Share Capital & Shareholders — SQE1 FLK1 Business Law and Practice

Your client's company is out of road. The overdraft is at its limit, suppliers are pressing, and its £1 ordinary shares have changed hands between members at no more than 40p. Then an investor offers £50,000, but only for 100,000 shares. That is 50p a share. The board thinks it a good deal and nobody else has offered a penny. Can the company do it? No.

This is Share Capital and Shareholders, and that answer opens the whole topic. Three themes run through it. How shares are created and issued. What rights the different classes carry. And how the law stops capital leaking back out to the members at the creditors' expense. Keep that company in mind. There is a way to do what it wants.

Here is the route. What share capital actually is, and the vocabulary you need. Then the two share classes and what separates them. Then allotment: who has authority, and who must be offered the shares first. Then how shares can be paid for. Then dividends, and the profits rule. Then capital maintenance, reductions and buybacks. And last, shareholder rights, the percentage thresholds, and class rights.

Start with what share capital is. It is money raised by issuing shares. You give the company money, you get a stake in it. And unlike a loan, it does not have to be repaid. Shareholders take their return through dividends and through the value of the shares instead.

Now the vocabulary, because the exam uses it precisely. Authorised capital is an old idea, abolished by the Companies Act 2006. Issued, or allotted, capital is the shares actually issued. Called-up capital is what members have been asked to pay. Paid-up capital is what they have actually paid. Nominal, or par, value is the face value of each share. Share premium is anything paid above it.

Nominal value is where your client came unstuck. Every share has one, say £1. Shares are often sold for more. Issue a £1 share for £5 and the extra £4 is share premium. But the nominal value is a floor. Section 580 says shares must never be allotted at a discount to it. A £1 share must be sold for at least £1.

Why so absolute? Because the nominal value is what the company has told the world its members contributed, and creditors rely on it. So the members cannot waive it, and being short of money is no excuse. The rule matters most precisely when a company is short of money. Pay less, and the allottee is liable for the discount, with interest.

But there is a fix, and this is what you tell your client. Subdivide the £1 shares into shares of a smaller nominal value, under s 618, and allot those instead. 50p a share is unlawful for a £1 share. It is perfectly lawful for a 50p share.

Two classes to know. Ordinary shares are the standard type, and ordinary shareholders are the real owners. A variable dividend, if one is declared. Votes. And on a winding up, whatever is left after everyone else has been paid, which may be nothing. Preference shares take preference in some way, usually a fixed dividend paid before the ordinary shareholders get anything, and priority on a winding up.

The trade-off is real. Preference shareholders usually have limited voting rights or none, and their return is capped, so they miss out in an exceptional year. Lower risk, lower reward. Then the variants. Cumulative, where unpaid dividends roll forward as arrears. Non-cumulative, where a missed dividend is gone for good. Participating, redeemable, convertible.

One point worth having. If the articles give a class a preferential dividend and say nothing else about it, the dividend is presumed cumulative. Arrears from the lean years accumulate, and they must be paid before a penny goes to the ordinary shareholders.

Allotment next. Allotment creates new shares. That is different from a transfer, where existing shares change hands. Directors need authority to allot them. For a private company with only one class of shares, s 550 gives the directors that authority automatically, unless the articles prohibit it. For anyone else, authority comes from the articles or from a members' resolution, and it can be limited by amount and by time.

Afterwards, a return of the allotment with a statement of capital goes to the registrar within one month, under s 555.

Now pre-emption, the members' protection against dilution. Under s 561 a company must not allot equity securities without first offering them to the existing ordinary shareholders. The offer must be on the same or more favourable terms, and in proportion to their holdings. Try one. Three members hold 50%, 30% and 20%. The company allots 1,000 new shares. How many must be offered to the member holding 30%?

Three hundred. Proportion is the measure, and the right belongs to every ordinary shareholder whatever the size of the holding. It can be got round, but only properly. A private company can exclude pre-emption in its articles, under s 567. Or it can be disapplied by special resolution, under s 569 to s 571. What the board cannot do is waive it. The right is the members'.

How can shares be paid for? Cash, or money's worth, meaning property, goods or services. A private company has wide freedom here. A public company does not. Non-cash consideration must be independently valued, under s 593. An undertaking to do future work cannot be taken at all, under s 585. And a quarter of the nominal value, plus the whole of any premium, must be paid up front, under s 586.

And before a public company can trade or borrow at all it needs a trading certificate from the registrar. For that, its allotted share capital must be at least £50,000, with a quarter paid up. That is £12,500 actually in the company. Allot £40,000 of shares and the certificate does not come.

Dividends. A dividend is a distribution of profit, and unlike interest on a loan it is not guaranteed. The company chooses. For a final dividend the directors recommend an amount and the members approve it by ordinary resolution. They can approve it, they can vote a smaller figure, or they can decline altogether. What they cannot do is vote themselves more than the directors recommended.

Then the rule everything turns on. A dividend may only be paid out of profits available for the purpose. That is s 830, and those profits are accumulated realised profits, less accumulated realised losses. Not capital. Paying a dividend out of capital hands the members their money back at the creditors' expense, and that is the thing this whole topic is built to prevent.

Interim dividends work differently, and the difference catches people. A final dividend, once declared by the members, becomes a debt the company owes them. An interim dividend is simply decided on by the directors, needs no approval from the members, and gives them no enforceable right. The board can cancel or reduce it at any time before it is actually paid.

Get it wrong and there are consequences. A dividend paid without sufficient distributable profits is an unlawful distribution. Directors who authorised it may be personally liable. And a member who knew, or had reasonable grounds to believe, that it was unlawful must repay it.

