SQE 1 - Business Law (Financing a business, financial records and accounting requirements)

What are the two types of company finance?

1. Equity finance

2. Debt finance

What is equity finance?

Equity finance (ie share finance) is the issue (creation) of new shares in exchange for consideration (ie where something of value is given exchange for a promise) received by a company. It generates money/assets for a company.

What is debt finance?

Debt finance (or loan finance) involves borrowing money in order to finance a business (either incorporated or unincorporated). The debt can either be secured or unsecured.

What is a share issue?

The process whereby new shares are allotted (created) in exchange for consideration received by the company, and the member is entered onto the register of members in respect of those shares. It can change the control of a company, as the number of shares increases.

Who is responsible for share issue?

Once a company is incorporated (which requires minimum one shareholder), the directors of a company are responsible for share issue.

What are the two key questions to ask concerning scenarios relating to share issues?

1. Do the directors have authority to issue the shares?

2. Do pre-emption rights apply?

What are director's authority in: private companies with unamended model arties and only one class of shares?

Before and after the issue, the directors are free to issue further shares of the same class by board resolution under MA3.

This can be done without prior reference to company members (s 550 Companies Act 2006)

Otherwise, the proposed issue of shares by the directors will require the advance authority of members via OR or by provision in the company's articles (s 551 CA)

What authority do directors have to allot shares in companies incorporated before 1 October 2009?

Unlike qualifying private companies incorporated on or after 1 October 2009, older companies generally cannot rely automatically on s550 CA 2006 to allot shares while their pre 2009 authorised share capital restriction remains in the articles.

What are director's authority in: companies incorporated after to 1 October 2009?

Must check the articles for restrictions, and amend if necessary via special resolution.

There are no restrictions in the model articles.

What must an authority to issue (via articles or by way of an OR) state?

- The maximum number of shares the directors are allowed to issue

- The date when the authority will expire (generally this will be no more than five years from the date the authority is given)

What must be done if an OR is passed concerning share issues?

Must be filed on Companies House with 15 days (ss 551(8)(9, 29 and 30 CA).

This is a rare example where an OR must be filed.

What are pre-emption rights?

The statutory pre-emption rights dictate that generally, on an issue of new shares, they must first be offered to the existing members on the same or more favourable terms, in proportion of their existing shareholders. They have a 'right of first refusal' for a period of at least 14 days (ss 561-562 CA)

When can the statutoty pre-emption rights be altered?

These rights can be:

- carried or removed for private company by contrary provisions in the articles (s 567 CA), either on incorporation, or subsequently by SR, the MAs do not vary statutory rights

- disapplied by SR of the members (ss 560, 570 and 571 CA)

- formally waived in relation to a specific issue (if all the members intended to decline the offer).

What is the rationale behind pre-emption rights?

They are designed to protect company members, where the effect of issuing shares would weaken their control of the company. This is because where new shares are issued, there is potential for an individual's percentage shareholding to decrease.

Clodagh has 55 of the 100 voting shares in a private limited company, which has unamended MAs.

What would be the consequences if a further 20 shares were issued to a new shareholder, for cash?

Clodagh's shareholding would be reduced to approximately 46%, so she could no longer pass or block ORs. On the facts, the statutory pre-emption rights would apply to protect her, she would have first refusal on 11 (55%) of the new shares.

What can be done to ensure greater protection of the statutory pre-emption rights?

Greater protection will be granted if the company's articles provide for pre-emption of any issues of shares (e.g for both cash and non-cash consideration)

Groth and Emanuel Limited is a private limited company, incorporated on 28 December 2015, with unamended MAs. It has 50k ordinary shares and 50k preference shares, and wishes to issue 20k new ordinary shares for cash.

Will authority be required, and will the pre-emption rights apply?

Authority will be required as the company has more than one class of shares (before and after issue). The pre-emption rights apply but may be disqualified by SR or waived if all of the shareholders agree.

If the shares were issued for non-cash considerations (eg transfer of property), the pre-emption rights would not apply. However, it would be an SPT if a director or connected person was buying the shares and the value of the asset(s) was substantial.

What are the ways shares can be issued?

