Legal Capital Rules in Hong Kong - Essay Example

An Evaluation of the Relevance of the Legal Capital Rules in Hong Kong in Relation to the Provisions of the Companies Ordinance Regarding Par Value Shares and the Restrictions upon Reduction of Capital and Share buy backs I. Introduction As juridical persons that maintains separate entity from their owners, corporations has the right to sue, be sue, enter into contract and borrow money on its own1. Together with this capacity comes the responsibility to perform its contractual obligations including paying debts to its creditors2. However, some provisions in the companies’ law have given corporations an escape route that can be used to circumvent the legal protection of legal capital in companies. In the United Kingdom, the enactment of the Companies Act 2006 has created a venue for corporations to return the capital investment to their shareholders to the detriment of their creditors. With more liberal provisions on the distribution of profits to it investors (see UK companies Act 2006 Sections 830 - 831), UK companies have more leeway when it comes to giving out dividends. Like in the United Kingdom, there are also provisions in the Hong Kong Companies Ordinance (Caption 32) that give companies more room to maneuver the release of funds of the company to its shareholders. Provisions on the maintenance of legal capital, the reduction of capital and shares buy backs in the Hong Kong Companies Ordinance give plenty of options to companies in terms of redistribution of capital shares to shareholders. Moreover, the Hong Kong Companies Ordinance is now going through a review process and during the series of consultation conducted by the government; some sectors believe that the revisions in the Companies Ordinance would make it easier for companies to circumvent the protection of legal capital3. Since there are provisions of the law that give more powers to the company to return capital to its shareholders, there are many sectors that believe that the protection of creditors under the legal capital rules is dead4. Their argument is that if the companies can reduce the amount of capital, buy back their shares of stocks at lower prices and distribute profits to its shareholders even if the company still have to recovered losses from previous years, creditors may not be able to collect their money in due time5. Despite the fact that the protection of creditors under the rules of legal capital has already been eroded, we cannot really say that this protection is already dead or totally useless. We have to understand that under Hong Kong laws, restrictions as to the issuance of shares, reduction of capital and buy back of shares are still very much alive6. In fact, there are still many provisions of the Hong Kong Companies Ordinance to this effect. To get a clearer picture of how the provisions of the law on legal capital still afford protection to creditors, let us take a close look at the issues of reduction of capital and shares buy backs. II. Capital Maintenance Doctrine and Par Value Shares Despite the claims of many that legal capital rules are no longer relevant, the provisions of the law regarding legal capital rules still stand. Technically, the Hong Kong Companies Ordinance does not have any specific provisions regard capital maintenance but there are many sections of the law that adhere to the principles of capital maintenance. Part II of the ordinance, specifically Sections 47A to 48, 48B to 50 and 58 to 62, provide for safety measure for creditors which in itself follow the principles of capital maintenance. On the other hand, Part IIA, specifically, Sections 79A to 79P, provides for rules regarding the distribution of capital. These two groups of provisions embody the doctrine of capital maintenance which was first developed in the United Kingdom way back in the middle part of the 19th century7. The general idea behind the doctrine of capital maintenance is that creditors lend money to the company based on the implied or express representation of the company that it will not distribute to the shareholders the money it borrowed from the financial institution8. This doctrine also give an assurance that in case of winding up, the company will first pay its creditors before it will distribute the proceeds of its assets to its shareholders9. Under the capital maintenance rules provided for the Companies Ordinance, the capital raised by the company cannot be returned to the investors except under special circumstances allowed by law10. Note that for the protection of its creditors, companies that are based in Hong Kong can only make payment to shareholders under the following circumstances: (a) dividends can only be paid through the company’s distributable profit, (b) except in cases of changes in the nominal value of shares, the company cannot reduce its capital without the court’s approval, and (c) the company can only buy back its own shares using the distributable profits or the proceeds of the newly issued stocks (see sections 47A to 48, 48B to 50 and 58 to 62 of the Hong Kong Companies Ordinance). Generally, in Hong Kong, a company cannot get financial assistance from creditors to acquire its own shares11. However, since financial assistance is technically not part of the rules governing capital maintenance, properly negotiated contracts for financial assistance that does not affect the assets of the company may be allowed under the law12. What the law sought to prohibit are those financial assistance or loans that can affect the financial status of the company as well as its ability to pay its creditors at the designated time. The application of the capital