Week 15 Chapter 6: Comprehensive Study Notes on Constituting a Company's Share Capital

Required Reading

• European Union (EU): Second Company Law Directive, articles $1(1)$, $2c$, $3$, and $6-11$.

• Germany (D):

  • Aktiengesetz (AktG): $\S\S 6-10$, $23(2)$ nos. $2$ and $3$, $(3)$ nos. $3-5$, $26$, $27$, $29$, $31-38$, $46-54$, $63-66(1)$, and $150-152$.

  • GmbH-Gesetz (GmbHG): $\S\S 3(1)$ nos. $3$ and $4$, $\S 5$, $7(2)$ and $(3)$, $8(1)$ and $(2)$, $9-9c$, and $19(2)$ and $(5)$.

  • Handelsgesetzbuch (HGB): $\S\S 266(3)(A)$ and $272$.

• United Kingdom (UK): Companies Act 2006 (CA 2006), sections $542$, $580-587$, $593-598$, and $610-615$.

• United States (US):

  • Delaware General Corporation Law (DGCL): $\S\S 102(a)(4)$, $152-154$, $156$, $162-164$, $101-108$, and $124$.

  • Model Business Corporation Act (Model Act): $\S 6.21$ (including nos. $1$ and $2$ of the Official Comment) and $\S 2.04$.

Introduction to Share Capital and Accounting Conventions

• Ownership and Shares: The stock corporation is uniquely characterized by investor ownership. These investors receive transferable shares of stock that certificate their rights as members and owners, commonly referred to as shareholders (Aktionäre).

• Initial Capital Definition: At the outset, if a corporation's only assets are cash and asset contributions made by shareholders in exchange for shares, the sum of these contributions equals the "share capital."

• Minimum Capital Requirements by Jurisdiction:

  • Germany: Requires a minimum capital (Grundkapital) of $€50,000$ for a public company/stock corporation to be incorporated ($\S 7$ AktG).

  • United Kingdom: Requires a minimum allotted share capital of $£50,000$ for a public company to commence trading (Section $763(1)$ CA 2006).

  • United States: Historically, it has never been common to require a minimum capital for general companies, except those in regulated sectors like banking or insurance.

• The "Par" or "Nominal" Value Convention:

  • Original Intent: Assigning a par or nominal value to each share was intended to ensure equal treatment among shareholders by requiring each to pay at least that value.

  • Calculation: Share capital is the product of the par value and the number of shares issued and allotted: \text{Share capital} = \text{par or nominal value of each share} \times \text{number of shares}.

  • Example: If $100$ shares are issued at a par value of $50$, the share capital is $5,000$.

• Share Premiums and Reserves:

  • Premium: An amount paid by an investor beyond the par value. If a share with a par value of $50$ is purchased for $60$, the $10$ surplus is the premium.

  • Accounting: Distributions of this surplus vary. It can be added to the share capital (totaling $6,000$ in the above example) or placed in a reserve account.

  • Reserves: Law dictates whether these reserves are distributable to shareholders. Allocation is often an arbitrary accounting norm.

• Arbitrary Nature of Capital Concepts: Par and nominal values are purely accounting conventions. Once a company's real market value or book value changes through operations, the share capital figure loses its relation to actual asset value.

• Dean Bayless Manning's Observation: Manning notes that while the concept of par worked for the "prototypical model" (initial financing where par was the subscription price), the system lost plausibility and workability as the enterprise became ongoing. In an ongoing concern, share prices reflect goodwill, growth expectations, and cash flow, making par requirements arbitrary.

• Modern Shifts:

  • Delaware: Allows shares to be issued without par value. Board of directors can state a specific sum as the "legal" or "stated" capital ($\S 154$ DGCL).

  • Germany: Allows no-par shares but mandates a "notional" or accounting value of at least $€1$ per share ($\S 8(3)$ AktG).

Minimum "Legal" or "Share" Capital

• Jurisdictional Terminology:

  • UK: Share capital.

  • US: Legal or stated capital.

  • Germany: Grundkapital.

• EU Requirements: Article $6$ of the Second Company Law Directive mandates minimum capital in public companies for all member states.

• Rationale for Minimum Capital:

  • Creditor Protection: It prevents shareholders from distributing assets intended to secure company debts to themselves. The Second Directive Preamble states share capital "constitutes the creditors' security."

  • Transaction Cost Reduction: Intended to lower costs for third parties entering credit relationships by providing a baseline capital maintenance requirement.

