Minimum Capital Rule and Creditors’ Protection in the UK

NB: We do not resell your papers. Upon ordering, we do an original paper exclusively for you.

NB: All your data is kept safe from the public.

Table of Contents

Introduction
Significance of the Minimum Capital Rule
Alternative Mechanisms
Conclusion
References

Introduction

A number of legal measures have been taken in the United Kingdom member states to protect creditors. These measures have been formulated with the intention of reducing the tension between the shareholders and creditors. This is particularly in relation to the way a company’s capital is allocated. The laws have been enacted to maintain capital for limited liability companies. In some cases, where these rules have not done enough in protecting the interests of the creditors, alternative regulatory measures have been used instead. Several countries in the United Kingdom have made reforms that abolish the minimum capital requirements. This is aimed at ensuring the protection of creditors. With the minimum capital rules being perceived as inefficient in ensuring creditors’ protection, alternative creditors’ protection mechanisms have been put in place (Bachner 100-120).

Significance of the Minimum Capital Rule

Minimum Capital Rule and Creditors Protection

The minimum capital rule was basically formulated with the intention of ensuring the protection of creditors. This rule usually requires incorporators to contribute a certain minimum value of assets to a company before it can be registered. This was initially perceived as a significant move in the company law, aimed at ensuring the protection of creditors. In such a case, the shareholder’s liability is limited to the capital invested and this is perceived as a move to ensure the protection of creditors. The law was basically enacted with the intention of ensuring that the parties involved are committed and serious with the establishment of the respective company. The contribution is made in form of an entrance fee which is imposed on the incorporators of that company. In case of early insolvency, this rule helps in ensuring that the creditor is secure and able to have a claim on the company’s assets. It, therefore, acts as security for the creditors and the greater the contribution, the more protection a creditor enjoys under this act. The rule, therefore, plays a significant role in the protection of involuntary as well as voluntary creditors who might not be able to protect themselves with security or binding covenants.

The Role of Minimum Capital Rule in Maintaining an Orderly Market

The rule is quite significant in helping maintain order in the market. It tests the incorporator’s seriousness and commitment. This helps in reducing cases of opportunists emerging to benefit from empty limited companies, those who would engage in fraudulent or speculative activities. This protects the creditors by ensuring order in the market. It protects creditors from companies that do not observe the minimum capital rule, some of which start with the minimum share capital of as low as two dollars.

Material Basis for the Minimum Capital Rule

The rule is also vital in furnishing the company with enough assets for the smooth operation of its commercial activities. This helps in protecting weaker creditors, who might not have higher bargaining power. They include employees, trade creditors as well as involuntary creditors. The fee is quite vital in ensuring that the company is able to survive in a competitive market or even make it easier to take credit so as to enhance its operations within the market. The rule also eliminates the risk of early insolvency for a company after its incorporation. This is because it is able to meet its initial commercial needs.

The capital maintenance principle has been adopted with the intention of protecting the creditors. It is found in the second directive, article seventeen and it stipulates that recapitalization is allowed for a company that has lost more than half of its initial capital. The board is supposed to call for a meeting and decide on the best way to recapitalize the company, hence getting it back on course. From all these provisions, it is quite evident that the minimum capital rule was meant to protect creditors’ rights as well as curb the issue of limited liabilities companies being misused by the shareholders (Lutter 400-410).

Need for a Rule to Reduce the Creditor-Shareholder conflict

A company is composed of different groups of people like shareholders and creditors. These groups have varied interests in the company, especially concerning the cash flow. This often results in a conflict of interest within the company. There is often conflict between these groups, particularly concerning the way in which a company’s capital is to be used. The shareholders are not usually held responsible for the company’s debts and the creditors do not usually have any claim beyond the company’s assets. This often results in conflict. The shareholders’ interest is to ensure that the money they invested in the company accrues more interest while creditors want the company to be in a position to pay its debts. In most cases, the burden of the company’s debts is passed onto the creditors. The minimum capital rule is therefore implemented with the intention of curbing the conflict that exists between the creditors and shareholders

The Minimum Capital Rule in Controlling the Shareholders’ Interests and Incentives

There has always been a conflict of interests between the shareholders and the creditors. While the creditors are obliged to ensure that the capital remains within the company, the shareholders have the freedom of acting as they would like in regard to the company’s capital. Different states have different laws that treat these two groups differ in regards to the protection of their rights.

The shareholders in a limited liability company do not have any obligation in regard to the debts that a company may have. They only benefit from the interests accrued from their contributions to the company and this acts as a great incentive for them to act opportunistically. For instance, the shareholders might be pushed by the desire to make a profit and engage in riskier undertakings than earlier planned for at the expense of the creditors. They might opt to increase the company’s equity whenever the creditors extend the credit without putting into consideration the risk factors.

