and the widows and children of such persons by granting money or pensions etc. Eve J. interpreted this power narrowly and held that the agreement fell outside of the powers of the company.
He restricted the use of “express or implied powers” by introducing three tests that needed to be satisfied in order for a transaction to fall within the scope of a power and as a result be considered to be intra vires. The first is whether the transaction is “reasonably incidental to carrying on the company's business”. The second is whether the transaction is a “bona fide transaction”. The third is whether the transaction is done “for the benefit and to promote the prosperity of the company”.Footnote 9
These three tests, if they had been adopted universally by the courts, would have transformed the ultra vires doctrine from involving questions as to the interpretation of the company's objects and powers into an enquiry into the benefits the company received through the transaction. Later decisions, however, have not wholeheartedly adopted Eve J.'s three tests. The tests were applied in some later cases, but distinguished in others. The pattern that emerges from the later cases is that In re Lee, Behrens was applied in cases where undervalue transactions involved shareholders and distinguished in cases where such transactions involved third parties.
This pattern can be seen with the cases of Re W&M Roith Ltd.,Footnote 10 where a pension agreement was considered to be ultra vires the company, and In re Horsley & Weight,Footnote 11 where a retirement policy was considered to be intra vires. The two cases will be analysed below.
B. Re W&M Roith Ltd. and In re Horsley & Weight
In Re W&M Roith Ltd., Plowman J. applied the tests in In re Lee, Behrens and agreed with the liquidator that the arrangement was not entered into for the benefit of the company but to provide for the widow of the director concerned.Footnote 12 In In re Horsley and Weight, Buckley L.J. found that In re Lee, Behrens concerned an implied power whereas the case before him fell within the scope of an express clause and was therefore valid.Footnote 13 He also distinguished Re W&M Roith Ltd. saying that in that case the judge treated as common ground that In re Lee, Behrens was applicable and evidently took the view that the agreement was a mere façade.Footnote 14
Academic commentators have criticised these distinctions as unconvincing.Footnote 15 The reason is that the facts of the two cases are strikingly similar. In both cases a long serving director of the company was towards the end of his employment given substantial pension entitlements. In both cases the question was whether this was within the capacity of the company. Both companies had objects enabling them to make benevolent payments to employees, directors and certain of their dependents. The respective decisions were reached by interpreting these substantially similar object clauses in different ways.
It is suggested here that one criterion upon which the two cases may be distinguished is the fact that in In re Horsley & Weight the retiring director had long ceased to be a shareholder when the pension agreement was entered into. Moreover, the parties to the agreement were the company, the retiring director and an insurance company. This conclusion receives support from Buckley L.J., who explicitly distinguished In re Horsley & Weight from cases where capital is returned to shareholders.Footnote 16 In Re W & M Roith, the director for the benefit of whose wife the pension was taken out was at the time the arrangement was made a controlling shareholder. The agreement was between the company and that director. It seems that the latter case could be understood as involving a disguised return of capital whereas in In re Horsley & Weight no such return occurred.
C. Ridge Securities v. I.R.C. and Charterbridge Corporation v. Lloyds Bank
Other examples showing an application of the tests in In re Lee, Behrens along these lines are Ridge Securities v. I.R.C. and Charterbridge Corporation v. Lloyds Bank.Footnote 17
Coincidently, the two cases were both decided by Pennycuick J. They both involved facts where within a group of companies one member of the group undertook a financial obligation for the benefit of another member of the group.
Ridge Securities v. I.R.C. concerned a number of subsidiaries which entered into a debenture agreement with their parent company.Footnote 18 Under the arrangement the subsidiaries would borrow a certain amount of money. In return the subsidiaries covenanted to pay the parent an annual sum described as interest equivalent to 99% of the gross dividends it received from the other subsidiaries within the group. This transaction was connected with other transactions designed to create a loss with the parent company. The court had to decide whether the parent company was allowed to treat the loss that had occurred as a result of these transactions as loss for the purpose of income tax.
Pennycuick J. found that the debenture transactions were ultra vires the subsidiary companies. He pointed out that none of the subsidiaries had any reason to issue a debenture unless the parent caused it to do so. Three of the subsidiaries concerned did not even have reason to borrow money at all. “Indeed, the terms of each debenture indicate that on the face of it the so called interest represented in fact a gratuitous disposition of an enormous sum by the company concerned in favour of the” parent company.Footnote 19
The learned judge's reasoning supports the conclusion that the case can also be interpreted as involving a disguised return of capital. He found that shareholders can take assets out of the company by way of dividend, by way of reduction of capital or winding up. They also acquire assets for full consideration. But they cannot take assets out of the company by way of voluntary disposition, however described, and if they attempt to do so, the disposition is ultra vires the company. In reaching his conclusions Pennycuick J. applied the three tests adopted by Eve J. in In re Lee, Behrens & Co. Ltd..Footnote 20
Notably, Pennycuick J. withdrew his unqualified adoption of these tests only five years later in Charterbridge Corporation v. Lloyds Bank.Footnote 21 That case was very similar to Ridge Securities v. I.R.C.. It also concerned a group of companies. When the group went through a phase of financial difficulties, one member guaranteed a debt owed by the company leading the group to Lloyds Bank. The directors of that member company also authorised a legal charge over its assets in favour of Lloyds Bank as in security for the same debt owed by the company leading the group. This was then challenged on the basis that the directors of the subordinate group member which gave the guarantee and the charge, who were also the directors of the company leading the group, had not given separate consideration to the interests of the first company. They instead had the well being of the whole group in mind.
Those challenging the transactions relied on In re Lee, Behrens & Co, arguing that they were not entered into for the benefit of the subordinated group member.Footnote 22 At first glance it would seem that Pennycuick should have, as he did in Ridge Securities v. I.R.C., applied the tests in In re Lee, Behrens & Co. This would have led to the conclusion that no separate consideration was given to the interests of the subordinate group member and that could have led to the transaction being considered to be ultra vires. This, however, did not happen.
Instead, Pennycuick J. revisited In re Lee, Behrens stating that Eve J. in his statement appeared to have dealt with two points that need to be kept separate. Pennycuick J. found that a distinction needs to be made between express and implied powers. In relation to express powers no inquiry needs to be made as to whether the transaction is reasonably incidental to the business of the company. Such an inquiry is only necessary in relation to implied powers.Footnote 23 The question as to whether the transaction was bona fide is principally a question relating to directors' duties. Also, the question as to whether a transaction done for the benefit and to promote the prosperity of the company was in Pennycuick's judgement “quite inappropriate” to the scope of express powers.Footnote 24
After analysing further case law Pennycuick J. felt obliged to “plead guilty to citing” the three tests “without entering upon distinctions” which he found necessary to be made in the case before him. He concluded that the state of mind of the directors of the company authorising the guarantee and the legal charge and of the bank officers is irrelevant upon the issue of ultra vires.Footnote 25
From the point of view of this article it is noticeable that the facts in Charterbridge v. Lloyds are very similar to the facts in Ridge Securities v. I.R.C.. Both cases involved transactions where a subordinate member of a group of companies entered into an obligation for the benefit of the company leading the group.Footnote 26 There is one fact, however, that explains why In re Lee, Behrens was applied in Ridge Securities v. I.R.C., but not in Charterbridge v. Lloyds.
