The directors have heard that a company must satisfy both realised profits test and the net assets test before it can pay a dividend to its shareholders – This statement is completely true in the case of a public limited company such as Fashion Designs plc in relation to the Companies act 1985. A public limited company must satisfy the realised profits test and the net assets test before it can distribute its profits by dividends to its members. This can be seen in s.263 and s.264.
Issue B: If on the basis of interim accounts the directors were to declare a dividend to preference shareholders in accordance with their class rights, but when final accounts for the year were completed the company discovered that it did not have enough profits to pay a dividend, what would be the legal position of the directors and the preference shareholders?
There are two issues that must be discussed to fully understand the situation, they are; when dividends can and must be paid which will outline the role and responsibility of the company directors in relation to the distribution of profits through dividends and then I will discuss the rights of preference share holders.
When Dividends Can & Must be Paid. As discussed already, dividends can only be paid from distributable profits which have been defined previously; also the realised profit test and net asset test must both be satisfied before a distribution can take place.
As to when dividends can be paid, it is decided by the board of directors how much should be paid out during the accounting period to the shareholders by declaring the dividend accordingly. A dividend can be paid at anytime, but it is common practice to wait until the financial year's results are reported before declaring a dividend. Interim dividends paid are set against the year's distributable profit.
When the directors are declaring a dividend they must consider the cash needed for continuing working capital requirements of the company and they can only pay a dividend out of distributable profit i.e. revenue profit and realised capital gains. Reserves of undistributed profit from earlier years may be carried forward, as well as any deficit, in order to work out the amount of distributable profit available.
The Preference Shareholder: The rights attached to preference shares are normally defined in the Articles of Association which usually contain the right to receive dividends at a fixed rate payable on specific dates. Dividends can only be paid when one is announced, if it not then no dividend will be paid that year. Dividends paid on preference shares are usually accumulated, so if a dividend is not declared in any year, the fixed rate percentage will be accumulated till the next year, only if the company is winding up is it that then the accumulated dividend does not have to paid. It is important to compare the cost to the company of paying dividends to preference shareholders with the cost of other methods of raising money for the business, e.g. a bank loan. For example, if there was a fall in interest rates, it is possible that the dividend agreed on the preference shares becomes more expensive to finance than the interest they would have to pay on a loan for the same amount raised by the share issue. In this situation I would advise redemption or repurchase of preference shares. Preference shareholders are not seen as longer term members of the company, they are seen mainly as just a way of raising cash.
If there isn’t profit available because none has been earned or because the directors decided to transfer all the profits to reserve and thus not distribute any profits to their shareholders; the preference shareholders cannot sue the company for his/her dividend as it is not due unless it is declared by the directors.
If the company directors fail to distribute profits, i.e. ‘passes’ its preference dividend, the right to it as a priority claim is usually carried forward. So if no dividend is paid on a 6 per cent cumulative preference shares in a year then the holders of those shares (even if not the same person who held them in the first year) have a priority entitlement to 12 per cent in the second year and so on. As long as the arrears of dividend is accumulated and paid before other shareholders, this is fine and will be the case for the preference shareholders in this situation.. (Webb v Earle 1875).
The payment of dividends is usually defined in the articles. Article 102 gives directors the sole power to decide if a dividend is to be declared. Directors also have the power to declare interim dividends without having to gain consent from the members.
Preference shares are usually expressly designated as cumulative to indicate the right to carry forward undeclared dividends as arrears to future years. Preference shares are deemed to be cumulative unless clearly defined as non-cumulative in the articles, which they are not in this case.
Issue C: Using the financial information given about Fashion Designs plc calculate the profits for the financial year 2006 and the maximum amount of distributable profits the company could use to pay dividends to it’s shareholders. Also prepare a balance sheet extract and explain the legal reasoning to justify answers.
Below is a balance sheet extract showing the company’s as well as its profit and loss reserves for the financial year 2006. I will go on to explain the figures on the balance sheet extract.
Net assets are equal to permanent capital plus profit/loss reserves, which for Fashion Designs plc is £780,000 in the financial year 2006. Permanent capital is the total of all the capital accounts as listed in the first section, which are: share capital, share premium account, capital redemption reserve and revaluation reserves, I will go on to explain what each of these is.
100,000 ordinary shares at a value of £1 gives the company a ordinary share value of £100,000, we have been told that the company has a fully paid capital of £100,000, therefore all of the ordinary shares have been paid for fully.