Without any rules that ensure the protection of creditors, shareholders are likely to engage in asset diversion, which is basically made possible by increasing dividends or their salaries hence reducing the capital of the company. They might also opt to increase the company’s debt leverage by taking more loans with the same or higher priority than the existing debts. This might in the long run plunge the company into economic turmoil and the burden is passed to the creditors. This, therefore, necessitates the formation of rules that help protect the creditors from such exploitation (Ferran 120-135).

Need for the Protection of Contractual and Involuntary Creditors

Contractual creditors usually contract with the company and have claims on that particular company. They include banks and other financial institutions. They may also be in form of those creditors that provide the company’s supplies, rent as well as electricity. On the other hand, involuntary creditors do not usually contract with the company. They may be those who are hurt or even killed in the course of the operations of the company and are to be compensated by the company under the state’s law. The employees, as well as the public in form of tax collectors, are just some of the examples of creditors in this category. These creditors usually have no guarantee for protection, hence the need for some mechanisms to be put in place to ensure that their interests are protected.

The United Kingdom Civil Law in Creditor Protection

Most member states of the United Kingdom have embraced the civil law culture, especially in relation to the company laws which were enacted with the major purpose of protecting the creditors’ interests. It is always perceived that if the creditors do not feel protected, they might not be compelled to invest in a company. The creditors’ interests have therefore been put at the same level as the company’s capital. Countries have therefore enacted laws with the intention of protecting the company’s capital as well as the rights of creditors, especially from the actions of the shareholders. These laws ensure that the creditors benefit from the company’s assets in the event of insolvency. The legal capital rules are therefore perceived as the measures put in place by the states in the United Kingdom so as to ensure that the contractual, as well as involuntary creditors, are protected (Milman 200). In the United Kingdom, the legal capital doctrine has been adopted by the member states with the aim of harmonizing company legislation across the states and ensuring the protection of creditors.

Role of the Second Law Directive in Ensuring Capital Maintenance

This legislation, also known as the capital directive, was formulated with the aim of governing the limited liability companies; ensuring capital maintenance as well as the alteration of this capital. This directive is primarily composed of two tiers. The first one stipulates that there should be the contribution of some amount in the form of capital before the company’s incorporation while the second one stipulates that such capital has to be maintained within the company. The legislation restricts the company capital from being redistributed to the shareholders as it acts as the company’s security. This helps in cushioning the company’s capital, which in the long run protects the creditors (MacMillan 100).

Capital Formation Rules

Article six of the directive requires that the incorporators contribute a certain amount of minimum capital before the incorporation. On the other hand, article seven of the second directive requires the contributions made to be in the form of assets that are capable of economic assessment. The legislation allows the shareholders to make a contribution in cash as well as payment in kind. This might be in the form of real property or even patents. In this case, however, experts are appointed to help in determining the real value of the contribution. They are therefore expected to provide a report that entails the description of the asset, the method used in determining its value, and the real value of that asset. It, therefore, helps in determining whether the shares that the shareholder receives correspond to the real value of the asset. Article 9 requires that the shares are issued during the company’s incorporation and they need to be at least 25% of the nominal value.

In most countries in the United Kingdom, companies are perceived to be more than just contracts. Some creditors are appointed to participate in the companies’ board meetings hence the need to protect the creditors. The incorporators are expected to meet a minimum capital requirement of at least 25000 Euros. The share capital amount also has to be clearly stated in the article of association. In the event that a business is transferred to the company, then a report that contains the financial activities of the business for two years has to be presented as well. Article nine of the directive requires that in case the asset given is payment in kind and there is a deficit to the initial minimum capital requirement; the remaining balance has to be offset using cash (Davies 99-105).

The Role of Capital Maintenance Regulation in a Company’s Capital

Article 15 of the directive limits the amount that can be paid to shareholders hence protecting the company’s paid-in capital. According to this article, the paid-in capital is usually counted as restricted capital and cannot be distributed among the shareholders. This helps in the protection of the creditors. The restricted equity is however never separated from other company assets, and it might be lost if the company starts its operations or engages in loss-making activities. Article 16 of the directive requires that in case the restricted equity is transferred to the shareholder either knowingly or unknowing, then the same must be returned to the company. This legislation helps in protecting the company’s paid-in capital. It is required that all the distributions to the shareholders be done in accordance with the directive.

Demerits of Minimum Capital Rule

Opponents of this rule however see it not only as inefficient in ensuring the protection of creditors, but also perceive it as being unnecessarily restrictive. It is therefore perceived as less effective when compared to other means of creditor protection like the signing of binding covenants and the use of security.