How MUST shares be issued in private companies with unamended MAs?

Shares may be issued fully paid or partly paid.

For private companies with MAs, MA21 states that they must be fully paid.

How are shares commonly issued?

Shares are usually issued at a premium (ie a price exceeding their base/nominal/par value).

How should any premium paid on shares be recorded on company accounts?

Any premium paid must be shown in the shares premium account on the balance sheet (s 610 CA).

Can shares be issued at a discount?

No, under s 580, shares cannot be issued for below their base/nominal/par value.

What are the administrative/filing formalities for issued shares?

-A return of allotments (form SH01) must be sent to Companies House within one month of the share issue (s 555(2) CA).

- Copies of any ORs or SRs must be sent to Companies House within 15 days

- Any relevant PSC forms must be filed

1. Share transfer

2. Share transmissions

What are share transfers?

Share transfer involves dealing with existing shares (eg on sale or gift). No new money or assets are generated for the company, as it is essentially a transaction between the transferor and transferee, whereby ownership changes. The number of shares remains the same, but there is potential for an individual's control of the company to change.

What are share transmissions?

Transmission is the transfer of shares by operation of law (e.g. to personal representatives (PRs) on death, or trustee in bankruptcy (TIB). When shares are transmitted, the PR/TIB may receive the dividends, but they do not become shareholders (MA27). They may apply to be registered as a member or sell in their capacity as a PR/TIB.

Mary has a 26% shareholding in Waterloo and Robinson Limited. The remaining shares are owned by Caroline (30%), Russ (25%), Natalie (15%) and David (4%). All of the shares have voting rights. Caroline transfers her shares to Russ.

What will be the impact on Mary.

With 26%, Mary will still be able to block special resolutions, but Russ (55%) will now be able to pass and block ordinary resolutions.

What is the 6-step process of a share transfer?

Step 1: Transferor completes and signs a stock transfer form (STF) and sends it with the share certificate(s) to the transferor (ss 770-772 CA)

Step 2: Transferee pays stamp duty on the STF (calculated at 0.5% of the consideration paid, rounded up to the nearest £5)

Step 3: Transferee sends the stamped STF and the share certificate(s) to the company

Step 4: Directors pass BR to approve/reject the transfer

Directors have absolute discretion under MA26 - check for special articles

Step 5: Transfer must be registered and the new share certificate sent to the new member within two months of the application (ss 771(1) and 776 CA) (unless the directors have the right to refuse the register the transfer)

Step 6: The company will update details of shareholders annually on the Confirmation Statement

Do directors have the right to refuse a proposed share transfer?

This is dependent on the the terms of the company's articles.

However, under MAs, MA26 grants directors an absolute discretion to refuse to register the transfer of shares.

Will the transferee of a share transfer automatically become a company member?

No, they only become a member when entered onto the register of members (s 113 CA).

Until then, the transferor holds the shares on trusts for the transferee, so if the directors exercise their discretion not to register, the transferee may never be the legal owner.

How must a transferor vote in GMs if they hold transferred shares on trust for the transferee?

They must vote according to the wishes of the transferee and must also hold any dividends on trust for them.

What are examples of restrictions that company's place place on transfers of shares?

Some companies may require to adopt other types of restrictions on the right to transfers in their articles, e.g.:

- requiring a member who wishes to sell to first offer shares to the existing members

- allowing the members freedom only to transfer to family or company members

What are dividends?

A dividend is a payment the company makes to its members, which provides them with a return on their financial investment in the company.

What are buyback of shares?

Where a company buys back its own shares, and the shares are cancelled.

What is the process for declaration of dividends being made out?

Step 1: Check profits are available (s 830 CA)

Step 2: MAs 30-35 - Check special articles

Step 3: Directors decide whether a dividend ought to be declared and make a recommendation to the members in general meeting (GM)

Step 4: Members vote (by OR) to pay themselves the amount as recommended by the directors or less (note that they cannot vote to pay themselves more than the recommended sum)

What can happen if a company fails to declare a dividend that is properly payable?

If a company fails to declare a dividend when it is properly payable, this can be grounds for unfairly prejudicial conduct.

