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Legal Capital: An Outdated Concept?

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Abstract

This paper reviews the case for and against mandatory legal capital rules. It is argued that legal capital is no longer an appropriate means of safeguarding creditors’ interests. This is most clearly the case as regards mandatory rules. Moreover, it is suggested that even an ‘opt in’ (or default) legal capital regime is unlikely to be a useful mechanism. However, the advent of regulatory arbitrage in European corporate law will provide a way of gathering information regarding investors’ preferences in relation to such rules. Those creditor protection rules that do not further the interests of adjusting creditors will become subject to competitive pressures. Legislatures will be faced with the task of designing mandatory rules to deal with the issues raised by ‘non-adjusting’ creditors in a proportionate and effective manner, consistent with the Gebhard formula.

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References

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  3. For example, in most US States, legal capital rules have either been abolished outright or simply withered into marcesence: see, e. g., B. Manning, Legal Capital, 2nd edn. (Mineola, NY, Foundation Press 1982). In the United Kingdom, pending reforms will considerably relax the application of legal capital rules to private companies: see infra, text to nn. 17–19.

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  19. The law regarding fraudulent conveyances — in English law, now known as ‘transactions as an undervalue’ and ‘transactions defrauding creditors’ (Insolvency Act 1986, ss. 238 and 423, respectively) — would strike down a transaction under which the company receives significantly less consideration than it gives and which takes place within two years of its entering corporate insolvency proceedings, provided that it was unable to pay its debts at the time of the transaction, or became so as a result. A distribution to shareholders is viewed in English law as a gratuitous transaction (Associated British Engineering Ltd v. IRC [1941] 1 KB 15; Wigan Coal and Iron Co Ltd v. IRC [1945] 1 All ER 392). Hence, if the distribution were such as to cause the company to become unable to pay its debts, it would be open to avoidance by a liquidator, in the same way as a return of capital failing the solvency test.

  20. Second Council Directive, Art. 6(1). That said, only 25 per cent of this need actually be paid up on formation: Art. 9(1).

  21. Companies Act 1985, ss. 11, 118 (minimum capital requirement stated to apply only to public companies).

  22. See, e. g., Second Council Directive, Art. 10.

  23. See M. Gelter, The Subordination of Shareholder Loans in Bankruptcy, Working Paper (2005). English law has never restricted this practice: see, e. g., Salomon v. A Salomon & Co Ltd [1897] AC 22.

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  25. If such a transfer renders the company insolvent, then other legal provisions protect creditors. A liquidator or administrator could seek to recover the payments as a transaction at an undervalue (Insolvency Act 1986, s. 238). Alternatively, the distribution may constitute a transaction defrauding creditors (ss. 423–425).

  26. In other words, the ‘best current market estimate’ of their worth. This will be their face value, discounted for the time value of money and discounted further for the risk of default. Even if the debtor does not become insolvent, creditors are still prejudiced if the risk of default increases above that at which they had priced it, and if the value of their debt claim matters to them as an asset. This would be the case if they wished to realise the value of the loan before maturity, as with bonds, secondary markets for syndicated loans, factoring of book debts, etc.

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  29. In other words, the ‘best current market estimate’ of their worth. This will be their face value, discounted for the time value of money and discounted further for the risk of default. Even if the debtor does not become insolvent, creditors are still prejudiced if the risk of default increases above that at which they had priced it, and if the value of their debt claim matters to them as an asset. This would be the case if they wished to realise the value of the loan before maturity, as with bonds, secondary markets for syndicated loans, factoring of book debts, etc.

  30. If such a transfer does in fact render the company insolvent, then other provisions protect creditors in any event. See supra n. 19.

  31. For the purposes of this discussion, it will be assumed for the sake of simplicity that directors act in the interests of shareholders. The key point for present purposes is simply that directors’ interests are more closely aligned with those of shareholders (who appoint and remove them) than with creditors.

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  34. Such constraints may arise (i) from legal restrictions on high interest rates (e. g., Insolvency Act 1986, s. 244, rendering ‘extortionate’ credit transactions unenforceable in the debtor’s insolvency); (ii) from ‘adverse selection’ problems in markets for corporate credit: very high interest rates tend to be least unattractive to those who do not intend to repay (J. Stiglitz and A. Weiss, ‘Credit Rationing in Markets with Imperfect Information’, 71 American Economic Review (1981) p. 393).