Ridge Securities v. I.R.C. concerned a transaction between the company and its shareholders where the company received substantially less value in return for what it gave to the shareholder. Charterbridge v. Lloyds, on the other hand, concerned a transaction between a company and an outsider lending money to another member of the same group of companies.Footnote 27Ridge Securities v. I.R.C. involved a return of capital to shareholders whereas Charterbridge v. Lloyds did not. This conclusion receives support from a dictum of Oliver J. in Re Halt Garage. He said that the real ground for the decision in Ridge Securities v. I.R.C. was simply that “no one sought to justify the application as having any connection at all with anything that the companies were incorporated to do and that it may, indeed [have] … been an illegal return of capital to shareholders”.Footnote 28
D. Rolled Steel Products v. British Steel Corporation and MacPherson v. European Strategic Bureau
This pattern of judges distinguishing In re Lee, Behrens in cases where a third party is involved and applying the case when a shareholder transaction is concerned can also be seen in more recent decisions, in particular Rolled Steel Products v. British Steel Corporation and in MacPherson v. European Strategic Bureau.Footnote 29
In the first case, Rolled Steel gave a guarantee and debenture to another unrelated company, British Steel. One effect of the transaction was that the majority shareholder of Rolled Steel was released from a substantial part of a liability that arose under a personal guarantee he had given earlier to British Steel. Vinelott J. found at first instance that the transaction was ultra vires in a “wider sense”. It fell within the scope of the powers of the company but it was entered into for an unauthorised purpose.Footnote 30 This reasoning was rejected by the Court of Appeal which held that the transaction was not ultra vires. Slade L.J. found that the three tests suggested by Eve J. in In re Lee, Behrens “should now be recognised as being of no assistance, and indeed positively misleading, when the relevant question is whether a particular gratuitous transaction is within the company's corporate capacity. To this extent the tests should be … finally laid to rest, though they may well be helpful in considering whether or not in any given case directors have abused the powers vested in them by the company.”Footnote 31
Rolled Steel's guarantee and debenture were found to be intra vires, but were nevertheless declared invalid because the directors of Rolled Steel had entered into the transactions in breach of the company's articles and in breach of their duties and because British Steel knew of this.
It is important to note that Rolled Steel Products v. British Steel Corporation involved a transaction between the company and another company which was not part of the same group. It was a transaction with an outsider and not with a shareholder. The conclusion that undervalue transactions with shareholders warrant a higher level of scrutiny receives support from Slade L.J.'s view that a transaction which is intra vires but which was entered into for an unauthorised purpose can be ratified in principle by the shareholders.Footnote 32 He conceded, however, that this “principle certainly is not an unqualified one. In particular it will not enable shareholders of a company to bind the company itself to a transaction which constitutes a fraud on its creditors see, for example, In re Halt Garage”.Footnote 33
Notwithstanding the Court of Appeal's disapproval of In re Lee, Behrens in Rolled Steel, the case found favour again with a differently constituted Court of Appeal in MacPherson v. European Strategic Bureau.Footnote 34 That case concerned payments that were made to shareholders for services they had originally agreed to provide to the company gratuitously. After the services had been provided to the company and in circumstances where the company did not have distributable profits the shareholders made an arrangement whereby they would receive a remuneration for the services rendered to the company. Chadwick L.J. applied In re Lee, Behrens and found that the transaction was ultra vires. They resulted in a distribution of company's assets to shareholders without provisions being made for the company's creditors. Chadwick L.J. found that this involved a breach of duty on the part of the directors and was also ultra vires the company as an attempt to circumvent the protection which the Companies Act provided for those who give credit to the company. In reaching this conclusion he applied In re Lee, Behrens finding that the transaction had not been “entered into for the benefit and to promote the prosperity of the company”.Footnote 35 Buxton L.J. agreed with Chadwick L.J.'s reasoning on the ultra vires point, and also found that the transaction had to be characterised as a distribution to shareholders in circumstances where the company was unable to make a distribution according to the CA 1985, s. 263(1).
E. Conclusion
What emerges is that judges have applied In re Lee, Behrens in circumstances where undervalue transactions have involved shareholders, but not where transactions have concerned third parties. In re Lee, Behrens, where the three tests were first stated, does not directly support this conclusion. There is no finding of fact in that case that the deceased director or his widow were shareholders. Footnote 36 But there is, on the other hand, also no finding of fact that they were not. The company was a private company, the director concerned was the managing director and he seems to have been in a sufficiently close relationship with the company for it to allow him to accumulate considerable debt towards the company.Footnote 37 It is possible that he and in his succession also his wife held shares. If that was the case, this case could also be viewed as case involving a disguised return of capital.
The cases also show that transactions at an undervalue between companies and their shareholders used to be analysed under the umbrella of the ultra vires doctrine. Judges asked themselves whether a contract was within the scope of an express or implied power or object restricting the capacity of the company according to its constitution. The cases show that notwithstanding the courts' general reservations towards undervalue transactions, undervalue transactions between companies and their shareholders are held to an even higher standard than similar transactions that are entered into with persons who are not shareholders.
Undervalue transactions with shareholders can also be characterised as involving a disguised return of capital to shareholders. It seems that the principle against disguised returns of capital which became the subject of an independent legal rule after the ultra vires doctrine was abolished already existed before then albeit as a subcategory within that doctrine. It will be shown in section VI.C and section VII that this has implications for the modern understanding of the law.Footnote 38
III. Disguised returns of capital as the subject of an independent rule
The first case where the idea that shareholder transactions can be construed as involving a disguised return of capital was put forward is Re Halt Garage.Footnote 39 The case concerned an excessive remuneration that was paid to a shareholder director. Oliver J. based his decision on an interpretation of the objects of the company and found that the payments made were not genuine remuneration which would have been authorised by the objects but a dressed up dividend to a shareholder.Footnote 40 He said that those dealing with the company are entitled to do so on the basis that its affairs will be conducted in accordance with its constitution. “Subject to that they are entitled to have the capital kept intact.” They have to accept the shareholders' assessment on the scale of “the remuneration of directors but they are entitled to assume that what is paid is genuinely remuneration.”Footnote 41 He did not propose to put forward a legal basis other than the effects attributed to the object clause for the conclusion he reached. He did not say that the payment in question would have been considered illegal even if he had found that it fell within the object clause. But he nevertheless adopted an approach to shareholder transactions that influenced later decisions.
The first decision that identified disguised returns of capital as part of a legal category independent of the ultra vires doctrine is Aveling Barford v. Perion.Footnote 42 The case concerned a sale of a piece of land at an undervalue by the company to another company which was controlled by the first company's shareholder. Hoffmann J. found that the sale constituted a breach of duty by the directors of the first company. In addition to that, he pointed out that a company cannot without the leave of the court return its capital. Hoffmann J. found that the transaction was a sale at a gross undervalue and amounted to a dressed up distribution.