However, a company will often wish to ensure that it has sufficient reserves available to deal with future liability.

When can dividends be made out?

Dividends can only be made out of 'profits available for the purpose' (s 830).

In essence, this means that the company must calculate its accumulated realised profits to date (ie its actual net profits to date) and deduct its accumulated realised losses to the date. Accordingly, a dividend may be paid even if a loss has occurred in that last year, provided that, over the years, the accumulated profits exceed the accumulated profits.

The company's articles will further regulate when and how the dividend is to be paid.

Why is buyback of shares a heavily regulated?

It is heavily regulated because it could leave the company in a financially precarious position (reducing available profits and/or capital).

When are the buyback of shares permitted?

Buyback of shares is permitted in limited circumstances, due to the principle of capital maintenance.

What is capital maintenance?

A fundamental principle which states that capital provided by shareholders must be maintained and must not be returned to them, as creditors rely on it.

What are the two ways to buyback shares in private companies?

1. Buyback out of profits

2. Buyback out of capital

What are buyback from profits?

A buyback of shares that is only permitted where distributable profits (s 830 CA) are available.

What is the process for buyback of shares from profits?

Step 1: Check shares are fully paid (s 691)

Step 2: Check articles do not prohibit buyback (s 690(1))

Step 3: Directors should consider their duties under ss 172 and 174

Step 4: Check profits are available by producing accounts - Distributable profits must be available or payment made from a fresh issue (s 692(2))

Step 5: OR required to approve contracts (s 694(2)) → Holders of shares being brought cannot vote and their votes DO NOT count (s 695)

Step 6: Copy buyback contract or a summary of it must be sent with written resolution or made available for inspection at least 15 days before the GM and at the GM (s 696(2))

Step 7: File forms SH03 and SH06 within 28 days (ss 707 and 708), cancel shares, update register of members, file relevant PSC forms and update PSC register. Make contract/summary available for inspection for ten years at the registered office once completed (s 702)

What is buyback of shares from capital?

A buyback of shares that is only permitted to the extent that distributable profits are unavailable.

In other words, a company cannot buyback out of capital if profits are available, they must use these first.

- Only private companies can buyback from capital and the procedure is more tightly regulated.

What is the procedure of buyback of shares from capital?

Step 1: Check shares are fully paid (s 691)

Step 2: Check articles do not prohibit buyback (s 709(1))

Step 3: Directors should consider their duties under ss 172 and 174

Step 4: Check whether profits are available by producing accounts (prepared no more than three months before the statement of solvency (SOS)) (s 712)

Step 5: No earlier than one week before the meeting directors must make an SOS (with auditors' report annexed( that the company will remain solvent for a year after the transaction (ss 714 and 716(2)). They may face personal liability and criminal sanctions if they do this negligently (s 715). The auditors' report must confirm that the SOS is not unreasonable (s 714(6))

Step 6: OR required to approve contract (s 694(2). SR required to approve buyback from capital (s 716(1)). Holders of shares being brought cannot vote and their votes DO NOT count (s 717)

Step 7: Copy buyback contract or a summary of it must be sent with written resolution or made available for inspection at least 15 days before the GM and at the GM (s 696(2))

Step 8: Copy of SOS and auditors' report must be available for inspection before and at the meeting, otherwise the resolution will be ineffective (s 718(2))

Step 9: Notice must be published in the London Gazette and national newspaper or actual notice to each creditor within 7 days of the SR (s 719) stating where SOS and auditors' report will be available and that creditors have five weeks to apply for an order preventing buyback (s 721). Before, or at the time, the SOS must be filed at CH (s 719(4))

Step 10: Copy SOS and auditor's report must be available for inspection until five weeks after the SR (s 702)

Step 11: Payment must be made in 2 weeks following five weeks of the SR (s 723(1)). File form SH03 and SH06 within 28 days (ss 707/8)

File SR

What are the timelines for the process of buyback of shares out of capital?