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  39. US studies from the early 1980s found a high incidence of dividend restrictions in covenants granted by randomly selected samples of firms. See, e. g., A. Kalay, ‘Stockholder-Bondholder Conflict and Dividend Constraints’, 10 Journal of Financial Economics (1982) p. 211 at pp. 214–216 (100 per cent of sample of bond indentures). More recent studies find that dividend restrictions (and covenants generally) are less commonly found, and less restrictive, in bonds than in bank debt: cf., R.C. Nash, J.M. Netter and A.B. Poulsen, ‘Determinants of Contractual Relations Between Shareholders and Bondholders: Investment Opportunities and Restrictive Covenants’, 9 Journal of Corporate Finance (2003) p. 201 at p. 218 (39.7 per cent of 1989 sample and 20.8 per cent of 1998 sample of bond indentures), with Bradley and Roberts, op. cit. n. 33, Table V (87 per cent of sample of bank loans over 1993–2001).

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  41. In an oblique sense, this ‘protects’ the involuntary creditors: see Schön, loc. cit. n. 2, at p. 441; D. Kershaw, Between Function and Effect: Why Capital Maintenance Regulation is Not Trivial for Involuntary Creditors, Working Paper, Warwick Law School (2005). However, the extent of such protection depends on adjusting creditors permitting non-adjusting creditors to free ride. If there are significant levels of non-adjusting creditors (e. g., because of a hazardous line of business), then both shareholders and adjusting creditors will be better off by arranging for the hazardous business to be carried on by a thinly capitalised subsidiary, or (the inverse) for non-adjusting creditors to be structurally subordinated by transferring ‘safe’ assets to a finance subsidiary, to which entity adjusting creditors then lend. See also supra text to nn. 27–28.

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  43. This does not, however, render the application of the distribution rules anything other than mandatory, because companies are unable to choose to raise equity capital without their operation (Ferran, op. cit. n. 2, at pp. 10–13; cf. Schön, loc. cit. n. 2, at pp. 438–439).

  44. See D.D. Prentice, ‘Corporate Personality, Limited Liability and the Protection of Creditors’, in R. Grantham and C. Ricketts, eds., Corporate Personality in the Twentieth Century (Oxford, Hart Publishing 1998) p. 99.

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  45. See ECJ, Case 212/97 Centros Ltd v. Erhvervs-og Selskabsstyrelsen [1999] 2 CMLR 551, 586–587, in which the Danish Government sought to justify their country’s minimum capital laws on the basis, inter alia, that they protected involuntary claimants.

  46. See sources cited supra in nn. 33, 38 and 39.

  47. Manning, op. cit. n. 3, at pp. 33–34.

  48. Armour, loc. cit. n. 2, at pp. 373–374.

  49. Myers, loc. cit. n. 35.

  50. See Bradley and Roberts, op. cit. n. 33, at p. 27 (high-growth firms significantly more likely to use dividend restriction in private debt agreements); Nash et al., loc. cit. n. 39, at p. 218 (high investment-opportunity firms significantly less likely to include dividend restriction in public debt agreements). This disparity probably reflects the fact that high-growth firms face particular uncertainty. In these circumstances, a covenant that might be readily triggered would be a useful lever of control for creditors who can renegotiate easily (see I.D. Dichev and D.J. Skinner, ‘Large-Sample Evidence on the Debt Covenant Hypothesis’, 40 Journal of Accounting Research (2002) p. 1091: private lenders set covenants tightly to use them as ‘trip wires’). However, such a covenant would be a hostage to fortune for dispersed creditors (public debt) who cannot renegotiate easily.

  51. See A. Cosh and A. Hughes, ‘Size, Age, Growth, Business Constraints and Management Characteristics’, in A. Cosh and A. Hughes, eds., Enterprise Challenged: Policy and Performance in the British SME sector 1999–2002 (Cambridge, ESRC Centre for Business Research 2003) p. 3 at p. 10.

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  52. The benefits of limited liability for the financing of listed firms are well known, namely that they: (i) permit share prices to be independent of the purchaser’s wealth and thereby to reflect information about the value of the firm; (ii) allow for diversification by shareholders, reducing the cost of risk-bearing; (iii) make passive investment a rational strategy, allowing for specialisation in the management and risk-bearing functions; and (iv) lower monitoring costs, both for creditors and shareholders, who no longer need to check on shareholders’ wealth levels. See, e. g., F.H. Easterbrook and D.R. Fischel, The Economic Structure of Corporate Law (Cambridge, MA, Harvard University Press 1991) pp. 40–62.