In contrast to Oliver J. in Re Halt Garage and the judges before him, Hoffmann J. did not arrive at his conclusion by way of interpreting the object clause of the company concerned. He also did not reach his conclusion by construing express or implied powers of the company. Hoffmann J. found that the general law does not allow a company without the leave of the court or the adoption of a special procedure to return its capital to its shareholders.Footnote 43 He then went on to hold that the sale to Perion was “not a genuine exercise of the company's power under its memorandum to sell its assets. … the sale was … ultra vires.”Footnote 44 Admittedly, this brings his analysis back within the scope of the ultra vires doctrine. But, the learned judge then concluded by holding that the transaction was “a sale at an undervalue which made it an unlawful distribution”.Footnote 45
The conclusion that a shift occurred from expressing concerns about shareholder transactions at an undervalue in terms of interpreting the company's objects and powers to looking at such transactions through the lens of disguised returns of capital as a legal category in its own right is also confirmed by a dictum of Neuberger J. He referred to the decision of Hoffman J. in Aveling Barford v. Perion as “judge made law”.Footnote 46 This confirms that the conclusion that the rule prohibiting undervalue transactions with shareholders has evolved out of the context of the ultra vires doctrine to form a legal rule in its own right.
The ultra vires doctrine has been substantially abolished. What has been said so far supports the conclusion that this has not affected the rule preventing companies from entering into transactions at an undervalue with their shareholders in circumstances where there is no distributable profit.
The nature and the content of this rule will be examined further below. The next section will address the question as to whether the prohibition of disguised returns of capital is a duty imposed on directors, which has external effect as an abuse of power on the part of the directors, or whether disguised returns of capital are illegal. After that the criteria which a transaction has to meet to be characterised as a disguised return of capital will be examined.
IV. Illegality versus Abuse of corporate Power
The nature of the doctrine preventing companies from entering into undervalue transactions with shareholders has been examined in an article by Professor John Armour. He writes that there are two separate doctrines which operate in this area of the law and which are not always clearly distinguished from each other. There is a doctrine prohibiting unlawful returns of capital. It applies to transactions with shareholders and their related parties. Under this doctrine transactions are found to be illegal. There also exists a still-developing restriction on what is sometimes termed abuse of corporate power.Footnote 47 Under the second doctrine directors entering into an undervalue transaction are in breach of their duty to act in the interests of the company as a whole.Footnote 48 The transaction is void provided that the other party was on notice of the fact that the directors did not act in the interests of the company. The second doctrine applies to shareholders but also to parties that are unrelated to shareholders.Footnote 49
The first observation to make here is that it is not possible for both doctrines to apply simultaneously. If a transaction is characterised as being illegal the illegality also affects the powers of the directors and of other agents of the company. Directors do not have the power to commit the company to illegal acts. Once illegality has been found there is no need to look further. A doctrine concerning an abuse of power can only apply in circumstances where the transaction is considered to be lawful but constitutes a breach of duty on the part of the directors and where that breach is considered to have external effect on the validity of the transaction.Footnote 50
As far as shareholder transactions are concerned we therefore need to determine whether undervalue transactions are considered illegal or whether they are subject to the scrutiny of an abuse of power doctrine.
In developing his argument on abuse of power Professor Armour cites ultra vires authority.Footnote 51 He also relies on a quote from MacPherson v. European Strategic Bureau.Footnote 52 The quote reads as follows,
[The scheme] is an attempt to circumvent the protection which the 1985 Act aims to provide for those who give credit to a business carried on, with the benefit of limited liability, through the vehicle of a company incorporated under that Act. As such, it fails to satisfy the first of the questions posed by Eve J. in Re Lee, Behrens and Co. Ltd. [1932] 2 Ch 46 at 51–52: “Is the transaction reasonably incidental to the carrying on of the company's business?” As Pennycuick J. pointed out in Ridge Securities Ltd. v. I.R.C. [1964] 1 All ER 275 at 288, [1961] 1 WLR 479 at 495:
A company can only lawfully deal with its assets in furtherance of its objects. The corporators may take assets out of the company by way of dividend or, with leave of the court, by way of reduction of capital, or in a winding up. They may, of course, acquire them for full consideration. They cannot take assets out of the company by way of voluntary disposition, however described, and if they attempt to do so, the disposition is ultra vires the company.
It is important to note the epithet by which Pennycuick J. qualifies the word “consideration” in that passage. The question is not whether the assets are acquired under some arrangement which contains the elements which the law requires for recognition as a contract. What is needed is “full consideration”; that is to say, the arrangement must be entered into for the benefit and to promote the prosperity of the company. The provisions in the 1991 agreement do not meet that test. [Armour's emphasis]
Professor Armour concludes that Chadwick L.J.'s requirement that the arrangement “be entered into for the benefit or to promote the prosperity of the company” is a reference to Re Lee Behrens and that case in turn is now properly understood as being an appropriate test for cases involving an abuse of power.Footnote 53 From that he infers that MacPherson can be interpreted as a case where the court has applied an abuse of power doctrine.
It is suggested here that the better view is to read the quote as a whole. Chadwick L.J. starts out by characterising the scheme as an attempt to circumvent the Companies Act 1985. That points to illegality rather than abuse of power. The requirement for full consideration as contrasted with the requirement for consideration in relation to contractual validity then further clarifies the circumstances in which a transactions are considered to be illegal.
Professor Armour's reading of MacPherson admittedly fits with the development that the company's constitution having ceased to have external effect now has internal effect binding directors in their relationship with the company. Directors who do not act in accordance with the constitution breach their duties. A good part of the cases on the ultra vires doctrine therefore continue to be relevant as authority defining the duties of directors. This, however, does not mean that all ultra vires authority has to be recharacterised in this way. The term ultra vires has been used by judges over time in more than one sense. It has been used to refer to limited capacity. It has been used to refer to limited authority. And it has been used to refer to illegality.Footnote 54
An abuse of power approach also appears to receive support from a dictum of Slade L.J. in Rolled Steel Products v. British Steel Corporation.Footnote 55 The learned judge found there that the purpose for which a transaction is entered into is incapable of causing a transaction to be ultra vires. That purpose is relevant in the context of directors' duties only. Slade L.J. went on to say that transactions entered into for an unauthorised purpose can be ratified by the shareholders but qualified this by exempting from this transactions which constituted a fraud on the company's creditors and by referring to Re Halt Garage as an example of such a fraud.Footnote 56 This could be read as meaning that undervalue transactions with shareholders, like the transaction in Re Halt Garage, constitute a breach of duty on the part of the directors, but do not form an independent category of illegality.
The dictum, however, was made obiter. Moreover, it was concerned with ratification only. It assumed that directors are not permitted enter into undervalue transactions with shareholders, but it does not say what form this prohibition takes. In particular, the statement would be reconcilable with both approaches. It would be true irrespective of whether one concluded that the prohibition of disguised returns of capital was subject to an abuse of power doctrine or whether it formed an independent category of illegality.
It has been shown above that the cases following Re Lee Behrens in the context of under value transactions with shareholders have been characterised by later authority as cases involving unlawful returns of capital. For example, Oliver J. found in Re Halt Garage that the transaction in Ridge Securities may have been an “illegal return of capital”.Footnote 57 Illegality also seems to have been the direction of Neuberger J.'s thoughts when he held that Aveling Barford v. Perion constituted judge-made law.Footnote 58 The learned judge did not qualify his statement by putting it into the context of abuse of power.
