Week 3 Law

• Capital Structure


  How a firm finances its overall operations and growth by using different sources of funds
• Sources of funds

  • Debt (bond issues or long-term loans payable)
  • Equity (common stock, preferred stock, retained earnings)
• Debt and equity


  Have different costs, specific to each company and how risky it is perceived to be, although based on economic factors
• Loan capital

  
  

  Comprises all longer term borrowings for the purpose of the business. E.g.:

  • Permanent bank overdraft
  • Unsecured loans from a bank or third party
  • Loans secured on assets either from a bank or third party
• Debentures


  Long-term loans issued by a company to raise significant amounts of capital
• Types of debentures


  • Single debentures
  • Multiple debentures
  • Debentures issued as a series
• Secured debentures


  Debentures with security over a specific asset
• Unsecured debentures


  Debentures with no security, also called "bare" or "naked" debentures
• Redeemable debentures


  Debentures that can be repaid
• Irredeemable debentures


  Debentures that cannot be repaid, also called "perpetual debentures"
• Advantages of debentures (for the borrower)

  • Debentures carry no voting rights, so do not dilute or affect the control of the company
  • Interest should be tax deductible for the borrower, thus reducing the effective cost of servicing the debt
• Disadvantages of debentures (for the borrower)

  • Interest must be paid out of pre-tax profits, irrespective of the profits of the company
  • Default may lead to liquidation and/or administration
  • High gearing may lead to adversely affect the company's share price
• Advantages of debentures (for the lender)

  • Debentures will rank higher in the event of liquidation – therefore a lower risk option than shares
  • Debentures holders have a contractual right to interest every year
  • Lender has the option to agree security for the debt, which may reduce their risk even further
• Disadvantages of debentures (for the lender)

  • Return is limited to interest payments – lender is only entitled to receive the nominal value of the debenture at redemption
  • Debentures carry no voting rights, so lenders are unable to directly influence the actions of directors
• Remedies for unsecured creditors in the event of default


  • Right to sue the company for debt
  • Right to petition the court for the compulsory liquidation of the company (if sum owed is >£750)
  • Right to petition the court for an administration order
• Remedies for secured creditors in the event of default


  • Take possession of the asset charged and sell it
  • Seek a foreclosure order from the court whereby ownership of the property will be transferred to him
  • Appoint a receiver over the assets
  • Seek an administration order (without court order)
• Fixed charge


  Security over a specific asset, which prevents the company from selling the asset without the consent of the creditor (charge holder)

  Company has no general freedom to sell the asset
• Advantages of fixed charges

  • The charge provides immediate and greater security for a loan
  • The asset cannot be disposed of without the lender's consent
  • The charge ranks higher priority than floating charges – i.e. it is the lowest risk/highest security
  • Interest rate likely to be lower for the borrowing company due to lower risk for the lender
  • Company may find it easier to borrow under a fixed charge due to feeling of greater security
• Disadvantages of fixed charges

  • Less freedom to deal with assets for the borrowing company
  • Lender at risk if the asset deflates in value or is destroyed
• Floating charge


  Security over a class of assets (e.g. inventory, receivables) where the company has freedom to buy/sell the charged assets in the ordinary course of its business

  the charged assets will therefore be subject to change from time to time
• Crystallisation


  The process by which a floating charge will attach to a specific asset, meaning the company can no longer deal freely with the assets. Turns floating charge into fixed charge
• Triggers for crystallisation


  • Liquidation
  • The company ceases to trade
  • Any specified event (e.g. devaluation)
• Advantages of floating charges

  • The borrowing company has freedom to buy and sell the charged assets – so are not tied down
  • The borrowing company has greater flexibility over the class of assets that can be charged
  • Assets generally more "liquid" than fixed charge assets
• Disadvantages of floating charges

  • The value of the security is unknown until is crystalises, the borrowing company cannot be made up any loss of value
  • Rank lower in order of repayment than fixed charges on liquidation
  • Due to higher risk, interest charged is usually higher than fixed charges
• Order of distribution on liquidation

  • Liquidators' costs
  • Fixed charge holders
  • Ordinary (employees) and Secondary (HMRC. For VAT, PAYE, Employer NICs) preferential creditors
  • Floating charge holders
  • Unsecured creditors
  • Shareholders
• Factors determining priority of charges

  • Equal charges rank in order of creation
  • Fixed charges rank above floating charges
  • Negative pledge clauses can prohibit future fixed charges from taking priority
  • Unregistered registrable charge has no priority over a registered charge
• Registration of charges


  
  

  • All charges must be registered under s741 CA06
  • Within 21 days of creation
  • Duty of the company to register the charge with the registrar of companies, but lender usually undertakes the register
• Failure to register the charge will result in the charge being void on liquidation and the company/directors being fined
• Veil of incorporation


  A company is a separate legal entity from its shareholders

  • Single legal entity - Sole trader, partnerships
  • Separate legal entity - Companies
• Articles of Association


  Bind the company and its shareholders, and the shareholders to each other
• Share capital


  The interest of a shareholder in the company measured by a sum of money, for the purpose of liability and interest
• Types of shares


  • Ordinary shares
  • Preference shares
• Ordinary shares


  Have full voting rights, not fixed dividend rights, and are entitled to surplus assets after repayment of preference shares
• Preference shares


  Usually have no voting rights, have fixed dividend rights paid in priority to other dividends, and are entitled to repayment of initial capital but cannot participate in surplus
• Ordinary shares (investor perspective)

  • Riskier as they are last to be paid out on a winding up
  • Can appreciate in value if the company is successful.
• Preference shares (investor perspective)

  • Provide a guaranteed income, and are less risky as they are repaid before ordinary shares
  • Downside is the shareholder will not benefit from capital appreciation and cannot vote on company business
• Ordinary shares (company perspective)

  • Carry voting rights, so majority might give away control
• Advantages of preference shares (company perspective)

  • Do not dilute control, but dividends must be paid and reduce discretion over use of profits
• Varying class rights


  1. Is the procedure contained in the articles?

  2. Yes - Must follow the procedure set out in the articles

  3. No - Variation requires a special resolution or written consent (i.e. 75% majority) of shareholders in that class
• Cumbrian Newspapers Group Ltd v Cumberland & Westmorland Herald (1986)

  • Claimant acquired a 10.67% stake in the Defendant company, with special rights attaching to those shares, including pre-emption rights and the right to appoint a director to the board. Defendant company passed a special resolution to remove these rights, but the courts held this was unlawful as they had effectively created a new class of share, with one shareholder, and alteration requires the shareholder's consent, which they refused.