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  54. Of course, the true extent of its impact will depend on a combination of factors, including the severity of the consequences of personal insolvency, and the extent to which corporate creditors demand personal guarantees from those setting up private companies.

  55. It is worth noting that an individual’s endowment of wealth has been shown to affect propensity to entrepreneurship (see, e. g., D. Blanchflower and A. Oswald, ‘What Makes an Entrepreneur? Evidence on Inheritance and Capital Constraints’, 16 Journal of Labour Economics (1997) p. 26). The most plausible interpretation of this result turns on risk aversion. Because of the declining marginal utility of money, a wealthier individual will suffer a lower decrease in utility for any given loss than will a poorer individual. Thus a wealthier individual will exhibit less aversion to bearing a risk of losing a sum of money.

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  56. Armour and Cumming, op. cit. n. 53, at p. 20 (Table 3). This result, using data on minimum capital requirements from the World Bank’s ‘Doing Business’ survey (available at: http://www.doingbusiness.org) is however only for a univariate correlation.

  57. See S. Djankov, C. McLeish and A. Shleifer, Private Credit in 129 Countries, NBER Working Paper No. 11078 (January 2005) pp. 18, 31 (incidence of private credit rating agencies positively correlated with level of private credit).

  58. The grant of a personal guarantee does of course undermine the benefit of risk-reduction for the entrepreneur. In the United Kingdom, such guarantees, whilst common, are not ubiquitous: see J. Freedman and M. Godwin, ‘Incorporating the Micro Business: Perceptions and Misperceptions’, in A. Hughes and D.J. Storey, Finance and the Small Firm (London, Routledge 1994) p. 232 at p. 246 (53.6 per cent of sample of owner-managers had given personal guarantees). And for those entrepreneurs that do not give personal guarantees, limited liability brings meaningful risk reduction.

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  59. See generally, G. Calabresi, The Costs of Accidents (New Haven, Yale University Press 1971); S. Shavell, Foundations of Economic Analysis of Law (Cambridge, MA, Belknap Press 2004) pp. 177–206.

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  60. The strategy is indeed adopted in Germany: see Schön, loc. cit. n. 2, at p. 438. In the United Kingdom, the Third Parties (Rights against Insurers) Act 1930 transfers liability insurance claims against an insurer of an insolvent firm from the firm to the party to whom it has incurred the liability, ensuring that tort victims need not share their recoveries with the debtor’s other creditors.

  61. Other strategies include imposing pro rata unlimited liability on shareholders for corporate torts (H.B. Hansmann and R. Kraakman, ‘Towards Unlimited Shareholder Liability for Corporate Torts’, 100 Yale LJ (1991) p. 1879) and granting priority in insolvency to tort creditors (D.W. Leebron, ‘Limited Liability, Tort Victims, and Creditors’, 91 Colum LR (1991) p. 1565).

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  62. Trade credit is typically offered on very similar terms within an industry: C.K. Ng, J.K. Smith and R.L. Smith, ‘Evidence on the Determinants of Trade Credit Terms in Interfirm Trade’, 54 Journal of Finance (1999) p. 1109.

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  63. See Bebchuk and Fried, loc. cit. n. 24, at pp. 885–886.

  64. See, e. g., M.A. Petersen and R.J. Rajan, ‘Trade Credit: Theories and Evidence’, 10 Review of Financial Studies (1997) p. 661 at pp. 678–679 (borrowers with observably higher credit quality obtain more trade credit); M. Burkart, T. Ellingsen and M. Giannetti, What You Sell is What You Lend? Explaining Trade Credit Contracts, ECGI Finance Working Paper No. 71 (November 2004) (more trade credit is granted where buyer is less able to divert inputs supplied to another use).

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  66. Alternatively enforcement could be effected by a regulatory agency.

  67. This could occur both within firms — creditors having differing time horizons, priorities, and repayment schedules — and between firms — creditors’ requirements varying with the debtor’s business and size — and means that a single term is unlikely to suit all. See H. Kanda, ‘Debtholders and Equityholders’, 21 Journal of Legal Studies (1992) p. 431 at p. 440; M. Kahan, ‘The Qualified Case against Mandatory Terms in Bonds’, 89 Northwestern University Law Review (1995) p. 565 at pp. 609–610.

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  68. See supra nn. 39 and 50.

  69. Most jurisdictions provide a general mechanism for renegotiating creditor contracts external to the constitution by means of a composition, whereby a majority of creditors can bind a dissenting minority. Nevertheless, it is usually the case that all creditors must at least be notified.