A company may issue shares at a premium by way of either cash or non-cash assets for a consideration is greater than the nominal value of the shares, without the need for special powers in its articles, The difference between the nominal value and the actual price issued at is called the ‘premium’, i.e. excess paid above the nominal value. There are rules set out by law that govern how this ‘premium’ is accounted for. Under S.130 a sum equivalent to the ‘premium’ must be transferred in to a special account called the ‘Share Premium Account’ which must be recorded on the company’s balance sheet as a separate sub-heading. The share premium account is considered a capital account and is part of the company’s permanent capital, furthermore as it is treated as a capital account it can not be used to pay a dividend, nor can it be reduced in anyway without the involvement of the courts. There are three exceptions where the company can use the share premium account with out having to go the courts, as defined by Jerry DeFreitas (in his book entitled ‘Company Law’ fifth edition 2006, p78) they are:
i) Paying up un-issued shares of the company to be issued to members as fully paid-up bonus shares.
ii) Writing off preliminary expenses, or the expenses of, or the commission paid or discount allowed on, an issue of shares (shares to underwriters at a discount) and debentures of the company, or
iii) Providing for any premium payable by the company on the redemption of debentures (and on the acquisition of its own shares if certain conditions set out in S.160 are satisfied).
Under to S.171 a private company is allowed to redeem or purchase its own shares out of capital, the cost of the acquisition must be paid from distributable profits or from the proceeds of a fresh issue of shares (S.160(1)(a)). When profits are used to finance the acquisition of shares, a sum equal to the nominal value of the shares has to be transferred to a capital redemption reserve (CRR) to compensate for the reduction in share capital (S.170(1)). This reserve is considered a capital account and is treated as part of the un-distributable reserves of the company.
Unrealised profits occur when assets appreciate in value, this increase in value is recorded in the company’s accounts in the revaluation reserve which is a capital account, if it found after a revaluation that there has been a reduction in the book value of its assets, then this amount it has reduced by will be recorded as a debit balance in the revaluation reserve. Unrealised profits can not be distributed to the shareholders as explained earlier when discussing the realised profit test. Furthermore any over all depreciation in value must be made good using profits before a distribution can take place as defined by the net profit test.
I have gone through and explained what each of the capital amounts recorded in the balance sheet extract are and why they are deemed as capital accounts which together represent the company’s total permanent capital and also that they can not be distributed to shareholders as profits.
A company is not allowed to make a distribution except out of profits available for the purpose as explained in S.263. This rule controls the distribution of dividends to its members. Non-distributable profits may be used for the:
- issue of shares as fully or partly paid bonus shares
- payments on redemption or purchase of the company’s shares
- reduction of share capital by means of extinguishing or reducing liability in relation to unpaid share capital or by repaying paid-up share capital
- distribution of assets to members in a winding up
The profits available for distribution are the accumulated realised profits, which have not previously been utilized by a distribution or capitalisation, less accumulated realised losses which have not been previously written off by a reduction or reorganisation of capital.
Both profits and losses must be accumulated i.e. the profit and loss account are recorded as a continuous record of the company’s financial profits or losses since incorporation. To pay a dividend out of current profits without setting off against those profits and losses of previous periods is not allowed.
I have calculated the distributable profit to be £480,000. Net assets are £780,000. Permanent capital must be subtracted as permanent capital is not allowed to be distributed as explained by the net asset test. Also as we can see that there has been a reduction in the book value of the company’s permanent assets of £30,000 which is revaluation reserve, then this must also be subtracted, as the net asset test required that if the value of the company’s permanents assets are decreased due to depreciation then this amount must be made good from realised profits before a distribution can take place.
Issue D: The directors are of the view that the net profits for the year are too low to give shareholders as adequate return on their capital; and so, with the support of the majority shareholders, they propose to pay no dividend for the financial year 2006; but rather to use profits to give themselves a pay rise. Explain to the directors the problems faced by minority shareholders to apply to the courts for a winding up order under S.122 (I) (g) Insolvency Act 1986 and S.459 of the Companies Act 1985 that the company should purchase their shares at a fair value.
Under S.122 (1) a company may be wound up by the courts on seven different grounds. The situation of Fashion Designs plc I believe falls under one of these seven grounds, which is; where it is just and equitable to wind up the company, which itself can be separated in to five broad categories which are not exhaustive; therefore can be extended by the courts at any time.
In the case of where it is just and equitable to wind up the company, this ground is available to the contributories, the DTI and in the case of a insolvent private company the directors and recipients of capital payment under S.171; which enables the courts to subject the exercise of legal rights to equitable considerations (Ebrahimi v Westbourne Galleries Ltd).