The Inefficiency of the Rule

The minimum capital rule is very significant in cases where the company begins its initial commercial operations. In some cases, however, the company might incur losses and transfer the burden to creditors. It is therefore only efficient in preventing early insolvency, but the creditors are not cushioned from the losses that are made by the company. It is perceived that the minimum capital requirement is vital in protecting the creditors’ assets. According to the European laws, however, the creditors have a choice of laying down the contracts that govern their partnership. In the event of insolvency, the minimum capital contributions only help in offsetting the voluntary creditors’ claims at the expense of the involuntary creditors, hence failing in its purpose of protecting all the creditors. The security of the involuntary creditors is therefore not guaranteed (Watson 50-70).

The rule has been perceived as one which caters to the collective interests of creditors rather than the individual interests of the respective creditors. The second directive requires that all limited liability companies stick to one standard minimum capital requirement. The rule does not therefore put into consideration the size of the company, the business requirements of the company as well as the risk of operating such a business. Each company in a real sense usually has its own commercial as well as organizational requirement. The Minimum capital requirement is usually uniform for all companies in the United Kingdom member states, hence its inability to ensure effective protection of the creditors. The rule fails to put into consideration an estimate of the company’s future liabilities and the future claims by creditors, hence failing in its mission to protect the creditors. According to this argument, therefore, the minimum capital requirement rule does not effectively protect the creditors, as it is deficient in the economic rationale.

The Rule Can Mislead Creditors

Creditors are usually at risk of assuming that the minimum capital requirement is a reflection of the financial credibility of the company, which might not be the case in the actual sense. It does not necessarily reflect the company’s assets, and this is risky to the creditors who might not have a clue of the financial position or the asset base of the company. The initial value of the assets at the time of the company’s incorporation might not necessarily be the same value at a later date. This is because such assets are likely to appreciate or depreciate in value, hence causing disparity in the estimated value of the assets at the initial and at a later date. This, therefore, fails to give the creditors a true picture of the asset value of the company at any particular time. The initial minimum capital requirement does not necessarily reflect the actual value of a company’s assets.

The Minimum Capital Rule Is a Barrier to Incorporation

The minimum capital requirement usually acts as a major barrier to the establishment of smaller companies. Some of these contributions might be high for the creditors of the small liability companies, hence hindering the establishment of such companies. Some of the countries in the United Kingdom have however opted to lower the minimum capital requirement so as to make it easier for the establishment of such companies. Even with such measures being taken, other factors like the global recession still make it harder for the establishment of such companies. The recent global recession experienced across the world resulted in a major reduction in the number of limited companies registered in the United Kingdom. The incorporators for small firms, therefore, find it difficult to start such firms due to the minimum capital requirement. With the shortfalls of the minimum capital requirements witnessed in the protection of creditors, a number of other measures have been put in place so as to ensure the protection of creditors.

Alternative Mechanisms

Contractual Mechanism

This mechanism is particularly used by voluntary creditors. These are creditors who make contracts with the company. They usually have more negotiating power,r and are more experienced hence the contracts made are usually reliable. With such a contract, the creditor is expected to charge a certain amount of interest. The agreement limits the company in certain ways, for instance, debtors are usually not allowed to invest, borrow or lend certain amounts of money without the approval of the creditors. Mortgages on real property are also restricted. The company assets cannot be used to offset the company’s debts or pay the shareholder’s loans before meeting the obligations as per the agreement.

In addition, before the agreement is set, the creditors may ask for additional security like bank guarantees and pledges. In some cases, even the personal security of the shareholders is required besides the initial capital requirement. This was for instance factored in due to the recent economic recession that has been witnessed across the globe. The ex-post mechanism, which is used in enhancing the security of the creditors, is quite significant in ensuring that both the voluntary and involuntary creditors are not overexploited due to the minimum capital requirements. Additional security that is needed before the agreement is signed therefore guarantees the creditors such protection (Kono 32).

In the event that the company fails to meet its obligations, or cannot offset its debt, under the ex-post mechanism, the creditors are allowed to access the assets of the shareholders or those of the mother company. This, therefore, ensures the protection of the creditors. Those member states in the United Kingdom that do not strictly abide by the minimum capital requirement base on this rule to enhance the protection of the creditors. They do not, therefore, insist on the minimum capital requirement. This ex-post mechanism has been vital in ensuring that the shareholders do not misuse the limited liability privileges. The administrative cost of this particular mechanism is much less when compared to that of the minimum capital rule.