  • Limited Liability "Dues": Viewed as the price paid for the privilege of limited liability, as seen in the nineteenth-century Ooregum Gold Mining Company of India Ltd v. Roper [1892] AC 125 (HL).

  • Entry Barrier: Acts as a hurdle against frivolous incorporation.

• Scholarly Challenges to Legal Capital Efficacy:

  • Deception of Creditors: Capital rules only protect against distributions to shareholders, not against the use of capital for operating expenses or the purchase of declining assets. Capital remains on financial statements even if the actual value has evaporated.

  • Economic Deterrence: High minimum capital requirements can deter startups and entrepreneurship. One study noted a negative correlation between minimum capital size (scaled for GDP) and self-employment in European countries.

  • Adjusting vs. Non-adjusting Creditors: Sophisticated "adjusting" creditors (banks) rely on collateral and covenants rather than mandatory capital. Unsophisticated (employees) and involuntary (tort victims) creditors are better protected by insurance requirements or specific insolvency rankings.

  • Complexity and Expense: The labyrinthine procedures to ensure payment and prevent distribution create significant transaction costs, sometimes outweighing the marginal utility of the protection.

Preventing "Watered" Stock

• Definition and Metaphor: "Watering stock" refers to the practice of underpaying for shares. The term originates from livestock fraud, where cattle were made to drink excessive water before being weighed for sale to artificially inflate their price. In corporate law, it means shares are sold for less than their stated value.

• Regulatory Forms of Prevention:

  • Prohibiting the sale of par value stock for less than par.

  • Requiring a minimum percentage of the issue price to be paid before share issuance.

  • Mandating reliable valuation of non-cash assets (in-kind contributions).

  • Restricting the types of non-cash assets eligible for payment.

Paying for Initial Shares: The German Rules

• Cash Payments:

  • Shares cannot be issued for less than par or notional value ($\S 9(1)$ AktG).

  • Payment Requirement: At least $\frac{1}{4}$ of the nominal value plus the full premium must be paid upfront. The shareholder remains liable for the balance, which must be paid within $10$ years or upon insolvency ($\S\S 36a(1)$, $54(4)$ AktG).

  • Strict Definition of Cash: Limited to Euros in hand or bank transfers.

  • Audit Trigger: If a board member is also an incorporator or receiver of material benefits, the formation process must be audited by independent auditors ($\S 33$ AktG).

  • Reserves: Premiums are placed in a restricted capital reserve ($\S 272(2)$ no. $1$ HGB; $\S 150$ AktG).

• Post-Incorporation Transactions (Nachgründung):

  • Goal: To prevent circumvention of in-kind contribution rules via a cash payment for shares followed by the company's purchase of an asset from that shareholder.

  • Rule ($\S 52$ AktG): Applies if a company, within $2$ years of establishment, contracts with an incorporator or a shareholder holding > 10\% of capital to purchase an asset for a price > 10\% of the capital.

  • Procedure: Requires shareholder approval (typically a $\frac{3}{4}$ supermajority), disclosure, and an audit of the asset's value.

• Disguised In-kind Contributions (verdeckte Sacheinlage):

  • Judicial doctrine focusing on substance over form to catch evasions not covered by statute.

  • Rebuttable Presumption: Arises if the share issue and asset purchase occur within $6$ months of each other and involve comparable values.

  • Legal Consequences: Previously, the transaction was void, forcing the shareholder to pay twice (cash for shares + loss of asset in bankruptcy). Since $2008$ (GmbHG) and $2009$ (AktG), the asset's value is credited toward the payment liability, but the shareholder bears the burden of proving that value ($\S 27(3)$ AktG).

• In-kind Payments:

  • Forbidden: Promises to perform services ($\S 27(2)$ AktG).

  • Requirements: Assets must cover the entire purchase price and premium. A commitment to transfer can remain outstanding for up to $5$ years ($\S 36a(2)$ AktG).

  • Procedure: Must be audited by an expert (usually an accountant). Incorporators must prepare a detailed incorporation report. The Satzung (articles of association) must specify the asset, value, contributor, and shares issued ($\S\S 27(1)$, $32$, $33(2)$ no. $4$, $34(1)$ no. $4$ AktG).

Paying for Initial Shares: The UK Rules

• Cash Payments:

  • No-Discount Rule: Shares cannot be allotted at a discount (Sec. $580$ CA 2006).

  • Upfront Payment: Consideration must cover at least $\frac{1}{4}$ of nominal value and the full premium (Sec. $586$ CA 2006).