As far as undervalue transactions with shareholders and their related parties are concerned the better view is that disguised returns of capital are illegal depriving directors of their powers to commit the company to such transactions. This is consistent with finding that directors purporting to enter into such transactions and giving away company assets in the course of doing so are liable for breach of duty.
As far as transactions with third parties that are not related to shareholders are concerned there may be scope to apply a doctrine based on an abuse of power argument, but the authorities cited in Professor Armour's article either do not involve claims rendering transactions void or do not concern the challenge of the validity of a third party transactions.Footnote 59
Moreover the abuse of power doctrine has been said to apply notwithstanding CA 2006, s. 40 which gives a power to the directors to bind the company that is free of any limitations under the company's constitution. Professor Armour writes that CA 2006, s. 40 does not affect the doctrine of abuse of power because it is imposed from general equitable principles.Footnote 60 The authority cited in support of this proposition is International Sales v. Marcus.Footnote 61 That case, however, did not concern a transaction between a company and a shareholder or a third party. Lawson J. found that the directors had “for no consideration handed over the … [company's] monies to the defendants without any obligation”.Footnote 62 It was about the company paying over money without any obligation to do so. It does not support a general rule that equitable principles would in all cases be unaffected by the statutory power. CA 2006, s. 40 is based on the First Company Law Directive. The fact that the abuse of power doctrine has its roots in equity is as such not sufficient to place it outside the scope of the rule.
The conclusion of this subsection is that disguised returns of capital are illegal. A transaction that involves a disguised return of capital is void.Footnote 63 Companies must not transfer value to their shareholders otherwise than in the form of distributable profits or in the course of a reduction of capital.Footnote 64
V. Subjective versus objective approach
The conclusion so far has been that undervalue transactions between companies and their shareholders are void if they amount to disguised returns of capital. In the next step of the analysis we need to determine how undervalue transactions are to be identified. Which criteria does a shareholder transaction have to meet to qualify as an illegal undervalue transaction?
Two approaches appear from the cases. The first approach examines the knowledge and the intentions of the company or of the company and the third party concerned. It will be referred to in this article as the “subjective approach”. The second approach looks at the effect of the transaction. It will be referred to in this article as the “objective approach”.
A. Subjective Approach
The first approach focuses on what either the company on its own or jointly with the other party to the transaction knew and intended to achieve through the transaction. If they intended to benefit the shareholder rather than the company or if the true objective was to transfer an asset to the shareholder at an undervalue the transaction is caught by the rule. This involves a requirement for a certain state of mind on the part of the company or on the part of both parties of the transaction. Examples for this approach are In re Lee, Behrens,Footnote 65Re W&M Roith,Footnote 66Re Halt Garage,Footnote 67 and Aveling Barford v. Perion.Footnote 68
In re Lee, Behrens and Re W&M Roith focused on the state of mind of the directors of the company and did not identify the state of mind of the party dealing with the company as an independent criterion.
For a transaction to be considered valid under the tests In re Lee, Behrens it had to be “reasonably incidental to the carrying on of the company”s business”. It had to be a “bona fide transaction” and it had to be entered into “for the benefit and to promote the prosperity of the company”.Footnote 69 Eve J. “enquired into the considerations operating in the minds of the directors”.Footnote 70 He did not require the person contracting with the company to satisfy any subjective elements.
In Re W&M Roith the agreement was entered into between the company and a director who held over two thirds of the company's shares. When the agreement was made the director was in poor health. He entered into a service agreement with the company whereby his widow would receive a pension a few months before he died. Plowman J. applied the tests In re Lee, Behrens, and found that “the whole object of the plan was to benefit not the company but Mrs Roith”. He held accordingly that the transaction was ultra vires.Footnote 71 He enquired into what the directors were trying to achieve. He examined their state of mind.
In Re Halt Garage and Aveling Barford, Oliver J. and Hoffman J. respectively stressed that the matter needed to be approached objectively, but then went on examine the knowledge and the intentions of the parties.Footnote 72 In contrast to In re Lee, Behrens and R&W Roith, they looked at the state of mind of the company as well as of the shareholders concerned. Both cases will be examined further below.
Oliver J. in Re Halt Garage said that an objective test applied. The test assumes that human beings are rational and apply ordinary standards. “The motive is more important than the label”.Footnote 73 A power must not be used as “a cloak for making payments out of capital to the shareholders as such”.Footnote 74 The word “cloak” implies that both parties to the transaction knew that their transaction was unlawful and designed it to circumvent the law.
Oliver J. refers to a remuneration as being “not a remuneration at all, but a dressed-up gift to a shareholder out of capital”.Footnote 75 Oliver J. also found that the sums paid “were so out of proportion to any possible value attributable to her holding office that the court is entitled to treat them as not being genuine payments of remuneration, but as a dressed up return of capital.”Footnote 76 The repeated use of the word “dressed up” suggests that both parties intended to circumvent the law.
In Sasea Finance Ltd. v. KPMG a subsidiary company (SFL) had borrowed money for the sole purpose of paying it over to other companies within the same group, thus enabling the recipient companies to buy shares in the holding company of SFL.Footnote 77 This was done to create demand in the shares of the holding company which was publicly listed. SFL did not have any business interest in the transaction. The case was decided on a strike out application. Hart J. held that SFL had an arguable case that it suffered a loss as a result of these transactions. Counsel had argued that there was no general doctrine in English company or insolvency law which enabled an attack to be made on a transaction simply because it was disadvantageous to the company or its creditors.Footnote 78 Hart J. found this too sweeping a statement.Footnote 79 Echoing Oliver J.'s words he wrote, “if in the absence of evidence of actual motive, the consideration given by the company is excessive by any objective standard, the inference that can be drawn is that the creation of the liability is merely a cloak for an unlawful return of capital.”Footnote 80 This implies that subjective elements need to be satisfied.
In Aveling Barford v. Perion Hoffmann J. held that the courts look at the substance of the transaction rather than at outward appearance.Footnote 81 The courts look at the matter objectively. Nevertheless, there appears to be a requirement for a subjective element. Hoffmann J. found that the transaction was a sale at a gross undervalue and amounted to a dressed up distribution. He said that the transaction was not a sham. It was the fact that it was known and intended to be a sale at an undervalue which made it an unlawful distribution.Footnote 82 He also remarked that this does not mean that payments need to have been made fraudulently or in bad faith: “bona fides (in the sense of absence of fraudulent intention) and genuiness are [not] necessarily the same thing.”Footnote 83 These statements imply that an intention of both parties to circumvent the law was present and relevant to Hoffmann J.'s reasoning.Footnote 84
Aveling Barford v. Perion was applied in Progress Property Company Ltd. v. Moorgarth Group Ltd.,Footnote 85 the recent decision of the Court of Appeal referred to at the beginning of this article. Mummery L.J. held that a transaction at an undervalue was not ultra vires in circumstances where it was not known and intended to be a sale at an undervalue. He found that there was no reason to doubt the genuiness of the transaction as a commercial sale.Footnote 86 In the case concerned the transaction was at an undervalue but the sale price was calculated on the basis of the value of the properties that was misunderstood by all concerned. Mummery L.J. held that “the authorities demonstrate that the issue is whether on the facts as they were genuinely perceived by [the director] to be, and having regard to the value and character of the payment” it could properly be characterised as something other than a gratuitous distributions to the shareholders.Footnote 87 This is a subjective test focussing on the state of mind of the directors concerned.