Of the five sub-categories in this section, I believe the situation of Fashion Designs plc will fall under ‘Oppression’. If the persons who control the company are guilty of serious oppression towards the minority shareholders of the company, in their capacity as majority shareholders or directors then the court has the power to order a compulsory winding up order based on just and equitable principles. In the case of Loch v John Blackwood Ltd (1924) the managing director along with his co-directors who held the majority voting rights refused to hold general meetings or to submit accounts to the petitioners or to recommend a dividend. The court ordered the winding up of the company based on the suspicion that the managing director and his co-directors were acting in this way deliberately to make the minority shareholders want to sell their shares to them at a undervalue. In the case of Fashion Designs plc I think it is obviously unfair that the directors and majority shareholders are choosing to give the directors a pay rise rather than issue a dividend to all the shareholders, this is clearly unfair and against the interests of the minority shareholders as they are unable to stop it through voting rights. It is also arguable that it does not seem in any way in the interests of the majority shareholders to give the directors a pay rise rather than declare a dividend especially when the directors from their own admission are saying the profits of the company are small. It could be alleged by the minority shareholders that as there seems to be no clear benefit to the majority shareholders they may be allowing the pay rise with the aim of achieving illegal interests, such as if it were the case that the majority shareholders are also directors who are just giving themselves a pay rise regardless of the performance of the company, they may also argue that the majority shareholders are deliberately trying to oppress them in order to motivate them to sell their shares. These arguments along with evidence would have to be explored by the court. The court may judge on a equitable basis and find that the minority shareholders are in fact being oppressed unfairly and issue a winding up order of the company. I would advise Fashion Designs plc to desist from taking this action as it may risk the company being ordered to be wound up by the courts. The court has the power under S.122 (2) to strike out the petition of a petitioner if the court feels that the petitioner did not act reasonably in not pursuing alternative remedies; namely S.459 remedy before petitioning for a compulsory winding up order.
Statutory protection of minorities is integrated in to the Companies Act 1985. Minority shareholders are given statutory protection against abuses carried out by company and it’s controlling shareholders. They can request the DTI to investigate or petition the courts for relief on the grounds of ‘conduct unfairly prejudicial’ to them, or they can seek to petition for compulsory winding up of the company under S.122 of the Insolvency Act 1986 as explained earlier. Under S.459 which is related to unfair prejudice, a member or person to whom shares have been transferred to or transmitted, have the right to petition the courts on the grounds that the company is, has or been or going to conduct the affairs of the business in a way that is prejudicial to the interests of the members generally or some part of them, in this case the minority shareholders are the petitioners. This legislation is in place to protect minority shareholders; but the powers can be used by majority shareholders but I would assume in most cases they could use their majority vote to control what ever problems they see rather than have to petition the courts. The courts will look at the conduct of the board of directors, as they are people who are entrusted to manage the affairs of the company. In the case of subsidiary companies in some cases it may be the case actual control is in the hands of the directors of the holding company, as Fashion Designs plc is not a subsidiary I will not go in to any further detail. The conduct that the petitioner is complaining about must be both ‘prejudicial’ and ‘unfair’. A definition of Prejudicial would be to cause financial harm to the petitioners interests such as to the extent that the value of the petitioners shares is seriously diminished or put at risk by the conduct of the company. ‘Unfairness’ is defined by the Lords in O’Neill v Phillips (1999) as when there is a breach of the legal rules set out by the petitioner that the company must conduct its activities by (rights of members in memorandum, articles or companies legislation). Another type would be when the directors in breach of their duties. Finally, when the rules are being used by the majority in such a way that is not in line with the equitable principle of good faith this would be deemed as ‘unfair’. Under S.459 minority shareholders are protected against director-shareholders paying them selves excessive salaries resulting in no remaining profits to be distributed to other shareholders or for the company to reasonably continue the business (Re a Company (No. 008699 of 1985) (1986). When petitioning the court on the basis of S.459 the actions of the petitioner are ignored unlike if petitioning on the basis of S.122 of the insolvency act.
When the courts grant relief on a S.459 petition can make many different orders based on the case. The order maybe that the petitioner will be allowed to commence civil proceedings in the company’s name as allowed under S.461. An order could be made that sets regulations for the future activities and conduct of the company such as refraining from acts complained about by the petitioner, an order can be made that requires the purchase of shares of any member of the company or by the company itself. Where an order is made for the purchase of a shareholder’s shares, the valuation of the shares should be done based on the principle of ’fairness’. According to the House of Lords in the case Scottish Co-operative Wholesale Society v Meyer (1959) they defined the valuation process to be that the share should be valued at the price before the prejudicial conduct diminished the value of their shares.
In conclusion I would strongly advise against the action of giving the company directors a pay rise rather than distribute shares, as it would leave Fashion Designs plc open legal action which will is likely to result in either compulsory purchase of shares of minority shareholders of the compulsory winding up of the company.
Word Count 4090 (including text of questions)
BIBLIOGRAPHY
Boyle, Birds , (2000), Company Law, 4th Edition, Bristol, Jordan Publishing
Charlesworth & Morse (1999) Company Law, 16th ed, London, Sweet & Maxwell
De Freitas, J (2006), Company Law, 5th Edition, Croydon, Castlevale
Pennington, R.R (2001), Company Law, 8th ed, London, Reed Elsevier (UK)
Mayson, French, Ryan, Company Law (2004), 21st ed, Oxford, Oxford University Press
Distributable profit: profit that can be distributed to shareholders through dividends under company law.