maintenance rules under the Hong Kong Companies Ordinance can be clearly seen the restriction imposed on companies against the issuance of no-par value shares. According to the Hong Kong Companies Ordinance section 5 paragraph 4: ‘In the case of a company having a share capital- (a) the memorandum must also, unless the company is an unlimited company, state the amount of share capital with which the company proposes to be registered and the division thereof into shares of a fixed amount’ Technically, the current rules regarding share capital requirement in Hong Kong requires the companies having share capital to issue par value share and then declare in their constitution their maximum authorized13. The rules also require the companies to keep the capital it raised through the issuance of these par value stocks within the company to be used for the company’s day to day business14. At present, the Companies Ordinance is under review and there are many suggestions from different sectors regarding the possible revision of section 5 paragraph 4. During the second consultation on the rewrite of the Companies Ordinance, different sectors suggested that companies should be allowed to issue non-par value stocks along with par value stocks. The rationale behind this suggestion is that the issuance of non-par value stocks will not affect creditors as most creditors do not rely in the amount of the par value stocks issued by company in determining as to whether or not they will lend money to the company15. In our present time, financial institutions rely more on the current economic realities rather than the amount of par value shares issued by the company in determining the financial stability of the company16. During the public consultation for the rewrite of the Hong Kong Companies Ordinance, there were a number of issues that the different sectors raised against the issuance of par value shares. Some of the issues raised against the issuance of par value shares are (a) the issuance of par value shares create unnecessary complexities in accounting, (b) it inhibits the ability of the companies to raise capital, (c) it involves costly and unnecessary registration proceedings, and (d) par value shares can often mislead the investors as to the real value of their investment17. As evidence of the existence of legal capital, par value shares have its limitations. Note that the ownership of a shareholder on the company is dictated by the amount of investment that he or she puts into the company18. Since par value shares bear fixed amounts, this means that the shareholder’s ownership, rights and liabilities is only limited to the amount written on the face of the stock certificate. Since par value shares have the effect of limiting the liability of shareholders to the amount written on the face of the stock certificate, there are many people who believe that par value shares do not serve the purpose of protecting the creditors19. If take a closer look at the nature of par value and no par value share, there isn’t really much difference between the kinds of protection afforded by the par value share and the no par value share to creditors20. We have to understand that both par value and no par value share represent a fraction or an aliquot part of the equity of the company and in most cases, the value of the shares do not give a clear indication as to the real value of the company’s assets. In reality, most companies set the par value of their shares very low to avoid certain restricts that are imposed by the government’s capital maintenance rules21. According to the Third Public Consultation on Companies Ordinance Rewrite of the Government of Hong Kong Administrative Region: ‘requiring new shares to be issued at par does not prevent dilution of the fractions of ownership held by earlier allottees of shares’ This can only mean that the issuance of par value as measure to restrict the value of stocks is in itself ineffective. Corporate opportunism will always find its way into the investment system. The fact that most creditors no longer rely on capital maintenance rules when assessing the ability of the company to pay its debts prompted many sectors in Hong Kong to push for removal of this restriction22. Many people believe that the removal of this restriction would create a simpler and clearer concept of investments in Hong Kong. As it is, it may be just a matter of time before companies in Hong Kong will have more freedom when it comes to issuance of stocks and capital generation. Will the removal of capital maintenance rules have negative impact on the creditors? Based on the consultation paper issued by the Corporate Law Reform Committee for the Companies Commission of Malaysia dated June 2005, since creditors already have their own mechanisms to ensure that their borrowers will be able to payback their loans, the removal of the capital maintenance rules may not have serious effects on the creditors. According to this paper, despite the removal of the restrictions on the issuance of non-par value shares, the creditors are still protected against bad debts. III. Share Buy Back Like in many countries around the world, the Companies Ordinance of Hong Kong allows companies to repurchase their shares of stocks. According to Section 49B of the Companies Ordinance: ‘except that such purchases may be made either out of or otherwise than out of its distributable profits or the proceeds of a fresh issue of shares, a listed company and an unlisted company limited by shares or limited by guarantee and having a share capital may, if authorized to do so by its articles, purchase its own shares (including any redeemable shares) …’ However, companies cannot just buy back its own shares at a whim. There are certain conditions that must be met before a company is allowed under the law to buy back its shares. Under to Section 49B, the company may buy back its shares to: ‘(a) settle or compromise a debt or claim; (b) eliminate a fractional share or fractional entitlement or in the case of a listed company, an odd lot of shares; (c) fulfill an agreement in which the company has an option or is obliged to purchase shares under an employee share scheme which had previously been approved by the company in general meeting; or (d) comply with an order of the court.’ Moreover, the Companies Ordinance requires the cancellation of the shares that the company have bought back (see Section 49A (4) and 49B (3)). Will the option of the company to buy back its own shares make it easier for companies to circumvent the provisions of the law that restricts the reduction of capital? The framers of the Companies Ordinance have installed mechanisms to prevent companies from circumventing the law. Sections 49K to 49O of the Companies Act clear provide measures before a company can buy back its shares. These mechanisms include the (a) a written approval of the members of the corporation of the plan to buy back the shares of the company (b) filing of a statutory form and auditor’s report stating that the company is solvent and has the capacity to pay its creditors; and (c) the publication of the intention of the company to buy back its shares. Like most other provision of the law, the repurchase or buy back requirements have exemptions. Section 49 BA (11) states that: ‘the commission may exempt any listed company from any of the provisions of this section, subject to such conditions as it thinks fit.’ On the other hand, the disclosure requirement for companies that purchase their own share is mandated by law and companies that do not comply with this disclosure requirement may be punishment under the law. IV. Reduction of Share Capital Other jurisdictions which used to require court approval companies to seek court approval have switched to a court free process. Under Chapter 10 of part 17 of the Companies Act 2006 of the United Kingdom, companies may now reduce their share capital without the approval of the court. In fact, the new capital reduction procedure in the UK as states in Sections 642 to 644 of the Companies Act 2006 only requires the members of the company to pass a special resolution approving the reduction, the issuance of a solvency statement by the Board of Directors of the company and the filing of these documents to the Registrar of Companies in the United Kingdom. The rationale behind this switch is that court free proceedings are often faster and more economical. In Hong Kong, the procedure for the reduction of share capital is not yet that liberal. As a general rule, the Companies Ordinance only allows the reduction of capital that is sanctioned by the court. Section 49O (3) of the Companies Ordinance so states that: ‘if the court thinks fit, (it may) provide for the purchase by the company of the shares of any of its members and for the reduction accordingly of the company’s capital…’ This goes to show that unlike in the UK, Hong Kong law still favors court procedures when it comes to determining as to whether or not the company should buy back its share or reduce its share capital. However, Sections 58 to 63 of the Companies Act and Section 58(3) together with the ancillary provisions introduced by the Companies (Amendment) Ordinance 2003 allow the for re-designation of the nominal value share without the approval of the court. Based on the results of the report of the consultations conducted in relation to the rewriting of the Companies Ordinance, most of the people consulted expressed that they are not comfortable with the idea of court free procedures in relation to the reduction of the shares23. According to the Companies Ordinance rewrite consultation report, the idea of merely asking the Board of Directors to issue a solvency statement does not sit well will the Hong Kong authorities and that most of those who participated in the consultation expressed their desire to let the companies seek the confirmation of the court before they initiate any share buy back24. The participation of the court in the deciding whether the company should or should not buy back their shares lends credence to the whole process. Compared to share buy back, reduction of capital may not be as attractive25 . Currently, in Hong Kong Companies Ordinance, the company will still need the approval of the court before it can reduce its capital but in buy backs, a company may no longer have to go through a court procedure if it can meet the requirements for exemption from court approval. The fact that reduction of capital involves court approval also means that the company will have to contend with a lot of paper works before it can initiate the share capital reduction procedure. On the other hand, although buy backs also involve a lot of paper work, the amount of paperwork involved in this case may not be as heavy as compared to reduction of share capital. V. Implications of the Legal Capital Restrictions contained in the Companies Ordinance On The Rights of the Creditor Some sectors believe that the provisions on the Companies Ordinance regarding legal capital make it easier for companies to circumvent the protection afford to creditors26. To some extent, this may be true. However, we have to understand that the law also has safety measures that can prevent companies from distributing its capital assets in such a way that a creditor or financing institution will be deprived of what is due to it. Note that Section 49O (3) so provides that the company needs the approval of the court before it can reduce its share capital or buy back its shares. Moreover, section 49N (1b) of the Companies Ordinance states that: ‘Where a private company passes a special resolution approving for purposes of this Ordinance any payment out of capital for the redemption or purchase of any of its shares… any creditor of the company, may within 5 weeks of the date on which the resolution was passed apply to the court for cancellation of the resolution.’ Clearly, the creditors have remedies and can go after the company if it they think that they will be prejudiced by the plan of the company to make payment out of capital. With the move from par value shares to no par value shares have detrimental effect on the part of the creditors? As pointed out earlier in this essay, most creditors no longer look towards the amount of capital shares of the company before they extend financial assistance to the company. As it is, the change from par value shares to non-par values shares may not have serious implications on the creditors. VI. Conclusion Despite the fact that laws governing the legal capital shares of companies are evolving, the protection that the law affords to creditors still remain. Safety mechanisms that are intended to protect the creditors are in place in the Companies Ordinance. The fact that companies still need the approval of the court before it can reduce its share capital and buy back its shares and the fact that creditors have the right to file an injunction to stop the company from reducing its capital or buying back its shares make it hard for companies to return the capital to investors without paying its creditors first. References: 1. Armour, J., Share Capital and Creditor Protection Efficient Rules for a Modern Economy (2000) 63 MLR 355 Armour Share Capital 355 2. Armour, J., Legal Capital: An Outdated Concept 7 European Business Organization (2006) Law Review 5 3. Chiffins, Brian Company Law: Theory, Structure and Operation (Clarendon Press Oxford1997) 4. Claessens, S., Djankov, S., Fan, J.P.H. and Lang, L.H.P., , ‘Disentanling the Incentive and Entrechment Effects of Large Shareholdings’ (2002), Journal of Finance, 62:2741-2771. 5. Companies Act 2006 http://www.opsi.gov.uk/acts/acts2006/pdf/ukpga_20060046_en.pdf accessed February 28, 2010 6. Companies Ordinance Rewrite Consultation Report Chapter 3 Capital Maintenance Regime http://www.fstb.gov.hk/fsb/co_rewrite/eng/pub-press/doc/3thPCCOR_Chapter3_e.pdf accessed February 28, 2010 7. Companies Ordinance Rewrite Consultation Report Chapter 2 Share Capital http://www.cr.gov.hk/en/publications/docs/062008_ch2-e.pdf accessed February 28, 2010 8. Companies Ordinance Rewrite http://www.fstb.gov.hk/fsb/co_rewrite/eng/pub-press/consult.htm accessed February 28, 2010 9. Corporate Law Reform Committee for the Companies Commission of Malaysia (June 2005) A Consultative Document on Capital Maintenance Rules and Share Capital: Simplifying and Streamlining Provisions Applicable to Shares http://www.ssm.com.my/clrc/cd2.pdf accessed February 28, 2010 10. Dixon R, Palmer G, Stradling B, Woodhead A, An Empirical Survey of the Motivation for Share Repurchases in the UK, (2008)Managerial Finance, Vol 34, Issue 12, pp886-906 11. Eastbrook and Fischel., The Economic Structure of Corporate Law (Harvard University Press 1991) 12. Enriquez & Macey, J., ‘Creditors versus Capital Formation: The Case Against the European Legal Capital Rules 86’ (2001) Cornell Law Review 1165, 1185 13. Espenlaub S, Lin S, Strong N, Wang C, Why do Firms Repurchase Shares: Free Cash Flow or Information Signalling?, (University of Manchester 2006). 14. Explanatory Notes To Companies Act 2006 http://www.opsi.gov.uk/acts/acts2006/en/ukpgaen_20060046_en_1 accessed February 28, 2010 15. Flader, Jack W., Director, Henley & Partners Far East Ltd., ‘Hong Kong Hong Kong: Amended Companies Ordinance Creates More Business Friendly Environment’ 27 January 2004 http://www.mondaq.com/article.asp?articleid=24145 accessed February 28, 2010 16. Ferran E., Creditor’s Interests and Core Company law (1999) Company Lawyer 314 17. Freshfields Bruckhaus Deringer, , ‘Consultation Study Concerning the Implications of Adopting a No-Par Value Share Regime in Hong Kong: Final Report’, pp.16-18 (29 November 2004). www.fstb.gov.hk/fsb/co_rewrite accessed February 28, 2010 18. Gugler, K., Mueller, D. C. and Yurtoglu, B. B., , ‘Corporate Governance and the Returns on Investment,’ (2004) Journal of Law and Economics, 47:589-633 19. Hong Kong Companies Ordinance http://www.hklii.hk/hk/legis/en/ord/32/ accessed February 28, 2010 20. Hong Kong Companies Ordinance Summary of Provisions http://www.legislation.gov.hk/blis_pdf.nsf/6799165D2FEE3FA94825755E0033E532/BFBC0BDE18CA0665482575EE0030D882?OpenDocument&bt=0 accessed February 28, 2010 21. Lie E, ‘Operating Performance Following Open Market Share Repurchase Announcements’, (2005)Journal of Accounting and Economics, Vol 39, pp411-436. 22. Morck, R., Wolfenzon, D. and B. Yeung, , ‘Corporate Governance, Economic Entrenchment, and Growth’ (2005) Journal of Economic Literature, September 23. Mueller, D.C., (2006), “The Anglo-Saxon Approach to Corporate Governance and its Application to Emerging Markets”, Corporate Governance, 14:207-219 24. Rickford Ed.,‘Reforming Capital: Report of the Interdisciplinary Committee on Capital Maintenance’ (2004), European Business Law Review 919-1027. 25. Third Public Consultation on Companies Ordinance Rewrite (issued on 26 June 2008) http://www.fstb.gov.hk/fsb/co_rewrite/eng/pub-press/doc/3thPCCOR_Chapter2_e.pdf accessed February 28, 2010 Read More