Reading Mummery L.J.'s decision one is left with the impression that the law is well settled and that there is a requirement for the parties concerned to intend the sale to be at an undervalue.Footnote 88 A closer look, however, at authority that does not appear to have been cited to the Court of Appeal or the judge at first instance in Progress reveals that the picture is not quite as clear. There also exists a line of cases that do not focus on the intention of the parties.
B. Objective Approach
The second approach is to focus on the effect of the transaction. On that approach a transaction is in breach of the rules if as a result of it assets are transferred from the company to a shareholder without adequate consideration. Based on certain objective criteria the transaction is characterised as involving a disguised return of capital. In some of the cases cited below it appears from the facts that the parties concerned knew or must have known of the discrepancy in value between the consideration given by the company and the consideration given by its shareholders. Notwithstanding this the reasoning of the respective judges does not indicate that the parties' knowledge or intentions were relevant to the conclusion that a disguised return of capital had occurred. The approach is therefore referred to as “objective approach” in this article. Examples for this approach are In re George Newman & Co,Footnote 89Ridge Securities v. I.R.C.,Footnote 90Barclays Bank v. British and Commonwealth Holdings,Footnote 91MacPherson v. European Strategic Bureau,Footnote 92 and a number of Commonwealth cases.Footnote 93
In re George Newman & Co, company's money was used inter alia to purchase an asset at a substantial undervalue from the principal shareholder and to refurbish the private residence of that shareholder. In deciding the case Lindley J., did not point to a specific requirement for the intention of the parties. He concluded that “[w]hen the facts are understood … these sums were in truth presents by the directors out of the company's assets to …[its principal shareholder] … and the question is whether these presents can be treated as valid against the liquidator on the winding-up of the company, which is hopelessly insolvent and which was largely in debt when these presents were made.”Footnote 94 Lindley J. found that the directors who were also shareholders had made presents to themselves out of money borrowed for the purposes of the company's business.Footnote 95 He held that “to make presents out of profits is one thing and to make them out of capital or for money borrowed by the company is a very different matter. Such money cannot lawfully be divided amongst the shareholders themselves, nor can it be given away by them for nothing to their directors so as to bind the company in its corporate capacity”. “The articles of this company, wide as they are do not authorise such presents.”Footnote 96 Lindley J. found that the directors were in breach of trust. He also said that it never seems to have occurred to the shareholder directors that they could not do as they liked with what they regarded as their own property, but which was in fact owned by the company.Footnote 97 Notwithstanding this he did not point to a separate requirement for the intention of the parties or the directors on the ultra vires point.
In re Walters' Deed of Guarantee the defendant guaranteed the payment of certain dividends towards the company's preference shareholders and having indemnified these shareholders had a contractual right against the company to be reimbursed.Footnote 98 Maugham J. found that the clause enabling the defendant to claim reimbursement was “ultra vires and void”. The reason was that it enabled the defendant to claim as a creditor. This might reduce the capital of the company otherwise than by expenditure on its objects and was inconsistent with the rule in Trevor v. Whitworth. No findings were made as to the parties' knowledge or intention.
In Ridge Securities v. I.R.C. Pennycuick J. found that the terms of the arrangement indicated that the “so called interest represented in fact a gratuitous disposition of an enormous sum by the company in favour of its parent company”.Footnote 99 He then went on to hold that shareholders can take assets out of the company by way of dividend, by way of reduction of capital or winding up. They can also acquire assets for full consideration. But they cannot take assets out of the company by way of voluntary disposition, however described, and if they attempt to do so, the disposition is ultra vires the company. It was clear from the facts that the parent company designed the scheme and caused its subsidiaries to enter into the transaction in question for a purpose outside of the subsidiaries' ordinary business. But, Pennycuick J. did not point to a requirement for particular knowledge or intention on the part of subsidiaries making the payment or of the parent company contracting with the company.
In Barclays Bank v. British and Commonwealth Holdings,Footnote 100 a scheme was designed to prevent a shareholder from selling a substantial shareholding in the open market and thereby causing the share price to fall. Instead of selling all the shares, the shareholder converted part of his shareholding into redeemable shares which were to be redeemed at certain future dates. In the event the company was unable to redeem the shares, the shareholder had the right to sell the shares to a special purpose vehicle which was financed by a consortium of banks. It was part of the terms of the arrangement that the company conduct its business within the realm of certain key ratios. The company was able to redeem two tranches of the shares, but defaulted on the following tranches. It also failed to remain within the ratios put in place by the scheme. The shareholder enforced the contract and sold the shares to the special purpose vehicle which called upon the banks to advance the necessary funds. The banks paid and sued the company for damages. Harman J. held that paying damages in those circumstances would amount to giving away the company's capital.Footnote 101 He found that it was “unlawful to make an agreement expressed to impose a liability to make a gratuitous payment, that is one not for the advancement of a company's business nor made out of distributable profits at a future date when in the event”.Footnote 102 It is, admittedly, highly likely that the scheme was designed by the parties with the knowledge and intention that the liability to pay would only arise in circumstances where the company did not have sufficient profits to redeem the shares. But, Harmann J. did not point to a requirement for any particular knowledge or intentions of the parties to the transaction.
Chadwick L.J. found in MacPherson v. European Strategic Bureau that the transaction was not entered into for the benefit and to promote the business of the company.Footnote 103 In doing this, however, he did not investigate the state of mind of the directors. He rather looked at the effect of the arrangement, concluding that it intended to achieve an informal winding up of the company's business circumventing the statutory provisions protecting the interests of creditors. It is suggested here that notwithstanding the use of terminology such as “intention” or “achieve objective”, the learned judge arrived at his conclusion by examining the effects of the transaction rather than the state of mind of the parties.Footnote 104 He concluded that in order for him to arrive at his conclusions it was not necessary to find that the arrangement was a “sham”.Footnote 105 It was enough to hold that “the provision [to pay remuneration in the circumstances] can have no place in an arrangement entered into for the benefit or the prosperity of the company. The parties have sought to achieve their objective without making proper provision for creditors; and their attempt must fail”.Footnote 106 Buxton L.J. in his judgment agreed with Chadwick L.J.'s conclusions on the winding up point and also found that the transaction had to be characterised as an unlawful distribution under the CA 1985, s. 263(1). He held that his findings “do not entail a holding that the agreement was a sham, in the sense that the parties to not genuinely think that they were rewarding each other for past services and were entitled to do so. Rather the method of reward that they chose was in danger of being characterised as a distributions of assets unless the basis on which it was explained and justified was capable of some other construction in law, in this case I am not satisfied that it was so capable”.Footnote 107
Lord Hamilton in Clydebank Football Club Ltd. v. Steedman also adopted an objective approach.Footnote 108 He held that, “If the transaction is genuinely conceived of and effected as an exchange for value and the difference ultimately found does not reflect a payment “manifestly beyond any possible justifiable reward for that in respect of which allegedly it is paid”, does not give rise to an exchange “at a gross undervalue” and is not otherwise unreasonably large, there will not to any extent be a “dressed up return of capital”. In assessing the adequacy of the consideration a margin of appreciation may properly be applied”.Footnote 109 In determining whether the test has been met he did not examine the parties' intentions but looked at whether there were business related reasons present that justified a price below market value.