Prepare accounts → Within three months before SOS

Contract available for inspection →

At least 15 days before GM

SOS → Within one week before GM

Publish notice to creditors → Within one week of SR

SOS to be made available/filed at Companies House/objection period → Within five weeks of SR

Make payment → Within week six and seven after SR

Flying Flags Limited, a private company with unamended MAs, has distributed profits of £500k and net assets of £1m. It wishes to buyback 50k fully paid £1 ordinary shares at their nominal value.

Can this be done?

This could be achieved through a purchase from profits only, not capital (as distributable profits are available). An OR will be required to approve the contract.

What is an equity security?

Equity security are ordinary shares (Defined by s 560 CA)

When allotting shares, in a private limited company what happens to the net asset value in the balance sheet?

The net asset will go up by the sale price of the share being sold multiplied by the total number of shares being sold. This is because the new shareholder will pay the sale price of the share to the company (this can either be the nominal value or a premium charge). The company will receive the money and it will not have to pay that money bank, therefore net asset value will increase.

What are the two key questions to ask concerning scenarios relating to debt finance?

1. Does the business have power to borrow and give security

How do we check whether a business (partnership and company) have the power to borrow and give security?

Partnership → Check the partnership agreement

Company → It will have the power to borrow and grant security, unless its articles say otherwise (s 31(1) CA)

What rules apply when a director votes on a board resolution?

The usual rules apply on declaration of interests and voting/counting towards the quorum apply when a director votes.

What are the resolutions for debt finance?

If a company has has unamended MAs → Directors may approve by BR (MA3) and must check memorandum to amend by SR

If company has amended MAs and formed before 1 October 2009 → check memorandum to amend SR

If company has amended MAs and formed after 1 October 2009 → check articles - amend by SR

What are the borrowing options available to businesses?

1. Loans (secured and unsecured)

2. Overdrafts

3. Revolving credit facilities

What is a revolving credit facility?

A hybrid between a loan and an overdraft/ The business can borrow up to a certain amount and may repay and re-borrow, when needed.

GENERATE QUESTION FOR THIS

Lenders will require security for a loam:

- a mortgage

- or charge (fixed or floating)

Lenders typically carry out due diligence in any secured lending

What is security?

A charge document (eg a debenture) will usually provide a lender with security for a loan. This means that in the event of default (eg failure to repay), the charge holder will have priority over unsecured creditors and may sell the charged assets to settle sums owed.

What is due diligence?

A process of investigation by the lender to ensure its interests are protected, the security will be validly granted and enforceable, and that title to the assets over which the charge will be sound. This may involve company, Land Registry, bankruptcy and winding-up searches, as well as investigation of title.

What is a mortgage?

A mortgage is the highest form of security. It involves the transfer of legal title to the mortgagee (lender) with re-conveyance/transfer back to the mortgagor (borrower) when the debt is satisfied (ie paid off in full). As such, it gives the lender an immediate right to possession. In the case of land, a mortgage is usually created by a fixed charge by deed.

What is charge?

A charge provides the lender with an interest in the property, but unlike a mortgage in the traditional sense, it does not transfer legal title.

What is a fixed charge?

A fixed charge is a charge taken over a particular asset or assets. The consent of the lender is required in order to deal with the asset(s).

What is a floating charge?

A floating charge is a charge taken over a particular class of asset(s) owned from time to time (tangible, eg stock and/or intangible e.g. intellectual property) and can only be granted by a company or LLP. The company/LLP can deal with the asset(s) without consent of the lender under crystallisation, as until then it 'floats over' rather than 'fixes on' the assets.

What is crystallisation?

On crystallisation, a floating charge 'fixes' on the assets in the particular class at the time (it becomes a fixed charge). Crystallisation usually occurs when a company becomes insolvent or any other event occurs which the charge specifies will cause crystallisation (e.g. non payment, ceasing to trade or other default).

What are the advantages and disadvantages of floating charges?

Advantages

- Grants borrowers flexibility to deal with assets that are constantly changing (eg stock) → It is common for such a charge to be over the whole 'undertaking' or business. Essentially means that the borrower can charge more assets and will be able to give more security for borrowing, which give them better terms.

- Advantage for lender is that they have security when it matters (on crystallisation)

Disadvantages

- The lender takes the risk that assets may not be replaced, and the security will usually be postponed to fix charge holders and preferential creditors, or may be set aside.

