The ability of a private limited company to purchase its own shares is a tried and tested method of providing an exit route for shareholders who are looking to cash in their investment, or who may be compelled to sell their shares following the termination of their employment, or as a result of death or incapacity. It can also be used as an effective way of returning surplus cash to shareholders or simply cleaning up the existing share capital structure pre-sale. However, failure to follow the share buyback procedure correctly can prove to be very costly. Not only can the transaction be set aside as void but it could also scupper any future plans for a share sale.
How can a fault in the share buyback procedure affect a company?
Although a company can issue shares with relatively few formalities, the Companies Act 2006 sets out a surprising number of prescriptive steps which must be followed if the company wishes to buyback any shares. These steps are aimed at preventing potential abuse, but if not followed precisely can have unintended consequences as highlighted by a recent acquisition involving our Corporate team.
We acted for the buyer on a share purchase where our legal due diligence exercise uncovered a defective share buyback from some ten years previous. In this particular case the main defects were a failure to pass the appropriate shareholder resolutions, to make the necessary filings at Companies House and attend to the payment of stamp duty due at the relevant time. After explaining the risks to our client, the buyer took a reasonably commercial view and decided to proceed with the purchase subject to suitable indemnities within the share sale and purchase agreement and a retention of part of the purchase price equal to the potential financial exposure created by the filing deficiencies.
However, perhaps understandably, the funder to the transaction took a more cautious view with the risk presented and instead insisted on the purchase proceeding by way of an asset purchase to eliminate the risk entirely. This had significant ramifications for the buyer; not least in the form of an additional charge to stamp duty in excess of £100,000 by structuring the transaction in this way. It also meant that the deal documentation needed to be re-drafted and negotiated afresh.
Consequences of breaching the Companies Act:
This difference in treatment stems from the consequences of the buyback failing to comply with the requirements laid down in the Companies Act meaning it can result in:
- The transaction being treated as unlawful and void (meaning the courts could potentially unravel the buyback transaction and deem that the outgoing shareholder is still the lawful shareholder of the shares); and
- An offence being committed by the company and each of its officers.
If the buyback is found to be void the original ‘phantom’ shareholder will potentially be entitled to the benefits that other shareholders have enjoyed from the date of the purported buyback, right up to the present day which could include; the right to attend and vote at meetings, the right to receive dividend payments and an entitlement to share in the proceed of sale of the company (which may include an uplift in the company’s value between the time of the alleged buyback and the time of sale). Clearly for both buyer and seller alike, this prospect is unpalatable but the alternative of curing the breach could leave the parties open to being held to ransom by the phantom shareholder who may view this as a golden opportunity to renegotiate.
The above case highlights the importance of ensuring the share buyback procedure is followed correctly first time as failure can prove very costly.
For further advice or guidance please contact Paul Tyrer, in our Corporate team, on 01260 282333.