In Australasian Oil Exploration v. Lachberg the High Court of Australia found that there was sufficient evidence that the value of the assets sold to another company owned by shareholders of the first company was vastly in excess of the purchase price.Footnote 110 This was held to amount to a return of capital by the first company to its shareholders. It did not make a difference that this occurred indirectly through a company which was owned by the shareholders. The court focused on the effect of the transaction. No requirements as to the knowledge or the intentions of the parties were imposed. It was also held that it was no defence that the transfer occurred at book value. It nevertheless amounted to an unlawful return of capital.Footnote 111 The same approach was adopted by the Supreme Court of New South Wales in Davis Investments Proprietary Limited v. Commissioner of Stamp Duties where a company sold assets at book value to its parent company.Footnote 112 The same approach was also adopted by the Supreme Court of New Zealand in Jenkins v. Harbour View Courts Ltd., where a company granted leases over its assets to shareholders in return for them having to pay only for outgoings with some provision for reserves.Footnote 113
In Redweaver Investments v. Lawrence Field, an agreement to pay liquidated damages was held to involve an illegal return of capital.Footnote 114 This conclusion was reached by reference to the machinery according to which the sum payable was to be determined. That machinery did not have an apparent relation to an appraisal of the amount of damages. It rather looked exclusively backwards at what the plaintiff paid as subscription money for its shares. That money would not have been an element in the plaintiff's calculation in the event that he had to prove damages. The reference to the liquidated damages in the agreement was held to be nominal. The true and obvious purpose of the agreement was to provide a machinery for the plaintiff to get back subscription money. The learned judge did not use terminology such as “sham” or “cloak”. He also did not refer to the parties' intentions. He reached his conclusion by examining “what in substances and effect is the character of the payment”.Footnote 115 He mentions that the parties' express arrangements may serve to “generate suspicion by furnishing indications of concealment or of circuitous arrangements”, but he did not further investigate the parties' knowledge or intentions in the case before him.
The cases examined in this subsection have adopted an objective approach. While there may have been evidence that the parties knew and perhaps even intended a transaction to occur at an undervalue, the judges deciding the cases did not identify the knowledge or the intention of the parties as an independent criterion that needs to be satisfied for a court to find that a disguised return of capital has occurred.
C. Conclusion
The conclusion of this section is that there are two approaches to deciding whether a particular transaction can be characterised as a disguised return of capital. The first approach is to examine the knowledge and the intention of the directors of the company or of both parties to the transaction. On that approach a disguised return of capital occurs if the directors did not intend the transaction to promote the prosperity of the company or if both parties concerned knew that the transaction was at an undervalue and intended it to involve a transfer of value away from the company to the shareholders.
The second approach does not examine the knowledge or intentions of the parties. It looks at the effect of the transaction. On that approach a disguised return of capital occurs if as a result of the transaction value is transferred from the company to a shareholder.
The next section will examine which of these approaches is preferable against the background of the English capital maintenance regime. The section will conclude that an arm's length test should be applied to identify transactions that involve a disguised return of capital.
VI. Identifying disguised returns of capital
The rule prohibiting disguised returns of capital does not operate in isolation. It is a rule enforcing the principle that in company law creditors have priority over shareholders. English company law aims at protecting creditors through a regime sometimes referred to as having the effect of maintaining the capital of the company. While the law does not prevent a company from losing money in the course of its business, it attempts to ensure that shareholders only receive return from their investment after creditors have either been paid or provision has been made for their claims in the company's records. This result is achieved by prohibiting companies from paying dividends to their shareholders otherwise than out of distributable profits. Companies may also make payments to their shareholders in the course of reducing their capital. All other payments are illegal.Footnote 116 Lord Watson held in Trevor v. Whitworth that the rules regulating reductions of capital aim at protecting “interests of the outside public who may become … creditors” of the company. “… the effect of these statutory restrictions is to prohibit every transaction between a company and a shareholder, by means of which the money already paid to the company in respect of his shares is returned to him, unless the Court has sanctioned the transaction.”Footnote 117 This means that companies must not make gratuitous payments to their shareholders. They are also not allowed to transfer money or another asset to their shareholders without receiving an adequate consideration in return.
The starting point of the analysis has to be that every undervalue transaction between the company and a shareholder is illegal. It is irrelevant from the perspective of the company's creditors whether something that has been taken by shareholders was taken in good faith or otherwise. Value has been taken away from the company and ended up in the pockets of the shareholders. The claim against the shareholders is not a claim for damages which would normally require a subjective element to be met. It is a claim to return something that rightfully belongs to the company and has to remain with the company for the benefit to its creditors. The fact that the shareholders or the directors of the company did not know about the fact that the consideration was inadequate is irrelevant. Shareholders may be able to rely on the fact that they have changed their position, but otherwise the rational underlying the rule requires a strict approach. There are, however, two concerns with a strict approach. These concerns will be analysed in turn below.
The first concern with a strict approach classifying a value transfer irrespective of the parties' knowledge as an unlawful return of capital has been referred to by Mummery L.J. who wrote the judgement in Property Progress Company Ltd. v. Moorgarth Group Ltd.Footnote 118 He reasons that a strict approach would mean that directors authorising a sale would always be at risk of a possible claim however reasonably they behaved.Footnote 119
This argument is born out of the concern that directors should not be held liable in circumstances when they have not acted unreasonably. But asking shareholders to return value they received does not amount to imposing liability on directors. A strict approach on disguised returns of capital does not interfere with the principles governing the law of directors' duties. The two need to be kept separate. It is one thing to conclude that capital has left the company and moved into the hands of shareholders who have to give it back because it belongs to the company's creditors. It is quite another thing to say that directors are liable to indemnify the company for that decrease in value.
It is possible to decide the first issue in favour of the company, but to conclude that directors are not liable for breach of duty. In Progress Property Company Ltd. v. Moorgarth Group Ltd. the lawfulness of the transaction and the liability of the directors concerned appears to have been decided at the same time without distinguishing one from the other. The case appears to have been pleaded on the basis that the directors had breached their fiduciary duty and also their duty of care. Donaldson QC acting as deputy judge wrote at first instance that the allegation of a disposal of the shares at an undervalue constituted an unlawful distribution, was therefore ultra vires and formed the basis of a claim for breach of duty against the directors of the company and a “consequent claim” against the shareholders. Footnote 120 The learned judge goes on to analyse Aveling Barford v. Perion against the illegality and ultra vires point and then concludes that the directors “subjectively knew and intended [the transaction] to be a sale at market value”.Footnote 121 This leads him to reject the claim against the director and “by extension” also against the shareholder in so far as it is based on the contention that the transaction is ultra vires. The use of the words “by extension” suggest that the judge was primarily looking at whether the director was liable and not finding him liable also excluded the shareholders from liability. The same thought process appears to have occurred at the level of the Court of Appeal when Mummery L.J. expressed his concerns about directors of company's being held liable for reasonable acts. It is suggested here, with great respect, that whether or not a particular transaction is illegal because it conflicts with the rule in Trevor v. Whitworth is independent of whether a director acted within his common law and equitable duties.