Which brings us to capital maintenance. The principle is simple. Once capital goes into a company it should stay there, or be used in the business. It should not come back out to the members at the creditors' expense, because creditors cannot reach the members behind the limited liability. The capital is a cushion, and the law guards it.

You have met most of the rules already. No shares at a discount, s 580. Dividends only from distributable profits, s 830. A company generally cannot buy its own shares. Financial assistance rules for public companies. And a reduction of capital needs a formal procedure.

So take reduction. A company might want to return surplus cash, cancel shares, or write losses off the balance sheet. Two routes. The court route, where the court satisfies itself that creditors are protected. Or, for a private company, the solvency statement route, under s 641 to s 644. All the directors sign a statement that the company can pay its debts now and will be able to for the 12 months after the reduction. No court needed. A public company must use the court.

Buybacks run on the same idea. A company can buy its own shares if the articles authorise it and the procedure is followed. The money must come from distributable profits, or from the proceeds of a fresh issue, though a private company can use capital with a solvency statement. The shares bought back are cancelled, so the share capital comes down.

Shareholder rights now. Vote at general meetings, usually one vote per share. Receive dividends if declared. Take a share of what is left on a winding up. Attend and speak. Receive the annual accounts. Appoint a proxy to vote for you. Requisition a general meeting. And, in some circumstances, bring a derivative claim.

Then the percentages, and these are quick marks. 5% to requisition a general meeting, and the directors must then call one within 21 days. 10% to demand a poll. 15% of a class to ask the court to cancel a variation of that class's rights. More than 25% to block a special resolution. More than 50% for an ordinary resolution. And 75% for a special resolution.

Try that last pair. An investor holds 27%, every member votes, and the other 73% want to alter the articles. Can they? No. Altering the articles takes a special resolution, and that needs 75% of the votes cast. Anything over a quarter is a blocking minority.

Last, class rights. Where a company has more than one class, you cannot strip one class of its rights using the votes of another. Under s 630 class rights may only be varied as the articles provide. If the articles are silent, you need the consent of 75% of that class, in writing or by special resolution at a separate class meeting. A general meeting of everybody will not do.

And there is a minority protection inside that. Holders of 15% or more of the class who did not vote for the variation can apply to the court to have it cancelled, within 21 days.

One last distinction, and it is a fine one. A company allots more preference shares carrying rights identical to the existing ones. The outside investors' voting strength within the class halves, and so does their share of anything paid to it. Is that a variation, needing 75% class consent? No. Each existing share keeps its dividend, its votes and its capital entitlement. Only the enjoyment of them is diluted. Dilution is not variation.

A word on how SQE1 tests this. You will not be asked to recall a case name or a section number. You get a scenario, five answers, and one instruction: pick the best. Learn the rules and what they do to facts.

This topic is almost without famous cases. It runs on the Companies Act 2006, so the sections are the pegs. If you keep only three. Section 550, which tells you whether the directors needed anyone's permission to allot. Section 561, which tells you who had to be offered the shares first. And section 830, which tells you whether the dividend could lawfully be paid at all.

Four traps. One: the no-discount rule is absolute. The members cannot authorise it, the company's financial straits do not excuse it, and it binds private and public companies alike. If the price is below nominal value, the answer is no, whatever else the facts say.

Two: an unlawful dividend does not just get unwound quietly. Directors who authorised it may be personally liable, and a member who knew, or had reasonable grounds to believe, it was unlawful has to repay it.

Three: a declared final dividend is a debt owed to the members. An interim dividend is not, and the board can pull it before payment. If the question turns on whether a shareholder can sue for the money, find out which kind it was.

Four: public companies are stricter throughout. Independent valuation of non-cash consideration. No undertakings to do future work. A quarter of the nominal value plus all premium up front. a minimum capital of £50,000, and the court route for any reduction. If the facts say plc, raise your guard.

Quick check. A private company's latest annual accounts show accumulated realised profits of £350,000 and accumulated realised losses of £120,000. They also show a gain of £80,000 on revaluing the office premises the company trades from. It has not sold those premises and does not intend to. There are no other reserves, nothing has changed since the accounts, and it holds plenty of cash. The directors want to pay the largest dividend they lawfully can.

How much is that? Three candidate answers. One: £350,000, the accumulated realised profits shown in the accounts. Two: £310,000, the realised profits and losses together with the revaluation gain. Three: £230,000, the accumulated realised profits less the accumulated realised losses. Pause here if you want a moment.

The answer is three. £230,000. A company may only distribute profits available for the purpose, and s 830 defines those as accumulated realised profits less accumulated realised losses. £350,000 less £120,000. The revaluation surplus is an unrealised profit and forms no part of that figure. It becomes realised only if the premises are sold.

Why the others fail. Option one lets the losses lapse, and they do not lapse. They must be deducted. Option two brings the revaluation gain in, and there is no rule letting an unrealised gain count, in whole or in part, until the asset is sold.

Five things to take away. One: your client cannot sell a £1 share for 50p, but it can subdivide first and sell the smaller shares. Nominal value is a floor, not a price. Two: the directors of a single-class private company can allot without asking anyone, under s 550. But the members must still be offered the shares first, under s 561.

Three: dividends come only from accumulated realised profits less accumulated realised losses. Four: the percentages are quick marks. 5% to requisition, 10% for a poll, 15% to challenge a class variation, over 25% to block, over 50% for an ordinary resolution, 75% for a special. Five: class rights need that class's own consent, but more shares ranking equally dilute without varying.

That is Share Capital and Shareholders. Next time, Minority Shareholder Protection.

Practise this topic with exam-style questions at sqe1prep.co.uk. This episode is for education and exam revision only, not legal advice, and we are not affiliated with or endorsed by the SRA or Kaplan.