  • Broad Definition of Cash: Includes cash equivalents, promises to pay, and releases of liability, provided performance is within $5$ years (facilitating debt-for-equity swaps).

• Post-Incorporation Transactions:

  • Sec. $598$ CA 2006: Requires expert evaluation and shareholder approval for asset acquisitions from an incorporator if the price reaches $10\%$ of issued share capital. This is narrower than German law as it only applies to incorporators.

• Share Premium Account:

  • Premiums must be placed in a "share premium account," treated as part of share capital (Sec. $610(1)$ CA 2006).

  • Permitted Uses: Funding ordinary operations, paying commissions on share issues, or issuing bonus shares.

• Merger Relief (Sec. 612 CA 2006):

  • Allows non-application of share premium rules during mergers where the issuing company acquires at least a $90\%$ holding in the target in exchange for share allotment.

  • Accounting Advantage: Permitting the acquiring company to record the investment at nominal value. This prevents the need to "write down" the target shares when dividends are paid from the target to the parent, thus allowing the parent to treat those dividends as distributable realized profits.

• In-kind Payments:

  • Procedure: Non-cash assets for public company shares must be officially appraised and reported to the registrar (Sec. $593$ CA 2006).

  • Exclusions: Rules are relaxed for reorganizations and mergers to facilitate transitions from private to public status.

  • Trading Certificate: Issued if the registrar is satisfied; serves as "conclusive evidence" of the company's power to do business and borrow (Sec. $761(4)$, $762(1)$ CA 2006).

Paying for Initial Shares: The US Rules

• Cash Payments:

  • Minimal regulation. No required minimum capital in DGCL or Model Act.

  • Partly Paid Shares: Allowed with no numerical restriction (e.g., no mandated $\frac{1}{4}$ payment) at issue (Sec. $156$ DGCL).

  • Par Value: DGCL requires shares not be sold for less than par, but corporations can issue no-par shares (Sec. $153$ DGCL). The Model Act has abolished the par value concept entirely.

• In-kind Payments:

  • Form: No restrictions on the form of consideration (Model Act Sec. $6.21(b)$; Delaware constitution restriction repealed in $2004$).

  • Valuation: The board of directors' judgment is conclusive. Delaware ($\S 152$ DGCL) allows this in the absence of "actual fraud." Model Act ($\S 6.21(c)$) states the determination is conclusive.

  • Regulatory Approach: US favors ex post court review governed by fiduciary duties (as in Lewis v. Scotten Dillon) rather than the ex ante audits favored by Germany and the UK.

Questions & Discussion

• Q1: What is the purpose of requiring a stated share capital? (Likely answer: Creditor protection, barrier to entry, and transaction cost reduction).

• Q2: Does required minimum capital successfully achieve this purpose? (Discussion focuses on scholarly criticism regarding capital versus operating expense usage).

• Q3: Requirements for amount and attribution: What does "fixed nominal value" mean (Sec. 542 CA 2006)? Must capital and contributions be paid?

• Q4: Minimum par values in UK and Germany? ($£50,000$ and $€50,000$ for public corporations).

• Q5: Compatibility of no-par shares ($\S 81$ AktG) with Second Directive Articles 1 and 6(1)? Differences between German and Delaware no-par shares? (German shares have a "notional" accounting value of $€1$; Delaware shares may have no restriction).

• Q6: Distinguishing cash and in-kind contributions? Why is the distinction important for policy? (Strictness of valuation and audit procedures).

• Q7: Why are services prohibited as capital contributions in EU/UK/Germany? (Difficulties in assessment/enforcement vs. claims for compensation for past services).

• Q8: The "no-discount rule": Statutory basis in EC, UK, and Germany? Does it exist in DGCL? Consequences for convertible securities ($\S 194 I$ no. 2 AktG)?

• Q9: Hypothetical Case (March 2007): A, B, C, and D establish X-Co (German AG). Each subscribes to $100,000$ shares (par $€1$, issue price $€2$). In July $2007$, X-Co wants to buy trucks from C for $€60,000$ . Advice on structuring? (Points to Nachgründung rules as it occurs within $2$ years and involves an incorporator).

• Q10(a): Accounting for the $€1$ surplus per share? (Discussion of restricted reserves in Germany vs. share premium account in UK).

• Q10(b): Purpose of UK merger relief provisions? (Facilitating distribution of pre-acquisition profits).

• Q11: Comparing detailed statutes: Sec. $582$, $583$, $585$ CA 2006 vs. $\S\S 27(2)$, $(3)$, $54(1)$, and $66(1)$ AktG.