The context against which the rule prohibiting disguised returns of capital operates mandates what the judges have called an objective approach. If value has been transferred from the company to a shareholder for an inadequate consideration it does not matter what the intention of the company or the shareholder were. The company's funds have been reduced through a shareholder transaction. A return of capital occurs every time a shareholder transaction results in the company receiving a consideration from a shareholder that is below the value of the consideration the company transferred to the shareholder in return.
The second concern with a strict approach is, however, that it is not always possible to identify the value of an asset with scientific precision. For some assets such as listed shares or certain commodities a public market exists and their current market value can be determined by reference to the public market price. For most other assets, however, no such pricing mechanism exists. For assets such as real property a liquid market may exist, but there may be different views on the value of a particular property which are all supported by good reasons. For assets that cannot be sold in a market a value can only be determined by reference to factors such as production cost or the price that is paid for comparable items for which there exists a market. Determining the value of an asset against this background is not a scientific exercise. It involves judgement and the outcome of a valuation is often understood to be an estimate rather than an exact figure.
Moreover, there may be circumstances in which a sale at a value below the market price may be justified by other considerations connected to the business of the company. Such discounts may be an expression of the company's hope to receive substantial orders in the future or of the company's appreciation of a longstanding customer. They may be mandated by other factors related to the business of the company such as a requirement to complete the transaction within certain time constraints.Footnote 122
Determining value involves making allowance for judgement being exercised in different ways. It is also necessary to investigate the business of the company concerned. But this does not mandate a subjective approach enquiring into what the intentions of the directors were and whether or not they believed that a transaction would promote the business of the company or occurred at an undervalue.
The valuation problem is also not addressed by a test that determines whether or not the parties intended to circumvent the law. The company and their shareholders know the law. Their unawareness of the rules or of the fact that their transaction occurred at an undervalue should not be available to them as a defence.
It also needs to be remembered that the rule against disguised returns of capital only concerns shareholder transactions. It does not restrict the company in its business with persons who are not shareholders. A breach of the rule also does not automatically render directors liable. It only requires the shareholders concerned who have received value that belongs to the company's creditors to return that value to the company.
The fact that more than one view on the value of an asset may be acceptable and the fact that sometimes business reasons justify a price below the market value is better taken into account on an objective approach accepting that value sometimes can only be expressed in terms of a price range and also taking into account the business reasons underlying the transaction.
A. Gross undervalue as the benchmark
One way of solving the valuation problem would be to restrict disguised returns of capital to cases where there is a substantial discrepancy between the considerations given by the company and the shareholders respectively.Footnote 123 Such an imbalance was present in a good number of the cases. In Re Halt Garage, Oliver J. said that a payment was made of out of capital which was described as remuneration but which was so manifestly beyond any possible justifiable reward for that in respect of which it allegedly it is paid.Footnote 124 Hoffman J. found in Aveling Barford v. Perion that the transaction was at a “gross undervalue”.Footnote 125
The fact, however, that a disguised return of capital was found to have occurred where a gross undervalue existed does not imply that in a case where the discrepancy in value is less pronounced the courts would or should necessarily find that no disguised return of capital has occurred. From the point of view of maintaining the company's capital it is irrelevant if the difference between the two respective considerations is large or small.
B. Book value as the benchmark
Another way of solving the valuation problem would be to take inspiration from two new sections that were introduced by the Companies Act 2006. Sections 845 and 846 of that Act regulate distributions in kind. They apply where a company has distributable profits and sells a non cash asset to a shareholder. If this sale is to be treated as a distribution, the value of the distribution is to be determined by the book value of the assets concerned.
The question arises if the book value of an asset is an appropriate benchmark against which it can be determined whether a disguised return of capital has occurred in circumstances where there is no distributable profit. It is suggested that this is not the case.
The sections only apply if the company has profit available for distribution and if the amount of the distribution were to be determined in accordance with the section the company would be able to make the distribution without contravening Part 23 of the Companies Act. The section does not apply if there are no distributable profits.
This conclusion is confirmed by the Explanatory Notes of the Companies Act 2006. These state that CA 2006, sections 845 and 846 were introduced to enable companies to transfer assets between members of a group at book value in circumstances where there is distributable profit without having to worry about being caught by the rule in Aveling Barford v. Perion.Footnote 126 The Explanatory Notes set out that Aveling Barford v. Perion was a case were no distributable profits were available to the company. It decided nothing about a situation where a company has distributable profits and makes an intra group transfer of an asset at book value. Nevertheless there was concern that such a transfer at book value may have an element of undervalue and that the transaction may be seen as constituting a distribution thereby requiring the company to have distributable profits sufficient to cover the difference in value. Companies Act 2006, section 845 clarifies the position where companies have distributable profits and determines the amount at which any distribution should be valued. It does not disturb the position in Aveling Barford v. Perion where the company does not have distributable profits.Footnote 127
While it may seem logical to apply book values to distributions in circumstances where there is profit the same is not true for disguised returns of capital. There is no equivalent rule permitting companies to treat the transfer of an asset to a shareholder in the course of a reduction of capital as a transfer at book value.
Moreover, if the company has distributable profits any unrealised profit that is attached to an asset which is recorded at a certain book value would, if the asset was sold, become realised profit. That realised profit would then be immediately available for distribution. From the point of view of the creditors, it is irrelevant if the asset with some unrealised profit attached to it is transferred to a shareholder at book value or if the profit is realised and then transferred to the shareholder. This reasoning, however, only applies if the company has distributable profits. If there is no such profit available the value above the book value of an asset would, if realised by the company, be available at first instance to creditors. It would not necessarily be available for distribution. If there are no distributable profits a sale at book value can amount to a disguised return of capital.Footnote 128 The conclusion of this subsection is that if there is no distributable profit a sale at book value can still involve a disguised return of capital.
C. Arm's length approach
Shareholder transactions must not involve a transfer of value away from the company. When determining whether such a value transfer has occurred it seems fair to start with an assumption. Oliver J. put forward the following assumption upon which he based his reasoning in Re Halt Garage. He assumed that human beings are rational and apply ordinary standards.Footnote 129 Applying this assumption, it can be inferred that a company normally carries out its business with a view to either making a profit or, if making a profit is not its objective, with a view to achieving a return that allows the company to sustain its activities. It therefore prices transactions with a view to generating sufficient return to serve its purpose and to preventing a transfer of value away from the company.
If this assumption is true there would normally be no cause for concern if a company transacts with its shareholders at arm's length. Conversely, it should not be possible for companies to enter into transactions with their shareholders for a return that is more favourable to the shareholders than the return which would normally be available for non-shareholders. In those cases the company has transferred value to its shareholders. By transacting at a lower price with its shareholders the company foregoes the return it would have received in an arm's length transaction.