Other ex-post Mechanisms

Mandatory insurance or liability for limited companies is also another mechanism used by the United Kingdom member states so as to protect the creditors. This however poses the same challenges posed by the minimum capital requirement. A uniform sum, set for the payment to the insurance company, might not effectively work to protect the creditors. This is because different companies pose different risks to the creditors. Some companies are smaller than others, others have greater risks than others, and different firms operate differently. A uniform insurance fee charged across different companies might therefore not cover or protect the creditors effectively. It is also difficult to come up with a standard figure that shall be applied across the companies to ensure maximum creditors’ protection for potential harm or any losses. Different companies usually have different commercial activities and are prone to risks of varying magnitude.

There are some instances whereby the insurance company becomes the creditor. It, therefore, becomes difficult to determine whoever is supposed to ensure the insurer. This policy might become more cumbersome than the minimum capital requirement when the sum to be paid to the insurance company is high, and hence burdensome to the creditors. When a company is having financial constraints, its shareholders might decide to give financial aid to the company so as to ensure that it continues running rather than starting the insolvency process. The aid might be in form of capital contributions or a loan given to the company. This is usually done with the hope that the loan would be recovered when the company proceeds with its operations.

The equity substitution law allows the shareholder’s loan to be converted to equity if a credible creditor does not come up to offer the company a loan. These ex-post mechanisms are quite effective in ensuring the protection of creditors, and they are not very burdensome to the creditors.

Lithuania is one of the countries that have very low minimum capital requirements for limited liability companies. The Second Directive is used in the country and it is applicable to private as well public companies. The drafted company law had suggested that the initial minimum capital be reduced so as to aid the start-up of small businesses and limited liability companies. The amount was however not reduced. This is because it was perceived that the move would make companies to be started with ill motives or be used for one-time projects. The monitoring of scrupulous companies could however be done effectively by looking at the companies’ financial statements as well as the tax registers.

The minimum capital requirement might therefore not be quite effective in preventing the scrupulous companies. The ex-post mechanisms are quite effective in ensuring the protection of the creditors. In some states in the United Kingdom like Lithuania however, these laws have not yet been fully implemented and they are not quite effective. The efforts to reduce the minimum capital have not yielded much and this has been burdensome to the incorporators. To protect the creditors in the future, the ex-post mechanisms particularly the contractual mechanism will have to be emphasized as it is quite effective. The minimum capital requirements on the other hand should be lowered and other hindering measures should be eliminated.

Conclusion

The minimum initial capital requirement has been adopted by most countries in the United Kingdom with the intention of ensuring the protection of creditors. This rule has however failed to effectively protect the creditors, and it cannot be fully relied upon to facilitate commercial activities of the company during its commencement. This is because different companies have different commercial requirements. Some are bigger than others while others are riskier. With inadequacies being witnessed in the minimum initial capital requirement rule, creditor protection can be enhanced by adopting the ex-post mechanisms like the contractual mechanism among others. The minimum initial capital requirement should be reduced so as to ensure that limited liability companies do not struggle with such barriers during their startups. Alternative mechanisms of ensuring creditor protection should be adopted instead (California 50-70).

Efforts have been underway in most states in the United Kingdom to review the minimum capital rule so as to ensure that it does not become a hindrance to the free market and it serves its purpose of protecting the creditors. Legislation that governs companies in most countries in the United Kingdom has been formulated under the company laws. These laws concern the contribution and maintenance of the companies’ capital and are basically aimed at ensuring that the creditors are protected. There has been immense pressure on the member states to amend these laws to ensure maximum creditor protection. The amendments being suggested on the company capital rules have to ensure that they are in line with the goals of the member states of the United Kingdom. Comparison has been made between the United Kingdom’s and United States company legislation particularly in regards to the minimum capital requirements. This is aimed at coming up with the best model in ensuring the protection of creditors and reducing the conflict between the creditors and shareholders.

References

Bachner, Thomas. Creditor Protection in Private Companies: Anglo-German Perspectives for a European Legal Discourse. Cambridge: Cambridge University Press, 2009. Print.

California, The University of. “Company’s limited liability.” The journal of corporate law studies (2009): 50-70. Print.

Davies, Paul. The Anatomy of Corporate Law:A Comparative and Functional Approach. Oxford: Oxford University Press, 2009. Print.

Ferran, Eilís. Corporate Finance Law. Oxford: Oxford University Press, 2008. Print.

Kono, Toshiyuki. An Economic Analysis of Private International Law. Tübingen: Mohr Siebeck, 2006. Print.

Lutter, Marcus. Legal Capital in Europe. Berlin: Walter de Gruyter, 2006. Print.

MacMillan, Fiona. International Corporate Law. Oxford: Hart Publishing, 2010. Print.

Milman, David. National Corporate Law in a Globalised Market: The Uk Experience in Perspective. London: Edward Elgar Publishing, 2009. Print.

Watson, Susan. Corporate Governance After the Financial Crisis. London: Edward Elgar Publishing, 2011. Print.

Click Here To Order Now!