Clark-Neal Stores Limited carries on business as a convenience store. There is a floating charge in favour of a bank over all of its assets including the stock.

Can the company sell a can of baked beans to a customer, Scott, without the permission of the bank?

Yes, this is possible before crystallisation, after which, the consent of the bank would be required. The consequences of having a fixed charge prior to crystallisation here would be ludicrous, as there needs to be a constant turnover of stock to make a profit.

What is debenture?

A debenture is a document which includes security in the form of a floating charge or sometimes both fixed and floating charges. Because they contain a floating charge, they can only be granted by a company or LLP.

Companies frequently give security this way.

Besides a security, what can directors/shareholders give a lender?

Despite not being a form of security, directors-shareholders may also give personal guarantees.

What are the general rules priority of security?

1. As between validly created charges if the same type, the first in time (date of creation) will have priority

2. As between a validly created fixed charge or mortgage and a floating charge, the fixed charge or mortgage will take priority (even if granted later) UNLESS:

- the document creating the floating charge contains a negative pledge clause; and

- the later fixed charge has notice of this prohibition at the time when it takes its charge

Can the general rules of priority be altered?

Yes, it is possible for lenders to agree to a different arrangement as to their priority by entering into a deed of priority.

What is a negative pledge clause?

A clause in a debenture which prohibits the creation of later fixed charges without permission.

Miller-Heidke Associates Limited granted a fixed charge over its London premises in 2010, a floating charge over its whole undertaking in 2015, and a fixed charge over its Birmingham office in 2020. The first charge was not correctly registered at Companies House, although the other charges were.

What is the order of priority?

The first fixed charge will be void against a liquidator, administrator or creditor as the priority rules are subject to registration. The second fixed charge, although granted after the floating charge, will take priority, unless the charge had notice of a negative pledge clause in the floating charge.

What are registration of charges?

Generally, all charges are registerable to Companies House (s 859A CA). Whilst registration is not compulsory, the consequences to non-registration are high so most secured lenders will include registration in their routine.

What is the registration process of charges?

The following forms must be submitted to Companies House within 21 days of creation of the charge (ss 859A(2) and (4) CA):

- form MR01

- A certified copy of the charge document

- the relevant fee

The company receive a certificate of registration (s 8591 CA) and must update its register of charges (if held)

What happens if there is a failure to register?

- A charge that is not registered in time is void against a liquidator, adminstrator or any creditor (ss 859H(3) and (4) CA(,

- The debt will be payable but will be unsecured (s 859H(4)

- There is potential for negligence against the solicitor for failing to register a charge

- Although there is provision for the courts to extend the deadline, this isn't guarantee and priority will only be enjoyed from the date of registration (s 859F)

- Fixed charges over land must also be registered at the Land Registry

A copy of the charge and MR01 should be made available for inspection and, when a charge is redeemed, form MR04 should be completed and sent to Companies House.

What are the remedies for debenture holders?

If a company or LLP defaults on repayment of laon, the debenture holder may:

- sue as a creditor

- petition for winding-up of the company

- utilise any powers in the debenture documents (eg the appointment of a receiver)

Typically, fixed charge holder will usually exercise their power to sell the charged assets.

When a private limited company borrows money from a commercial lender, what will happen to the net asset value in the balance sheet?

The net asset value will go down by the amount of interest and fees being charged on the loan (if any).

When a company borrows money, it receives cash so the current assets will increase. However, it also takes on the same corresponding liability, the obligation to repay the money. So overall, net asset value should stay the same - an increase in one area and a corresponding decrease in another.

However, commercial loans usually come with fees/charges and interest to pay so that will mean that the net asset value will go down.

If there are no charges or interest (for example if the money is being lent by a family member of one of the shareholders on favourable terms - no fees, no interest) the net asset value should remain the same.

What is the differences between loan finance and equity finance: Return on investment?

Equity Finance:

- Dividends may be paid if profits are available. Capital value may decrease or increase, share issue may reduce both dividends and the value of shares, as the shareholdings is diluted

Loan Finance:

- Interest will be paid under contract terms. Capital value will remain constant. Security may be taken to protect the lender. other remedies may be available

What is the differences between loan finance and equity finance: Membership Rights?

