Minimum Capital Rule
By laythmosa
Published On April 3, 2019
Company Act 2006 imposes a requirement on newly incorporated public companies with respect to their initial capital. A company that is a public company cannot engage in any trading or borrowing unless it has been issued a “trading certificate” which cannot be issued unless the nominal value of the company’s allotted share capital is not less than the authorized minimum1. The statute sets the minimum at £50,000 but at the same time allow incorporators to pay only 25% of the amount initially.
The idea
The idea of a minimum capital, taken as face value, is to oblige shareholders to contribute to the venture with their own money. This sends the message that the owners of the venture genuinely believe that their venture will be profitable to the extent that they have their own money at stake2. Moreover, this contribution by shareholders is believed to protect creditors by providing a minimum equity cushion which shareholders cannot distribute back to themselves. In this sense, minimum capital considered to be an ex-ante approach to controlling abuse of limited liability3.
However, the extent to which imposing a minimum value of company`s assets at the time of incorporation (or registering a private company as public) provide protection to creditors has been the subject of much debates. In the UK, the introduction of minimum capital was a result of the Second Directive. The English law did not impose such a minimum before. This was attributed to the idea that the protection of creditors is entrusted to the laws of insolvency and tort using ex-post tools such as wrongful and fraudulent trading4. In this essay, I am going to show that the minimum capital rules could be made to have significant impact, but it would not make sense on a cost/benefit analysis to implement such reforms.
The analysis
Thorough analysis of the minimum capital rule reveals that the protection it provides is overstated. First, the minimum amount required is fixed and arbitrarily set. The amount fails to reflect the particularities of each company, which have different risk exposures at different stages of its life. Moreover, the amount does not adjust to inflation. Second, the protection it provides is relative to the total capital of the venture; for large projects the minimum capital does not provide the intended protection5.
Third, the paid-in capital may be used to purchase equipment (that depreciate and lose value) or to finance working capital. This reduce the minimum capital to only a figure on the company’s financial statement that does not reflect the real value of the company`s assets. In addition, initial asset required is long gone when the company becomes insolvent6. Finally, other tools are available to protect the different types of creditors. Equity amount can be set through market mechanism by comparing debt/equity ratio across similar companies. New investors can withhold their investment if the company debt/equity ratio falls below the industry’s ratio. In addition, adjusting creditors can impose certain provisions regarding the amount that the owners must put into the business (in which case other creditors will enjoy the same protection as if the statute imposed such an amount) or can get a security in return for the loan. In addition, adjusting creditor put more emphasis on risk of insolvency and the quality and certainty of future cash flows than on minimum capital when agreeing on a loan. While Trade creditors can protect themselves by reservation of title clauses7. Moreover, the statute can require companies that is engaged in hazardous activities to carry insurance in which the premium paid is proportionate to their potential risk and the insurance company act as an ongoing monitor for the firm’s activities8.
Ability of capital rule
There are ways that can enhance the ability of minimum capital rule to protect creditors. One way is by imitating the minimum capital adequacy ratios used for banks who are requested to have an equity capital ratio in proportion to their risk-weighted assets. However, this option is not economical since the efforts to design, set, monitor and enforce a minimum capital that changes with each company`s risk exposure would be huge. In addition, the estimation of the appropriate level of capitalization will be difficult and it involves a lot of subjective decisions9.
Another way is to increase the minimum capital required or by linking it to some inflation measure. However, this method will inhibit entrepreneurship as it will increase the price for limited liability without solving other shortcomings of the minimum capital rule such as it will be long gone at the time the company file for bankruptcy.
Conclusion
In conclusion, the company act 2006 imposes a minimum capital for public companies to meet. The aim for usch rule is to provide creditor protection by obliging owners to contribute to the business from their own money and to ensure that companies operating a hazardous activity will not be undercapitalized. However, upon careful analysis, the minimum capital rule does not provide adequate protection to creditors. The amount set is arbitrarily fixed. It is not linked to the company`s financial needs (based on its risk profile) nor it is linked to an inflation index.
Moreover, the minimum capital requirement is used to purchase equipment that depreciates or to finance working capital and it will be long gone when the company becomes insolvent. Minimum capital rules could be made to have a significant impact. One method is to imitate the minimum capital adequacy ratios used in the banking and financial center. This method, however, will be costly in terms of finding the appropriate capitalization for each enterprise and in terms of monitoring and enforcing companies to top up (although monitoring and enforcing could be assigned to creditors). The second method is to increase the amount of minimum capital or to link it to an inflation index but this will not overcome the other deficiency of the minimum capital rule.
1 Company Act 2016 S 761-762.
2 Armour, J. (2006). Legal Capital: an Outdated Concept? European Business Organization Law Review, 5–27.
3 Davies, P., & Worthington, S. (2016). Gower Principles of Modern Company Law. UK: Thomson Reuters.
4 Schön, W. (2004 5(3)). The Future of Legal Capital. European Business Organization Law Review, 429–448.
5 Kershaw, D. (2009). Company Law in Context. Oxford University Press.
6 Reinier, K., Armour, J., & Davies, P. (2009). The Anatomy of Corporate Law: A Comparative and Functional Approach. Oxford University Press.
7 Rickford, J. (. (2004, Issue 4). Reforming Capital: Report of the Interdisciplinary Group on Capital Maintenance. European Business Law Review, pp. 919–1027.
8 Armour, J. (2006). Legal Capital: an Outdated Concept? European Business Organization Law Review, 5–27.
9 Grantham, R., & Rickett, C. E. (1998). Corporate Personality in the 20th Century. Hart Publishing.