  70. These problems may be illustrated obliquely by reference to the difficulties caused by an earlier form of ‘collective term’, that is, the corporate objects clause. Originally conceived as a means of protecting investors, the mechanism was abandoned in the twentieth century, essentially because its costs exceeded its benefits: see Cheffins, op. cit. n. 42, at pp. 527–531.

  71. Companies Act 1985, s. 17. The better view is that breach of such a restriction would render the distribution void: see EIC Services Ltd v. Phipps [2004] EWCA Civ 1069 (protection for third parties for acts in excess of company’s powers provided by First Directive does not extend to shareholders in their capacity as such).

  72. See, e. g., Cheffins, op. cit. n. 42, at pp. 426–431.

  73. For example, if a company incorporated in Member State A (which applied the incorporation theory) then carried on business in Member State B (which applied the real seat theory), the courts of Member State B would reason that the company’s proper law would be that of Member State B, and consequently, because it was not incorporated under that law, it was not validly formed at all.

  74. See supra n. 5.

  75. See generally E. Wymeersch, ‘Centros: A Landmark Decision in European Company Law’, in T. Baums, et al., eds., Corporations, Capital Markets and Business in the Law (London, Kluwer Law International 2000) p. 629; M. Siems, ‘Convergence, Competition, Centros and Conflicts of Law: European Company Law in the 21st Century’, 27 European Law Review (2002) p. 47; C. Kersting and C.P. Schindler, ‘The ECJ’s Inspire Art Decision of 30 September 2003 and its Effects on Practice’, 4 German LJ (2003) p. 1277; S. Rammeloo, ‘At Long Last: Freedom of Establishment for Legal Persons in Europe Accomplished’, 11 MJ (2004) p. 379; J. Lowry, ‘Eliminating Obstacles to Freedom of Establishment: The Competitive Edge of UK Company Law’, 63 Cambridge Law Journal (2004) p. 331.

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  76. Moreover, the mere fact that the company was incorporated in Member State A solely to avoid laws which would otherwise apply were it incorporated in Member State B does not constitute an ‘abuse’ of that freedom: Centros, supra n. 5, at paras. 27–29; Inspire Art, supra n. 5, at para. 96.

  77. ECJ, Case C-55/94 Gebhard v. Colsiglio dell’Ordine degli Avvocati e Procuratori di Milano [1995] ECR I-4165.

  78. Centros, supra n. 5, at paras. 35–37.

  79. Inspire Art, supra n. 5, at para. 135.

  80. See, e. g., C. Kersting and C.P. Schindler, loc. cit. n. 75, at p. 1290; T. Koller, ‘The English Limited Company — Ready to Invade Germany’, 15 ICCLR (2004) p. 334 at pp. 341–343; Rammeloo, loc. cit. n. 75, at pp. 403–406.

  81. Council Regulation (EC) No. 1346/2000 of 29 May 2000 on insolvency proceedings, OJ 2000 L 160/1. Jurisdiction over insolvency proceedings was specifically excluded from the Brussels Convention (now consolidated as Council Regulation (EC) No. 44/2001 of 22 December 2001 on jurisdiction and the recognition and enforcement of judgments in civil and commercial matters, OJ 2001 L 12/1: see Art. 1(2)(b)).

  82. Armour, loc. cit. n. 6, at pp. 405–406.

  83. In addition, the adoption on 25 October 2005 of the Tenth Company Law Directive on Cross-Border Mergers (2005/56/EC, OJ 2005 L 310/1) will now facilitate regulatory arbitrage for established companies.

  84. See supra n. 6. See also Armour, loc. cit. n. 6, at p. 386.

  85. A typical example of many such agents found by a Google search is Coddan CPM UK, which offers, via the internet, same-day incorporation of a UK private company for a fee of £42. The website has versions, explaining arbitrage opportunities, in Spanish and German. See http://www.ukincorp.co.uk.

  86. See J. Simon, ‘A Comparative Approach to Capital Maintenance: France’, 15 European Business Law Review (2004) p. 1037; E.-M. Kieninger, ‘The Legal Framework of Regulatory Competition Based on Company Mobility: EU and US Compared’, 6 German Law Journal (2005) p. 740 at p. 768.

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  87. Rammeloo, loc. cit. n. 75, at p. 409.

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    John Armour (Faculty of Law)

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Armour, J. Legal Capital: An Outdated Concept?. Eur Bus Org Law Rev 7, 5–27 (2006). https://doi.org/10.1017/S156675290600005X

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