Equity Finance:

- Yes

Loan Finance:

- No, creditors do not become members

What is the differences between loan finance and equity finance: Investment repaid?

Equity Finance:

- Usually on sale or termination

Loan Finance:

- Under terms of agreements

What is the differences between loan finance and equity finance: Transferability?

Equity Finance:

- May be restrictions on transfer (e.g. MA 26)

Loan Finance:

- Usually transferable

What is the differences between loan finance and equity finance: Regulation?

Equity Finance:

- Heavy Regulation via CA 2006

Loan Finance:

- Subject to contract law so less stringent

What is the differences between loan finance and equity finance: Taxation?

Equity Finance:

- Dividends not deductible for corporation tax purposes

Loan Finance:

- Debenture interest is deductible for corporation tax purposes

What are business accounts?

How do businesses prepare their accounts?

Business accounts are based on the double-entry system

What is a profit and loss account?

The profits and loss account show whether the business has made a profit or a loss in the relevant period (this will usually be the financial year).

The basic formula is income minus expenses which gives the net profit.

What is income?

Income is usually recurring and includes sales (for trading businesses), profit costs (for service businesses), interest received and rent received.

What are expenses?

Expenses are usually incurred and exhausted over a short period of time. They are necessary to keep the business running. They include stock purchased (for trading businesses), wages, utilities, rent, interest paid, insurance, repairs, petrol and hire charges.

What is a balance sheet?

The balance sheet is made up of two parts:

- First part shows the value of a business at a particular point in time

The basic formula is assets minus liabilities

Current assets minus current liabilities = net current assets

Total assets less total liabilities = net assets

2nd Part - is relevant for unincorporated business

- shows what is owed to the owner (ie where the money from the business has came from), at a particular point in the time. Basic formula is capital plus net profit (from the profit and loss account) minus drawings

What are assets?

Assets are also the result of expenditure, but their benefit is usually spread over a linger period of time. These include more permanent 'fixed assets' eg land, vehicle and machinery) and the more 'fluid' current assets* (eg debtors and cash).

What are liabilities?

Liabilities are sums owed by the business (eg loans and creditors). Those repayable within a year are current liabilities and those repayable beyond then are long-term liabilities.

What are capitals?

The sum invested in the business by the owner(s).

What are drawings?

Money withdrawn by the owner(s) of an unincorporated business, on account of profits owed to them.

What is the difference between expenses and liabilities?

Liabilities are things that the business owes (e.g. such as a loan) but the interest paid on the loan would be an expense (because it is recurrent).

Adjustments

What are the different types of adjustments?

1. Prepayments

2. Accruals

3. Closing stock

4. Stock/work in progress

5. Opening stock/work in progress

6. Depreciation

7. Bad debts

8. Doubtful debts

What are prepayments?

These are payments that the business had made in advance, on account of a service or something that will not be used until the next financial year.

These are deducted as an expense in the profit and loss account and included as a current asset in the balance sheet.

Sergiu, Marina and Eugeniu are in partnership and have an accounting period that corresponds with the calendar year. They place an order for the stationery on 15 December but will not receive and be able to use it until the following year.

What will be the impact of this be on the accounts?

This is a prepayment, it will be deducted as an expense in the profit and loss of account and included as a current asset in the balance sheet.

What are accruals?

These are payments the business will make in an arrear, for service used in the financial year, but not yet paid for (the opposite of prepayments).

These are included as an expense in the profit and loss account and a current liability in the balance sheet.

What is closing stock/work in progress?

This relates to stock (for trading businesses) and work in progress (for service businesses) that has not been used/bill in the current financial year.

It is included as income in the profit and loss account and a current asset in the balance sheet.

Sergiu, Marina and Eugeniu are in partnership as a firm of solicitors and have an accounting period that corresponds with the calendar year. At the close of business in the current year, they have unbilled work in progress of £10l.

What will be the impact of this be on the accounts in the current year?

This is closing work in progress. It will be included as income in the profit and loss account and a current asset in the balance sheet.