This approach receives inspiration from the third test formulated by Eve J. in In re Lee, Behrens.Footnote 130 That test involved the question as to whether the company had acted with a view to promoting the business and the prosperity of the company. The test was stated as a subjective test examining the state of mind of the directors concerned. The subjective element of the test, however, can be explained by the general approach towards assessing the decision making of directors prevalent at the time the decision was made. The courts and the law have since moved towards applying objective standards to corporate decision making. Expressed in objective terms the third test in In re Lee, Behrens supports an arm's length test comparing the transactions concerned with other transactions the company normally enters into and assuming that the company's business is normally carried out with a view to allowing the company to sustain its activities in the long term.
For transactions that are of a scale or type that the company does not normally carry out the assumption would be that the company would have contracted with a third party at market value. This makes it necessary to determine the market value of whatever the object of the transaction may be. If the valuation produces a price range, the transaction would have to fall within that price range in order for it not to be characterised as a disguised return of capital. But any price within that range would appear to be acceptable.
Here too, however, there may be considerations connected to the company's business that justify a transaction below market value. One example would be Clydebank Football Club Ltd. v. Steedman where the transaction had to be completed within tight deadlines to permit the company to continue its operation albeit with different owners.Footnote 131 In Progress Property Company Ltd. v. Moorgarth Group Ltd. the judge at first instance and the Court of Appeal decided the issue on the assumption that there was a discrepancy in value without investigating the fact of the particular case.Footnote 132 There are therefore no findings of fact that would allow conclusions as to whether the particular transaction was carried out within a reasonable band of values or whether there were objective business reasons justifying the price.
Looking at bands of values and allowing reasons related to the particular business of the company to be taken into consideration gives judges sufficient room to take into account the realities of commercial transactions. It also gives adequate affect to the principle that company creditors have priority of shareholders which requires objective criteria to determine if a disguised return of capital has occurred. The arm's length approach suggested in this article is different from a subjective approach which will also look at different views of value and business reasons because the shareholders' and directors' honest belief or good faith is not a defence to the claim.
The approach advanced in this article, admittedly, requires the courts to decide on the facts of each case whether a shareholder transaction has satisfied an arm's length test. It is, however, not unrealistic to assume that the courts are able to take such decisions. They will be assisted by expert evidence. Moreover, courts in Germany have for many years applied arm's length criteria to disguised returns of capital for both private and public companies. In doing this they were able to develop a coherent body of jurisprudence that has been well documented and commented on.Footnote 133
D. Conclusion
The conclusion of this subsection was that transactions between companies and their shareholders must be carried out at an arm's length.
This means that shareholders are treated differently from other people that the company normally transacts with. While it is possible for a third party to validly receive a gift from a company shareholders must not be beneficiaries of such gifts. This is not surprising. The Companies Act has implemented a creditor protection regime that does not prevent companies from losing money when dealing with third parties. It only puts restrictions on the shareholders' ability to receive return from the company. Shareholders are permitted to receive return from their companies only after creditor interests have been looked after. A company must not transfer value to its shareholders otherwise than in the form of distributable profits or through a capital reduction.
VII. Consequences of a disguised return of capital
It has already been mentioned that an agreement that is characterised as a disguised return of capital is void.Footnote 134
Shareholders need to return what they have received from the company.Footnote 135 The question that arises however is if shareholders having received a payment are able to rely on CA 2006, section 842.
Section 842 of the Companies Act 2006 states that a member having received a distribution in contravention of Part 23 must repay it to the company if he knew or has reasonable grounds for believing that it was so made. “Distributions” are referred to in CA 2006, section 829 as “every description of distribution of a company's assets to its members, whether in cash or otherwise” subject to certain exceptions including reductions of capital and winding-ups.
An argument in favour of applying CA 2006, section 842 to disguised returns of capital is, however, that judges have sometimes referred to a situations where a disguised return of capital has occurred as involving an “unlawful distribution”.
For example, Buxton L.J. found in MacPherson v. European Strategic Bureau that the agreement was in danger of being characterised as an unlawful distribution of assets, but did not reach a final conclusion on the matter.Footnote 136 Hoffmann J. in Aveling Barford v. Perion referred to the transaction as being in breach of the rule that “capital may not be returned to shareholders”.Footnote 137 He then went on to characterise the transaction as involving an “unlawful distribution” or a “dressed-up distribution”.Footnote 138 In Clydebank Football Club Ltd. v. Steedman an “unlawful distribution” is referred to as involving “in substance a gift of capital” and “an unlawful return of capital”.Footnote 139
These statements were, however, not made in the context of applying CA 2006, section 842. Moreover, it appears that the scope of that section is better limited to circumstances in which the directors have declared a profit without taking into account CA 2006, Part 23 or where they made a mistake in applying CA 2006, Part 23. Part 23 contains rules according to which directors need to calculate profit. Shareholders are not required to verify the directors' assessment of the company's financial situation against this background. They are able to assume that the statutory requirements have been met when they receive a payment by the company that has been classified as a distribution. They only need to return such payments if they knew or had reasonable grounds for believing that the payment was made in violation of Part 23.
The rule prohibiting disguised returns of capital is independent of the statutory regime governing distributions. It was first stated under the umbrella of the ultra vires doctrine where the knowledge of the parties concerned did not have an effect on the availability of a remedy. The common law classified shareholder transactions at an undervalue as a sufficiently serious irregularity for them to be dealt with by the ultra vires doctrine. This classification continues to be relevant even after the ultra vires doctrine has been abolished and disguised returns of capital have come to be classified as illegal rather than ultra vires.
VIII. Conclusions
This article examined the boundaries of an important principle of company law. It analysed the rules requiring a company to maintain its capital and the circumstances in which a transaction will be characterised as being in breach of these rules. The capital maintenance rules mandate that shareholders only receive return on their investment after creditors have either been paid or provision has been made for their claims in the accounts of the company. Shareholder claims are subordinate to creditor claims. A transactions whereby a company transfers an asset to a shareholder at an undervalue falls foul of these rules if it is characterised as a disguised return of capital.
The courts used to scrutinise undervalue transactions with shareholders under the umbrella of the ultra vires doctrine. The article argues that the cases following In re Lee, Behrens which have long puzzled academic writers can be explained as involving disguised returns of capital. When the ultra vires doctrine was abolished, an independent rule prohibiting disguised returns of capital emerged. That rule renders transactions which transfer assets at an undervalue to shareholders void.
The article argues that a difficult problem lies in identifying such undervalue transactions. Courts have adopted two different approaches, all of which have significant shortcomings. The article promotes an objective approach. It puts forward an arm's length test requiring companies to transact with shareholders at the terms which they would apply if the shareholder was a person not connected with the company. This leads to the default position that companies need contract with shareholders at market value. When determining market value courts need to take into account that the value of an asset can sometimes not be determined with scientific precision. If more than one view on the value of an asset is supported by good reasons any value within this range of prices is acceptable. The article also argues that a price below market value may be supported by reasons relating to the business of the company such as a requirement to complete a transaction within a certain time window.
The final conclusion of the article is that shareholders are unable to rely on CA 2006, s. 842 with the consequence that they must repay what they have received as a result of a disguised return of capital irrespective of whether they knew or had reasonable grounds for believing that the transaction was unlawful.
